Prop Trading vs. Hedge Funds — What’s the Difference?

The main difference between prop trading vs. a hedge fund is that prop trading firms use the company’s own money to trade, while hedge funds use customer deposits. 

It’s important to note here that companies such as hedge funds, brokerage firms and investment banks, which otherwise take deposits from customers, can also have prop trading desks that only trade with the company’s own money, and not with customer deposits.

In fact, prop trading firms/desks and hedge funds often use a similar array of strategies in their attempts to make a profit. Both often engage in strategies such global macro trading, fundamental analysis, quantitative analysis, algorithmic trading and various forms of arbitrage. In contrast to passive long-term investing strategies, prop trading operations and hedge funds take a much more active approach.

What is prop trading?

“Prop trading” is shorthand for “proprietary trading”. The term refers to the practice of a company trading in markets with its own money, instead of trading money deposited by customers. Any profits generated through prop trading are retained by the company. 

Companies engage in proprietary trading with the goal of achieving returns that exceed those achieved through investment styles such as index investing or bond yield appreciation. Of course, it’s worth keeping in mind strategies that have higher potential returns usually have higher risk as well. 

Prop trading also allows companies to become market makers, which then enables them to provide liquidity and turn a profit from the spread between bid and offer prices.

Depending on the context in which it’s performed, prop trading is sometimes controversial. In the cryptocurrency industry for example, several exchanges have come under scrutiny for allegedly performing prop trading on their own platforms. 

Since exchanges have access to information that’s not available to customers, this can create serious conflicts of interest, as exchanges with prop trading operations could potentially use inside information to get an advantage or front run their clients.

In the United States, the Volcker Rule places restrictions on banks when it comes to operating proprietary trading desks or investing in hedge funds or private equity funds. The Volcker Rule was introduced in the aftermath of the 2007-2008 financial crisis with the goal of limiting banks from making speculative investments that ultimately increase risks for customers.

What is a hedge fund?

A hedge fund is an investment fund that utilizes complex trading and risk management techniques with the goal of achieving greater than average investment returns. Hedge funds typically take on more risk than mutual funds, which are more heavily regulated. For example, hedge funds could leverage their assets or utilize derivative financial instruments like options and futures contracts to enact more complex investment strategies.

Hedge funds take investments from clients and make money by charging fees. The typical fees charged by a hedge fund are a management fee (usually 2% on net asset value of an investor’s shares) as well as a performance fee (usually 20% of profits). 

Generally speaking, retail investors can’t invest in hedge funds, as they are only available to accredited investors. In the context of the United States, an accredited investor is an individual who has a net worth exceeding $1 million. Banks, brokerage firms, insurance companies and other types of companies are also considered accredited investors.

There’s many different types of hedge funds, depending on what kind of investments they focus on. Here’s a few of the most common types of hedge funds:

• Global macro funds, which base their trades on significant events in the economic or political sphere. Such funds typically trade stocks, bonds, commodities and currencies, often through derivatives.
• Trend-following hedge funds, which typically use futures contracts to benefit from assets exhibiting significant price momentum. Trend-following hedge funds enter long and short trades, and are on the lookout for opportunities across practically all asset classes. 
• Relative value hedge funds, which aim to take advantage of valuation discrepancies, simultaneously buying and selling assets. Relative values seek to returns that are uncorrelated to the broader market.
• Activist hedge funds, which seek to gain a significant stake in companies and use this influence to change how the company is run, with the goal of making a profit.

Some of the biggest hedge funds include Bridgewater Associates, Renaissance Technologies, AQR Capital Management, Two Sigma and Citadel. All of the funds we mentioned here had assets under management in excess of $50 billion as of December 31, 2022. 

Hedge funds vs. prop trading firms — The bottom line

When comparing prop trading firms vs. hedge funds, it’s important to understand that they often use similar strategies in an attempt to make profits. Both will use complex investment strategies in an attempt to beat average market returns. Often, the S&P 500 index is used as a benchmark for evaluating the success of such strategies.

The key difference between prop trading vs. a hedge fund is that prop trading firms use the company’s own money and keep all of the profits. Financial institutions can have their own prop trading desks, which trade with the company’s own funds instead of using customer deposits.

Meanwhile, the business model of hedge funds is to pool client funds, deploy the money in a variety of strategies, and charge a fee on the profits generated. Hedge funds will also charge a management fee irrespective of the fund’s success or failure in any given time period.

If you’re interested in learning more about the world of investing, take a look at our article exploring how to invest $500,000.