Hedge Funds vs Proprietary Trading: A Comprehensive Guide

Key Takeaways

• Hedge funds manage money on behalf of clients (usually wealthy individuals or institutions)
• Proprietary trading firms provide their capital to traders and split profits with traders
• Prop trading greater autonomy and lower barriers to entry
• Hedge funds are highly regulated and come with high fees and investment minimums
• Both offer high earning potential but differ significantly in structure and strategy

What Are Hedge Funds?

Hedge funds are pooled investment funds that use a range of strategies to generate high returns for investors. They are typically open only to accredited or institutional investors due to their complex nature and risk level.

The term “hedge funds” is crafted of two words:

• Hedge – means “protection” 
• Funds – means “money”

Therefore, hedge funds are entities or private pools of money that ensure the protection of your funds even in situations of market downturn. 

How Do Hedge Funds Work?

Hedge funds work by pooling money from investors and using it to invest in different markets using distinct strategies to earn profits. The main motive of hedge funds is to generate more money in comparison to the invested money in the market.  

Hedge fund managers make decisions based on market trends, data, and analysis. Profits made from successful investments are shared among investors, while the hedge funds earn money via performance fees and management fees.  

Who Are the Key Players in Hedge Funds?

• Fund Managers – They are the ones who manage and plan where to invest the money of their investors. You can consider them like the “captains” of the ship. 
• Analysts – They are the individuals who research and analyze investments and help fund managers to make good decisions. They’re like the “detectives”.
• Investors – The ones who put their money in the hedge funds to gain some profits. Investors are mostly elite-class rich people or business tycoons who invest in hedge funds. 

How Do Hedge Funds Make Money?

Hedge funds primarily make money by using two ways:

1. Performance Fees – When hedge funds make a profit, they take a cut of those profits as a performance fee. This fee is usually the percentage of the profits that the fund makes for its investors.  Generally, it’s 20% of the profits that funds cut as performance fees.
2. Management Fees – The fee that is charged for managing the money of the investors is known as the management fee. Hedge funds usually cut 2% of the total amount of money that investors have in the hedge fund. Management fees are like paying hedge funds as a service fee for managing investors’ money. 

Pros and Cons of Hedge Funds

The advantages and disadvantages of hedge funds are: 

Pros:

• Diversified Strategies Reduce Risk – Hedge funds are known for using various investment strategies, like buying and selling undervalued and overvalued stocks or investing in distinct financial instruments and assets in the market. Therefore, the diversification of strategies helps spread risk and can potentially lead to more stable and higher returns. 
• Managed by Experienced Professionals – Hedge funds are managed by experienced and knowledgeable professionals who always try to make informed decisions and aim to maximize profits for investors. 
• Potential for High Returns – Hedge funds are considered the best investment approach because it has the potential to gain very high returns as compared to other investments, especially when market conditions are favorable.  

Cons:

• High Fees – Hedge funds typically charge higher fees, including a management fee (a percentage of the total investment) and a performance fee (a percentage of the profits made). These high fees can eat up all your returns. 
• Minimum Liquidity – Hedge funds often have restrictions on when you can withdraw your money. Investors have to complete their lock-in period and then the notice period to get their money out. The time of these specific periods can vary depending on distinct hedge funds.
• Large Minimum Investment Requirements – Investing in hedge funds requires a lot of money, which makes them accessible to only the elite class and wealthy individuals or institutions.  Therefore, a high investment shows that they are not an option for everyone. 

Example of a Hedge Fund

Let’s take Bridgewater Associates as an example – one of the largest and most well-known hedge funds in the world. Founded by Ray Dalio, it manages billions on behalf of institutions like pension funds and governments, using a strategy called macro investing.

This means the fund makes decisions based on global economic trends (such as interest rates, inflation, or political shifts), aiming to profit in both rising and falling markets.

As an investor, hedge funds like Bridgewater Associates give you access to professionals who manage your money using research-driven strategies. They have high entry requirements, however, and may only be available to you if you’re an accredited or institutional investor. 

What Is Proprietary Trading?

Proprietary trading (or “prop trading”) is when a firm provides its own money to traders to trade financial instruments like forex, crypto or commodities. The goal is to generate profits for the firm, rather than earning commissions from client trades. 

➤ Learn more about prop trading firms. 

The term “proprietary trading” is made up of two words:

• Proprietary – means “something that is owned or operated by a particular company” 
• Trading – means “the buying and selling of trading instruments like forex pairs, commodities, indices, cryptocurrencies, etc. to make some profit.” 

Therefore, the buying and selling of trading instruments by using firms’ own money to gain profit is known as prop trading.

How Does Proprietary Trading Work?

Prop firms provide their capital to traders, who must first pass a qualification challenge. Profits are typically split between trader and firm, while losses are absorbed by the firm. Learn more about profit splits here. 

Traders make decisions on which instrument to trade and share the profit earned with the prop firm. Proprietary trading is a high-risk and high-reward approach for prop firms as they take full responsibility for the losses. 

Who Are the Key Players of Proprietary Trading?

• Traders – These are the individuals who actively engage in the buying and selling of financial instruments such as commodities, indices, currencies, and others using the prop firm’s money. 
• Risk Managers – These are those people who monitor and control the amount of risks the traders are taking in the market. Risk managers ensure that traders are within safe limits to prevent big losses for the prop trading firms. 
• Proprietary Firms – These are the firms or companies that are equipped in prop trading. They provide trading capital and resources to traders.