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Difference between Hedge Fund and Prop Trading
The growth of hedge funds, in terms of the number of funds and the total assets under management, has risen significantly during the past decade. Despite the business's widespread interest and rapid growth, the term "hedge fund" still lacks a uniform legal meaning. However, it is well known that the only people who can afford to invest in hedge funds are incredibly wealthy individuals and enormous institutions.
Prop trading, another financial instrument with a similar business concept, is often confused with activity. In reality, they are both active in the same markets and employ many of the same trading strategies and practices. But don't let their similarities fool you; some key differences exist.
What is Hedge Fund?
Hedge funds, which are a type of alternative investment vehicle, are often organized as private partnerships and have their tax and regulatory bases located in countries with lower tax rates. Hedge funds are a type of non−traditional mutual fund. Hedge funds are notoriously complex and private, making it difficult to learn about the business as a whole.
Hedge funds may be thought of as pools of capital that invest across a wide range of asset classes and rely on the performance of a small number of other funds carefully chosen to maximize returns for investors. They use risky asset management techniques and intricate trading tactics to increase profits. Money comes from respectable investors or institutions like endowments or pension funds, as well as extremely wealthy individuals who can afford to lose money on hazardous trading strategies.
Typically, hedge funds are investment firms that solicit capital from a wide range of investors, invest that capital in the financial markets for the purpose of generating absolute returns, and collect enormous fees from their clients. There are two names for hedge funds− private equity and hedge funds. They use investment strategies that differ significantly from the norm in the realm of personal finance.
What is Prop Trading?
Banks and other financial organizations engage in proprietary trading, commonly known as "prop trading," to capitalize on short−term price fluctuations in asset markets. When financial organizations invest their own capital rather than the capital of their clients, they are said to be engaging in proprietary trading.
The term "prop trading" refers to the practice wherein a financial institution (such as an investment bank, hedge fund, or commercial bank) uses its own funds to make investments in the stock market, bond market, or other markets where the institution believes it has an edge. As a result, prop traders' profit motives often clash with those of their clients. Interest rate and credit products, mortgage−related securities and loan products, and other asset−backed securities are only some of the ways these firms make money. Furthermore, they have holdings in the commodity and currency markets, as well as related derivatives. Prop trading, in contrast to hedge funds, involves making risky wagers on one's own books.
Differences: Hedge Fund and Prop Trading
The following table highlights how Hedge Funds are different from Prop Trading −
| Characteristics | Hedge Fund | Prop Trading |
|---|---|---|
| Investment Model | They are investment businesses that seek capital from outside investors, collect that capital, and then invest it in various financial markets in order to create absolute returns. | They invest their own money rather than the money of their customers so that they may profit from the short−term price swings that occur in asset markets. |
| Flexibility | The money comes from foundations and pension funds, as well as other managed funds, life insurance firms, and exceedingly wealthy people. | Leverage financial products such as mortgage−related securities, asset−backed securities, commodities, and currencies, as well as derivatives of these financial instruments. |
| Incentive | On top of the fees for management, fund managers typically charge a substantial amount for the services that they provide. | By trading on behalf of its clients, the company benefits not from charging fees but rather from direct market profits. |
| Leverage | When it comes to investing methods and the categories of assets they are permitted to invest in, hedge funds are subject to fewer or no limitations. | Prop trading includes a greater degree of risk because prop traders do not deal with the funds of their clients but rather trade using their own money. |
Conclusion
Fund managers don't have as much to worry about from the government because of the relatively lax laws that apply to hedge funds. Therefore, investment managers have more flexibility to allocate funds among several types of pooled investment vehicles, including limited partnerships, trusts, and limited liability corporations. However, hedge fund returns don't follow the usual distribution since managers of hedge funds must achieve a particular level of economic success before they are entitled to receive incentive fees.
Trading only for the benefit of the business performing the prop trading and without engaging in client−related trading is called "prop trading," and it is quite similar to the investing technique utilized by hedge funds.
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