Hedge Fund vs. Proprietary Trading

by Rose Johnson ; Updated July 27, 2017
Hedge fund managers possess many years of investing experience.

The investment-management industry deals with many complex financial instruments and trading strategies involving institutional investors. Hedge fund trading and proprietary trading are two common types of investment methods used in the industry. Hedge fund managers invest in many types of financial securities to earn a return on the investments. The clients of hedge funds include high-net worth individuals and financial institutions. Proprietary trading only involves banks directly trading market securities to earn a return for their own benefit. Both types of investing methods possess advantages and disadvantages for investors and the financial institutions involved.

Understanding Hedge Funds

Hedge funds gather money from high-end investors to make trades in hope of earning positive returns on their investments. Hedge funds use many investment strategies to earn a profit, and some strategies are extremely risky. According to information presented on Columbia University’s website by the Columbia Investment Management Association, hedge funds mainly use 14 specific strategies to limit risk and volatility while generating positive returns. Some banks and other financial institutions invest in hedge funds and are called funds of hedge funds. Financial institutions investing in a hedge fund rely on the positive returns of the hedge fund to earn a profit for themselves.

Pros and Cons of Hedge Funds

An advantage of hedge fund investing is the ability of hedge funds to generate positive returns through their hedging and leveraging strategies despite the direction of the equity and bond markets. Hedge funds typically generate higher returns without incurring as much risk as other types of investment funds. Hedge funds are not open to everyone, but only investors with a large amount of capital, which is a disadvantage for small investors. Another disadvantage of investing in a hedge fund is that hedge funds are not required to register with the Securities and Exchange Commission, so very little federal oversight exists.

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Understanding Proprietary Trading

Proprietary trading consists of a financial institution making short-term market trades to earn a profit for the company. This is in contrast to the normal business operations of investment banks, which include earning a commission through buying and selling investments on behalf of clients. A firm may trade stocks, bonds, derivatives, commodities, foreign securities and other types of financial instruments. Some financial institutions establish proprietary trading desk to set aside a certain amount of money for employees to trade on the company's behalf.

Pros and Cons Proprietary Trading

The advantage of proprietary trading for financial institutions is that it allows them to earn revenue outside of their normal business operations. Many banks engage in proprietary trading because of the belief that they possess a competitive advantage to earn substantial returns. Proprietary trading is extremely risky and some banks have lost billions of dollars through investing in risky securities, which resulted in many financial institutions receiving government funds to remain viable. According to an article written by Steve Gandel in "Time," nearly every bank that struggled during the financial crisis in 2008 lost billions of dollars due to proprietary trading.

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