QuantFeed: Hedge Funds vs Prop Trading Firms (2024)

This article aims to explore the fundamental distinctions between hedge funds and proprietary trading firms, particularly concerning portfolio managers (PMs). Nevertheless, many of the insights provided also pertain to traders and quantitative researchers. Key areas of comparison include technology and infrastructure, execution capabilities, organizational structure, percentage payouts, and more.

Introduction:

While we acknowledge that some of the points discussed below may be relatively broad and not universally applicable to all firms classified as "Hedge Funds" and "Prop Firms" – for instance, certain proprietary trading firms may adopt pod structures, and some hedge funds may thrive on collaborative setups – we have chosen to highlight key traits that are indicative of what a portfolio manager might encounter when considering roles at either type of firm.

Proprietary Trading Firms:

Advantages:

• Longer-term Perspective: Proprietary trading firms typically adopt a more long-term outlook when hiring portfolio managers (PMs). They evaluate performance over a span of two years rather than the shorter six-month window often seen in hedge funds, often resulting in a less competitive environment.
• Access to Expertise: PMs at proprietary firms often have access to teams of Quantitative Researchers, Fundamental Research Analysts, and Quant Developers, rather than needing to individually hire for their team. This access to diverse human capital enhances decision-making capabilities.
• Internal Liquidity: Some market-making firms offer internal liquidity, bypassing the need to route orders through external banks as hedge funds often do. This leads to quicker execution and more favorable trade prices.
• Enhanced Execution: Proprietary trading firms typically boast superior execution capabilities compared to hedge funds. They utilize low-latency execution technology, commonly employed in high-frequency market making, which PMs can leverage for their trading activities.
• Higher Percentage Payouts: In certain cases, proprietary trading firms offer percentage payouts ranging from 30% to 40%, providing PMs with lucrative compensation opportunities.
• Access to Capital: Prop trading firms typically maintain prime brokerage relationships with top-tier investment banks, enabling them to trade on leverage. This means that although a firm may allocate only $50 million, PMs have access to significantly larger amounts, ranging from $200 to $225 million (4-4.5x leverage), to execute trades.
• Collaborative Environment: Proprietary trading firms generally foster a more collaborative culture, opting against a pod-versus-pod setup commonly found in hedge funds. This eliminates competition for resources and capital allocation, fostering a more cohesive working environment.

Drawbacks:

• Discretionary Bonus Structure: Several proprietary firms implement a discretionary bonus system, which may not guarantee percentage payouts. While this doesn't preclude the possibility of earning substantial bonuses, it does entail uncertainty until the payout is announced.
• Team Culture Variability: The team dynamics within prop firms may not appeal to all PMs, as some prefer complete autonomy and an "eat what you kill" mentality, which isn't always prevalent in such environments.
• Preference for Hedge Fund Setup: Some PMs may not find prop firms appealing due to their inclination towards the setup and culture typically found in hedge funds, preferring not to be associated with market makers.

Hedge Funds:

Advantages:

• Scalability: Hedge funds are structured to accommodate the scaling of a PM's strategy to its maximum potential allocation.
• Performance-Based Compensation: Senior standalone PMs in hedge funds often enjoy a standard industry practice of earning 20% of Profits and Losses (PnL), creating a meritocratic "eat what you kill" ethos.
• Ready-to-Go Infrastructure: Platform hedge funds often offer comprehensive tech, support, and data setups, facilitating a swift launch for PM strategies.
• Entrepreneurial Opportunity: PMs have the freedom to build their teams from scratch, enabling them to select the individuals who align with their strategy, unlike the team constraints often seen in prop firms.

Drawbacks:

• Performance-Driven Attrition: Certain hedge funds are known for annually culling underperforming PMs, prioritizing short-term gains over longer-term investments in talent.
• Technological Limitations: Some platform hedge funds may suffer from outdated technology, resulting in inferior data access and execution capabilities compared to prop firms.
• Non-Collaborative Culture: In some hedge funds, a competitive atmosphere prevails among PMs, hindering the exchange of innovative ideas and strategies, as they vie for capital allocation without collaborative discussions.
• Dependency on External Order Execution: Many hedge funds lack internal market-making desks, necessitating the routing of orders through external banks, potentially impacting execution efficiency.

Conclusion:

Each firm offers its distinct advantages and considerations, underscoring the importance of thorough comprehension before engaging in any introductions. This level of recruitment necessitates both recruiters and candidates to grasp the intricacies of each firm and position, aligning the candidate's strategy with the optimal environment. We invite any questions and are happy to engage in discussions regarding our clients' capabilities and hiring preferences.

Written by Owen Burton, Systematic Trading Recruiter at Tardis Group.

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