Prop Trading vs. Hedge Funds: Key Differences

Written By
G. Dautovic
Updated
May 21,2024

Both hedge funds and prop trading have surged in popularity in recent years. This is mainly due to the potential for high returns offered by both financial instruments through sophisticated trading strategies.

However, they often get confused due to their operation within the same markets. In reality, proprietary trading firms and hedge funds are more dissimilar than they are alike.

What Is Proprietary Trading?

Proprietary trading, commonly known as "prop trading," is a high-risk, high-reward activity where a bank or firm trades with its own capital to generate profits. Prop trading firms aim to make profits independently by trading stocks, derivatives, currencies, and other financial instruments. This sets them apart from traditional financial institutions that prioritize client service.

Since proprietary trading firms use their own capital, the potential for both profits and losses is significant. As a result, they attract highly skilled and experienced traders to trade on their behalf. These traders benefit from the firm's resources and technology, utilizing various prop trading strategies and leverage to generate substantial profits for both the company and themselves.

What Are Hedge Funds?

A hedge fund is a private investment fund that utilizes investor funds to generate profits for clients, while charging management and performance fees. Similar to prop traders, hedge fund managers employ complex trading strategies and can utilize derivatives or leverage to outperform average investment returns. However, hedge funds trade with their clients' funds, leading them to implement risk management practices to protect those funds. Consequently, hedge funds are generally considered a lower risk trading activity.

Hedge funds are exclusively open to accredited investors who meet specific wealth requirements. In the United States, this entails having a net worth exceeding $1 million. Accredited investors also include institutions such as banks, brokerages, and insurance firms.

Key Differences Between Hedge Funds and Prop Trading

The table below show how prop trading and hedge funds differ from each other:

Hedge Fund

Prop Trading

Investment Model

Hedge funds seek outside capital from wealthy, accredited investors and invest it into financial markets for absolute returns.

Prop trading companies use their own capital to seek short-term gains in various financial markets.

Regulation

Hedge funds are much less regulated, with some regulatory oversight for those not qualifying for the private fund advisor exemption.

Prop trading faces high regulation due to the Volcker rule, especially for traditional banks and financial institutions.

Fees

Hedge funds typically use a "two and twenty" fee structure, charging a 2% management fee and a 20% performance fee.

Prop trading shares profits with traders, such as a 90:10 split in favor of the trader.

Flexibility

Hedge funds have much more flexible policies and investment strategies available.

Prop trading firms have restrictions on trading strategies.

Risk Exposure

Hedge funds assume risk on behalf of accredited investors.

Prop trading companies stake their own capital and assume personal risk.

Similarities Between Proprietary Trading and Hedge Funds

As demonstrated above, prop trading and hedge funds exhibit several differences. However, there are still noteworthy similarities. The primary one is, naturally, the shared goal of generating profit. Additionally, both hedge funds and prop trading firms participate in active trading, employing experienced traders to operate in various financial markets.

Lastly, both prop firms and hedge funds employ similar trading strategies and actively practice risk management. This involves promoting diversification, utilizing risk limits, determining position sizes, and employing hedging techniques to safeguard capital.

Find a Trusted Prop Trading Firm

Best for: High profit split

FundedNext

Fortunly's Rating: Our editorial team determines the rating based on a set of evaluation criteria developed for each product and service category.

FundedNext Logo
OVERVIEW

FundedNext boasts extremely low commissions and spreads, and has an ever-growing customer base, with more than $50 million in payouts and 51 thousand traders already funded by the company.

  • Dedicated Account Manager
  • 15% profit split from the start
  • Low starting price
Get Funded
On Official Website
TRADABLE ASSETS:
Forex, Indices, Commodities
PROFIT SPLIT:
Up to 90%
TRADING PLATFORMS:
MetaTrader4, MetaTrader5
MAXIMUM CAPITAL:
$4,000,000
Best for: Forex traders

TopStep

Fortunly's Rating: Our editorial team determines the rating based on a set of evaluation criteria developed for each product and service category.

TopStep Logo
OVERVIEW

TopStep is a leading futures trading prop firm, with more than $10 million in trader payouts since 2020 and a high customer trust. With a wealth of educational resources and different account types, TopStep is a great choice for experienced and beginner prop traders alike.

  • Leverage is up to 1:100
  • Provides digital coaching
  • Beginner-friendly
Earn Funding
On Official Website
TRADABLE ASSETS:
Futures
PROFIT SPLIT:
100% on first $10,000 and then 90%
TRADING PLATFORMS:
TSTrader, Quantower, Sierra Chart, T4, MotiveWave and more
MAXIMUM CAPITAL:
$150,000

In Conclusion

As we can see, there are many notable differences between hedge funds and prop trading firms. The key distinction lies in prop firms trading with their own capital, while hedge funds employ funds from affluent investors to generate profits for both clients and themselves.

FAQ

What is the difference between a prop trader and a hedge fund trader?

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Prop traders engage in trading with the company's capital, whereas hedge funds pool resources from accredited private investors and financial institutions, charging fees based on the profits they generate for clients.

Is prop trading better than hedge fund?

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Proprietary trading attracts traders seeking greater autonomy and higher profits, while hedge fund managers typically handle larger investments with more diversification and professional management.

Are hedge funds prop traders?

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Hedge funds invest and trade in the same financial markets as prop traders—such as stocks, derivatives, and bonds—yet these institutions operate in distinct ways and under different levels of regulation.

About author

I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.

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