What are the differences between prop groups and hedge funds?
* Prop groups trade the (proprietary) capital of the firm's owners. Historically, prop groups evolved from market making functions. As algorithmic trading has taken over much of the true market making, most prop firms have retained their short-term roots and trade short-term (largely intra-day) opportunities, making use of significant leverage. Prop firms can operate in futures markets or stocks; occasionally both.
* Hedge funds trade the capital of investors, some of whom may be owners/partners in the firm and others who will be high net worth individuals and/or institutional investors. Hedge funds traditionally invest, not trade. They run portfolios of positions, rather than trade in and out of a limited number of instruments daily. Hedge funds trade a wide variety of strategies and often will run different strategies within a single fund to achieve diversification for investors.
* A hybrid structure is known as the "family office". This is an organization that manages money like a hedge fund, but trades only the capital of the friends and family of the founder. Very high net worth individuals may establish family offices to avoid the regulation of hedge funds while retaining the practical benefits of hiring portfolio managers.
What are the advantages of affiliating with prop groups or hedge funds?
* Access to capital. This can be significant, as many early career traders simply lack the capital to earn significant dollar returns.
* Access to other skilled traders. This varies greatly from firm to firm and requires due diligence.
* Access to superior tools and equipment. Larger firms can afford to invest in software and trading platforms that help traders find opportunities and better manage risk.
* Access to structured learning experiences. This varies wildly across firms. Some run actual training programs, some offer mentoring within groups, some offer little if any training. This requires particular due diligence.
* Access to markets. Prop firms and hedge funds can open access to markets that might be too expensive or difficult for traders to trade on their own. A prop firm that is a member of an exchange can pass along a favorable commission structure to its traders. A hedge fund with strong relationships with prime brokers can meaningfully expand a trader's access to global markets.
What are the pitfalls of affiliating with prop groups or hedge funds?
* Fees - Sometimes these can be onerous. There are some bad players out there that make their money more from the commissions and seat fees they charge traders than from facilitating the success of their traders. If you're paying high commissions, you are a customer of the firm you work for, not an employee. Caveat emptor.
* Payouts - If you trade on your own, you keep 100% of your profits before expenses. If you trade at a prop firm, that payout may be closer to 50%. If you trade at a hedge fund, it will typically be below 20%. That isn't a problem if you have significant access to capital and if you're getting value in return for the profit-share. But you want to make sure that's the case.
* Job Security - If you cannot sustain profitability, these firms will not retain you. That can make it difficult to find a new position. One limitation of making trading a career is that it doesn't readily prepare or position you for alternate careers. This is an important consideration to think through if you're contemplating raising a family and need a measure of stability in your career.
How do I break into a prop group or hedge fund?
* Build your own trading track record - Even if it's with small capital, you can demonstrate good decision making, sound risk management, and trading skills.
* Develop knowledge and skills that make you valuable to a firm - There is always a need for quantitative talent, programming experience, and specialized knowledge of specific markets or regions.
* Join an existing group within a firm - This is my favorite way for young professionals to join a hedge fund, but it takes networking and that development of specialized knowledge and skills. Increasingly, we're seeing prop firms build out groups as a way of leveraging their talent and offering ongoing mentoring of developing traders.
Affiliating with a trading firm is definitely not for everyone. You may not want to make trading your career, and you may have sufficient access to capital and other resources to build your own trading business. One structure that is interesting is known as "arcades", where traders bring their own capital, enjoy higher payouts, but share office space and resources. That can be a nice blend of affiliation and independence for experienced traders.
If you do decide to look into affiliating with a firm, watch for those sketchy players that take advantage of the hopes and dreams of unwitting early career traders. If a group claims to offer education and training, get the details about their curriculum. If the firm offers great payouts, check out the (hidden) fees and commissions. If the firm promises access to capital, find out exactly how much access their experienced traders have.
Finally, culture matters. Some trading firms care a lot more about their traders--and are much more devoted to growing them--than others. Talking with traders already working within the firms is a great way to learn about the culture and the opportunities and pitfalls of affiliation.
Bottom line: If you want to join a top firm, learn some top skills and get some specialized experience that will make you an asset to the company. Going with no track record and no specialized skills and loudly proclaiming your "passion" for trading is a great way of failing to distinguish yourself to any solid organization.
Further Reading: Joining a Prop Firm
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