Understand hedge funds and prop trading firms — Stock-Market notes

WHAT are they?

WHY do they exist? (First-principles reasoning)

Markets need two things: capital and liquidity.

Investors want returns that beat a plain index, especially returns uncorrelated to the market so a crash doesn't wipe them out. → Demand creates hedge funds.
Markets need someone always willing to buy and sell so trades happen instantly. → This creates market-makers, a core prop-firm role.

HOW hedge funds make money — the fee structure

The classic model is called Two and Twenty.

Formula Hedge fund fee (Two and Twenty)

Let $A$ = assets under management, $r$ = fund's gross return for the year.

Management fee = $2\%$ of assets = $0.02 A$ (charged regardless of performance).
Performance fee = $20\%$ of the profit = $0.20 \times (rA)$ (only if profitable).

$\text{Total fee} = \underbrace{0.02\,A}_{\text{mgmt}} + \underbrace{0.20 \times r A}_{\text{perf, if } r>0}$

Derivation of investor's net return $r_{net}$ : Starting capital $A$ . After gross return: $A(1+r)$ . Subtract fees: $A(1+r_{net}) = A(1+r) - 0.02A - 0.20 rA$ Divide by $A$ : $\boxed{r_{net} = r - 0.02 - 0.20\,r = 0.8r - 0.02}$ (valid when $r>0$ ; when $r\le 0$ the $0.20r$ term drops, so $r_{net}=r-0.02$ .)

HOW prop firms make money — capturing the spread

Prop market-makers profit from the bid-ask spread, not from fees.

Figure — Understand hedge funds and prop trading firms

Side-by-side comparison

Feature	Hedge Fund	Prop Firm
Whose money?	Investors' (LPs)	Firm's own
Revenue	Fees (2 & 20)	Trading P&L / spread
Regulation	Reports to investors, disclosure	Lighter (no outside clients)
Typical horizon	Days → years	Micro-seconds → days
Key risk to firm	Losing investors	Losing own capital

Common mistake Common misunderstandings (Steel-man → Fix)

1. "Hedge funds always hedge / are low-risk." Why it feels right: the name literally says hedge. Fix: Many run concentrated, highly-leveraged, risky bets. "Hedge" is historical, not a risk guarantee. 2. "Prop firms manage my savings like a mutual fund." Why it feels right: both trade markets. Fix: A true prop firm takes no outside client money — you can't invest in it. 3. "The performance fee means the fund shares my losses." Why it feels right: 20% of profits sounds symmetric. Fix: They take 20% of gains but $0\%$ of losses — asymmetric. The high-water mark rule partially corrects this: the fund can't charge a performance fee again until it recovers past losses back above the previous peak. 4. "AUM = the firm's own money." Fix: AUM (Assets Under Management) is clients' money for a hedge fund; the firm's own money is tiny in comparison.

Recall Feynman: explain to a 12-year-old

Imagine two lemonade sellers. Kid A (hedge fund) takes money from neighbours to buy lemons and sell lemonade. Whatever profit comes, Kid A keeps a small cut plus a fixed "helper fee." If lemonade flops, the neighbours lose their lemon money — Kid A still took the helper fee. Kid B (prop firm) uses his own pocket money for lemons. Every glass he buys cheap and sells a tiny bit dearer, thousands of times, keeping all the profit — but if it flops, only his own pocket money is gone. So: hedge fund = plays with others' money for fees; prop firm = plays with own money for the spread.

Flashcards

What is the core difference between a hedge fund and a prop trading firm?

A hedge fund trades other people's (investors') money for fees; a prop firm trades its own capital and keeps all P&L.

What does "Two and Twenty" mean?

A 2% annual management fee on assets + a 20% performance fee on profits.

Is the management fee charged even in a losing year?

Yes — the 2% is unconditional; only the 20% performance fee requires a profit.

Derive an investor's net return under 2-and-20 for a profitable year.

r_{net} = r - 0.02 - 0.20r = 0.8r - 0.02

If a fund earns 15% gross, what is the investor's net return under 2-and-20?

0.8(0.15) - 0.02 = 10\%

What is a high-water mark?

A rule preventing a fund from charging performance fees until it recovers past losses back above its previous peak value.

Why is a hedge fund called a "hedge" fund?

Historically it hedged by going long good assets and short bad ones to profit regardless of market direction.

How does a prop market-maker earn money?

By capturing the bid-ask spread over many trades: profit ≈ spread × quantity × number of round trips.

What does "absolute return" mean vs a mutual fund's goal?

Making positive money in up AND down markets, rather than just beating a benchmark index.

Can a retail investor put savings into a prop trading firm?

No — a true prop firm takes no outside client money.

Why is the performance fee criticized as asymmetric?

Fund takes 20% of gains but 0% of losses, so risk and reward are not shared equally.

Connections

Market Participants
Mutual Funds vs Hedge Funds
Bid-Ask Spread and Liquidity
Market Makers
Leverage and Short Selling
Accredited Investors
Absolute vs Relative Returns
High-Frequency Trading

Concept Map

Hinglish (regional understanding)

Intuition Hinglish mein samjho

Dekho, hedge fund aur prop firm dono market me paisa banate hain, par sabse bada farak hai — kiska paisa risk pe laga hai. Hedge fund doosron ka paisa (rich investors, pension funds) manage karta hai aur uske badle fees leta hai. Sabse famous model hai "Two and Twenty" — yaani 2% management fee (chahe profit ho ya loss, ye lagta hi hai) plus 20% profit ka hissa. Isliye agar fund 15% kamaata hai, toh investor ko sirf 10% milta hai, kyunki $0.8 \times 15\% - 2\% = 10\%$ .

Prop trading firm bilkul alag hai — ye apna khud ka paisa lagata hai, koi client nahi. Ye mostly market-making karte hain: bid-ask spread capture karke. Matlab ₹100.00 pe kharido, ₹100.05 pe becho, spread ₹0.05 — chhota lagta hai, par hazaaron trades me bahut ban jaata hai. Saara profit unka, saara loss bhi unka.

Yaad rakho — "hedge fund" ka matlab low-risk nahi hota; naam purana hai jab woh long-short karke hedge karte the. Aur ek important point: performance fee asymmetric hoti hai — fund gain ka 20% leta hai par loss ka 0%. Isko thoda balance karne ke liye "high-water mark" rule hota hai — jab tak fund apne pichle peak tak recover na kare, dobara performance fee nahi le sakta. Exam aur real investing dono me ye difference samajhna zaroori hai.

Test yourself — Market Participants

Connections