With apologies to Mark Twain, close observers of financial markets could be forgiven for thinking rumours of the death of proprietary trading in Investment banks have been greatly exaggerated.
Despite the best intentions of the Volcker rule there remain entities and groups of traders in banks who continue to carry out what any neutral observer would classify as proprietary trading. In a world where there is more importance placed on how things appear than what they actually are, banks can shield a multitude of Volcker ‘sins’ within asset management units and by ‘hedging’ client flows. Others can even afford to be less discreet given the location of their global headquarters and bankroll more visible proprietary activity.
Plus ca change? Not necessarily. The volume and reach of proprietary trading has certainly declined and has led to a well documented exodus of talented proprietary traders from banks to hedge funds. In the last 2 years there have been negligible instances of investment professionals returning to banks from Hedge Funds or being hired from Hedge Funds by banks. This road has been marked by individuals either setting up their own funds as well as individuals joining existing Hedge Fund platforms.
With the benefit of 4 years hindsight can the direction of travel from bank to hedge fund be considered a no brainer? Up to a point. Hedge Funds benefit from being mostly privately held companies, with an entrepreneurial culture which can set its own rules. Those with large AUM can afford to attract top bank proprietary traders by committing significant day one capital allocations (USD200m and upwards), lucrative pay out ratios (typically 14-18% of profit and loss) and, assuming success in this scenario, a much more immediate payback, compared to the stock deferrals and cash caps suffered by former colleagues in the banking businesses they have left behind.
Despite the ‘pull factors’ outlined above the hedge fund industry is littered with the debris of business failure and underperformance that indicates a road far from being paved with gold. Whilst portfolio managers (as proprietary traders become during their Damascene conversion) in Hedge Funds can experience significant financial upside, theirs is a very transparent existence. Make money and get paid according to contract, make no money and survive on a hedge fund salary (considerably lower than the reweighted banking salary bands) - lose money and its P45 time. Not an unreasonable culture but the real money is made by owners and partners of Hedge Funds who combine a large amount of assets generating a 2% management fee and superior investment performance of which they take 20%. Only a very small handful of hedge funds can consistently point to success in both over several years. For the others it is an annual battle to generate performance and raise and keep assets within their business for what is a notoriously fickle investor base.
So is remaining within a bank necessarily a bad thing? Maybe not. Assets available to apply risk are significantly larger and more stable than hedge funds, the infrastructure is far more developed, and there is a much smaller risk of one’s employer going bust. The challenges currently are the constraints being demanded by regulators which are making aggressive proprietary trading very difficult and the compensation structure in banks making the rewards less appealing.
Given Proprietary Traders and Hedge Fund portfolio managers are in the business of making money by as broad as means as possible and being rewarded handsomely for success Hedge Funds probably have the edge for now. There is not a pot of gold at the end of the Mayfair rainbow for all of its inhabitants although the canaries probably still smell plenty of gas down at the Wharf.