Hedge Fund model vs Prop Shop model

I have been talking to a couple prop shops recently, and I got a chance to sit down with the owner of a prop shop that specializes in fixed income derivatives. Since to be a part of the shop you have to put up your own capital (typically $500k to get a seat and play with the house's money), and I only have a fraction of that in the market, our conversation was more towards the prop shop model vs the hedge fund model.

The owner has spent his time around big banks, hedge funds, and prop shops - and aside from running the prop shop he is a professor at a top business school. I took lots of notes through our conversation, and I've decided to share a bit about the hedge fund vs. prop shop model.

In the hedge fund model, you are using client money to try and make more money. However, the structure is setup such that the fund manager gets all the spoils. You can compare such a hierarchical structure to those found in mail-order catalog networks and knife selling agencies. There are the work horses and the decision makers, then there's the guy who gets to decide who the decision makers are and call shots on the shots. The example I have seen used for this model is the pyramid of wine glasses, where the top glass always gets filled first before the second tier glasses get filled. Furthermore, the lions share of profits from the hedge fund model comes from not the 20% profit but the 2% management fee; getting paid just to play.

In contrast, prop shops pay significantly more based on performance. You pay to play upfront, usually contributing some form of capital to play with company money. You lose, you don't get paid; you win, you keep 35-80% of your profits depending on various factors. The owner compared himself to the house: people pay to play, play with house money, some win and some lose, but the house gets a cut off each bet. The traders get the research and execution they need, and the house gets paid. +1 Props.

Personally I don't trust hedge fund managers who don't have their own skin in the game, there's a real moral hazard there. Prop shops have the "better" model in that regard as well, as losses are shared between your self and the shop. Mallaby argues in More Money Than God that the hedge fund model is better than big banks in terms of moral hazard, and I agree, but that's not saying much. +1 Props.

After we finished the conversation, it seemed that we agreed on one thing. You should definitely go spend some time in the big banks/hedge funds to learn how to trade. However, once you know how to and are finding/making profitable trades, the prop shop model is a better alternative compared to staying in a hedge fund. That is, of course, unless you start your own fund.

The owner's approach? Find the market and become the house. As long as people are trading, the house gets paid. And the house gets paid well.