As banks spin off their proprietary trading groups into hedge funds to comply with a new law, traders will find themselves in a tougher environment.
Independent hedge funds face higher funding costs and often have less capacity to nimbly take advantage of opportunities in tough markets, traders said.
Without the infrastructure of their parent banks, senior hedge fund managers may have to spend more time on such matters as marketing and managing accounting staff than their counterparts on proprietary trading desks.
Add it all up, and investors are likely to be skeptical of the funds' ability to generate outsize returns, bank executives and hedge fund experts said.
"Being out on your own as a hedge fund is a totally different animal from being inside a bank," said Brad Alford, founder of Alpha Capital Management, a firm that advises high net worth individuals about investments, including hedge funds.
"I don't want my clients to be a guinea pig in this kind of an experiment," Alford added.
Still, banks are hopeful. With the Dodd-Frank financial reform law putting limits on dealers' proprietary trading, major banks are considering how to change that business.
Goldman Sachs Group Inc is planning to turn its proprietary equity trading unit into a hedge fund that raises money from outside investors, sources familiar with the firm said.
Morgan Stanley might also be close to spinning off its FrontPoint Partners unit, according to news reports.
Many have made the transition from proprietary trading to hedge fund management before. Eric Mindich, for example, was a senior proprietary trader at Goldman Sachs before starting up Eton Park Capital Management in 2004.
But professionals who have made the move said it can be tough. Proprietary traders have a single boss — the bank that supplies them capital — while hedge fund managers have many bosses, namely their investors.
Reporting to a financial institution can have real advantages. For example, Goldman Sachs' traders are usually assigned a strategy, but can stray from that remit if they convince their managers they have a great idea.
"I've interviewed traders from Goldman before and they say, 'I can try anything I want,'" said one senior executive at a rival.
Hedge fund managers usually have less flexibility, because their investors demand that they follow a particular strategy.
"I might see an opportunity in Asian equities, but my investors don't pay me to invest there," said one former Goldman trader who now works at a U.S. hedge fund.
That means hedge fund managers often have less capacity to pursue unusual trades. One of Goldman's great assets, according to many former employees, is its ability to seize opportunities quickly in markets, as long as trades stand up to scrutiny from within the firm.
Hedge fund managers face other constraints, too. They typically need to keep cash on hand to meet investor redemption requests, which can weigh down returns.
When markets are particularly tempestuous, hedge fund managers fear big redemptions and therefore have to keep more cash, making them less able to seize opportunities.
Proprietary traders often have lower capital costs than hedge funds, which means a strategy that demands a lot of borrowed capital, such as fixed income arbitrage, is harder to execute profitably outside of a bank.
Goldman Sachs is still unsure about what to do with their fixed income and credit proprietary trading operations, CNBC reported on Thursday, which experts said may be because more of those strategies rely on cheap leverage.
To be sure, there may be opportunities as banks reduce their proprietary trading businesses. For example, if multiple banks stop trading fixed income arbitrage, the opportunities in that strategy may increase even for hedge funds with higher borrowing costs. And the best traders will likely be able to raise money in any environment.
But life in a hedge fund will be different enough to be jarring for most proprietary traders, experts said.
"Traders will not be happy about this change," said Steve Kohlhagen, who ran derivatives businesses at First Union and later Wachovia.
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