By Dan Wilchins

NEW YORK (Reuters) - 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 Incis 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.

NOT HAPPY

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 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.
(Reporting by Dan Wilchins; editing by Andre Grenon)