Why do most of the good prop firms have substantial market making operations while almost no hedge funds pursue this strategy? I can't think of any hedge fund besides Citadel that makes markets, while prop shops like Getco, SIG, Jane Street and CTC, are all based around it.
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You raise a good question. This is because many of the high frequency strategies that some of the large hedge funds run can be classified as pseudo-market making in nature. However, from the viewpoint of tradition MM vs. tradition HF, they are two completely different vehicles whose purposes in the marketplace are different.
The goal of a market maker is to provide liquidity at a microstructure level. The goal of a hedge fund is to generate alpha which may mean providing liquidity at a macro level.
Market making is not a capital intensive business as much as its a labor intensive business. In the liquid, exchange traded markets where Jane Street, SIG operate, you don't need a ton of capital to operate and make markets. However, what you do need is top of the line technology and good traders because generally the more trader = the more profits as you can provide liquidity across more products.
For many of these market makers, they are REQUIRED to show markets a certain percentage of the time to retain certain exchange access privileges as well as obtaining liquidity rebates (this is big: even if its $.0001 per share traded with large enough volume you can make beaucoup $$$). So, when markets are crashing and everyone is hitting the MM's bids (they are buying as markets are going down) they have no recourse but to keep on showing bid/asks.
Hedge funds need to be more scalable where they might provide liquidity at a macro level (ex: Asian currencies crashing, there is some value, so lets put in 100mm to work). They will not care about tick by tick liquidity as much as traditional MMs. However, again some of the high freq strategies run by HF can be considered to be pseudo-MM nowdays.
Here is an article about it: http://infoproc.blogspot.com/2007/07/hedge-funds-or-market-makers.html
Market making is a strategy that is very labor and technology intensive, not capital intensive. Also, the strategies have an extremely high Sharpe ratio, but are not scalable. Thus, they are ideal for a firm with a small capital base. Remember that at a prop shop you are trading the owner's money, so he does not want a massive amount of risk on. The high Sharpe ratio of a market making strategy is ideal for this.
By contrast, a hedge fund is managing other people's money, with only upside fee (the fund manager doesn't lose anything if the fund declines, but he gets 20% of the upside). So from the fund manager's perspective, why on earth would you do market-making in a hedge fund? You are just giving up 80% of the profits for no reason. The 20% upside incentive structure thus causes hedge funds to run capital-intensive, scalable, lower Sharpe ratio strategies.
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