FORBES | The New Quant Hedge Fund Master
On a recent rainy October evening, Peter Muller, 52, sits at a piano on the stage of Manhattan's City Winery, playing with the band from his third album, Two Truths and a Lie. In between songs about love, heartbreak and relationships, like his Bruce Hornsby-reminiscent "Kindred Soul," Muller describes the long, strange trip he has taken in and out of high finance.
The tieless suits in attendance, from places like Goldman Sachs and Blackstone, paid as much as $1,000 a ticket to raise nearly $55,000 for the Robin Hood Foundation. And while Muller tells them of his early discovery of music, the existential crisis of his 30s, buddies he left behind in California and his family, there is a sense that many in the room just want to be in the orbit of the hottest hedge fund manager on Wall Street today. "I know you all had your choice of hedge fund manager CD-release parties," quips Muller. "Thank you for choosing ours."
Pete Muller is the latest, greatest member of a growing band of hedge funds that use complex math and computer-automated algorithmic models to buy and sell stocks, futures and currencies based on statistical correlations and aberrations that can be found in the market. During 2015, when many hedge fund managers--from mighty activists like Bill Ackman to noted short-sellers like David Einhorn--lost money, Muller spun the market's volatility into gold. The largest fund of his three-year-old PDT Partners firm, which oversees $4.5 billion, was up 21.5% net of fees in the first 11 months of 2015.
"We knew that Pete has a magic touch," says J. Tomilson Hill, the billionaire who runs Blackstone's $70 billion hedge fund investment unit. "I happen to be a big fan of Cézanne, and Pete is in his own way as gifted as Cézanne was." Paul Tudor Jones, the billionaire hedge fund manager, adds: "He is up there with the best and brightest--bar none."
Indeed, Muller's fund is so coveted that even Wall Street's power elite are willing to effectively grovel to get in on PDT's action. Many hedge funds stipulate that limited partners remain "locked up," or prevented from redeeming funds, for a predetermined period, usually one year. PDT is the opposite. Its biggest investor, Blackstone, actually agreed to be locked up for no less than seven years--in return for Muller's assurance that he would not kick it out of his biggest fund for the same period of time. Others requested the same lockup restrictions--and were refused. Even more astonishing is Muller's 3% of assets under management fee, and performance fees that rise to 50% of profits for benchmark-beating performance, compared with the already maligned industry standard of 2-and-20.
"Our goal is to be the best quantitative investment firm on the planet, but not in terms of number of assets, in terms of quality of the products," says Muller in his first interview since opening his new firm. "To take money out of the market with as little risk as possible and build a place people who are smart are drawn to." Muller's niche formula has also let him take plenty of money out of the market personally: Forbes estimates that in the last three years alone he's made $200 million before taxes, including gains on his own capital.
It's mid-November 2015, the U.S. stock market has given back all of its gains, and hedge fund managers around the globe are wringing their hands in anticipation of sending out another batch of disappointing investor letters. Muller is sitting in his Manhattan office. He is wearing a gray sweatshirt and jeans and has a Zen-like calm. His research chief has just left his office after telling Muller about a promising finding that could lead to the improvement of one of PDT's main models. "When people buy or sell in a desperate or hurried fashion, it tends to be helpful to us," says Muller, who is otherwise tight-lipped about what has gone right this year.
There are two screens in Muller's office: a flat-panel display on his desk showing the movement of his hedge fund's positions and a much larger screen on the wall that displays a real-time high-definition stream of the surfing beach at the foot of his house just north of Santa Barbara, Calif. When he's at PDT's headquarters in New York City and the waves are big, Muller sometimes yearns to be hanging ten. Luckily this doesn't happen too often, because Muller spends two-thirds of his time at his California home, where responding to "surf's up" is a regular ritual.
Muller may not appear to be a workaholic like many other Wall Street titans, but he is obsessive about his algorithms and problem solving, and he can get lost in deep thoughts for hours, days. His fear of burnout is real--he already dropped out of Wall Street once in 1999--and diversions like music and surfing are almost a necessity.
Pete Muller and his band of quants at PDT. (David Yellen for Forbes)
Muller grew up in suburban Wayne, N.J. His father was an electrical engineer and his mother a psychiatrist. He was good at numbers and loved music. At Princeton he studied math and played in a jazz band. After graduating, he headed to northern California to play music for rhythmic gymnasts and, figuring he had to pay the bills, eventually went to work for BARRA, a pioneering research firm that catered to quantitative financial firms. In 1992 he joined Morgan Stanley in New York as a proprietary trader to see if he could use math and computers to trade himself. Some of his investment banking colleagues were skeptical about the new math guy in the office. He called his group Process Driven Trading, or PDT. "I wanted to win and prove myself," Muller says.
Nobody outside the bank knew it, but for a long time Muller was Morgan Stanley's supersecret weapon, making big contributions to its earnings each year, hidden in the firm's income statement under "principal transactions."
Muller was able to carve out his own quiet area at Morgan Stanley's Manhattan headquarters, where his team of math nerds could dress casually away from the bank's testosterone-fueled, high-octane trading hordes. Muller became intensely focused on figuring out patterns that could help him beat the market. It was thrilling and exhausting. He thought and talked about it all the time--couldn't even sit through a Broadway show without stressing over it. "He is really smart, but a lot of smart people get lost in theory," says Kim Elsesser, a computer programmer and mathematician from MIT, and Muller's first key hire. "He also has very high expectations of himself and other people."
As Muller gained success and autonomy at Morgan Stanley his behavior became somewhat erratic. He detached from the office at a second home in Westport, Conn. in part because the pressures of work were overwhelming. His mind became so overloaded with mathematical formulas that he could no longer play music. Crossword puzzles became an escapist obsession; he even created them for the New York Times. By 1999 Muller started to feel like he could no longer find happiness on Wall Street.
"I was out of balance personally," Muller says. He went on sabbatical, rediscovering his love of music partly by busking in New York subway stations and sojourning in far-off places like Bhutan. After returning in 2000 he spent the next several years essentially as an advisor to the fund he created, PDT. Muller today likens it to a kind of executive chairman position that left him time to do other things, such as practice yoga and produce two music albums with titles like Just One Lifetime. He also met his wife, Jillian.
The soul-searching lasted about seven years, and Muller says it sent his trading operation into a period of stagnation. Muller then rolled up his sleeves and came back full-time to PDT in 2006. Unfortunately his return just about coincided with the quant meltdown of 2007, when the precipitate drop in subprime mortgage securities triggered deep losses for many firms. Under pressure from Morgan Stanley, Muller was forced to liquidate part of his portfolio. "Morgan Stanley Star Is Among Those Battered; No Time for Music Now," the Wall Street Journal 's front page blared.
As with many on Wall Street, the financial crisis changed the game for Muller. He had produced the kind of returns that would have made him a billionaire had he been an independent hedge fund manager. But working for Morgan Stanley always appealed because he didn't have to worry about raising cash, appeasing clients or back-office details. It was plug and play. He couldn't invest his own money in PDT, but he was well-paid, receiving a cut of his unit's profits, and could singularly focus on solving market puzzles.
There was also the tricky issue of the intellectual property Muller developed but Morgan Stanley owned. But 2008 exposed the danger of being dependent on one client, namely Morgan Stanley. It also gave birth to the Volcker Rule, a piece of legislation designed to make it impossible for a proprietary trader like Muller to work at a bank like Morgan Stanley. Over the next few years Muller engaged in on-again, off-again negotiations with the Wall Street firm about their operating arrangement.
"We preferred to stay together, but as the Volcker Rule emerged it became clear that would not be permitted," says Jim Rosenthal, Morgan Stanley's chief operating officer, who led the last round of negotiations with Muller. "Sadly, this was a business that was a steady source of revenue and profitability and did not pose significant risks to the firm."
In the end Muller would manage Morgan Stanley money until the end of 2012 and control the intellectual property Morgan Stanley was no longer permitted to use. Under the terms of the deal Morgan Stanley would get a cut of the fee revenue of the new, independent PDT for an undisclosed period of time.
On New Year's eve 2012 Muller transferred all of his group's investment positions from Morgan Stanley to PDT Partners. It wasn't only the positions and intellectual property that came with him--so did every single member of his 80-person staff. Invigorated, Muller went to work, increasing his new business and nearly doubling his employees.
"It feels great to have your own place," says Muller from his office on the top floor
of a midtown Manhattan building formerly occupied by Random House. "I never felt like I had to have my name on the door, but I didn't own it before, and in hindsight I didn't recognize the psychological impact of that."
In order to make his mathletes more comfortable Muller has had special glass walls constructed that are slightly curved to deflect sound and maintain the quiet workplace needed for concentration. Outside those quiet areas there are Ping-Pong and foosball tables near the kitchen and meeting rooms with whiteboards covered with mathematical formulas. Employees never wear suits; they run book clubs and organize poker nights that Muller sometimes attends. (He has made a final table at the World Series of Poker.)
Not much is known about Muller's black box models. He traded using two different strategies at Morgan Stanley that have morphed into the two hedge funds he now runs. The PDT Partners Fund is a statistical arbitrage fund built on models that have never had a down year. The $3 billion fund was up 21.5% in the first 11 months of 2015, and given its high fees, its gross returns were running at about 40%. Since inception in 2013 PDT Partners Fund has produced annualized net returns of 18.5%. Another fund, $1.5 billion Mosaic, has a longer time horizon and had produced returns of 10.5% net of fees through November of last year and 8.5% annualized in three years. PDT also has a Fusion Fund, which allocates cash between PDT Partners and Mosaic.
Returns like that are beginning to rival the long-reigning king of quants, Renaissance Technologies, known for market-defying consistency and for producing a net worth of $14 billion for its professorial founder, James Simons. While Muller is not yet even a billionaire, some say he is the new Simons.
Like Renaissance PDT is a Ph.D. farm, with 35 researchers who spend most of their days developing trading algorithms. They are organized into five teams by the asset class and time horizons they work on. Some work on futures contracts with longer holding horizons while others toil with statistical arbitrage strategies that trade stocks over a medium time horizon of several weeks. Most efforts to come up with new models tend to start with two-week-long deep dives but can grow into research projects that last a year. PDT has one open problem today that its people have worked on for four years.
Fun & Games: Muller's crossword puzzles have a loyal following. Solving this one will reveal another puzzle regarding a famous guitarist. Answers can be found on pmxwords.com.
And while most Wall Street research analysts expect their best ideas to find their way into firm portfolios within weeks or months, PDT takes an academic approach to portfolio change. Researchers know that their models may not affect returns for two years or more. In fact, PDT is still using models today with concepts that were initially developed 15 years ago, but models do decay over time and need to evolve with the market. "We are more intent in building a group of Ferraris than a bunch of Toyotas," says Tushar Shah, research chief at PDT.
Finding the right minds for Muller's model-making is almost as hard as decoding statistical arbitrages hidden in markets. Big data and sheer computing power have become a driving force in PDT's business model. Like other quants, PDT routinely competes with tech firms for leading programmers and mathematicians. It is now hiring more computer engineers than mathematician-researchers. Experts in machine learning are in high demand, so poaching talent from the likes of Google and Microsoft has become popular of late.
It's not always the eye-popping first-year salaries of several hundreds of thousands of dollars that hook new Ph.D. recruits. PDT researcher John Sun, 30, was finishing up an MIT Ph.D. in electrical engineering and computer science when he got an e-mail from Eunice Baek, Muller's longtime partner who manages recruiting. Sun would frequently get these sorts of e-mails and ignore them, but this one pulled him in. It said people at PDT like Lord of the Rings, science fiction and board games such as Settlers of Catan.
Like most PDT job candidates, Sun was flown to New York for a 36-hour interview on the second Saturday of November at PDT headquarters, where Muller and his partners tried to determine if Sun had the smarts and was someone with whom they could spend a lot of time. The guts of the recruiting weekend include a modeling interview and then collaborative algorithmic-based problem-solving games in which candidates are separated into small teams that Muller watches closely. PDT has a 3.5% turnover rate, and while the hours are not grueling, the work is demanding--trying to solve stock market puzzles often ends in failure.
"I want their shower time because in the shower they are thinking about things that get them to solve the problems," says Muller.
While Muller is supersecretive about the details of his models even to limited partners, who seem to invest on faith--he is adamant that PDT does not engage in ultra-high-frequency trading. Ferreting out small market inefficiencies is core to PDT's strategy, and what is also clear is that, for Muller, the more trading going on in markets the better. "There is a limitation on how much volume we can trade naturally built into our systems," Muller says, adding he will almost certainly return some capital to his investors at the end of 2015, as he did in 2014. Trust in Muller's machines is paramount, and he rarely intervenes manually, even when jarring upheavals temporarily defy his model's predictions.
Spending seven months of the year with a surfboard at the ready or composing in front of a keyboard, instead of obsessively staring at a CNBC ticker, probably gives Muller's PDT an advantage. Instantaneous information and constant volatility are the new reality of global markets. Whether it is index investing or robo-advisors, the discipline and brainpower of machines are winning on Wall Street. The rise of the quants is just beginning. "It will get harder, but we are prepared, and as information becomes more widely available and computing power increases, the strength of our models will improve," Muller says. "Quantitative investing is the best way to manage money, period."