July 7 (Bloomberg) -- At Caffe Vivaldi in New York’s Greenwich Village, Peter Muller bangs out a repertoire full of Carole King riffs on the piano along with his own soft-rock compositions that draw on the likes of Van Morrison and Cat Stevens.
“It’s not the same anymore,” he croons. “I’m still looking for my home.”
In the audience, couples sip house cabernet and applaud politely. Some drop $10 tips into a metal bucket.
About 40 blocks uptown in a 42-story skyscraper overlooking Duffy Square, straw-haired Muller, 47, performs for a tougher crowd -- as the multimillionaire math whiz behind one of Wall Street’s most secretive trading machines, Bloomberg Markets magazine reports in its August issue.
Muller is the founder of Morgan Stanley’s Process Driven Trading group, or PDT, a 70-person band of Ph.D.s and computer jockeys. They use algorithm-rich programs to bet Morgan Stanley’s money on pricing discrepancies in global markets.
Muller, who has had no outside investors to please, has kept the strategies and performance of PDT under wraps, stoking the curiosity and envy of rivals.
“They say: ‘I know him. He made a boatload of money for Morgan Stanley,’” says Arjun Divecha, chairman of Boston-based GMO LLC, who manages about $18 billion using quantitative techniques. “They don’t know how he’s done it.”
Muller makes no apologies for his obsessive secrecy.
“I want my competitors to know absolutely nothing about what we do,” Muller says in his corner office, which is decorated with pictures of his wife, Jillian, and their two children as well as a pair of battered snowboards he retired years ago.
A troubadour, yoga enthusiast and math geek, Muller makes an unlikely Morgan Stanley executive. The 5-foot-10-inch (1.78-meter), 160-pound (73-kilogram) manager wears a handmade silver amulet around his neck that incorporates Native American symbols for sun, water and mountains. He practices ashtanga yoga, a style that incorporates synchronized breathing. He’s also a champion Texas Hold ’em poker player and writes New York Times crossword puzzles several times a year, garnering a core group of online fans.
Since he started PDT in 1993, its investments have returned an estimated annual average of more than 20 percent through 2010, according to a person close to the group. As a proprietary-trading desk, PDT uses different accounting rules than hedge funds. Its return figure has been adjusted to approximate its performance as if it were a hedge fund.
Hedge funds on average gained 10.4 percent annualized, net of fees, from July 1, 1993, through 2010, according to Chicago-based Hedge Fund Research Inc. The person says PDT notched that record with a Sharpe ratio of 3 to 4. The ratio measures risk-adjusted performance, and on this basis PDT generated 10 times the returns of the Standard & Poor’s 500 Index. The index gained about 8 percent annualized during that time.
“Wow,” says Daniel Celeghin, a partner at Casey, Quirk & Associates LLC, a consulting firm in Darien, Connecticut. “Those numbers would put them in the top echelons of quant managers.”
After almost two decades at Morgan Stanley, Muller is about to go out on his own, a move precipitated by the biggest regulatory overhaul of Wall Street since the Great Depression. Banks are jettisoning or closing groups like PDT as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Barack Obama signed into law in July 2010.
The law’s Volcker rule, named for former Federal Reserve Chairman Paul Volcker, bars banks from maintaining prop-trading operations and restricts the amount they can invest in hedge and private equity funds to 3 percent of their tier 1 capital. They can also own no more than 3 percent of such funds.
Spinning Off PDT
In its 2010 annual report, Goldman Sachs Group Inc. disclosed it had liquidated most of its long-short prop desk positions and was doing the same with its global macro group. Morgan Stanley in March completed the spinning off of FrontPoint Partners LLC, a hedge fund it acquired in 2006. Bank of America Corp. disclosed in April a plan to sell its main private-equity business to management.
Now, it’s PDT’s turn. In January, Morgan Stanley said it would spin off the group at the end of 2012 as a separate firm -- retaining an option to buy a preferred stock position in the new company for undisclosed terms.
For decades, prop desks have played a crucial role in the transformation of investment banks such as Morgan Stanley from advisory and underwriting businesses to trading powerhouses that bet huge amounts of their own firms’ money. Once the closely held Wall Street partnerships began tapping the public markets for capital, prop desks could wager with shareholders’ money.
Vanishing Profit Centers
By the mid-2000s, prop traders were at the center of the exploding markets for collateralized debt obligations, or pools of bonds, and derivatives, which are instruments that derive their value from an underlying asset. These products were high-octane fuel for the credit bubble that ultimately blew up Bear Stearns Cos., Lehman Brothers Holdings Inc. and American International Group Inc.
As the curtain falls on prop trading at banks, their profits may suffer. Morgan Stanley in 2008 began to pull back on risk partly by reducing leverage, and since then its fixed income trading revenue has been sluggish. Morgan Stanley’s net income fell 45 percent in the first quarter of 2011 from $1.78 billion a year earlier. While firms don’t generally disclose profits from prop trading, Goldman characterized it in 2010 as constituting about 10 percent of revenue in most years.
The loss of this profit engine, along with other Dodd-Frank restrictions on products such as derivatives and debit cards, will hurt Wall Street banks’ returns in coming years, says Charles Peabody, an analyst at Portales Partners LLC in New York.
“It’s the cumulative effect of Dodd-Frank that will lower expected returns,” Peabody says. “Just about every business is facing some kind of crackdown.”
Mark Lake, a spokesman for Morgan Stanley, says the bank won’t comment on PDT.
Prop traders aren’t going away; they’re just changing addresses. Dodd-Frank only sought to end the practice in banks to reduce risk. Traders have been relocating to hedge funds and nonbank Wall Street firms such as KKR & Co.
PDT makes most of its money using statistical arbitrage, or stat-arb, former Morgan Stanley employees say. When PDT’s research suggests that a stock is temporarily overpriced based on its trading history, the group bets against it while piling into corresponding underpriced securities.
No Down Years
In a group of a dozen oil services stocks, six might be rising on a given day and six falling. At some point, the trend reverts: The gainers begin to fall and vice versa. For PDT, figuring out the precise time to place its bets is the tricky part.
PDT has lost money in only two quarters since its inception and never in a calendar year, according to two people familiar with the matter.
Muller skippered PDT through the August 2007 quant meltdown, when overleveraged hedge funds and other investors lost billions of dollars during a four-day period. PDT, along with other Morgan Stanley prop desks, lost $390 million in a single day, according to Morgan Stanley filings. Yet it powered back to finish the year in the black, people close to PDT say. The group also lost heavily in the fourth quarter of 2008 amid the global credit crash but still made money for the year.
“I think Peter is brilliant,” says Clifford Asness, co-founder of AQR Capital Management LLC, a $39 billion quantitative investment firm in Greenwich, Connecticut. “PDT will be a top-quality firm.”
The AQR Global Risk Premium fund ranked sixth in Bloomberg Markets’ February list of the top-performing large hedge funds, with a return of 27.3 percent for the first 10 months of 2010.
With PDT off to a strong start in the mid-1990s, Vikram Pandit, then Morgan Stanley’s head of institutional equity, wanted to know more about the secretive trading group, says Graham Giller, a researcher who worked with Muller. Giller says Pandit told him to find out details about PDT’s strategies.
“He felt it was the intellectual property of Morgan Stanley,” says Giller, who now runs Giller Investments (New Jersey) LLC in Holmdel. Giller says Pandit never set up a meeting at which Giller could inform him of what he had discovered. Pandit, Citigroup Inc.’s CEO since 2007, declined to comment.
Wary of Quants
In going solo, Muller will have to drum up capital from investors who have grown wary of quants, whose returns have lagged behind those of other types of traditional managers for more than six years.
Equity managers using quantitative strategies generated a cumulative return of 37 percent from the start of 2005 through April 2011 compared with 49 percent for equity managers deploying traditional or combined approaches, according to EVestment Alliance LLC, an Atlanta research firm.
The assets of quant funds were down 10 percent as of December from their peak of $157.5 billion in 2007, as tracked by research firm Lipper Inc. And new fund launches in 2010 were less than half of the 2005 peak of 189.
“Quantitative managers have been losing market share, and it’s fairly significant,” says Mark Thurston, head of global equity research at Russell Investments in Seattle.
The underperformance may be due to cyclical forces, as beaten-down value stocks that many quant funds invest in have tended to lag behind their more-expensive growth counterparts in recent years. The decline may also stem from an abundance of quant-managed money pursuing similar strategies.
“Everything goes in cycles,” Muller says. “Success creates more competition.”
PDT keeps a low profile within Morgan Stanley’s headquarters. In the elevator vestibule at its ninth-floor offices, a plain, 7-inch-by-7-inch (18-centimeter-by-18-centimeter) plastic sign reads “Process Driven Trading.”
Muller has created a distinctive corporate culture at PDT, rejecting the eat-what-you-kill ethos practiced at some hedge funds. He cites a childhood book, “Watership Down,” as informing PDT’s environment.
The fantasy novel by Richard Adams tells the story of a nest of rabbits on an odyssey to find a safer home in the English countryside. Each of the principal rabbits -- with names such as Bigwig and Fiver -- excels in some area: intelligence, physical strength, intuition. After tribulations, they make it to their new abode.
What does this tale have to do with PDT? “It’s a community coming together with each individual contributing their unique skills,” Muller says. “It’s the whole that benefits.”
PDT has operated as a quasi-independent group within Morgan Stanley for almost 20 years, Muller says. Dede Welles, 41, is the legal head; Amy Wong, 43, serves as operating chief; and Eunice Baek, 41, runs human resources.
Baek canvasses schools such as Massachusetts Institute of Technology and California Institute of Technology for Ph.D.s in math-heavy fields with an interest in applying research to the real world.
“I had grown disillusioned with academia,” says Denis Dancanet, 43, PDT’s head of futures trading, who has a Ph.D. in computer science from Carnegie Mellon University in Pittsburgh. “Maybe three people care what you do.”
Eli Ofek, a former New York University finance professor, also left academia for PDT. In 1998, Muller offered him a job after attending a class taught by Ofek, who is PDT’s fundamental research chief.
In Manhattan, researchers gather for free-roaming discussions at the lunch table.
“The range is broad, from the technology to solve Rubik’s Cube, to sports, to politics, to the rate at which flesh-eating bacteria can eat your arm,” says Tushar Shah, 40, PDT’s chief scientist, who has a Ph.D. in physics from MIT and joined the group in 2000.
Muller personally pays for weeklong vacations for the group to locales such as Grenada and Jamaica to celebrate good years. PDT off-site retreats have included white-water rafting in Maine and a paint ball competition in upstate New York. Despite a spate of new hires, Muller says employee tenure at PDT averages 7 1⁄2 years.
Researchers work in teams on PDT’s strategies, with Muller and Shah meeting independently with each group. “There was a hub and spoke structure,” says Giller, who has a Ph.D. in experimental elementary particle physics from Oxford University and worked at PDT from 1996 to 2000. “The ideas were funneled to a central conduit.”
There, Muller and his closest cohorts use a program called an optimizer to allocate assets among the different strategies to generate the most profit with the least risk. Nobody else knows its details.
PDT’s strategies often focus on discrete markets such as U.K. equities, former employees say.
In the late 1990s, Shakil Ahmed, a Yale University computer science Ph.D., worked on U.S. equity stat-arb strategies. Wong, who has an M.S. in electrical engineering from MIT, oversaw investments based on fundamentals, such as earnings. Giller built a statistical method utilizing interest-rate forecasts. And Mike Reed, a Ph.D. in electrical engineering from Princeton University, ran a U.K.-based stat-arb equity strategy.
All contributed to PDT’s reputation as a cauldron of white-hot quantitative talent.
Attracted to Puzzles
Muller says his group will expand after it’s spun off and rechristened PDT Partners LLC. Ownership will be spread among 11 partners. They will pursue strategies that may be less predictable than what Morgan Stanley is comfortable with.
“We have strategies that can take large amounts of capital,” Muller says. “But they are not as consistent. They’ll make money almost every year but not almost every quarter.”
A native of Philadelphia, Muller says he was born hard-wired for math. His Austrian-born father, Kurt, was a chemical engineer with Essex Chemical Corp. His mother, Eva, a native of Brazil, was one of the first women to practice medicine there and later became a psychiatrist.
“I was attracted to puzzles and games,” Muller says.
The family moved into a shingled ranch house in the New Jersey suburb of Wayne, 21 miles (34 kilometers) west of New York. At Wayne Valley High School, Muller was named one of two class mathematicians.
“He was one of the top kids that came through Wayne Valley High,” says John Gross, former chairman of the school math department. “He was involved in everything.”
Muller, a captain of both the Frisbee and Quiz Bowl clubs, was also a member of the yearbook staff, German club, Honor Society and Model UN club. Muller’s yearbook quote: “All men by nature desire to know.”
At Princeton, Muller’s skill at frisbee caught the eye of classmate Ken Nickerson, who would later help build PDT’s stat-arb business. Muller was a star on the Ultimate Frisbee team in 1983 when it won the mid-Atlantic open championship.
He was a member of the Colonial Club, one of Princeton’s famed eating clubs, founded in 1891 and housed in a sprawling porticoed mansion. Muller would sit down in the club’s parlor and play the grand piano, leading singalongs. He graduated in 1985 with honors and a B.A. in mathematics.
That summer, Muller drove across country to the San Francisco Bay Area and soon took a job as a researcher and programmer at Barra Inc. The pioneering quant firm in Berkeley used complex mathematics to help active fund managers measure and control risk. Muller was soon presenting papers at client conferences, where he became a favorite, partly because he incorporated cartoons into the slides.
He jogged once a month under the full moon with fellow employees. One mentor, former research chief Richard Grinold, recalls discovering a coding problem with Barra’s analytics.
“We thought it was going to take five to six months to fix,” he says. “Peter came up with a solution: one person, two days.”
Muller also worked on a problem for Renaissance Technologies LLC, a Barra client. The hedge fund co-founded by Jim Simons wanted to know which U.S. Treasury maturities would be most efficient for it to park its excess cash in.
After the assignment, Renaissance offered Muller a job. But at the time, Muller was under the spell of the efficient-market hypothesis, which says beating the markets long term -- as Renaissance sought to do -- wasn’t possible. Muller turned down Renaissance’s offer.
Joins Morgan Stanley
By 1992, Muller was becoming restless and cooked up an idea of using Barra’s quantitative techniques to forecast returns rather than just model risk; Barra could manage money itself. Management turned down Muller’s proposal, and the 28-year-old decided it was time to move on.
A headhunter put Muller in touch with Morgan Stanley, which was then looking for a quant strategist to drum up business. Muller had bigger aspirations and cut a deal with Derek Bandeen, a prop-trading executive. Muller had two years to get a profitable trading system running. If he failed, he would perform the strategist’s job. PDT was born.
In 1993, as Muller began building a team at Morgan Stanley’s Sixth Avenue headquarters, his business model and ethos mimicked Barra’s, not Wall Street’s.
“From the beginning, PDT had its own culture,” he says. Muller’s first hire was Kim Elsesser, a Morgan Stanley information technology specialist in its equity division.
“We clicked,” says Elsesser, 46, who, in addition to other jobs, hired programmers to write code that Muller needed.
Within a year, Elsesser says, PDT was making serious money. A computer monitor was set up to show real-time profits and losses.
“We had a little party when we made our first million dollars,” she says. “At the time, it seemed like a lot of money.”
Muller struck an agreement with management. If PDT met its profit targets for one week, PDT employees could dress casually the next. By 1996, PDT was sizzling. “It was like an express train,” marvels Giller, the former analyst. “It was generating millions of dollars a day. It would just appear on the screen. It was surreal.”
As profits grew, PDT employees talked often about splitting off from Morgan Stanley. Muller says he negotiated with management for a greater slice for himself and his colleagues.
“We don’t need to be paid as if we are running our own hedge fund, but it needs to be close enough so we don’t feel taken advantage of,” he says he told Morgan Stanley executives.
Muller could play hardball with compensation, which led to a lot of back-and-forth negotiations. “It wasn’t specifically based on the performance,” Giller says. “It was always an unpleasant experience.”
By 1999, after seven years running the group, Muller was burned out and negotiated a sabbatical with a steep pay cut. Ahmed, who was managing stat-arb strategies, stepped in for the founder. Muller traveled, kayaking in the Grand Canyon and trekking to the kingdom of Bhutan.
The multimillionaire also took his electronic keyboard into New York’s subways to busk -- performing for dollar bills and change. “One of the things that makes me feel most alive is performing live,” he says.
Muller returned to work a year later on a reduced schedule while he recorded CDs and played in coffeehouses. Over the next five years, Muller’s role evolved into that of a chairman. During that time, he says, innovation slowed within the group. There were fewer new hires developing fresh ideas and that showed in the group’s returns, with competitors gaining on PDT.
Mack Backs PDT
“The gap between our results and those that we considered the best was narrowing,” Muller says. “The pace of research and innovation was not at a level that would keep us competitive.”
Ahmed declined to comment. A person close to the situation disputed Muller’s view, saying under Ahmed there were new hires and strategies and that relative performance was strong.
In 2006, Muller successfully lobbied management to reinstate him as sole head of PDT. Ahmed left the group and later joined Citigroup.
Muller pushed Morgan Stanley executives to hire new staff and raise outside capital to invest alongside it. Muller says then-CEO John Mack, who had rejoined Morgan Stanley the previous year after a five-year hiatus, offered to furnish whatever capital PDT felt it could handle. Mack, 66, declined to comment.
In August 2007, Muller confronted the greatest financial storm of his lifetime. Tightening credit markets triggered a panic as leveraged quant funds tried to exit many of the same positions.
“We were all trying to figure out how much selling pressure there was and when it was going to abate,” Muller says.
The PDT founder says he wanted to hold on to his money-losing positions, betting on a reversion. But ultimately Muller agreed with Mack that PDT should reduce its leverage and increase cash.
“If we had traded the model without cutting risk, we would have had our best year ever,” Muller says.
The bank and PDT made a similar mistake the very next year, as the subprime contagion morphed into a global rout in the fourth quarter of 2008. Morgan Stanley cut back capital, and the group lost money for the quarter.
In late 2009, Muller says, he approached then-co-president James Gorman to ask for three changes at PDT: Employees should be allowed to directly invest in its funds, PDT should be permitted to employ new strategies to attract outside capital and employees should own the group in whole or part.
Gorman, 52, said he could work on addressing the first two requests but resisted him on the third, people familiar with the matter say. Gorman, who became CEO in January 2010, declined to comment.
Today, as regulators write rules for the Dodd-Frank Act, Muller is poised to see his third wish fulfilled. Regulators are set to release a final proposal in October for implementing the ban on prop trading at banks. The Federal Reserve said in February that banks would generally have two years to comply once the rule takes effect.
Quants are laying odds that PDT will prosper on its own. “It’s an incredible opportunity to be spun out,” GMO’s Divecha says. “They have this wonderful machine that prints money. Now, they’ll be using it to print money for themselves rather than Morgan Stanley.”
As investors still bruised from past losses steer clear of quant funds, Muller is confident that PDT’s reputation will lure money his way. People close to PDT say institutions looking to make investments have already approached Muller.
Muller will also need to contend with critical matters unrelated to trading -- accounting, legal, compliance -- and build a marketing department.
“Anytime a manager goes from a proprietary-trading desk in a large investment bank to an independent business, it can be difficult,” says Robert Frey, who left Morgan Stanley in 1988 to start Kepler Financial Management, a fund he later merged into Renaissance Technologies. “It can be like taking a beautiful hothouse flower and planting it outside.”
About a decade ago, Muller co-wrote the song “I Wish I Had a Madman,” which could be the anthem for his new firm. It’s about the Spanish conquistador Hernan Cortes, who torched most of his fleet upon arrival in Mexico in 1519 to prevent his crew from deserting him on his odyssey of epic plunder.
“The men knew they had to go forward,” Muller sings. “No looking shoreward, forward to glory and gold.”
To contact the reporter on this story: Richard Teitelbaum in New York at firstname.lastname@example.org.
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