The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (13 page)

One day, Muller saw an ad from a small financial engineering outfit in Berkeley called BARRA Inc. for a programmer who knew Fortran, a computer language commonly used for statistical problems. Muller didn’t know Fortran (though he had little doubt that he could learn it quickly) and had never heard of BARRA. But he applied for the job anyway, interviewing for it at BARRA’s Berkeley office.

Muller strolled into BARRA’s office confident, his mind crackling with the theoretical mathematics he’d learned at Princeton. But he was completely unfamiliar with the quantitative financial world he was stepping into, having never taken a finance course. He even considered himself something of a socialist and had needled his girlfriend, a parttimer at the
Wall Street Journal’s
San Francisco bureau, about being a capitalist shill. But he was theoretically intrigued by how money worked. More than anything, he wanted to start making some of it, too.

Before the interview, Muller made a pit stop in the men’s bathroom and was horrified by what he saw: a cigarette butt. A compulsive neat freak and health nut, Muller despised cigarettes. The butt was nearly a deal killer. He thought about canceling the interview. There was simply no way he would work in an office where people smoked. Reluctantly he went ahead with the interview and learned that BARRA didn’t allow smoking in the office. The butt must have been left by a visitor.

After a string of interviews, he was offered the job, and accepted. Muller didn’t know it at the time, but he had just stepped into the world of the quants.

By 1985, BARRA was the West Coast
axis mundi
of the quant universe. The company was founded in 1974 by an iconoclastic Berkeley economics professor, Barr Rosenberg, one of the pioneers of the movement to apply the ivory tower lessons of modern portfolio theory to the real-world construction of portfolios. A tall, lanky man with a wavy mop of hair, he was also a longtime Buddhist. Rosenberg had always defied rigid categorization. In the 1960s, he’d studied how groups of patients reacted in different ways to the same medication. At the same time, he’d been collecting data on stocks, an interest that developed into an obsession. He noticed that just as patients’ reactions to
drugs differed, stocks exhibited strange, seemingly inexplicable behavior over time. There must be a logical way to find order beneath the chaos, he thought.

One way to understand how stocks tick is to break down the factors that push and pull them up and down. General Motors is a medley of several distinct factors in the economy and the market: the automobile industry, large-capitalization stocks, U.S. stocks, oil prices, consumer confidence, interest rates, and so forth. Microsoft is a mix of large-cap, technology, and consumer factors, among others.

In the early 1970s, working long hours in his Berkeley basement, Rosenberg had cooked up quantitative models to track factors on thousands of stocks, then programmed them into a computer. Eventually Rosenberg started to sell his models to money management firms that were increasingly dabbling in quantitative strategies (though few were as yet remotely as sophisticated as the high-powered hedge fund Ed Thorp was running out of Newport Beach). In 1974, he started up a firm called Barr Rosenberg Associates, which eventually turned into BARRA.

In just a few years, BARRA developed a cultlike following. Rosenberg scored a hit with the company’s Fundamental Risk Management Service, a computerized program that could forecast a stock’s behavior based on categories such as earnings, industry, market capitalization, and trading activity.

By the time Muller arrived at BARRA, thousands of managers were running money using the newfangled quantitative strategies. Rosenberg himself left BARRA in 1985, soon after Muller was hired, with a small group of colleagues, to start his own money management firm, Rosenberg Institutional Equity Management, in Orinda, California. Within a few years it was managing several billion dollars in markets around the world. (More recently, Rosenberg has drifted away from the worldly pursuit of riches and has been teaching courses on Buddhism for the Nyingma Institute in Berkeley.)

One of
the first projects Muller worked on at BARRA concerned an analysis of the various components of stock returns, the bread and
butter of BARRA’s factor models. Just before he left, Rosenberg took a look at Muller’s work and demonstrated his ability to see the push and pull of economic forces at work in the market.

“This factor must be oil prices,” he said. “Look at the spike during the energy crisis. … And this one must be related to interest rates.”

One problem: Muller had screwed up the math and the data were bunk. He reworked the analysis and sheepishly showed the results to Rosenberg.

“This makes much more sense,” Rosenberg said. “This factor must be the oil factor. … And here’s where the Fed came in and tightened.”

While this showed that Rosenberg could quickly convert math and models into real-world events, it also demonstrated that the models could fool the best in the business. Even with all the high-powered math, there always seemed to be a bit of the witch doctor in Rosenberg and the quant methods he spawned. The constant search for hidden factors in market prices could turn into a voodoolike hunt for prophecies in chicken entrails, dark portents in cloud shapes.

The relaxing, sun-splashed atmosphere of BARRA was something of a revelation to Muller after the do-nothing burbs of Jersey and the cloistered corridors of Princeton. It was the mid-1980s. Nostalgia for the sixties was on the rise. And there were few better places to catch that wave than Berkeley, a short hop to the surfer hangouts at Half Moon Bay and the hippie haven of Haight-Ashbury. Of course, working for a financial research outfit didn’t exactly fit the classic hippie mold, but Muller was fine with that. He’d had enough of scrounging for money, playing music for peanuts. The $33,000-a-year salary he was making at BARRA was a boon, and there was certainly more to come. Most of all, he was determined that however much money he made, he wouldn’t turn into Ebenezer Scrooge. Rosenberg had already set an example that one could make buckets of money and still retain a sense of spirituality.

And life was good at BARRA. The casual atmosphere. The go-easy dress code. The only guy seen in a suit was the company’s marketing chief. Employees would take long lunches to talk about academic theory, politics, world events. Muller had a girlfriend and was playing part-time in a jazz band. Once a month, a group of employees
would take late-night runs under a full moon, followed by a trip to a bar or, even better, an ice cream parlor.

Muller quickly learned Fortran and worked on fixing code for the company, but he was itching to learn more about the real work going on at BARRA: financial modeling. He put aside his music and buried himself in the literature of modern portfolio theory: Eugene Fama, Fischer Black, Robert Merton, the classics.

He was also becoming drawn into a new hobby: poker. He started haunting the Oaks Card Room in Emeryville, a twenty-minute ride from BARRA’s office. He devoured poker strategy books and was soon cleaning up at the Oaks’ high-stakes tables.

Gambling turned into an obsession. Muller would spend ten to fifteen hours a week playing cards at the Oaks. Sometimes he dove into marathon sessions that tested his endurance. Once he started playing at 6:00
P.M
. after work on a Friday and didn’t stop until 10:00
A.M
. that Sunday. Driving home, he was so exhausted that he fell asleep at a stoplight.

In 1989, Muller got an assignment to do some work for a new BARRA client, a hedge fund operator called Renaissance Technologies. Jim Simons was looking for expert help to solve a thorny problem he faced with one of his funds named Medallion.

The problem involved the most efficient use of Medallion’s spare cash. Muller’s solution was so clever that Renaissance offered him a job. But he was skeptical and turned down the offer. Still under the spell of academia, he believed in Fama’s efficient-markets hypothesis and the mounds of research that claimed it’s not possible to beat the market over the long haul.

He soon changed his mind about that.

By
1991, Muller was pulling down a hundred grand a year. He lived in a beautiful house in the Berkeley Hills with his girlfriend and had a great job with enough spare time for his jazz band, gobs of poker, and surfing on the side. But he wanted more.

That year, BARRA went public. To Muller, the company seemed different after the IPO, less hungry, less energetic, less creative. A number of employees, good ones, left for other companies or to work
on their own projects. Muller had an idea he thought could breathe new life into BARRA: use the quantitative models it developed for clients to manage its own money. In other words, set up an internal BARRA hedge fund. He had just the right people to run it, too: his poker buddies from the Oaks, all BARRA employees.

The firm’s higher-ups scotched the plan. It wasn’t a good idea to launch a risky operation so soon after the IPO, they said. Andrew Rudd, BARRA’s CEO, suggested Muller create new models to forecast returns for stocks and sell them to clients. It wasn’t quite what Muller had in mind, but he agreed. In short order, he helped design BARRA’s best-selling Alphabuilder system, a PC-based software program that could analyze expected returns for stock portfolios.

Then he quit.

“Who the
fuck are you, and why the fuck do you get an office?”

“I’m fucking Peter Muller, and I’m fucking pleased to meet you.”

Muller stared bullets at the wiseass Morgan Stanley salesman who’d barged into his office as though he owned it. Muller had only recently begun setting up a quantitative trading group at Morgan, and this was the reception he got?

It had been like this since the day he arrived at the bank. After accepting a job at Morgan, and with it an incredible increase in pay, he’d given notice at BARRA and taken six weeks of R&R, spending most of it in Kauai, the lush, westernmost island of Hawaii. The transition from the placid green gardens of Kauai to the rock-’em-sock-’em trading floor of Morgan Stanley in midtown Manhattan had been a rude shock. Muller had been promised his own office and a battery of data sources before his arrival, but on his first day at the bank he saw that none of his requests had been met.

Until the promised office arrived, he’d found a seat at a desk in the middle of Morgan’s football field of a trading floor and called a former BARRA colleague, Tom Cooper, who was working at a hedge fund in Boston.

“How can you work in an environment like this?” he asked.

Suddenly a woman sitting next to him grabbed the receiver from his hand. “I need that phone!”

Muller stared back in shock as she barked out trades that involved markets in Chicago and Tokyo. Politeness wasn’t an option when money was on the line, Muller was learning. BARRA and its quaint quant models suddenly seemed a world away.

A friend sent Muller congratulatory flowers for his new job. The bouquet was delivered to his desk on the trading floor. It was raw meat to the grizzled traders around him:
Look at the California quant boy and his pretty flowers
. What had he gotten into? Muller wondered. The energy was maddening. Everyone was packed like sardines, shouting, sweating—and wearing suits!

This wasn’t California. This certainly wasn’t Berkeley. This was New York fucking City, this was Morgan fucking Stanley, one of the biggest, most aggressive investment banks in the world, and Muller was right in the boiling heart of it.

ASNESS

The muscular professor strode to the podium and faced yet another roomful of bright-eyed students eager to learn the secrets of how the stock market really worked. The professor, Eugene Fama, had been teaching at the University of Chicago since the early 1960s. Now, in September 1989, he was universally acknowledged as one of the brightest thinkers about financial markets and economics on the planet. Fama ran a hand across his balding head and squinted at the gangly sprawl of twentysomethings before him.

One trait about Fama that immediately jumped out to new students was his forehead. It was unusually large, high, and wide, traced with a stack of deep-cut lines that undulated like waves as he barked out wisdom about the markets in his Boston brogue as if agitated by the powerful thoughts percolating in his basketball-sized cranium. Clad in a loose-fitting blue cotton button-down shirt and tan chinos, he seemed more a refugee from the school’s philosophy department than a tough-minded guru of the money set.