Do You Have What It Takes To Make It At A Hedge Fund? The Neal Berger Interview

Editor’s Note:

The following is an interview done by Dave Goodboy in conjunction with
RealWorldTrading.com.

After you read the interview, talk about it
here.

Brice

Hi I’m Dave Goodboy,
Executive Producer of Real World Trading.  Today, I am fortunate enough to be
here with Neal Berger who is President and Managing Partner of Apogee Asset
Management, LLC in New York City.  Neal has extensive experience in both trading
and managing hedge funds.  I am thrilled to be able to interview you, Neal. How
are you today?

 

Neal: Very Well. Thank
you Dave for taking the time to speak with me today. 

 

Dave:
My pleasure, I understand that you run quite a large hedge fund located on Fifth
Avenue in NYC. Let me start out by just asking you a little bit about your
trading background.  What initially got you into the market?

 

Neal: Well, I have been
on Wall Street for the past 18 years.  15 of those years I have been a
Global-Macro trader.  I started my career at Morgan Stanley. Subsequently, I
went to Fuji Bank, which is now called Mizuho. I believe it is the largest bank
in the world.  I traded primarily the US interest rate market on a directional
basis, looking at things like Fed Policy and the direction of interest rates.  I
spent about four and a half years there.

 

Dave:
Was that in Japan?

 

Neal: No, that was in
the World Trade Center in New York.  I was actually there during the ’93 bombing
which was a scary enough experience. Fortunately, I wasn’t there for the bombing
that happened in 2001.  After I left there, I went to a hedge fund called
Millennium Partners, which at that time was a $90 million hedge fund, relatively
unknown.  Today they are about $4 billion and one of the most successful hedge
funds in the business.  I was lucky to get into a hedge fund on the ground floor
that had become as successful as it has. 

 

Dave:
How long did they exist before you started with them?

 

Neal: Millennium had
actually been around since 1989 and I joined in 1995.  They had already been
around for six years.  At that time, capital-raising for hedge funds wasn’t as
robust as it is today. Today guys are going from zero to $1 billion in two
years. Millennium started with about $30 million and by 1995, even including the
growth of capital and capital-raising, they only had about $90 million. This was
considered normal back then. It really was a different environment for raising
capital.  Hedge funds in general were very much thought of as a peripheral type
of investment.  They weren’t considered the mainstream investment that they are
today.  Just to continue on with my career, I joined Millennium where I was
trading Interest Rates, Currencies and major commodity products.  I did very
well, got a bunch of guaranteed packages around the street, and ended up going
to Chase Bank to be one of their Senior Proprietary traders.  I spent a couple
years with Chase, and then went to work for a family office.  The family office
was that of a gentleman who had been investing in hedge funds since 1973, and
was one of the pioneer investors in hedge funds.  I worked inside of his family
office running a global-macro portfolio with an idea toward building a track
record and using his contacts to raise a substantial hedge fund while at the
same time act as his hedge fund allocator. I would go around and meet his
existing suite of managers, which were some of the most famous managers in the
business.  I would, also, be his first line agent to meet new managers as well
as run my global-macro portfolio.

 

Dave:
Can you name some of the managers that our members might know?

 

Neal: Sure, Stan
Druckenmiller, Steve Cohen, Julian Robertson. There weren’t that many managers
around in 1973.  He also had relationships and contacts with other high net
worth individuals and they sort of gravitated toward these managers.  He likes
to say he invested with Julian Robertson before Julian Robertson became Julian
Robertson. 

 

Dave:
Wow!  You really got right into the Who’s Who of the
business.

 

Neal: Yes, he is an
investor in my Fund today.  It was a good opportunity to meet some of these
superstar managers and really learn some of the strategies they were deploying
and to gain exposure to new managers that were coming in looking for his
capital.  Obviously a new manager, someone who is looking for your capital, and
marketing to you, is very willing to open up and tell you exactly how they are
making money and exactly what they are doing.  It is a very good opportunity to
learn about strategies and how people are making money when you are an
investor.  Unfortunately, 1998 hit, the year of the Long Term Capital collapse
and my global-macro portfolio was down 2%.  We felt that the original premise of
starting this hedge fund which was to raise a substantial amount of money was no
longer going to be possible in light of the fact that it was going to be very
difficult to raise capital being down a couple of percent the first year out of
the gate.  This was especially true in an environment where the technology
managers like Larry Bowman and Janis were all making 30-40% returns.  It became
apparent that we weren’t going to be able to execute on the initial vision that
we had set forth.  At the same time, Millennium Partners had grown to be a $1
billion hedge fund.  At that time, Israel Englander, the general partner of
Millennium, asked me to come back to work for Millennium, which I did to trade a
much more significant portfolio since he had grown.  1999 was a moderate year
for global-macro.

 

Dave:
Tell me about the global macro strategy.  How does it work?

 

Neal:  Global-macro is a
very environmentally dependent business.  Most global-macro traders are
essentially trend followers, and if there are good trends that are in place in
the market it can be quite a successful strategy.

 

Dave: 
The trends in oil, the dollar and some metals seem to fit the global macro niche
presently.

 

Neal:  Exactly, we have
a big trend in the dollar, gold, silver, and oil.  It’s a great environment for
global macro guys.  Trends usually coincide with a turbulent global landscape
where there are episodes of war, upheaval, inflation, depression, recession and
that sort of thing.   However when the landscape is very serene, like it was in
1999 where there were very few episodes of war, if any, or inflation, or
recession, there are very few trends in the market. As such, it becomes very
difficult for a global-macro trader.  We made a small to moderate amount of
money in 1999, and I approached the General Partner of Millennium in early 2000
with the idea of going to trade some equities and he introduced me to one of his
very close friends who had been an equity trader for over 35 years.

 

Dave: 
Did this trader have any special or unique strategies that he taught you?

 

Neal:  Yes, his game was
basically getting very large allocations of newly issued IPOs. I did that for a
while and was extremely successful. I like to call it relationship arbitrage, or
information arbitrage.

 

Dave:
Can you explain what you mean by “relationship arbitrage”?

 

Neal:  Sure. It’s
essentially knowing the right people in the various investment banks who can
benefit you by giving you large allocations of IPOs or other useful
information.  Obviously, you need to pay those people appropriately so that they
have incentive. We had a nice little run, but unfortunately, a dollar shy and a
day late, that business sort of died with the collapse of the NASDAQ and the
lack of new issues.

 

Dave: 
What happened next ?

 

Neal:  I found myself in
2001, examining my skill set whereas I had traded successfully every product
available and I had been exposed to many, many attractive strategies.  I had
been an investor on behalf of the family office, and having worked at arguably
one of the premiere multi-strategy funds in the business, the natural course was
to create a multi-strategy, quantitatively oriented fund similar to my former
employer Millennium Partners which had an outstanding track record over 14
years.  Roughly speaking, they are up almost 17% annually with very few drawdowns to speak of.  That is basically the genesis and the formation of how my
fund came about. 

 

Dave: 
You basically modeled Millennium?

 

Neal: Well yes.
Millennium doesn’t have a franchise on multi-strategy funds.  Obviously, since I
had worked there on two occasions it’s natural that the way that fund does
business is going to have an influence on how I am doing business here at
Apogee.  Especially since they have been very successful, there is no reason not
to emulate their success.  I think some of the larger funds, Millennium
included, that are running $3-5 billion have a very large hurdle or benchmark to
overcome on an annual basis, in terms of the amount of dollars they have to
extract from the marketplace in order to have a reasonable return. 

 

Dave:
Their size hurts them?

 

Neal: Right, when you
are running a $4 billion fund and your annualized net return is 17%, you have to
take $800 million-$1 billion in profit out of the marketplace to be consistent
with your long-term average. That is a very difficult task in some environments.
Some years that is entirely possible when there are enough edge-providers out
there.

 

Dave:
What do you consider “edge providers”?

 

Neal:  Edge providers
are normally the retail public or the retail public through mutual funds.  When
there is not enough activity by those players, all the arbitrageurs have
difficulty. In a year like this, where the edge-providers have not been as
active in providing the edge, while at the same time the number of hedge funds
out there competing for that edge has increased dramatically, the landscape for
Arbitrage has been quite difficult.  The demand-supply equation for capturing
edge is much more unfavorable and its much more difficult to extract that kind
of money out of the marketplace on an annualized basis in this environment.

 

Dave:
What would you say is the ideal size of a hedge fund
today?

 

Neal: Well, when you use
the word hedge fund it’s a very ambiguous question because different hedge funds
pursue different strategies.  If you are a global macro hedge fund, a CTA or a
Long/Short Fund, there really is not much limitation.  I’m really in the
arbitrage world, and in the arbitrage world, I would estimate we should not be
running more than $1-2 billion worth of assets.

 

Dave:
Give me a definition of what you mean by arbitrage and why account size will
hinder you.

 

Neal: An arbitrageur is
essentially, a scavenger trying to capture pieces of meat, so to speak, that are
being thrown off by the larger edge providers.  By definition you need to be
smaller in order to capture these scraps.  In other words the edge-providers
need to outweigh the edge-demanders, or the arbitrageurs.  So in the current
environment I would say $1-2 billion or $1.5 billion maybe. Obviously, the
current environment is different from the environment that existed two years
ago, and it will be different from the environment that will exist two years
from now.

 

Dave:
I see. It’s constantly in flux.

 

Neal:  Exactly. 
Typically, I view myself as someone who is trying to follow the baitfish around
the world. The baitfish are the retail investing public, speaking in terms of an
arbitrageur.

 

Dave: 
That’s a cool and easy to understand analogy.

 

Neal:  The retail public
either invests directly, or they invest through mutual funds, or pension funds,
and those are usually the long only, indiscriminate buyers and sellers.  This
asset class has generally lost their love affair with European and U.S.
equities.  For example, maybe in Asia you are starting to see a lot of flow of
retail investments toward that region.  Consequently, we have started looking at
a lot of Asian arbitrage opportunities but so are a lot of other arbitrage hedge
funds.

 

Dave:
Let’s get back to the basics.  Can you define what a hedge
fund is?

 

Neal: The old joke is a
hedge fund is anything you can slap a 1 and 20 fee structure on, meaning, a 1%
Management fee and a 20% incentive fee. There is some truth to that.  Everyone
wants to call themselves a hedge fund nowadays because its sexy, and quite
frankly, the fee structure is generally higher when you call yourself a hedge
fund.  In fact, there has been a push recently to start some long-only hedge
funds. I am reading the most current issue of “Hedge fund Alert,” it says
‘Sirios Capitol jumps on long only bandwagon’.  This is on the front cover. 
There are a lot of hedge funds that are just starting long only funds. I heard
that Steve Mandel of Lone Pine is starting a Long-only fund now.

 

Dave: 
What’s the official definition?

 

Neal:  Ok, here’s the
legal definition:

Hedge
Funds are any type of Private Investment Partnership operating under certain
exemptions from registration under the Securities Act of 1933 and Investment
Company Act of 1940. They are alternative investment vehicles tailored to the
needs of sophisticated, high net worth investors. The term ‘hedge fund’ is a
misnomer as hedge funds do not necessarily employ hedging strategies. Hedge
funds are generally structured as a limited partnership with a General Partner
responsible for the investment activities and day-to-day operation of the fund
and, Limited partners, who are investors providing capital but not participating
in the operation of the fund. Limited Partners have limited liability. Their
exposure to loss is limited to their investment. The General Partner has
unlimited liability and is liable for the activities of the partnership.

Hedge
funds are generally free to undertake potentially more risky and volatile
positions, thereby exposing investors to potentially substantial profit, as well
as, substantial losses. Given the high risk nature of such investing, Hedge
funds are prohibited from general advertising and are required to limit
investment to ‘accredited investors.’ An accredited investor is either any
natural person whose individual net worth, or joint net worth with that person’s
spouse exceeds $1 million at the time of purchase or, any natural person who had
an individual income in excess of $200,000 in each of the two most recent years
or joint income with that person’s spouse in excess of $300,000 in each of those
years and who reasonably expects reaching the same income level or greater in
the current year.

The fund manager
enjoys full flexibility to take positions in markets as appropriate and is
generally compensated with a management fee to cover expenses plus an incentive
fee (generally 20% of profits) based on the profitability of the fund. This
compensation structure gives the manager an incentive to provide investors with
absolute returns. Typically, the manager makes money only if the investors make
money. Currently, there are approximately 7,000 funds with over $900 billion
assets under management.
 

Dave:
Did you see the latest on Mark Cuban and his new gambling hedge fund?

 

Neal: Yes, and I think
that is actually closer to a hedge fund then a long-only hedge fund.  To me, a
hedge fund is a vehicle that allows the manager the greatest amount of
flexibility and the least amount of constraint to pursue any and all
opportunities that present themselves. As a result, it is generally unregulated,
but at the same time its only meant for a certain type of investor who can
afford to hire advisors to evaluate the investment or, in a worst case scenario,
can afford to lose the money that they put into the fund, hence the accredited
investor rule.  The lines between what is a hedge fund and what is a mutual fund
are certainly blurring.  Everyone wants to be associated with the word hedge
fund and be a hedge fund.  There is a half-truth to what I said before jokingly
that a hedge fund is anything you can slap a 1 and 20 fee structure on. 

 

Dave: I
know there is some standard paperwork that is involved in every hedge fund.  Can
you tell us a little about the offering circular and subscription agreement?

 

Neal: Things are
changing with the new SEC regulations to require hedge funds to become
registered but that won’t take effect until 2006.  Up to now, you are basically
required to put forward an Offering Memorandum, a Limited Partnership agreement,
and a Subscription Document.  This is primarily the entire scope of
documentation necessary.   The Offering Memorandum, and Limited Partnership
agreement basically state all the rights and obligations of the fund, and all
the rights and obligations of the investor.  They are usually written quite
broadly to give the manager the most authority to execute on what they would
like to do.  The subscription document is meant to qualify the investor, and ask
the investor questions about their net worth, and their investment experience.
It’s not dissimilar from a brokerage account questionnaire where they ask you
how many years of experience you have, your net worth, etc. That’s really all
the documentation up until now that has been necessary.  This is a private
placement, private investment partnership and up until now has generally been
unregulated by the SEC. 

 

Dave:
I bet many hedge fund managers are concerned about these new regulations.  When
do they take effect?

 

Neal: Yes, I believe it
is February of 2006.

 

Dave:
What exactly are these new regulations.  Are manager going to have to have a
Series7 license?

 

Neal: Probably a Series
7 amongst other things.  First of all, it’s a regulation that pertains to any
hedge fund that is running more than $25 million.  This actually excludes quite
a large amount of the universe.  Out of the 7-8000 hedge funds that are out
there, the average (median) size is only $10 million.  Amongst all the numerous
hedge funds out there, many of them, fall under the category of even having to
register because they run less then $25 million.  But for hedge funds that run
more then $25 million, they will be required to register with the SEC. This is
an effort by the SEC and some of the other regulators to respond to the
increasing popularity of the investment vehicle.  We have almost $1 trillion in
actual cash invested in the asset class, and when you leverage that, it is
obviously multiples of this amount.  The asset class requires some type of
regulation and oversight and I think it’s a good step that they are moving in
that direction. 

 

Dave:
OK, is your fund global macro?

 

Neal: Well we aren’t a
global-macro fund.  I myself am a global-macro trader.  I come from a
global-macro background.  We are a multi-strategy, quantitatively oriented
arbitrage fund. 

 

Dave:
Tell me some more fund strategies and types of hedge funds.

 

Neal: Sure, obviously
the most popular hedge fund is the ‘Long/Short Fund’, which is very simple. 
They are generally just stock pickers who choose a portfolio of longs, and a
portfolio of shorts.  Some of them are dollar neutral, meaning they have an
equal amount of longs and an equal amount of shorts.  But most of them have a
long bias where they keep some net long exposure to the marketplace, and that is
probably the most popular hedge fund structure.  It is also the simplest to run,
and the simplest for an investor to understand, which is probably why it is the
most popular.

 

Dave: 
That sounds just like a mutual fund that would be allowed to go short.  Nothing
fancy there.

 

Neal:  Yes, but for the
most part, many people feel, and I agree, that those types of hedge funds are
not much more than de-leveraged long funds.  They will generally underperform
bull markets, and outperform bear markets, but it is the most popular strategy. 
Amongst other strategies are, Convertible Arbitrage funds.  This is where
certain hedge funds are involved in buying convertible securities and stripping
out the components. There is a certain embedded optionally within a convertible
bond which a manager is looking to capture.  It is not an area that I am overly
familiar with, so I really can’t go into it too much because it really isn’t my
area of expertise.  But it is a broad category of hedge funds that get involved
in convertible trading. 

 

Dave: 
I see, the convertible arb fund is sort of like having a preferred stock and a
regular stock issued on the same company, so you short one and buy the other?

 

Neal: I think that is
more into the capital structure arbitrage space. Capital structure arbitrage is
another strategy within the hedge fund universe.  Typically you will trade the
senior debt versus the junior debt, or debt versus equity, or maybe credit
default swaps versus puts, and things like that.  You might be right. 
Convertible bond arbitrage is not an area that we are focused on because we feel
it is a pretty saturated strategy.  There is a lot of money already invested in
that space and it is just not something that we are overly focused on but it is
a category of hedge funds.  Another category is Event Driven type hedge funds. 
Again, a lot of these categories are very broad.  Event driven can mean anything
from distressed, to merger arbitrage, and everything in-between.   Anything that
essentially has a catalyst.  Sometimes these categories are made very broad to
allow the managers the greatest amount of latitude within its framework to
explore any possibilities that may exist.

 

Dave:
A successful trader that wants to start a hedge fund, can
you offer any advice for somebody like this?

 

Neal: Sure, but a hedge
fund isn’t just about being a successful trader, although that certainly helps,
or being associated with successful traders. A hedge fund is also running a
business.

 

Dave:
So it takes much more than just trading skill to manage a hedge fund?

  

Neal:  Yes, there are
things involved in running a hedge fund like marketing, administration, investor
relations, legal, and accounting, that just because you are a successful trader
doesn’t necessarily mean that you are talented at any of the other aspects of
it.  Particularly, I would emphasize capital raising.  I have seen many a
successful trader not be able to get of the ground and not be able to make any
head-way simply because they are not really good marketing people. They don’t
have the connections and they don’t have the ability to market their product.
Sometimes it’s very hard to do that task because you are so focused on trading. 
But marketing is a job in and of itself.  You are called away to meet with many
investors and to go make presentations and things like that.  The marketing
aspect doesn’t necessarily go hand and hand with being a good trader.  It’s
doable if you are capitalizing the fund yourself, where you have enough money to
feed yourself and build a track record, and we are talking about a substantial
amount of money. If you are just going to just thread water with $5-10 million,
it’s going to take you a long time to get to $100 million+ unless you have a
good marketing engine.

 

Dave:
Is there a way around having to market the fund yourself?

 

Neal: You can always
hire third party marketers and people like that, but at the end of the day,
people want to meet the actual portfolio manager and that the portfolio manager
MUST be able to articulate his/her vision in a concise and effective manner. 

 

Dave:
These marketing firms, do they work off a percentage basis or do you pay an
upfront fee?

 

Neal: Many of them will
attempt to get an exclusive relationship with a hedge fund, many will ask for a
retainer.  I myself work with a couple of marketing firms.  I don’t have any
exclusive relationships and I don’t give any retainers.  I pay them purely on
success based compensation scheme. If they raise me assets, generally the
standard fee in the industry is to pay these marketers 20% of the General
Partner’s earnings on any capital that has been introduced into the hedge fund

 

Dave:
Along the same lines, not in marketing, but do you pay for strategies and
trading tactics?

 

Neal: Yes, occasionally,
we utilize headhunters, or recruiting firms, which obviously is a very
formalized arrangement.  If we do have somebody that we have a relationship with
and they bring us a superstar trader, and somebody that we think fits into the
fund, we are certainly willing to compensate for that.  One of the greatest
challenges that the hedge fund industry faces, as a hedge fund manager, is not
necessarily getting capital.  There is a tremendous amount of capital flowing
into the business.  It’s that we are all competing for the top talent.  Even the
firms that are completely closed to new capital, some of the most famous firms
in the world, are all looking for very, very talented individuals who can run
some of the money. Competition for talent is very high up there on the priority
list. If someone is able to find talent for me, I am certainly willing to
compensate them for that.  With that said, the caveat is that we are extremely
selective.  We have a very strict criteria of who we are interested in bringing
on, and that they have a very specific edge. We are interested in strategies and
traders that exploit a legitimate and specific edge in the marketplace. We want
strategies that not only exploit an edge, but that are repeatable. The trader
must have good risk control, a good pedigree and a good track record.  The
selection process is quit stringent. 

 

Dave:
What instruments does Apogee trade?

 

Neal: We trade a lot of
different instruments because we have 10 different strategies.

 

Dave: 
Can you tell me the 10 strategies?

 

Neal: Currently, we are
involved in Equity volatility arbitrage, International Statistical Arbitrage,
Closed-End Fund Arbitrage, Capital Structure Arbitrage, Odd-Lot Mortgage
Aggregation, Commodities Trend Following, Environmental Credits Trading,
Systematic Pattern Recognition, ECN rebate trading, and PIPES.

 

So we trade everything from
U.S. equities, U.S. options, foreign equities, meaning Italy, Spain, France,
Belgium, Portugal, Netherlands, Japan.  We also trade mortgage securities,
closed end funds, credit default swaps, oil futures products, probably a bunch
more that I am not even thinking of at the moment. 

 

Dave:
So pretty much the entire spectrum?

 

Neal: Yes, pretty much. 
We trade environmental credits, pollution credits.  We trade a whole broad
spectrum of products that we think we can deploy strategies that legitimate
edges and inefficiencies.

 

Dave: 
I know you guys traded using the market timing strategy
before it was declared illegal.  Can you tell me a little about “market timing”
and what this means in the hedge fund world?  I know it has a very different
meaning than typically thought of by day traders.

 

Neal: Market Timing, as
it is known in hedge fund circles, typically involves the trading of Mutual
Funds at ‘stale-priced’ NAVs. To be clear, the strategy has not been declared
illegal. What has always been illegal is the trading of Mutual Funds after the
final calculation of the NAV, which has recently been interpreted as 4 pm
(Martin Act). Furthermore, quid pro quo relationships with the Mutual Fund
companies in an effort to garner specialized treatment has been deemed improper
and severe penalties have been paid by those engaged in such practices. With
that said, Apogee had never engaged in either of those practices and thus, has
never come under fire in it’s usage of that strategy. However, as the strategy
has been tainted or is otherwise considered taboo, Apogee has for some time now
abandoned all strategies that involve the trading of Mutual Funds. Furthermore,
the Mutual Funds have materially changed their pricing methodology thus
rendering this strategy all but ineffective presently.

 

Dave:
Well, Neal, thank you for joining us today.

 

Neal: My pleasure, thank
you for taking the time. 

 

 

Editor’s Note: You can find more great
trader interviews at www.realworldtrading.com.

 

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