Imagine for a moment that you were approached by a very wealthy foundation, and they asked you to invest their money. They offer a low asset-based fee, but the assets are so large that it looks like a dream to you. Then they tell you the conditions:

• We want this fund to last forever.
• It must be able to deliver cash proceeds of 5% of assets each year.
• We want it to generate a return that exceeds 7%/year over the long haul.
• It must be able to do this through all environments, regardless of war, including civil war, socialism, famine, plague, etc. This is the “forever fund.”
• And if inflation becomes rampant, over 5% / year, you need to earn the inflation rate plus 2% at minimum.

You gulp, and say, “But sir, that’s impossible. The need for current cash is at odds with a forever mandate. Investing to earn the greater of 7% or 2% more than inflation is an unattainable goal. Who can predict inflation? Away from that, the record of investors during times of extreme societal stress is bad at best.”

From Bloomberg, I quote our Treasury Secretary:

“I believe deeply that it’s very important to the United States, to the economic health of the United States, that we maintain a strong dollar,” Geithner told reporters in Tokyo today.

I previously thought that I could reveal almost nothing of my visit last week to the US Treasury. As it is, I can talk about it, but not quote any officials there, nor say who was there from the Treasury.

The first surprise was that only bloggers were there. I expected reporters from major papers, but that was not the target audience. The closest thing to mainstream media would have been Megan McArdle, who presumably said she would be there (there was a placard for her), but did not show. The rest of us were independents:

After my last book review, a reader asked how I was able to read so many books, given my other responsibilities. My answer is this: I keep a book near me at all times. When I get a break, I read a few pages. Over a week, that means a book gets read. That’s how I read so many books.

I had a number of friends that liked "Nerds on Wall Street: Math, Machines and Wired Markets," by David Leinweber (Wiley, 2009), and I liked it as well. The book has a number of strengths. The author explains complex financial instruments in relatively simple terms, and the same goes for complex trading techniques.

Why don’t average investors use discounted cash flow analyses? Typically, they don’t use them for several reasons.

In a prior job, I spent a decent amount of time on Affordable Housing tax credits. The idea was to reduce my life insurance company client’s taxable income to the point where they would be close to but not subject to the corporate alternative minimum tax. Occasionally my work would take me on trips to industry conferences on Affordable Housing. When I would go to these meetings, there would be a panoply of players there — Banks, Insurers, Utilities, perhaps a health insurer or two, and a few other odd tax-focused companies would attend. In addition to tax benefits, often banks could get some amount of Community Reinvestment Act [CRA] credits for financing affordable housing.

Oh, there were Fannie (FNM) and Freddie (FRE), also. They each represented 1/3rd of the investment base, leaving 1/3rd to everyone else. So at the conferences, there would be a lot of them around. Throw a rock, hit someone from a GSE.

Bond indexes are what they are. They represent the average dollar invested in the bond markets. Those that say that the indexes are flawed miss the point. Indexes represent the average return of an asset class, with all of its warts and wrinkles. That is the nature of an index -- it earns what the asset class as a whole earns.

So what if big issuers dominate the index? The average dollar in bonds reflects that. Do you want to take a bet against the average? You probably do, and I do as well. But it is not the purpose of an index to make that bet, so much as to facilitate that bet for active managers.

1) Perhaps the US Treasury is getting a few things right. Let’s start with lengthening the average maturity of Treasury debt. I have backed this idea in the past. It is worthy to note that zero coupon yields peak out around 20 years out, and then start declining. It is quite possible that debt longer than 30 years might price at a discount to 30-year debt, if for no other reason than there is a demand for longer debt as an asset to fund longer liabilities with seeming certainty.

The US Treasury is finally getting some sense in this matter, and is looking to lengthen their maturity profile. Good for them; let’s see if foreign investors are willing to take down longer-dated dollar-denominated debt.

Most of us were kids once. I think I was a kid once, but my memory is fuzzy. I do remember playing the card game “War." Nice game, but suppose that if you were dealt a weak deck you had the option to look at the opponent’s deck, and stack yours to meet the challenge. That would be a sharp example of how game theory could be used to defeat a stronger player.

This book -- The Predictioneer’s Game: Using the Logic of Brazen Self-Interest to See and Shape the Future,by Bruce Bueno de Mesquita (Random House, 2009) -- is a little further afield than I usually go, because this is not an economics or finance book in the traditional sense. The book describes using game theory to solve complex problems, and possibly, affect the results in your favor, or, the favor of your client.

This was a book that I did not ask for. Wiley has been sending some books unsolicited. I’m not glad on all of them, but I am glad they sent this one.

When I write a piece, and entitle it “Toward…” it means that I don’t have all of the answers. Typically I think I am getting somewhere, but the speed of progress is open to question. That said, good questions and constructive criticism aid me on my way.

From Private Equity Beat at the WSJ: Toward a new theory of the cost of equity capital, on the Aleph Blog. We confess to not being entirely up on the benefits of Modern Portfolio Theory versus Modigliani-Miller irrelevance theorems, which is probably why we are journalists and not PE execs. But we nonetheless find this analysis of how to price equity interesting.

I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:

• Beta is not a stable parameter; also, it does not measure risk well.
• Company-specific risk is significant, and varies a great deal. The effects on a company with a large amount of debt financing is significant.

What did they do in the old days? They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks. If less scientific, it was probably more accurate than MPT. Science is often ill-applied to what may be an art. Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.

My research sometimes takes me into the nooks and crannies of finance. I know it is wonky, but I actually enjoy tearing into complex prospectuses in order get a sense of where value is.

One of my current projects is on large companies that have more than one share class. Some easy questions:

Since I met him at a Baltimore CFA Society meeting in 2001, I have appreciated the intelligence of Mike Mauboussin. (My old boss was his roommate in college, so I was told, the name is pronounced “MOE-bus-son.”) He was early to pick up on the value of behavioral economics and nonlinear dynamics (”chaos theory”).

I have a bunch of pieces “ganged up” to go on real estate, international economics, government policies, market risks, and a book review on “Think Twice,” but tonight the topic is pensions, with a side order of Bill Miller. Hopefully I will get to the other topics next week.

Defined benefit [DB] pension plans have run into the perfect storm: lousy equity returns and low high-grade bond yields. It makes the last great pension crisis in the late ’70s look good — at least they had higher yields back then. Thus this article from the Washington Post. Many pension plans face almost impossible odds of catching up, raising the odds significantly of more plan terminations, where the two main losers are healthy defined benefit plans, who will have to pay higher amounts for PBGC coverage, and pensioners with high benefits, because those benefits will be cut.

What makes a good ETF in the long term? My, what a question, driven by the ETFs challenging the limits of what is prudent. Maybe it is easier to start with what makes a bad ETF, then:

• Headline risk can be eclipsed by credit risk. All ETNs, Currency ETFs, and ETFs that use non-exchange-traded swaps, sometimes for commodity funds, take credit risk. Did you know you were taking credit risk?
• Roll risk — for commodity funds, trying to replicate the returns of the spot market using the futures market works only when there aren’t a ton of funds trying to do so. The flood of funds into front month futures contracts incites other funds to front-run the activity, capturing the profits that the commodity funds were trying to make. (For storable commodities, better to take delivery and store.)
• Market size risk — an ETF can become too large relative to liquidity or regulatory constraints of the market, and it no longer tracks its benchmark well — again, mainly a commodity fund problem.
• Irreplication risk — This is mainly a bond market theme, but once the ETF defines the index, only index bonds can be bought in proportion to the index. I ran into this personally in 2002, when I ask ed why a certain bond traded rich. The answer came that it was in a common index, but it was a small bond issue in proportion to its weight in the index. Many investment banks were short the note to provide liquidity, but could not source the bonds to cover the short because most were in index funds. I would keep an eye out for those bonds, and would sell them to those short for a small markup when I found them. For ETFs, the trouble is that arbitrage can’t take place, because bond buyers can’t find certain rare bonds in order to create new units in exchange for expensive ETF shares. That is one reason whey NAVs get stretched versus market prices.
• Abnormal or faddish theme — the risk is that they become too dominant in the trading of less liquid companies in their ETFs. But away from structural risks is the faddish investment risk. The ETF only gets created as the fad is about to go into decline.

In one sense, the market can reward non-consensus views, particularly when they are small compared to their relative advantage in their sub-markets. In the same way, the market can punish those that become too large for the pond that they swim in. Growth will be limited or negative. Even the efforts to create more capacity, create it at the cost of credit risk.

Analyzing currencies is weird, and most people don’t get it. Sometimes, I think I don’t get it. There is nothing fixed in our economic world, no fixed measure of value. Everything trades against everything else. Currencies exist to make the trading easier. Imagine a matrix that is millions by millions, with trillions of exchange rates for one good or asset against another. With currencies, it simplifies. Each nation prices out goods and assets in their own currency, and then currencies trade against each other, subject to arbitrage with commodities, and commodity-like assets.

Anyone who has read me for a while knows that I am not a bull on the US Dollar. But where I part ways with the grizzly bears (call me a teddy bear ), is that the fundamental accounting identities must be maintained. Whatever country of our world has the status of reserve currency must issue debt, and a lot of it, that other countries can invest in to park their idle cash balances.

While at our last denominational meeting, I made the offer to the pastors of my denomination that if they needed investment advice, they could contact me for advice. Out of eighty or so pastors that that could have asked for advice, one e-mailed me. (The pastors and elders did elect me to the pension board, to help manage the relationships with the defined contribution fund managers. I’ll do my best for them.) The pastor is young-ish, with a wife and six kids. He had 60% invested in a broad bond fund which had a high exposure to investment grade corporates and high yield (and AAA CMBS), and 40% in a stable value fund. This is a redacted version of what I wrote to him:

• Equities — somewhat overvalued at present. (US and foreign)
• Credit — Investment grade credit is slightly overvalued, and high yield is overvalued.
• Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties. There will be more defaults, both in commercial and residential.
• Yield Curve — Steep. It is reasonable to lend long, so long as inflation does not take off.
• Inflation — Low, but future inflation is probably underestimated.
• Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
• Commodities — the global economy is not running that hot now. There will be pressures on resources in the future, but that seems to be a way off.
• Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

Alas, but all good things in the human sphere come to an end. Penn Treaty [OTC:PTYA] is the biggest insurer failure since 2004. Now, don’t cry too much. The state guaranty funds will pick up the slack. The banks are jealous of an industry that has so few insolvencies. Conservative state regulation works better than federal regulation.