The Earning Power of Art

"Art Is A Fairly Simple Investment Vehicle" Article by Craig Mattoli Much to my surprise, I continue to hear a lot of talk about art funds and art stocks and their success at attracting investors, especially, here, in China. We even recently wrote a commentary about art funds, brushing off the very idea for anyone serious about investing in art. In the meantime, we keep hearing about more people jumping into the fray. In China, more and more people seem to be getting into the auction business, which has its shady side, and opening art stock funds and exchanges, too. And while sitting through a boring slideshow about why art can make money, I had a change of heart about the usefulness of these new art investment vehicles. So, let us step back, first, to look at the basics of finance. Finance is the allocation of funds over time under conditions of risk. The central precept of financial theory is that an investment is worth the present value of its expected future cash flows, discounted back to the present at the investor’s required rate of return. Ex post, a return can have come from some kind of cash flow, like dividends, partnership distribution, and interest, and/or from capital gains. The focal point, then, becomes percentage annual return on investment, which is dollar return divided by investment. The other important detail from financial theory is that returns can be further enhanced with leverage and that risk can be diminished with hedging. The object is to get high return on investment, while minimizing risk. And it is as much an art, as art, itself. For traditional investments, like stocks, bonds and commodities, the asset backing the security contract is capable of generating cash from sales of a product at a fairly certain price, in the regular economy. A company makes earnings by making and selling computers, and from its net cash flow it can pay interest to bondholders and dividends to stockholders. A stockholder leverages his returns, first, through the use of cheap money provided by bondholders and by leveraging his own equity through margin borrowings against his stock. He can also make a capital gain or loss when he sells his holdings. A buyer of wheat futures can leverage his initial investment with margin borrowing and sell the wheat to a miller on the spot market at delivery time. A farmer could hedge the sales price of crops he just planted by selling wheat futures due for delivery at harvest time. Of course, the traditional investment industry has spawned many new products. There are options, real estate investment trusts, securitized mortgages, investment funds, investment advisors, investment analysts, investment consultants, and funds of funds, to name a few. From its primary businesses: collecting brokerage fees, investment banking fees, and income from proprietary trading, all low risk or no risk businesses, the investment community has grown with the growth of its products. For the most part, those additional products are simply repackaging of the original traditional products; the ultimate packaging among them, over-the-counter derivatives. The idea behind some of the repacking is what is known in behavioral finance as reframing, usually with an obscure frame to show to the potential investor. The broker-dealers, the “sell-side,” are the real professionals. In addition, there is a “buy-side” of the investment business, which includes large institutional investors, funds, and retail investors. Indeed, more and more, over the past quarter century, the buy-side has tried to subsume or move more into the businesses of the sell-side with many examples of disastrous results leading to a number of financial crises. Investment products are created by both the buy side and the sell side, and the buy side has also moved into the fund business, during all of the merging and reshuffling that has gone on kin financial markets over the last few decades. Art is a fairly simple investment vehicle. In art, income is mostly in the form of capital gains. The institutional investors are museums, foundations and other large collectors, including corporations. Some of those institutional investors are capable of generating some cash flow from effective rental of art by selling admission to viewings and trading in exhibitions. Many museums do not do much trading in art but, instead, get art loans and gifts from collectors. Art dealers are the central professionals, and auction houses act as wholesale exchanges, mostly as brokers, but not, normally, as dealers. Art dealers maintain inventories of art. They also do IPO’s of new art and act as market makers for their artists. They also function as brokers for other dealers and collectors. They can get one hundred percent interest-free leverage with no downside risk, in some of the transactions and services that they perform, acting as agents for artists and art sellers. They can earn commissions and can make capital gains. They might also generate income with charges for exhibitions or other types of space rental and from rental of art, itself. Thus, art can generate capital gains as well as ordinary income. It can also be highly leveraged. Only an art dealer can be short against the box, which can be done, only, by broker-dealers in securities, too. In this situation, the dealer is effectively both long and short the same thing, with a percentage spread locked in. Moreover, dealers offer a display area, both in galleries and online. Art auction houses can take advantage of some, but not all, of the same types of leverage. For example, in the case of guarantees, they are giving a put option to the seller. Normally, dealers do not offer puts. Art derives its value from quality of workmanship, scarcity, and its use for display or interior decoration. In display in museums, it generates ticket income or rental income from rentals to other museums. However, it seems that the income that many museums generate is insufficient to sustain their display businesses, in that many receive supplemental funding from donations, loans and gifts, and some have even had financial problems or closures, recently. For interior decorating, some antique fixtures, like beds, chairs and couches, serve functional purposes for interior outfitting. Others, like paintings and sculpture, are purely for visual satisfaction and enjoyment but are, by no means, necessary for nest building. Marketing and relative valuation give art its additional value. First art is valued relative to other art. Then, art is valued relative to other investment assets and necessary items of living. Thus, the value of much of art is tenuous, and there are examples of artists whose art has been in one day and practically worthless, the next. There has also been much volatility in art prices of even established artists, over the years. Art funds are basically an attempt to leverage art, not the way that dealers do, but by using other people’s money, not the manager’s. However, although the fund manager can make fees, the only way that the fund can earn returns for investors is from sales of art. The only way that investors can get money is from distributions of fund proceeds, if any, after sales are made, unless they can sell or cash out their fund investment, which is in most cases restricted. Investors also cannot enjoy the benefits of leverage or hedging. Moreover, how will sales of their art be effected? The choices for these funds are to sell privately or through auctions or dealers. However, unlike liquid investments, like stocks, art sales usually cannot be done on demand. Foot leather is required for private sales, sales through dealers can take time, and sales to dealers or through auctions houses are at discounts to retail value. Thus, there are severe limitations on both returns and risk management for investment in art funds. In the end, they provide a source of income for the creator and manager, just like other packaging in the investment business does. They also fit a perceived need or profile, just like other investments designed by the investment community. Art stock exchanges, with limited numbers of stocks with very limited capitalizations, have popped up in several cities in China over the last year. These art securities cover portfolios of one artist’s works. The initial experiences were blowout pricing, resulting in indeterminate closure of trading. An art stock exchange was also opened in France. Certainly, if any depth of these markets were developed, they could be used by collectors, art funds and dealers alike if there were, in addition, the ability to sell them short. Then, you could hedge your actual art portfolio. Problems are: the ability to short, liquidity of the markets, limited number of artists and works covered, and mismatches of the underlying art-stock portfolio composition versus works held by an investor. In summary, we see that art is useful for display, either for earning money from pay-for-view or, simply, for personal enjoyment. However, funds take advantage of neither of these aspects of art but only seek to benefit from eventual realized capital gains. Moreover, like funds of stocks, art funds will stay invested in art, in up markets and in down, and the ability to liquidate, in down markets, is much more limited than, say, it is for stocks. Funds also cannot take advantage of other tactics that are available to professional dealers, like maintaining partial monopolies on art and zero-cost leverage. Although that market does not have enough depth, at this point in its development, the art stock market could be potentially useful for real investors, in art, not as a means of investment but to hedge their real positions in art. Of course, in the absurd limit, if all art were held by funds and securitized, it would no longer have any intrinsic value at all. After working on a PhD in mathematical physics, Craig Mattoli received an MBA at NYU’s Stern School of business and worked on Wall Street as an arbitrageur in the 1980s. Having been a collector of artistic things since age six, he accelerated his art purchases during his Wall Street years, and in the 1990s, bought and renovated an 18th century estate near New Hope, Pennsylvania, and created an internationally recognized art inn. After selling the inn in 2000, he eventually ended up in China. He is, currently, CEO of Red Hill Capital Corporation, which specializes in arbitrage and inefficient markets and owns Leona Craig Art with a gallery, in Guangzhou. He also teaches finance and economics at South China Normal University.

The Earning Power of Art

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Published December 12, 2011

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The Earning Power of Art