There has been a lot of commotion, in the art markets, these days, about new art investment vehicles.  They include art funds, art stocks, and outside guarantors of auction stock.  We even recently commented about art funds, in another piece.  In the mean time, 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 there is an art stock exchange, in France, and an exchange-traded fund, in Russia.

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 salient feature 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 come from some kind of cash flow, like dividends, partnership distribution, and interest, and or capital gains.  The focus is on percentage annual return on investment, which is dollar return divided by investment.  Returns can be further enhanced with hedging and leverage.  The object is to get high return on investment, while minimizing risk.

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 through the bondholders and margin borrowing.  He can also make a capital gain or loss when he sells his holdings.  A buyer of wheat futures can leverage his holdings and sell his wheat to a miller at delivery 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, 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 business 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 broker-dealers, the sell-side, are the real professionals.  In addition, there is a buy-side of investment products, which includes large institutional investors and retail.  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.

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 to generate further rental income.  Many museums do not do much trading in art but get loans and gifts from collectors.  Art dealers are the central professionals, and auction houses act as wholesale exchanges, mostly as brokers, but not 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 act 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.  They can earn commissions and make capital gains.  They might also generate income with charges for exhibitions or other space rental and from art rental.

Thus, art can generate capital gains as well as ordinary income.  It can also be highly leveraged.  An art dealer can be short against the box, long and short the same thing, which can be done only by broker-dealers in securities, too, with a percentage spread locked in, in his business as a broker-dealer in art.  Moreover, dealers offer a display area, both in galleries and online.  Art auction houses can also take advantage of some of the same type of leverage.  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.  Museums can also trade in art.  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 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.

So, art funds are basically an attempt to leverage art, 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 selling privately or through auctions or dealers.  Moreover, 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 stocks have popped up in several cities, in China, over the last year.  The stocks cover portfolios of an artist’s works.  The initial experiences were blowout pricing and closure of trading.  An art stock exchange was also opened in France.  Now, these vehicles could be used by collectors, art funds and dealers, alike, if there were the ability to sell art stocks 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 mismatch of the portfolio versus a work held by an investor.

In conclusion, art is useful for display, either for earning money from pay-for-view or for personal enjoyment.  However, funds take advantage of neither of these aspects of art but only seek to benefit from 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, for stocks. After all, liquidity is defined as the ability to quickly sell an asset without much loss in value by the time a sale can be effected.  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 dept, at this point in its development, the art stock market could be used by real investors, in art, to hedge their positions.  In the absurd limit, however, if all art were held by funds and securitized, it would no longer have any intrinsic value.

© 2011 Craig Mattoli, CEO
Red Hill Capital Corp., Delaware USA, owner
Leona Craig Art, Guangzhou, China

Each year, China celebrates one of its most important holidays: Mid-Autumn Day.  It occurs in September, on the night of the full moon, and represents the beginning of the Fall.  Celebration includes, family gatherings, walks to look at the moon, and moon cake, a cake created just for that day, like fruit cake during the Western Christmas-Chanukah-New Year season.

Moon cake is a big part of the celebration, and stands at department stores begin to pop up several weeks before the day.  Another more subtle activity is moon cake arbitrage,  It begins with moon cake makers selling gift certificates to Chinese companies, many of which are government agencies or companies, who give them to employees.  Just about everyone in the country gets a moon cake from their work, it seems. 

The moon cake manufacturer sells the gift certificates, en masse, to a company for, say a 30% discount, on Y200 cakes.  Then, moon cake arbitrageurs stand around the vicinity of the ,moon cake stands and offer to buy the certificates for Y80.  And they sell them back to the company for Y120.

Thus, the arbitrageur makes a 50% return on his capital, and the moon cake company, who is effectively short moon cake certificates, covers its short at a return of about 20%.  Almost all of the parties, the original short seller, the moon cake maker, the receiver of the free gift certificate, and the moon cake arbitrageur, make money.  All funded by the companies who buy moon cake gift certificates for their employees.

We were recently asked to write an article about the Chinese art market for China Economic Review.  The final edited version to fit space is in the September 2011 issue. You can read it at
Painting by Numbers.

Tianjin Plus Magazine recently interviewed Craig Mattoli about the art market.  The interview can be seen on page 23 of the July 2011 issue, which you can download at Tianjin Plus July 2011.

We put the English language version of an article that we have just written for Beijing Collector and Investor Magazine about art funds and art stocks on our Leona Craig Blog.

Craig Mattoli
Leona Craig Art
Guangzhou, China: 86 136 3241 0877
Website: http://www.leonacraig.com
11 Gui Gang Three Road, Dongshan Kou, Yuexiu district, 
Guangzhou, China 510080
广州市越秀区东山口龟岗三马路11号
086 020 37625069

Modern economics and investment analysis had their beginnings with the theories of the mathematical physicist, John Von Neumann, in the early 1900’s.  The early work in these fields assumed that the actors were rational, something which more modern finance has finally scrapped.  Along with that axiom, it was also assumed that games, including investment, were fair games.

A fair game is one in which a player has an equal chance of winning and losing.  This concept also led to the introduction of Gaussian Normal probability distributions (the famous bell-shaped curves), into finance, as they are symmetrical, conforming with equal probability of winning or losing.  Another convenience of Gaussian distributions is that they can be completely described by two parameters: the mean and the variance of the distribution.

There is an a priori reason to expect that the distributions of investment would not be Gaussian: technically, one can win an unlimited amount, so, positive returns could be unlimited, while losses (at least for unlevered investment) are limited to 100 percent of your investment.

The fair game theme also leads to assumptions of efficient markets, which are markets in which you cannot earn abnormal returns because that would not conform to fairness.  Fairness in the sense of efficient markets means beating the general market.  In that sense, the zero of the game is recalibrated to return on the market, and you have an equal chance of doing better or worse than the market.

In truth, people are not rational, markets are not really efficient, and investment is not a fair game.  We should already have a clue for that in looking at all of the people who get paid money to be in the investment business.  Of course, many of the people who are in the investment business are actually paid for marketing, not investing, so, we should already realize that people in the investment business make use of psychology, in marketing, to take advantage of the fact that people are not rational.  For those who are truly professional investors, barriers to entry, in terms of ability, capital, knowledge, etcetera, serve to create market inefficiencies, which professionals take advantage of.  Connecting with the efficient market theories, professionals have or develop information and process it more quickly than the man-on-the-street, which gives them an advantage and which turns investment into an unfair game.  They also use other tactics, like stop loss orders, portfolio diversification, limiting capital committed to one position, to also make the game unfair by biasing their aversion to loss.  They also primarily deal in arbitrages, many of which are completely riskless.

More rigorous mathematical financial analysis began in the 1950’s, when the Von Neumann methods were applied to find minimal variance (the measure of risk) portfolios. Then, in the 1970’s, the capital asset pricing model was developed, and, in the mid-1970’s, stochastic processes, which are, basically, the calculus of Gaussian distributions, were applied to develop the Black-Scholes options model, and the pursuit of that line of investigation continues into today.  Another school of investigation, behavioral finance, began in the 1980’s, and its focus has been on the irrationality of people in games.

A final aspect of the Gaussian distribution, which finally led the rational the mathematical school to realize that distributions in investment are not Gaussian, is that 99.9% of all possibilities lie within three standard deviations of the mean.  After the stock market crash of 1987, it was pointed out that a crash of that magnitude, under perfect Gaussian statistics, could only happen once in 3 billion years.  And, thus, began the search for better fit distributions, skewed to one side, and the fair game hypothesis was finally dethroned.

© 2011 Craig L. Mattoli, Red Hill Capital Corporation, Delaware, USA; all worldwide rights reserved.

Pomegranates, in Chinese Culture, represent wealth (technically, if you go back further, it is many sons).  Wishing you all prosperity in the new year.



From Craig, Ayu, Fanny, Carrie, Yiling, and Longlong

While there are many securities and commodities markets, there are even more market indexes, including for art markets, these days.  Market indexes are meant to represent some sort of all-in-one measure of market prices for a particular market.  There are composite indexes of the various exchanges, like the NYSE composite index.  Often, indexes are weighted averages of the individual stocks (or other assets) that they include, with the weighting depending on the relative market capitalizations or on the relative prices of the components.  Other indexes include stocks from various exchanges, not just one.  The Dow Jones 30 Industrial Averages, the DJIA, includes 30 so-called blue chip stocks, the icons of industry, from both the NYSE and the NASDAQ.  There are also the Dow Transports and the Dow Utilities indices composed of stocks of companies in the transportation and the utility industries, respectively.  There is a basic difference in computations of indexes, like the NYSE and the DJIA.  The former is an example of a capitalization weighted index, while the latter is a price weighted index.

The index business, itself, has become big business, and index compositions have become more effective.  Simple price weighting, as that used in the Dow Jones 30 stocks, might not be appropriate when considering a large set of diverse stocks of divergent total market capitalizations.  Other adjustments have also become part of the index constructions mainstream, as we shall discuss, subsequently.  Indeed, even the NYSE Index has recently redefined itself; in the figure, we show the differences in its old and new definitions.

To summarize the differences in the old and the new NYSE index, exchange-traded funds and derivative instruments have been eliminated in the new construction.  In that regard, index funds and other exchange traded funds, which are, themselves, portfolios of stocks, not pure stocks, have been taken out of the index, as have other derivatives products, which also are not true stocks.  The change to a float-adjusted market capitalization basis means that the market floats of all of the component companies are adjusted to reflect the true amount of shares that are available for public trading, eliminating certain shares that are effectively out of the public domain.  That can make a large difference, especially in many of the newer foreign markets.  For example, when the Russian Trading System (RTS) changed reporting of its market capitalization to a float-adjusted basis in 2004, the capitalization decreased by about two-thirds.

Also new was the creation of a total return index, in order to account for dividend returns, which is useful for making comparisons of real stock and portfolio returns to the index.  In total return indexes, such as those that have been created recently for the NYSE and the NASDAQ, the index is calculated in a manner that assumes that all dividends are reinvested as they are received.  In that regard, whereas traditional price indexes can provide a measure of capital gains on stocks, in the aggregate, the total return index gives a broad measure of return, including dividends and capital gains.  It is especially difficult for an investor to get a handle on total return, on her own.  On the one hand, the dividend yield for all stocks on the NYSE is around 1.5 percent per year, but it is quite useful to have the higher precision of a company-calculated total return index.  Again, such an index will have different meanings and significances to, for example, a tax-free institutional investor and a tax paying individual.  We shall discover other types of weightings and adjustments when we discuss international stock market indexes and investing.

It will be instructive to take some time to look at example computations of the two more common types of indexes.  In computing a price weighted index, the prices are all added together, and the result is divided by the number of stocks, like in the case of the DJIA, 30.  In that regard, a percentage change in the average summed index is equal to the sum of the percentage changes of each member of the average. 

Example Index Construction

Price weighted index For example, we can compose a price weighted index of two stocks, A, price $50, and B, price $30, the AB index, as AB Index = ($50+$30)/2 =$40 Thus, the “portfolio” of stocks, included in the index, weights the stocks by their dollar prices.

Capitalization based index The index is formed by weighting each member of the index by its total market capitalization, i.e., the total stock market value, shares outstanding times price per share.  To compute a capitalization weighted index for A and B, assume that the total capitalization of A is $1 million, and that of B is $2 million.  Then, the capitalization weighted AB Index is computed as [$50x$1 million +$30x$2 million]/$3 million = $36.66.

For a capitalization based index, percentage changes in the larger capitalized component will have a greater affect on the index.  For example a 10% change in the smaller component of the AB index would correspond to a 3.3% change in the index, while a 10% change in the larger component results in a 6.6% change for the index.  Therefore, understanding the construction of an index is necessary for understanding the information that it conveys.

There are other well-known capitalization weighted indexes for the U.S. stock markets.  One is the Standard and Poor’s (S&P) indices: including the S&P 500, the top 500 stocks as rated by S&P, the S&P 100, and even composites of certain sub-class stocks.  Other indices, like the Wilshire 5000, include over 6000 stocks from the NYSE, the AMEX, and the NASDAQ.  Some of the Russel indexes include securities on an international scale.  Morgan Stanley Capital International (MSCI) maintains and publishes index for a large number of international investment portfolios.  Therefore, care must be taken in garnering information from such indexes.  The DJIA tells us only what is happening with prices of 30 better stocks, which information might not apply to all stocks.  The S&P index gives a better view of stocks, but the more general course of stock prices, like in the NYSE or the Wilshire 5000, may be different from even the broader S&P 500 view.  There are also bond, commodity, investment fund, and art market indexes.

Moreover, you will find that all stock markets around the world have several indexes associated with them.  For example, there are the Nikkei 225 and the TOPIX indexes for the Tokyo Stock Exchange, the FTSE All Share and the FTSE 100 for the London Stock Exchange, the WIG and the WIG 50 for the Warsaw Poland Stock Exchange, the TASI in Saudi Arabia, the CASE 30 on the Cairo and Alexandria Exchange, the LuSE index for Lusaka, Zambia, and the TEPIX in Tehran.  Often, there are indexes for a particular exchange created by the exchange, itself, and by outside companies, like FTSE, S&P, MSCI, and Dow Jones.  To be sure, a great demand for indexes has come from institutional investors and investment fund managers who will use indexes as benchmarks for portfolio construction and performance evaluation.

We point out that the specific stocks that are included in these indexes can change over the years.  For market composite indexes, like the NYSE Composite index or the NASDAQ Composite, the indexes naturally change as new stocks get listed and old stocks get delisted.  Even, indexes that maintain a set number of stocks change their composition, periodically.  For example, before the 1929 stock market crash, the DJIA included such names as International Nickel and Victor Talking Machines, which you would not even recognize, today.  Indeed, at this point in time, knowledge of stocks that will be removed from or added to an index has risen to the level of inside information.

In order to get information from market indexes, you have to understand how the index is composed and what information it gives you.  When we recently asked Artron, an art market information service, in China, how their various Chinese art market indexes were constructed, no one could actually tell us, and they said that we were the first to ever ask.  Investment advisors even play games with indexes.  For example, fund of fund managers and brokers have indexes of their funds, but as old ones leave the index and new ones are added, there is a natural bias to the upside, as losers are eliminated and winners are put in.

© Craig L. Mattoli 2004-2010 All rights reserved.  No part of this monograph may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior express written permission from Craig L. Mattoli, RedHill Capital Corp., Delaware, U.S.A.: clm@clmattioli.com.

Caixin Magazine, in Guangzhou recently published an article called the overvalued Yuan.  We wrote our own commentary on our Red Hill China Blog, which you can link to http://bit.ly/b2TxbF .

Especially, now, since I have been living in China where people are desperate to get ahead in the modern capitalistic Chinese world I have seen many people who believe that, if they charge a high price, they will be able to get rich quick and retire early.  As a former member of the Wall Street proprietary trading community, in arbitrage, I have always been taught that greed is not good.  The Wall Street expression goes: bulls make money, bears make money, and pigs end up broke or in jail.

A basic law of economics, based on psychology and logic, is that the demand curve is downward sloping: people are more willing to buy a [product, if the price decreases; less willing, if the price increases.  Then, equilibrium will occur at the intersection of the upward sloping supply curve and the downward sloping demand.  To fill in a few more details, total revenue can be found as the rectangle on such a supply-demand graph touching the intersection and going to the origin of the graph: it is simply Revenue = PxQ where P is the sales price per unit and Q is the quantity sold.

Profit is defined as revenue - cost, which can be put into equation form as: I = R - C = PxQ - ATCxQ, where ATC is the average unit cost and I stands for income or profit.  From calculus, we know that a maximum (technically, an extremum, which could be a max, min, or turning point) is found by taking the first derivative of something and setting it equal to zero.  Thus, in the case of profits, we have the condition for maximum ΔI/ΔQ = QxΔP/ΔQ + P - QxΔATC/ΔQ - ATC = 0.  Other standard concepts, in economics are marginal variables, which are just first derivatives of quantities.  Specifically, marginal revenue = MR = ΔR/ΔQ = P + QxΔP/ΔQ, which is always less than P with downward sloping demand, and marginal cost = MC = QxΔATC/ΔQ + ATC.  In the latter case, we also, note that since cost curves are U-shaped, MC will be under ATC for sometime, and it will cross over at minimum ATC, then, move above it. 

Looking back at our profit maximization condition, we see that we can rewrite it as ΔI/ΔQ = 0 = MR - MC.  Thus, without going into the proper secondary condition for actual maximization, which requires that the second derivative is less than 0, we arrive at the profit maximization condition MR = MC, which simply says that we should sell units up to the point where marginal revenue is just equal to marginal cost.

That condition, in turn, gives us a price and quantity for sales.  If we sell less than that maximal quantity at higher prices, our profits will be less than maximal; if we sell more than that quantity at a lower price, the same is true.  That this theorem is valid, even in the case of a pure monopoly, tells us that we should abide by it because even a pure monopolist, much less a lowly competitor in any other business, cannot get away with charging any price they desire.

For more analysis and information about finance and investment, please visit our website http://www.redhillcapitalco.com .

Craig L. Mattoli, CEO
Red Hill Capital Corporation, Delaware, USA
© Red Hill Capital Corp. 2010, all worldwide rights reserved