The Earning Power of Art
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.
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
Posted by Red Hill Capital Corporation at 10/23/2011 1:25 AM 
Categories: Arbitrage, Finance, Inefficient Market, Investment Strategy
Tags: art market art art investment art fund art stock art stock exchange art auction art dealer investment investment strategy investment tactics leverage short against the box
Categories: Arbitrage, Finance, Inefficient Market, Investment Strategy
Tags: art market art art investment art fund art stock art stock exchange art auction art dealer investment investment strategy investment tactics leverage short against the box
Comments