I used to brush off the idea that anyone could be serious about investing in art. Yet in China, more investors seem to be jumping into the fray. They are getting into the auction business – which has its shady side – opening art stock funds, and even starting exchanges. And then, while sitting through a boring slideshow about how art can make money, I had a change of heart.
Take a step back and look at the basics of investing. The central precept of financial theory is that an investment is worth the value of its expected future cash flows, discounted back to the present at the expected rate of return. These returns can come from dividends, partnership distribution, interest or capital gains, but the real focal point is the annual return on investment. After gauging the expected returns, the next step is to maximize those gains with leverage and minimize risk with hedging.
Finance by any other name
Art shares many of the same properties as more traditional investment classes. It is a fairly simple investment, generating income mostly in the form of capital gains. Auction houses function as wholesale exchanges – mostly as brokers, and not normally as dealers.
Museums, foundations and other large collectors are the institutional investors in this market. Many museums do not trade much in art, instead acquiring art loans and gifts from collectors. Some can generate cash flow by selling admissions for viewing or trading in exhibitions – effectively renting out their assets.
The central players in the market are art dealers. They not only maintain their own inventories of art; they function as brokers for other dealers and collectors and can even launch “IPOs” in the form of new art and artists. These brokers can get 100% percent interest-free leverage with no downside risk and in some transactions they act as agents for artists or art sellers. They earn a commission fee and might also generate income by charging admission for exhibitions or renting out the art itself.
Art can therefore generate ordinary cash-flow income, as well as capital gains. It can also be highly leveraged. Only an art dealer can be “short against the box” (i.e. hedge against assets they already own). In this situation, the dealer is effectively both long and short the same asset, with a percentage spread locked in – similar to the role played by broker-dealers in traditional securities.
Art auction houses can take advantage of some, though not all, of the same types of leverage. For example, in the case of guarantees, they are giving a put option to the seller, something dealers usually do not offer.
Pricing the priceless
As for the assets themselves, art derives its value from its aesthetic quality, its scarcity and its use for display or utility as interior decoration. In display in museums, it generates ticket revenues or income from rentals to other museums. Art is first valued relative to other art; it is then valued relative to other investment assets. The value of much art is therefore tenuous, and there are examples of art which has been “in” one day and practically worthless the next. Even the art of established artists has undergone much volatility over the years.
Crucially, art sales are relatively illiquid because the buyers are few. Connections and salesmanship are required to solicit private buyers, and sales to dealers or through auctions houses come at a steep discount. This presents severe limitations on both returns and risk management.
Art exchanges have popped up around China over the last year. If these markets develop further they could be used by collectors, art funds and dealers alike. At the moment, however, they suffer from thin capitalization and a limited number of artists and works. Most importantly, investors lack the ability to short art equity, which would enable them to hedge their risk.
Art funds, meanwhile, are basically an attempt to leverage art – not the way that dealers do, but by using other people’s money. True art funds lack plenty of features found in other securities, or even other positions in the art industry – drawbacks such as illiquidity, little low-cost leverage and underdeveloped markets. But at the end of the day, they provide income for investors who do their research, just like any other product in the financial world.
Craig Mattoli is CEO of Red Hill Capital and owner of Leona Craig Art in Guangzhou, China