Wednesday, December 16, 2009

The art of saying no to an investment

As I saw the Osian’s Art Fund story unfold last week, I was reminded of the numerous times reporters had made art fund story pitches to me in the last four years. This was the time of the giant asset bubbles across the globe—real estate, stocks, oil and, of course, art. Everybody was gorging on the cheap cash still in the system.

One of my reporters, who dared ask hard questions at the time of the Osian’s fund float, was told how art was only going to boom by the promoter of the fund, who also advised her to go and learn some art before she covered this area. Three years later, it does seem like she doesn’t need to learn more about art and that he needs to learn more about investing. Needless to say I spiked all rah-rah stories on art and only ran the do-not-invest stories.

Retail investors in India have asset allocations skewed heavily in real estate (illiquid) and bank deposits (no real return) and buying an art fund is inappropriate in terms of what it will add to their portfolio. Remember, speciality investments are return kickers (that carry very high risk) and should form less than 5% of an already diversified portfolio. My hesitation to recommend art funds comes out of three reasons.

One, they are unregulated. While having a regulator does not prevent fraud (as the Satyam case shows), it does lay down rules and redressal procedures. The system may be shaky, ponderous and leaky, but it tends to work for those who keep at it.

The second reason is the valuation of art. Experts may talk about well-defined global processes that are able to construct an art index and value each piece according to some norms, but I don’t understand how fakes would fit into this valuation formula. The memory of fake stock certificates has very quickly faded away as we’ve got used to a superior system of demat shares.
Now, all stock certificates are converted into information that sits on computers and the problem of duplicate and fake shares is over. But stock certificates don’t need to get hung in galleries or living rooms, and paintings, the underlying asset of the art fund, do. So, art in demat is not an option and that leads to worries about fakes and the wrinkle about valuation.

The third reason is liquidity. What Osian’s is facing is a liquidity problem rather than an intent to cheat. It has been unable to sell all the paintings in time, at the value it wanted, to return the money of the investors. The year 2008 showed everybody the true face of the liquidity risk. And the fact that this risk is not just about the lack of money in the system, but also about getting a fair value of the asset you are trying to sell at the time when you are trying to sell. Mutual funds in India were faced with this last year, when there was a sudden run on liquid funds as everybody withdrew cash.

As funds ran to sell their bonds, they realized that while the price at maturity was intact, there was nobody with the money in the system willing to buy. The basic law of economics is that if there are no buyers, prices must go down. And once the word gets out about a distress sale, buyers have bargaining power to hit you hard. And hence the liquidity risk.

For the investors in Osian’s, the good part is that it is not a plantation company that has sunk into oblivion. Perhaps having a high-profile fund promoter worked to the advantage of the investors of this fund. Investors are still being promised a return (and not just the principal) on their investment. Regulators in the US watch for instances where investors scream murder, very carefully. They have come to understand that investors do not complain when markets are up, but they yell loud and clear when they lose money.

While the protests due to market volatility are ignored, those that deal with badly constructed products, sharp sales practices and other regulatory failures are worked on.

The issues for Indian regulators are two. One, the capital market regulator must examine why art funds look like, are structured like and to all investor eyes are a mutual fund, complete with a trustee company and a sponsor.

The Securities and Exchange Board of India must also examine how registered intermediaries could sell unregulated products such as art funds. The Reserve Bank of India (RBI) must examine the role of banks in selling these unregulated products to investors. Pankaj Butalia, an investor who has got part of his principal back, has alleged that his bank sold him the fund without adequate caveats. Surely, RBI will have to ask hard questions of that bank, and of the others who are selling financial products without due diligence.

Till the regulators get this piece right, the best way to invest in art is to hang a painting in your living room, enjoy it and then pass it on to your kids.

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