Investing in art can be very different than filling out a portfolio of stocks, bonds and perhaps a few alternatives. However, art investments fill the box of many of the basic attributes one looks for in filling out a portfolio. These include portfolio diversification, hedging inflation risk and non-correlation (near zero beta) to the broad economy (resilience to recession).
Portfolio Diversification: Art is recognized for its diversification value to a portfolio due to its weak correlation with equities and bond markets, thus reducing unsystematic risk from the perspective of efficient asset allocation. This has been cited in several studies. Furthermore, The Index of Fine Art Sales indicates the strong returns potential of art, with a calculated 10% annualized return (Korteweg et al., 2015).
Hedging Inflation: J.P.Morgan’s Kyle Sommer argues in “The Art of Investing in Art,” (Thought Magazine, 2013) that in times of rising inflation, art can be an effective hedge, protecting capital against inflation erosion. This was verified by a parallel study into Turkish art, “Art and the Economy: A First Look at the Market for Paintings in Turkey,” by Erdal Atukeren and Aylin Seckin.
Recession Resilience: Art is considered a defensive asset for its ability to protect its value and thus withstand times of economic downturn. During times of uncertainty and/or high volatility, conservative and risk-averse investors will reduce their exposure to the most vulnerable markets (primarily equities) and shift their capital towards safer assets.
Bruno S. Frey and Reiner Eichenberger in “On the return of art investment return analyses” (1995) argue that expected volatility (expressed quantitatively by standard deviation) and illiquidity are less sensitive/elastic to extrinsic shocks as the art market is saturated with consumers and what they define as pure collectors, anchoring demand. Melanie Gerlis in, “Art as an Investment? “ (2014) confirms that liquidity is one of art’s “most glaring risks.”
Research dictates that a phenomenon, termed “illiquidity premia,” exists across international markets, and, as an intrinsic factor, may contribute to the significant returns of art. The concept explains the strong, positive correlation between illiquidity and returns over time the market is believed to compensate/make consideration of investors holding less liquid assets.
Given the relatively lower volatility (standard deviation) profile of art, it can be used to improve the risk/return trade-off of a portfolio, thus producing a superior portfolio.
Improving Art Market Conditions
Art is becoming more attractive as an asset class due to its increasing transparency and reduced barriers to entry, although, Sommer criticizes the current lack of transparency, attributing it to the commonality of private transactions, barter and use of art as collateral. Research and data are becoming more comprehensive and widely available. Furthermore, components such as the ability to store artwork offshore render art more lucrative as an asset class, as collectors can use art as a tax-shield to preserve a greater percentage of their acquired wealth.
In 1904, a group of collectors, under the direction of Andre Level, saw the inception of an informal art fund, whereby they pooled together their capital and purchased 145 pieces of contemporary art with a view of making money. After a designated period of 10 years, the collection was liquidated at auction, generating a four-fold profit for the group according to Anna Jozefacka. Following the compound annual growth rate formula (CAGR), this equates to an annual return of 14.87%. The S&P 500 delivered an annualized return of 6.08%.
The Wealth Effect
As economies mature, economic activity begins desaturating the primary sector and populating the secondary and tertiary sectors. Simultaneously, wages per capita begin to rise, living conditions on the aggregate rise and per capita disposable income rises. With other conditions remaining the same, this provokes an increase in discretionary spending and consumption of luxury/leisure/non-essential goods. This was described by Martin Lettau and Sydney Ludvigson in “Understanding Trend and Cycle in Asset Values: Re-evaluating the Wealth Effect on Consumption,” (American Economic Review, 2004). This shift into cultural and leisure spending as incomes rise is described by the wealth effect and is expected to contribute to the further blossoming of the art market on a macro-economic level.
Paul Crosthwaite explains in,” What a Waste of Money : Expenditure, the Death Drive, and the Contemporary Art Market,” that from the perspective of private economic gain, investing in art can scaffold attempts of establishing symbolic capital, evidence of one’s knowledge, prestige, status, sophistication and cultural credibility; access to an exclusive and creative social milieu as one accrues wealth.
Most recently, China has seen buoyant growth, complemented by rapid maturation and economic consolidation. This process minted a large school of millionaires (from 100 to more than 2,750 in 14 years, 2,650%). This rapid creation of new wealth spurred sizeable investments in the art market, particularly in traditional chinese works of art.
Sommer states that, more generally, newly created wealth in emerging markets (such as China, Russia, and the Middle East) has increased market participation in the trade, improving market resiliency.
As well as being a safe asset to hold during times of economic busts, during economic booms, market sentiment improves and there is more money in circulation, and thus, investors begin purchasing more leisure goods.
A key driver in incentivizing investment and consumption is expansionary monetary policy. These policies are adopted with the intention of restricting money supply, such as through low (or negative interest rates). As interest rates are lowered, the rational investor is inclined to invest their money in assets to generate a return. The opportunity cost of not investing increases. Ergo, as interest rates are lowered, demand across all asset classes rises- in particular, art.
The Case Against Art Investing
There is no getting around the fact that art is not a typical investment and has unique problems for investors.
A group of Stanford researchers has unearthed an upward selection bias in returns, causing an overstatement of annualized returns, which researchers calculate to be roughly 6.5% over the period from 1972 to 2010, not the 10% suggested by the Blouin Art Sales Index (BASI), utilizing hedonic regression with the hybrid model approach. Furthermore, the study title “Does it Pay to Invest in Art? A Selection-corrected Returns Perspective,” by Arthur Korteweg, Roman Kräussl, and Patrick Verwijmeren found that art delivered a Sharpe ratio of only 0.04, while U.S equities deliver a Sharpe ratio of 0.30. Over the same 1972-2010 period, being invested in the (highly liquid) S&P 500 would have delivered an annualised return (CAGR) of 10.07%.
Overlooked Costs and Considerations
Entering the market and managing art is capital and time-intensive; and art is a relatively illiquid asset class. Art is not fungible, and cannot be sold back to a centralized market instantaneously as one could do with equities. Converting one’s art back to cash — bringing to auction and paying related fees— can be timely and costly.
Furthermore, this relies on the assumption that somebody else wishes to buy it, and there is less of a pressing need for a counterparty to want to buy a piece of art. Investors may be bound by the rules of the club. Informally, there are rules on reselling over short periods of time. Don Thompson pointed out in his book “The curious economics of contemporary art,” that failure to adhere to the unofficial rules of galleries and auction houses may adversely impact the reputation of an investor— being blacklisted and labelled a flipper— in what is a relationship-centric business.
Pieces of art may be subject to high volatility as economic conditions shift, and as artists’ work comes in and out of favor (see “A tale of two artists,” right). Notice the high correlation between the two artists from 1997 through 2009, and the divergence after 2009. An investor looking at this might assume the value in the first period followed broad sector metrics and diverged after 2009.
The price of a piece of artwork is not (positively) linear over its lifetime. Moreover, art does not render any tangible dividends, only a pleasure/utility dividend according to Benjamin Mandel. The only capital gains are made on the increase in market value at sale (from purchase), net costs. Costs are unaccounted for in return index models and can represent a sizeable margin in an artwork’s price, such indices are thus naïve, and moribund with respect to indicating real financial returns.
In between the time a piece has been purchased to when it comes back to market, there are high transaction costs implied via taxation, preservation (potential reparations), storage, transportation, insurance (and related protection), auction house commissions and associated legal fees), and expert consultation. In his research, Thomas Fillitz estimates purchase and resell fees to constitute as much as 25% of final sale prices
The art market and competition within it is highly unregulated according to Gerlis. Monopolies over artwork can be built freely; cartels can collude and fix prices or bid up prices to an artificially inflated level. Sans legal implication, investors cannot fall back on the Financial Services Compensation Scheme (UK’s regulatory authority for authorized financial services firms) or similar bodies if an investment turns sour. And this is unlikely to change. The art market is widely deemed a leisurely past-time of the ultra-wealthy, so there is little pressing moral imperative to reconcile any governance and oversight.
It has been conferred that the art market is a financial bubble, that the hikes in market value are unsustainable and not rationalized by the underlying assets. The market is propped-up only by notional demand and herd-mentality competitive bidding of the plutocrats according to Crosthwaite. Art critic Brian Sewell expects a false market implosion. This sentiment was echoed empirically in a recent (BASI-based) study, which concluded that a speculative bubble emerged in late 2011 and was still in a mania phase of formation for Post-War and Contemporary and American Art Market Segments, assuming the relationship that the price of an asset is equal to its discounted expected fundamental value.
The random price mechanisms and supply/demand dynamics of the art market have been attributed to behavioral theory according to William J. Baumol. This dependence on human behavior, as opposed to measurable fundamentals, results in an erratic, unstable and unpredictable market, a speculative nature that typically should be avoided by the risk-averse investor.
Potential Conflicts of Interest
One important consideration, according to Thompson, is that all intermediaries act in their own interests. They do not owe their clients a fiduciary responsibility. Their relationship is one founded on bona fides - and thus, conflicts of interests may arise. An infamous example of this would be the events that transpired between collector Dmitry Rybolovlev and rogue-dealer Yves Bouvier. Rybolovlev is suing Bouvier in various international venues for defrauding him by $1 billion in the purchase of 38 works of art. The UK lawsuit also threatens to pull in Sotheby’s and Samuel Valette, the auction house’s vice chairman, whom Rybolovlev says was partly complicit in the alleged scam. All parties deny any wrongdoing. Bouvier claims he simply found and sold art work to Rybolovlev. Apparently Russian oligarchs don’t like paying retail. It is a complicated story that that delves into the secretive world of high-end art collection.
This is an example of how the art world operates in an environment of opaqueness and information asymmetry, a testament to the true lack of understanding of the pricing and value of art and the difficulty of conducting accurate and truly indicative due diligence.