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Investing in Fine Art as an Alternative Asset Class



Dissatisfied with performance in the equity and bond markets, investors have been tapping into "alternative asset classes," previously alternative asset classes like real estate and private equity are today main stream.



Some investors are now hoping to find shelter in alternative investments such as fine art, wine, antique furniture and even stamps.



Is fine art a good investment



On the surface, these alternative investments' performances are alluring. Indices tracking the performance of high-class art have held up well in the recent economic slowdown, while art auction houses report record prices. Art as an object of investment has been debated for long.



However, in the age of 20 percent returns on stock markets and a long bull market, the concept of art as an investment option was passed over. But the corporate scandals, poor stock market performance and low interest rates hanging overhead has prompted a revisit.



In one of the most prominent examples of art investing, the British Rail pension fund in the 1970s invested 2.9 percent of its portfolio, or about 40 million, in ten different categories of fine art earning a return of 40 percent per annum above inflation until 1999. Ariel Salama, the Global Head of Private Banks at ABN AMRO, predicted in April 2005 that $30 billion of capital would move into art funds in the next ten years.



How does art fit in a portfolio



Wolfgang Wilke of Dresdner Bank also argues that top quality art tends to be more stable than most financial investments in difficult times.



Further, the long-term trend for art prices trends upwards, "Art is a scarce product and not reproducible at will. Rising incomes over the long-term ensure a steady rise in demand for works of art against falling supply."



For investment quality art the limited supply adds to the increasing demand, this imbalance would lead to a natural price appreciation over the long run.



There is a growing body of research into the art market, prominent among them are from professors Jianping Mei and Michael Moses, at New York University's Stern School of Business, who found that art has outperformed S&P 500 excluding transaction costs (as they are not included in stock market indices such as the S&P 500 either).



In the past 50 years, their research indicates that art has outperformed fixed income but underperformed equities. And in the past two and half years of stock market losses, art has outperformed equities. The Mei/Moses All Art index, which is based on the resale values of paintings sold at public auction in New York, shows a 50-year compound annualized return of 10.47 percent, vs. 10.95 percent for the S&P 500 and shows a low correlation of 0.04 percent with the US stock market. Consequently, advocates argue that art has the ability to reduce the risk of a portfolio when combined with the other assets.



Three risk warnings:



1. Opaque, illiquid and unregulated market - research covers only deals done in auctions



Thin and opaque markets make it easy for the insiders to artificially inflate the prices. For instance, price-fixing collusion by the two major auction houses in 2000, Sotheby's and Christie's, defrauded art investors by millions of dollars.



2. Subjectivity of intrinsic value - difficulties in valuation



Critics contend that investing in art disregards the traditional yardsticks of financial valuation since they do not generate income streams that can be discounted. It is a bet on the price appreciation of something whose value defies financial logic. Bill Muysken, Global Head of Research, Mercer Investment Consulting, feels, "Art works do not generate any income, except to the extent that income can be obtained from lending them to galleries, and they incur negative income in the form of storage and associated costs. Whilst some artworks have appreciated enormously in value over time, it is difficult to make a case for art works overall earning a positive net rate of return in real terms over the long run."



3. High transaction costs - storage, auctions and dealer fees



Critics of art funds argue that art indexes can be misleading because they do not take the considerable transaction costs into account. Works sold at auction normally carry both a buyer's and seller's premium of 10 percent or more of the knock down prices, and dealers can charge as much as 50 percent. "Art funds may be able to negotiate with auction houses to drive the commissions down, but that isn't clear yet," says Karl Schweizer, head of art banking for UBS Global Asset Management in Basel, Switzerland.



Final thoughts



The art market is highly inefficient as characterized by low liquidity, high transaction costs, low transparency, and highly differentiated products. We believe there is greater potential to outperform in this type of market than in an efficient one, such as the US or UK equities market, where countless analysts and individual investors compete to find and act upon the smallest new insight about a public company before it is reflected in the share price. The art market requires deep knowledge and skill; it is precisely these less explored corners of the wider investment universe where the greatest rewards can be found.



Different valuation methods must be applied in art investments, value can be determined by factors such as provenance, condition, medium, subject matter, and size.



Finally, securitization is an ongoing trend that has gained momentum with the spread of globalization, to the benefit of increasingly wider groups of investors. These benefits are typically enjoyed first by a small, privileged group of insiders, then by a wider group of sophisticated investors, and finally become retail investment opportunities available to all. Equities and bonds made this journey over the last century, and funds-of-funds are now making more non-traditional investments, such as hedge funds, REITs and private equity, accessible to individuals with smaller and smaller amounts of capital to invest. We believe that art now beginning down the same path.



Kevin Foong is senior partner at Courthauld Investments. Research and drafts by Alex James.






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