Investing in art lowers financial risks due to low correlation with other asset classes

The mechanisms of art market economics are either little known, or considered peculiar. At first glance, the dual nature of art may seem quite complex. Art yields nonfinancial aesthetic rewards, sometimes called psychic returns, and it is a capital asset that gives financial returns when its value appreciates over time.

A principal reason why art is a financial asset is that the art market is an evolving industry, which grows through generating new customers and is continuously expanding to new countries, raising the demand for aesthetically superior art works.

The theory of the zero sum game explains the values — at times quite extraordinary — achieved in the art market. Contrary to other markets, increased demand doesn’t translate into increased supply. There is only one artwork that a collector can acquire at the expense of another. This is the value of desire that makes art an attractive asset for investment purposes.

According to academic studies, the long-term performance of artworks is about 6% and it can even reach 12% in times of economic growth. This is without taking inflation into account.

What makes art particularly attractive is that it has a low correlation with other asset classes and, therefore, provides opportunities to lower financial investment risks if it is combined in a portfolio with other asset classes. The history of the art market shows that certain artworks by selected artists offer stability in tough economic times, and a growing number of wealth managers recommend that artworks should form up to 5% of a welldiversified investment portfolio.

So what characterises art as an asset class? One of the leading art market economists, Clare McAndrew, says that the top attributes include the uniqueness of each artwork for which there is no close substitute. Irrespective of demand, the quantity of the supply does not change, which is why prices can soar dramatically. In this sense, the art market has zero elasticity.

Another feature is the subjective nature of art valuation. McAndrew argues there is a way to quantify the subjective value of art, otherwise described as taste.

If a fair valuation range for art prices for a specific artwork by an artist is considered, the excess paid over this range equals the value of the subjective premium inherent to art prices. There is a view this excess is the monetary value a collector is prepared to pay for psychic returns over time.

Art also has a reputation for being relatively illiquid. This is because art in private hands trades sporadically and a typical cycle to market can take 30 to 40 years — and because it trades on so-called “thin markets” where there are few buyers and few sellers.

Portability is another characteristic of art that distinguishes it from asset classes such as property. Artworks can be readily shipped to the most opportune markets and be sold anywhere.

But, like property, it is a physical asset, which implies there are holding costs. These include costs to maintain, store, restore and insure, which are typically quite high. Transaction costs to buy or sell art works are also high. While auction fees for art are high compared with other asset categories, in SA these are lower than in the UK or the US.

There are specific risks associated if art works are being considered for investment purposes. These are title, authenticity and provenance; financial risk linked to the fluctuation of art prices; and physical risk because art is a material asset and can become damaged.

Poor advice and judgment can also negatively affect a portfolio’s value. Most established collectors do not rely on their own tastes and seek expert advice on finding the best-quality works without paying too much for them.

The total art market — dealer as well as auction house turnover — was estimated at $45bn in 2016, offering huge investment potential.

For newcomers interested in entering and benefiting from this growing market, there are attractive alternatives. Art funds offer a mechanism to invest capital into art while mitigating the risk of buying the wrong artworks that have little chance of appreciation.

The first art fund was established in 1974, when the British Rail Pension Fund invested in more than 2,500 artworks and reportedly delivered an aggregate return of 11.3% a year over the next 25 years. In 2015, the art fund industry was conservatively estimated at $1.2bn.

The cost of managing an art fund can be high due to asset holding costs. The fee structure is typically modelled after hedge funds and is about 2% of the value of the assets that are under management.

The main advantage of art funds, which are based on a partnership between art experts and finance professionals, is the professional discernment to value art correctly.

Art-secured lending is a more recent niche credit service that allows art owners to leverage the captured value of their art assets. It allows dealers, collectors and institutions to take advantage of the opportunity to borrow money by using their artworks as collateral.

Such art banking follows various models. In the US, for instance, borrowers are able to hold on to artworks used as collateral but in most of Europe and in Hong Kong, the lending institution requires that borrowers hand over artworks for safekeeping in vaults.

Art lending is currently not available in SA. In 2015, the overall size of the art-lending industry was between $15bn and $19bn, dominated by private banks.

Stock exchanges for investing in fine art were first launched in China, France and more recently the UK with Artstaq. Due to the fact that the share prices are listed, the pricing process becomes more transparent, which increases investor confidence.

Art stock exchanges effectively extend the art market to trade comparatively to other financial markets, thus increasing transparency in an opaque art market. They could be setting a model for future trading in the art market.