The Art of Investing in Art

By Kyle Sommer
kyle.e.sommer@jpmorgan.com

Art has long been considered an "investment of passion" that not only offers aesthetic utility but the potential of economic benefit. Only recently, however, has art been viewed through the lens of modern portfolio theory and considered a potential alternative investment as part of a portfolio of assets. Though research continues to shed more light on what has been historically an opaque market, studies show that art can offer long-term return potential that is uncorrelated with other asset classes.

Market paradigms have shifted dramatically over the last several decades, as newly created wealth in emerging markets like China, Russia and the Middle East have increased new participants in the art trade, which has given the market signs of greater resiliency. Undeterred by a rough economic environment in recent years, collectors globally are paying record sums for top works. Despite art's attractive upside as an investment, the lack of market transparency, illiquidity and high object costs have generally kept participation to a select class of wealthy individuals. However, growing interest in the art market has spurred the creation of new investment products that invest in art and give a new breed of investors exposure to the art market. In the following pages, we will examine the unique aspects of the art market, highlight recent trends, weigh the pros and cons of investing in art and discuss ways to gain exposure to this unique asset class.

Global Art Market Overview

Given the murky nature of the art market, it is often misunderstood by investors. Unlike most traditional asset classes like stocks or bonds, there is very little transparency associated with art trading. A large segment of the market is executed through private transactions, which makes it difficult for outsiders to gain insight. Detailed information mostly comes from publicly available data on transactions executed through auction houses. Though Sotheby's and Christie's are the biggest and most well known, countless others exist around the world. This overall lack of transparency makes estimating the size of the market challenging. So just how big is the global art market? According to The European Fine Art Foundation (TEFAF), the total size of the global art market is about $60 billion, which reflects public auction data and an estimate of art gallery and private art dealer sales during 2011. This represents a six-fold increase in size over the last 20 years.

There exist several types of players in the art market. The buy-side is heavily concentrated in high net worth individuals (HNWI) and collectors. Art dealers, corporations and museums are also major buyers in the market. In a recent survey of wealthy individuals, almost 50% of respondents own fine art and, on average, art makes up nearly 4% of the average HNWI's total wealth.¹ On the sell side are auction houses, galleries and the artists themselves. In addition, intermediaries such as art consultants and private banks help facilitate transactions through expertise, research and financing.

As global wealth grew exponentially beyond North America and Europe in the last several decades, the art market has become more globally influenced than ever before. According to the 2012 RBC/Capgemini World Wealth Report which analyzes economic factors that drive wealth creation, Asia-Pacific surpassed North America in high net worth individual population to become the largest HNWI region for the first time. With newly acquired wealth, demand for luxury goods increases. Fueled by triple-digit growth in recent years, China (including Hong Kong) has overtaken the U.S. as the world's largest market for art and antiques, representing 30% of the global market in 2011, versus 29% for the U.S.

Figure 1: Art market share in 2011 (and change from 2010)

Source: The European Fine Art Foundation

Performance and Diversification Potential

To understand what drives the art market, it's important to recognize what the main motivations are for buying art. Art is a unique investment in that there are many non-monetary reasons for buying. Surveys have shown on average only 10% of HNWIs own fine art and paintings purely as a financial investment, though other surveys suggest a much higher percentage.² Regardless, the actual non-financial value, though difficult to extract from overall value, shouldn't be ignored. First, there is an intangible value associated with having a piece of art that one can enjoy. Art provides collectors with social status and prestige — an outlet to signal their wealth or lifestyle to others. There are also the philanthropic benefits of purchasing art. This can be done through financing young and up-and-coming artists, or building a collection to preserve cultural heritage. Chinese buyers for example have been repatriating cultural assets that have been in the hands of western owners (which has contributed to a rise in values of Chinese works in recent years).³ The obvious monetary benefit is the opportunity to gain a return on investment, though investors also recognize art as a way to store value to hedge inflation and diversify their portfolio allocation.

Several studies have been conducted to measure the historical returns of art. The two main approaches in measuring performance are analyzing repeat sales of the same object at auction and developing a hedonistic model, which takes into account characteristics and qualities of the individual works. Though calculation methodologies, sample data and time periods vary, most studies show that over long periods of time, art prices have trended upwards, kept pace with inflation and, in several studies, have outperformed equities or bonds over certain time periods.⁴

It is worth noting, however, that there are several limitations in measuring art performance. Typically only auction records are used. Though auction data is large and represents a wide range of price points and collecting categories, much of the turnover in the market (i.e., private sales) isn't captured. In addition, transaction costs and other fees aren't fully reflected. Auction fees for the buyer can exceed 10-20% of the hammer price. Other on-going expenses such as storage, insurance, advisory and appraisal costs may also eat into returns.

The Mei Moses® World All Art Index,⁵ which is calculated annually and based on resale values of paintings sold multiple times at auction, shows positive returns over the last 50 years, slightly lagging the S&P 500. As Figure 2 shows, art as measured by the Mei Moses World All Art Index has done particularly well on a relative basis in recent years, outperforming U.S. and international equities and U.S. fixed income over the last 10- and 15-year time periods. This is due in part to a relatively soft correction during the 2008 recession and a quicker recovery.

Figure 2: Art has shown positive returns over the long-term, albeit mixed relative to other asset classes (as of 2011)

Source: Barclays Capital, Morgan Stanley Capital International, Standard & Poor's, Bloomberg, FTSE International, Beautiful Asset Advisors® LLC

Volatility (standard deviation of annual returns) of art was lower than U.S. and international equities as well as commodities over the last 25 years. Art tends to move in slow and long-term cycles. Looking at performance on a risk adjusted basis (returns divided by standard deviation) over the last 50 years, the Mei Moses World All Art Index (0.55) matched that of the S&P 500 Index. On a 25-year basis, the Mei Moses World All Art Index (0.45) looked relatively strong, outpacing the MSCI EAFE as well as the S&P 500.

Our analysis suggests that art may add diversification benefits within the context of an investment portfolio. Figure 3 shows that over the last 25 years, art (as measured by the Mei Moses World Art Index) had almost zero correlation with U.S. equities, and was negatively correlated with fixed income and REITs.

Figure 3: A good diversifier? Art shows low or negative correlations to other asset classes over the last 25 years

It is worth noting certain art genres will do better than others, for a number of reasons. Art can be an unpredictable investment in which returns can be heavily influenced by not only a number of macro-factors such as economic growth and inflation, but also micro-factors unique to the market such as global interest in certain genres and changes in trends, tastes and culture. Similar to the equity market, sectors will behave very differently in terms of performance and volatility (think technology vs. utilities). "Sectors," or genres of the art market will also perform quite differently. As Figure 4 shows, over the last 25 years, the Mei Moses World Post-War Contemporary Index greatly outperformed the Mei Moses World Impressionist Modern Index with quite different volatility. As with other asset classes, investors should look to diversify their holdings to manage their exposure to one specific genre, artist or type of work.

Figure 4: Genres can perform differently based on changes in tastes, trends and culture

Source: Beautiful Asset Advisors LLC

As emerging markets become wealthier, the art market is likely to continue to be comprised of a much more diverse set of art buyers. This is generally good news for the art market. When investors are concentrated in one geographic region, the art market as a whole is very sensitive to that region's economic environment. For example, a steep decline in the art market in the early 1990s was in part attributable to the decline in the Japanese economy. During the highly inflationary 1980s, Japanese investors were investing heavily in the art market. As the Japanese real estate market collapsed, wealth crumbled and many segments of the art market crashed. A more global market makes a more resilient one. As Figure 5 shows, the performance of the Mei Moses All World Art Index took almost a decade to recover from the early 1990s when the market was more concentrated geographically in a small number of wealthy countries, while the downturn during 2008 was short lived in comparison.

Figure 5: Global participation has added depth to the market giving it signs of greater resiliency

Source: Beautiful Asset Advisors LLC

As a store of value, art has shown to be an effective hedge against rising prices when inflation is high. Figure 6 shows the average yearly return for years when inflation (as measured by the Consumer Price Index) is higher or lower than the 40 year median (3.4%) and rising or falling from 1 year prior. On average, art has done significantly better over the last 40 years when inflation runs high, particularly high and rising. Returns on art appear weakest in a low inflation environment. Our analysis of art performance in various environments suggests that art can be used as an effective store of value in prolonged periods of high and rising prices.

Figure 6: Returns in different inflation environments from 1972 to 2011

View larger image


Note: U.S. Equities: S&P 500 Index, Commodities: S&P GSCI, Art: Mei Moses World All Art Index. High and low inflation distinction is relative to median CPI-U (source: BLS)

Gaining Exposure

Investors may look to gain exposure to art through funds. Funds that specialize in art works remain few, though that number has grown in recent years, as global interest in art has steadily increased and investors sought out higher performing investments in an ultra-low interest rate environment. It is estimated that the global art fund industry is approximately $700 million with over 40 unique art funds.⁶ Not surprisingly, about a third of that number is located in Asia, with China fueling most of the recent growth. Art funds vary in terms of structure and strategy but are generally defined as privately offered investment vehicles that seek to generate returns through the buying and selling of works of art. In such a model, investors typically do not have input into the acquisitions and rely solely on the investment manager. Most funds have a defined investment period and pre-determined liquidation date, in which all art work must be sold. This can be seven to ten years depending on the fund. Minimum investments for these funds vary, with several starting at $250,000.

Institutional investors, such as pensions and endowments, have historically been reluctant to invest in art or art funds. The British Rail Pension Fund (Railpen) is widely considered one of the first institutional investors to allocate money to a fund of art works. In the mid 1970s, about $70 million, or about 3% of Railpen's capital was invested in approximately 2,500 works of art. This collection included a wide range of works including paintings, manuscripts, furniture and ceramics. Railpen was reportedly able to deliver an annualized return of 11.3% in their art allocation from 1974 to 1999. Critics, however, were quick to point out that most of the returns came from just a few works that were sold at a very good time in the market. Despite the return potential, institutional investors have largely kept out of the market. It is worth noting, however, views on alternatives have evolved significantly over the last several decades and will continue to evolve. What most fiduciaries today consider "mainstream" alternatives: namely, hedge funds, private equity and real estate, weren't always considered mainstream. Today, over 22% of institutional investors' portfolios are in such investments, a significant increase from just a few years ago.⁷ Whether or not art will be accepted as a viable alternative asset remains to be seen. However, given a low interest rate environment for the foreseeable future, unease about the global equity and bond markets and chronic pension funding shortfalls, less mainstream assets like art may draw more attention among institutional investors seeking greater return and diversification potential.

Conclusion

The art market has undergone significant changes over the last several decades. Newly acquired wealth in emerging economies has globalized the market in many ways, giving the market much needed depth and resiliency. Studies have shown relatively strong returns over extended periods of time, and recent risk-adjusted performance looks comparable with other traditional asset classes. Low and even negative correlations with equities and fixed income suggest an allocation to art can potentially diversify one's portfolio. In addition, solid returns during periods of high and rising inflation indicates that art can be an effective hedge against inflation. Performance measurement of the asset class is not without limitations and assumptions which should be considered when looking at historical returns.

Collectors invest in art for a variety of reasons. However, art as a pure financial investment poses challenges. It is highly illiquid, the market lacks transparency and efficiency and it is expensive to acquire and maintain. Investors looking to gain exposure to art have many new options with the advent of new financial products and specialty funds. As with any asset class, investors must do their homework. Learning about the market, genres, history, trends and artists is a must and assessing how it would fit in a broader asset allocation is critical.

Special thanks to Michael Moses, co-founder of the Mei Moses family of fine art indexes and Beautiful Asset Advisors LLC, for his contributions to this article.

¹ Wealth Insights, Profit or Pleasure? Exploring the Motivations Behind Treasure Trends, Vol 15; Barclays Wealth and Investment Mgt
² In the 2011 RBC/Capgemini Global Wealth Management Financial Advisor Survey, 42% of advisors believe their HNW clients invest in art primarily for its potential to gain in value.
³ http://www.mindfulmoney.co.uk/9567/investing-strategy/is-art-the-alternative-investment-of-2012.html
⁴ Auctions and the Price of Art, Journal of Economic Literature Vol.XLI, September 2003, Ashenfelter, Orley and Graddy, Kathryn
⁵ Used with permission. More information about the Mei Moses Art Indexes can be found at www.artasanasset.com
⁶ www.artvest.com
⁷ The figure is from a 2012 Russell Investments global survey of 144 large institutions. Source: "Pension Funds Embrace Alternatives"; efinancialnews.com