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WHAT MAKES ART AN ASSET CLASS

November 28, 2017

The mechanisms of the art market economics are generally little known and considered as peculiar by many who are not familiar with it. At first glance, the dual nature of art may seem quite complex. On the one hand, art yields non-financial aesthetic rewards, sometimes called psychic returns, on the other, it is a capital asset that gives financial returns when its value appreciates over time.

We are often asked what makes art a financial asset. A principle reason is that the art market is an evolving industry, which grows through generating new customers and it is also continuously expands 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, that are achieved in the art market. Contrary to other markets, increased demand doesn’t translate into increased supply. There is only one artwork that one collector can acquire at the expense of another. This is the value of desire and it makes art an attractive asset for investment purposes.

According to academic studies, the long term performance of artworks is around 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 well-diversified investment portfolio.

So what characterises art as an asset class? One of the leading art market economist, Clare McAndrew, explain that the top attributes include the uniqueness of each artwork for which there are 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. Interestingly, McAndrew argues there is a way to quantify the subjective value of art, otherwise described as taste. If we consider a fair valuation range for art prices for a specific artwork by an artist, the excess paid over this range equals the value of the subjective premium inherent to art prices. There is a view that this excess is in actual fact the monetary value a collector is prepared to pay for psychic returns over time.

Art has also a reputation for being relatively illiquid. This can be explained by the fact that art in private hands trades sporadically - a typical cycle to market can take 30 to 40 years – and that it trades on so-called ‘thin markets’ where there are few buyers and few sellers.

Portability is yet another characteristic of art which distinguishes it from other asset classes, like for instance property. Artworks can be readily shipped to find their way to the most opportune markets and be sold anywhere globally. But like property, it a physical asset which implies there are holding costs. These include costs to maintain, store, restore and insure art pieces and these are typically quite high. In addition transaction costs to buy or sell art works are high. While auction fees for art are high compared to other asset categories, in South Africa these are lower than in countries like 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, physical risk because art is a material asset and artworks can get damaged.  Poor advise and judgement can also impact negatively on a portfolio’s value. Today the majority of established collectors do not  rely on their own tastes and seek expert advice. The guidance most collectors expect from art advisors is to help them find the best quality works without overpaying for them.

The total art market, consisting of a combination of dealer and auction house turnover, was estimated at USD 45 billion in 2016, thus offering a huge investment potential. For newcomers who are interested in entering and benefitting 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 dates back to 1974, when the British Rail Pension Fund invested in more than 2,500 artworks and reportedly delivered an aggregate return of 11.3% per annum over the next 25 years. In 2015, the overall art fund industry was conservatively estimated at USD1.2 billion.

The cost of managing an art fund can be high since there is necessary asset holding costs. The fee structure is typically modelled after hedge funds and is around 2% of the value of the assets under management. But on the upside, investors benefit from much sought-after expertise in art purchasing. Art funds are based on a partnership between art experts and finance professionals and the main advantage is the professional discernment to value art correctly and to not overpay for art works.

Art-secured lending is a more recent niche credit service which 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 safe keeping in vaults. Art lending is currently not available in South Africa. In 2015, the overall size of the art-lending industry was between USD15 and USD19 billion, dominated by private banks.

Stock exchanges for investing in fine art have been launched first in China, France, and more recently the UK with ARTSTAQ. With the share prices 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.

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