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Managing the risks of art investment

Randall James Willette is Managing Director of the London-based Fine Art Wealth Management serving wealth managers and their private clients on art management and investment.

For most years since 1960 art prices have continued to outpace the world stock markets – justification that art investment can be an important component of a family's investment portfolio. But prices are volatile, so beware of the risks

Collector's marks are pieces of evidence used by art historians and academics to help establish the history of ownership for a drawing or print. They can provide guidance on the provenance and authenticity of a work, thus affecting its investment value.  Just as one must undertake proper due diligence with regard to financial investments, the same holds true for art. Even the most experienced collector benefits from professional guidance in today's fast paced and complex art market. The demand for high quality works of art with strong provenance and in good condition makes them particularly interesting as a long-term investment. Proper research and documentation can be very important to their investment value.

The role of experts
Collectors, investors and art institutions require maximum reliability in attributing works of art. But information relating to origin, which is often several hundreds of years old, does not always prove reliable. Since the artist who created the work of art may no longer be available, the expert must assess the extent to which he believes the piece of work can be attributed to one or other artist on the basis of years of study and experience. The 'expert' must possess comprehensive knowledge and the ability to make comparisons on all phases of the life and circumstances of the artist – something not always easy to establish.

In most cases an expert is compelled to examine the historical material and form his own opinion. The contradictions which arise in this context have less to do with the subject of art history as they have to do with the expert himself. Rivalries and personal egos can have a negative effect on producing an impartial assessment.  One must also remember that experts are human and capable of mistakes. It is not surprising that a new generation of technical experts sometimes come to a diff­erent perspective than their predecessors.

Equally, it is not uncommon for an expert's work to be forgotten and later rediscovered, or for aspects which were once highly praised to be criticised. We eventually recognise that the value of an item depends on the value accorded to it by the individual. The proper docu­mentation or an illustration in a book can decide whether a painting has a lower or higher value. At the same time, there are inexperienced investors who allow themselves to be advised  without being capable of assessing whether the experts are providing a good or bad service.

Ultimately, the art lover who possesses an instinct for quality will continue to further his education (depending upon the intensity of his efforts) and eventually reach a sound and independent verdict. Because of his personal experience he is capable of recognising the quality of an expert and consequently the value of expertise.

Art as investment
Art can be an important component of a family's investment planning and portfolio diversification strategy. For those who invest wisely, its high long-term returns and low correlation to stocks can justify serious attention as a long-term investment.

But given the lack of transparency in the international art market, measuring the risk associated with art volatility is difficult. Art prices can be highly volatile and difficult to track. The global art economy includes dealers, collectors, galleries and auctioneers with many transactions undertaken privately and unreported. Indeed, the only publicly available data on art sales comes from the auction houses.

For the best indication of how art performs as an investment one must look to the Mei Moses Fine Art Index, which tracks fine art sold at auction. This category includes paintings, watercolours and sculptures, but not decorative arts or collectibles. Michael Moses and Jianping Mei, professors at the Stern School of Business in New York, compile the index and regularly track the auction market. The index tracks individual items sold and records when they are sold again, measuring the price increase with each transaction. This provides a more precise measure of return than average prices.

The index shows that for most years since 1960 art prices have outpaced world stock markets. Since 1960 the annualised compound return for art has been 11.1% – just ahead of the 10.7% figure for stocks. Art has shown annual returns of 4% over the past five years compared with 2.1% for the Standard & Poors Index. In the past three years, art has achieved annual returns of 1.8% against an 11% decline in S&P Index.

This is not to say that there have not been short periods when stocks outperformed art. The US stock market's strong rise made the first six months of 2003 one of the few periods since 1960 when shares prices clearly outperformed art as an investment.

For example, returns from art as measur­ed by the Mei Moses Fine Art Index fell by 3% in the first half of 2003 while the S&P share index rose by 12%. Impressionist and American art produced strongest perform­ances while 'old masters' were weak.

Although art continues to outperform stocks it has higher risk given that prices are more volatile than stocks. Individual works can have great price swings. Equally important from an investment standpoint, art is less liquid. As pointed out by Mei Moses, while the general market may be quite vibrant, the market for a particular work can be very thin with few expectant buyers. And unlike other asset classes such as equities, bonds or property, art produces no income. This makes it difficult to securitise art assets and raise capital against high value works in capital markets. Lack of liquidity therefore demands a diversified art portfolio and long-term planning strategy.

Low correlation with shares
Another attraction of art is its low correlation with other financial assets and its diversifying effect on an investment portfolio. Despite the decline of many stock markets art has remained relatively buoyant over the past three years, although market volumes have fallen.

According to Mei Moses, the correlation between the percentage change in the Mei Moses semi-annual art index and the S&P 500 total return index is a low 0.098, indicating that art may be appropriate for portfolio diversification.

Mei Moses have three market valuation indices (masterpieces, middle market, low-purchase price art) comparable to large-capitalisation and small-capitalisation share indices. A way to analyse the effect of pur­ch­ase prices on returns is to create an index based on objects that have sold at auction more than once for each of three valuation tiers of art prices much like the large cap, middle cap and small cap indices for shares.

Since 1952 the 'low-purchase price' valu­ation index, which comprises art objects within the lowest 33% of auction purchase prices, has strongly outperformed both 'middle market' and 'masterpiece' indices. Indeed, the low-price index outperformed the S&P 500 for almost the entire 50-year period through 2002. The performance of masterpieces – the top 33% of auction purchase prices paid each year – was about the same and substantially under­­­­performed the low-price index. Measured against the long-term perform­ance of the S&P 500, masterpieces tend to under­­perform while low-price paintings tend to outperform the general art auction market.

Due diligence
Just as one should obtain independent and objective advice when making a financial investment, the same holds true for investing in high value works of art. This is not always easy. To date such advice has been provided largely by art dealers, galleries and auction houses for whom conflicts of interest often exist. Unlike other investments, the art market lacks professional regulation and there are no established industry standards of practice for the purchase and sale of art. 

Family offices should seek advice from professional advisers who have no vested interest in art and can draw on expertise from both the academic and commercial art worlds. This approach would be consistent with the practice (known as open architecture) used by wealth managers for financial services to source experts in their field from outside providers.

There are a variety of experts within the art market, from art historians and dealers to valuers and restorers. Credentials should include membership of officially approved associations and vetting committees for major inter­national art fairs. Experts should be recognised leaders in their field or cons­ultants to major museums and collectors.

Period of change
Meanwhile, the art market is entering a period of accelerating change and complexity. At the same time, conflicts of interest within the market are giving rise to the need for independent and objective advice on art investment. This is all the more important as the prices of quality art with strong provenance and good condition are expected to continue to increase in the long term.

Whether families choose to integrate art assets into their overall wealth management strategy as a portfolio diversification tool must rest with them and their professional advisers based on each family's investment objectives. Ultimately, it is the personal enjoyment from art where the real pleasure of this investment lies and the emotional reward rather than any financial dividend one receives from investing in art.

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