In the eye of the investor - By Buttonwood

Buttonwood

In the eye of the investor

Feb 22nd 2005
From The Economist Global Agenda
Source

Efficient markets are producing boring returns these days. Is investing in one of the least efficient—art—a better bet?


NOT long ago, Buttonwood dropped in on the auction rooms at Sotheby’s, on London’s New Bond Street. The room was full, the bidding brisk. It brought back the heady days of the late 1980s, when it seemed that anything in a frame could be sold for a fortune and all the upwardly-mobile talk was of investing’s newest asset class. That was before the art market collapsed in 1991, of course, and the world’s two most prestigious auction houses found themselves in court explaining how they happened to have fixed prices between them.

Those heady days are back, it seems, and the price of art is once again making headlines. The London season kicked off earlier this month with sales at Christie’s and Sotheby’s that raised more than £110m ($205m), well up on takings a year earlier. They built on strongly recovering sales throughout 2004. One highlight last year was the $3m paid for Maurizio Cattelan’s life-sized wax image of Pope John Paul being felled by a meteorite. From the ridiculous to the sublime, another was the sale of Picasso’s “Boy with a Pipe”, which, at $104m, displaced Van Gogh’s “Portrait of Dr Gachet” as the world’s most expensive work of auctioned art.

Financial types have not been slow to note that art is hot again. At least half a dozen investment funds devoted to art have recently been set up or are being mooted, and another six or so may emerge this year.

What is new this time around is that a host of analytical tools is making it possible to approach the art market with a degree of financial dispassion. The other novelty is that the vehicles are being constructed specifically along the lines of hedge funds, private-equity funds and mutual funds, allowing investors to buy shares in a pool of art. As Bruce Taub, the former Merrill Lynch investment banker who set up Fernwood Art Investments, points out, this is another step down the long highway of democratising investment by securitising assets (bundling them up and selling shares in the resulting pool). Just as mutual funds made shares more accessible to average investors, so these art funds have the potential to open up the world of painting and sculpture to those who do not have generations of farmland or oil money behind them.

It is easy to see why investors might be interested: art seems to offer a way to ginger up returns on traditional financial assets. Art outperformed the S&P 500 stunningly over the five years from 1999 to 2004, according to the Mei/Moses art index created by two professors from New York University’s Stern School of Business (see chart below). That gap dwindles to nothing over half a century, but what matters, says Michael Moses, is that returns on art are not correlated with returns on shares. Owning both art and stocks can reduce the volatility of a portfolio by up to 20% while returning about the same amount, he reckons.

Britain’s Barclays Capital tests this theory in detail in the latest edition of its Equity Gilt Study, published on February 22nd. Barclays looks at how art and other assets performed over different phases of the business cycle and over different periods of time, using data from 1970 onwards. Art does best when the economy is growing, and it survives the ravages of inflation better than most, it transpires. Art prices rise when bond returns slump, and move broadly in tandem with property and (less so) commodities. Because its price bounces around so much, investors have to hold art for at least 35 years to be certain of real annual returns. All in all, and subject to tonnes of caveats, the best portfolio mix for a pension-fund investor, in particular, with a horizon of ten years or more would include a 10% weighting in art.

Those caveats, though, are important. The art market is hugely “inefficient”—ie, you lose your shirt if you don’t know your way around. Art is diverse, hard to value, expensive to trade and often impossible to unload at a profit. Even the best indices say only so much about art as an investment: they do not include private sales or, usually, works that fail to find a buyer at auction.


The new art funds think they have got round some of those drawbacks. Philip Hoffman, who used to work for Christie’s and last year founded the Fine Art Fund, says that more than 80% of its purchases are made directly from owners and attract no commission. Because the fund is closed-ended (investors have to leave their capital in for ten years), it can buy art on the spot for cash at good prices and cannot be forced to sell at a loss to meet redemptions. He says that it has already bought and sold some works with a profit of more than 45%.

Fernwood’s Mr Taub admits the drawbacks exist but sees virtue in necessity. The inefficiencies in the art market mean that knowledgeable investors can get the sort of performance that they could hardly hope for in the relentlessly analysed equities market. One of the two funds that Fernwood will launch this spring will reflect the skills of classic collectors, spreading risk by buying art over eight asset categories and permitting investors to come and go at fixed intervals. The other will reflect the practices of art-market professionals, amassing a war chest for opportunistic buying.

Buttonwood is all for diversifying portfolios, and thinks art is at least as jolly as pork bellies. But there are a few worries. One is that no matter how sophisticated the portfolio analysis used, it is simply not possible to discount mathematically the chances that Damien Hirst’s polka dots are going to appeal more in 20 years than Jeff Koons’s dinner plates. And this market, with more than $1 trillion in assets, is virtually unhedgeable.

Another concern is that most of the funds will be more lightly regulated than ordinary retail vehicles. Since they seem to be requiring a minimum investment of $250,000 from people with liquid assets of at least $5m, this may be fair enough. But there is talk that the ante could be as little as $50,000 through “feeder” banks, and that looks more questionable.

History prompts a third reflection. In the 1980s, Japanese buyers dominated the market for Impressionist and Modern art. Their bidding spree was backed by what turned out to be largely illusory wealth created by a bubble in share and property prices at home. The bubble burst, a lot of art was unloaded quickly and Japan has yet to emerge convincingly from the recession that followed. The Japan of two decades ago was very different from the America and Britain de nos jours, but the level of asset prices here nowadays does provide food for thought. Van Gogh’s “Portrait of Dr Gachet” made headlines when a Japanese businessman bought it for $82.5m in 1990. Fewer recall that it changed hands some years later for one-eighth as much.


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