Unlocking the Potential of Art Investment Vehicles.

• Author: Xiang, Alice

INTRODUCTION

Art as investment has become an increasingly prominent feature of the art world. (1) It is now common for investors to collect pieces based largely on their anticipated future resale value rather than their aesthetic value. (2) Surveys have found that half of art collectors consider investment returns to be an important motivation for their art purchases, (3) and 88% of wealth managers think art and collectibles should be included as part of a wealth management offering, (4) up from 55% in 2014. (5)

Heightened interest in art investing, along with growing interest in investing in pleasure assets more generally, (6) has led to a boom in the art market despite conflicting accounts regarding the attractiveness of returns on art investment. (7) According to a recent study, the global art market has exploded over the last ten years, nearly doubling in size. (8) This boom is driven not only by U.S. investors, but also investors from emerging markets like China. (9) Given that the population of ultra-high-net-worth individuals, the main players in art investing, is expected to grow by 43% by 2026 (in large part due to increases in wealth in emerging economies), the global art market is likely to continue to expand. (10)

Why have these investors been drawn to the art market? Four features of art have made it an attractive investment option. First, although the aggregate long-term rates of return in the art market tend to trail those in the stock market, (11) investing in art can be a valuable component of a portfolio diversification strategy. (12) Some studies have found that art prices have a low correlation with other asset classes, and may thus outperform the stock market during economic downturns. (13) Second, during periods of high inflation, when the purchasing power of currency is falling, art acts as a store of value. (14) Third, with the number of ultra-high-net-worth individuals increasing worldwide, art prices have the potential to grow tremendously, generating large returns for investors. (15) Finally, certain subsets of the art market have seen very large returns in recent years, increasing public attention on the potential of art for investment. For example, Post-War art (16) has seen a 308% increase in price indices over the past decade. (17) Although the art market initially floundered in the wake of the financial crisis, these factors have all contributed to generate the recent growth in art as investment.

The benefits of investing in the high-end art market, however, are largely only available to very wealthy individuals. Although artistic patronage has shifted over time from private commissions to institutional funding, (18) and technology-driven online art businesses have shown the potential to lower transaction costs and barriers to entry, (19) art investing generally still requires connections to the art world and the employment of costly middlemen. (20) Moreover, the fundamental vehicle for art investment remains the same: a single investor must put up enough capital to purchase an entire piece of artwork. Because a well-diversified portfolio requires that investors buy many pieces to mitigate idiosyncratic risk, art investing is almost exclusively the province of the wealthy. Moreover, the illiquidity of art as an investment product makes it less attractive to less wealthy investors who are less able to lock up their capital into assets they might have difficulty liquidating in the near future. (21) That limited investor pool means that less wealthy individuals who would otherwise want to take advantage of art's financial and aesthetic value are excluded from the market, preventing the art market from reaching its full cultural and economic potential. As it has been for much of history, art investment is still largely restricted to a select group of elite investors.

A potential exception to these general limitations is art investment vehicles. Art investment vehicles are entities that allow groups of investors to pool their resources and reap the financial rewards of art as investment without individually owning the underlying artworks. One type of an art investment vehicle is an art fund. Art funds emerged in the 1970s and allow investors to pool their money to invest in a collection of art. (22) Art funds buy a set of pieces, store them until a maturation date, sell them, and then distribute the profits to investors. During this time--generally between five and seven years (23)--the art fund might loan the pieces out to its investors or to institutions, (24) but otherwise the pieces are completely removed from the market. (25) The benefits of art funds are that they allow investors with little knowledge of or connections to the art market to invest in the art market without dealing with the selection, maintenance, and promotion of pieces.

Despite these advantages, however, art funds still suffer from illiquidity, inaccessibility, and weak returns. Most art funds are structured like private equity funds, with high fees and long-term lock-ups. (26) Modeling themselves after other private equity funds, art funds typically charge a management fee of 1-3% annually and a performance fee of 20% of the profits. (27) In addition, with required minimum investments as high as $1 million, participation in art funds is still generally restricted to very wealthy individual investors. (28) Moreover, the art-fund market remains a very small portion of the overall art market; out of the estimated $64 billion art market, (29) art funds only manage around $834 million of assets. (30) The art-fund market has been shrinking every year since its high of $2.1 billion in 2012. (31) Thus, while art funds have increased access to the art market to those with few connections to or little knowledge of the art market, their impact has been very limited.

Aside from doing relatively little to expand access to the art market, art funds have had limited financial success. The British Rail Pension Fund (BRPF), which started investing in art in the 1970s, is usually cited as one of the first art funds and has been the only large institutional art fund to date. In 1974, faced with high rates of inflation and poorly performing stock markets in the U.K., the BRPF decided to diversify its holdings by investing 3% (around $70 million) of its portfolio in fine art. (32) After liquidating its art holdings in 2000, (33) the fund achieved an average annual rate of return of 4% (in real terms) on its art collection, though mainly as a result of highly profitable investments in impressionist artworks that were fortuitously sold at the peak of the prices in that market. (34) Moreover, the U.K. stock market ended up having a massive recovery, with the FTSE-Actuaries Index rising from 61.92 in 1974 to over 3,000 in 2000. (35) Although the BRPF's investment in art succeeded in its stated goal of producing a real return after inflation, in hindsight the fund would have performed much better had it not invested in art. (36) Thus, although the BRPF is often cited as one of the first success stories in institutional art investment, (37) its success was very limited at best.

Most attempts to create large, diversified art funds, however, have not experienced even this modest level of success, instead dissolving due to internal scandals, failing to raise sufficient funds, or liquidating their holdings with losses. (38) One of the few extant firms to have weathered these challenges successfully is the Fine Art Group (previously known as the Fine Art Fund), which has raised over $500 million. (39) But even the Fine Art Group's returns have been disappointing, with the firm recently reporting a return of around 5% on its latest fund. (40) Overall, the limited and weak track record of the art-fund market has undermined its attractiveness to investors. (41)

Besides art funds, another form of art investment vehicles is art exchanges. Art exchanges allow less affluent investors to buy and sell highly liquid shares in the resale value of collections of artworks owned by companies that transact on the exchange. (42) The idea behind art exchanges is that they mimic public stock exchanges with low barriers to entry by allowing investors to easily sell their shares to other market participants. (43) Just as stock exchanges allow investors to buy and sell shares in companies, art exchanges allow investors to buy and sell shares in "art management companies," which specialize in buying, managing, and selling artworks. Unlike art funds, art exchanges do not require minimum capital contributions and therefore are generally not limited to high-net-worth investors. (44) Moreover, by providing investors with a robust secondary market for their shares, investors are not locked in for several years as they are in art funds.

In terms of legal structures, the fundamental difference between the art fund model and the art exchange model is that art funds have external management structures whereas the art management companies selling shares on art exchanges have internal management structures. Art funds are managed by external managers who work for a firm that manages multiple funds. (43) This creates benefits of economies of scope and scale from managers being able to manage multiple funds and the resources of the firm being spread across these funds. (46) In contrast, art management companies, like other types of companies, have their own management teams. (47) Given the important role experts and middlemen play in the art market, the economies of scope and scale gained from sharing human capital across funds can be very beneficial in the art market. Nonetheless, the increased accessibility and liquidity offered by art exchanges could make them more attractive to less affluent investors who are excluded from the art fund market.

Art exchanges have been attempted over the past few years in the United States, Europe, and Asia with varying...