by Gerhard Beukes, VP & Group Head of Fund Development & Management
What makes an investment risky? Maintaining a general view, price uncertainty would make an investment risky as an investor would not be able to predict its price, which is determined by its inherent valuation. A valuation of any conventional asset is driven by old-fashioned demand and supply drivers and – more theoretically – by its present value of future cashflows. A buyer and seller thus have some guardrails to determine what a reasonable valuation of an asset can be, after which a specific market price can then be driven by macroeconomic conditions and participant biases.
As an asset class, art is tricky. Conventional portfolio analysis rarely recommends art as a material contributor to a well-diversified portfolio of assets. When considering an asset class, two factors need to be considered – firstly, its price and related transaction costs, and secondly, the cost of holding the asset during ownership.
What is the value of a piece of art? It is what a buyer and seller agree the price is, or the price the auctioneer hammers down. It’s driven by forces that correspond to mainstream markets (expecting price appreciation, pride, assuming increased future demand), but quantifying these forces is near impossible. Apart from speculators, the price is driven by the beauty or passion held in the eye of the buyer.
Due to the specialized nature of the art market, the demand pool is fairly small (compared to the global asset market as a whole). Contributors are typically passionate and will likely exhibit an acquisition bias, which places a natural upward pressure on prices due to the relatively small supply of top shelf quality art pieces. Speculative buyers disrupt this market often by looking to capitalize on a new artist or craze, more cash rushing into the market, or other circumstantial drivers.
Due to its eclectic nature, art would be expected to contribute to a portfolio via uncorrelated returns, however this is not necessarily the case. At times when global asset classes perform well, entrants flush with cash may enter the market to distort prices even further. At times when global markets retreat, speculators seek to exit their art investments, often leading to price discrepancies to the downside. Consequently, there may be a stronger than average correlation between art and conventional assets.
Liquidity is arguably the biggest challenge that owners face. According to reports from Art Basel and UBS, high value works (priced over $1m), represent around 60% of the market’s total value, but account for only 1% of annual transactions. This implies that the top tier is extremely narrow. Should an investor in the other tiers need an exit, it may take a substantial length of time to find a buyer, and bid-ask spreads may be severe for the seller – who may have to revert to fire sales. This illiquidity may wipe out years of perceived gains with a particular piece of art.
Combining the above risks, lending against or borrowing to acquire art could almost be defined as legalized gambling and should be avoided by a rational investor. Furthermore, this practice will amplify already incoherent pricings.
If that rollercoaster is not enough to make your stomach turn, consider the second component of an asset’s cost: its holding cost. This may be more measurable, but it is by no means immaterial.
Even for more mature and therefore stable segments of the art market (think pieces of art that are known outside niche market participants), there are challenges. Storage costs (including cost of security and climate-controlled mechanisms) along with costs of insurance and logistics can be crippling and may reduce the total return of such an asset substantially.
While we certainly appreciate the beauty and value of art, we caution investors against making it the backbone of a financial portfolio due to the inherent risks of the asset class. Do buy art that you like and place it in a prime place for you and others to enjoy. Do not, however, place it at the foundation of a well-diversified asset portfolio.
