There are few markets that arouse as much fascination as the art market does. The art market is indeed a market in which goods can be simultaneously objects of beauty, stores of value and opaque investments. An increase in worldwide demand due to wealth creation in emerging countries has pushed prices upward and attracted the attention of the wealth management industry. However, art works consist of very specific type of asset class. They are illiquid, difficult to value and subject to the volatility of taste.

The emotional value of a work of art

Most people are often confused by the exuberance of the art market. At Sotheby, one of the most famous auction houses in the world, an entire sale session can easily bring up several millions of dollars in one go. In May 2015, at Christie’s, another famous auction house, the “Women of Algiers” of Picasso was sold for a staggering amount of $179 million, exceeding all estimates.

It is indeed hard to understand how some people can go obsessed about art. In theory, price reflects the value someone attaches on a work of art. This value, in turn, reflects personal consumption utility, i.e., in economic theory, the utility that someone derives from the consumption (or the mere admiration) of a work of art. This utility is driven by the beauty or quality of the latter but can be also influenced by other factors. Among them is the “collection effect”. The more Pre-raphaelite paintings a collector has, the more he or she would be willing to pay for an additional Pre-raphaelite painting in order to complete his or her collection. Another factor is called “provenance”. For example, White Center by Rothco has seen its price inflate thanks to its provenance from David Rockefeller in the year 1950’s. In May 2007, it was sold for $72.84 million at Sotheby’s. Finally, a last factor that can influence the price of a work of art and that is often underestimated is the competition between collectors.

Aside from the price derived from personal consumption utility, there is also a market price, i.e. a price that is defined by the law of supply and demand in the market and which is slightly or significantly different from the original price (a little bit as the discrepancy between book value and market value in finance). A major obstacle here is that it is often hard to do mark-to-market in the art sector as each work of art is unique and has no replica. Besides, many individual factors such as provenance, collection effect or competition influence to a large extent the value a collector attributes to a work of art, complicating any attempt to perform mark-to-market.

Source: Deloitte Luxembourg & ArtTactics & Finance Report 2014

According to a survey made by Deloitte Luxembourg in collaboration with ArtTactics in 2014, only an extremely small minority of investors in arts engage in that activity for investment purpose only (see illustration above); the vast majority of respondents do purchase art because of the emotional value they derive from it.

Art as an asset class

As has been outlined by many observers, it is not that obvious to put the art market into a particular type of asset class. An asset class is defined as “a group of securities that exhibit similar characteristics, behave similarly in the marketplace and are subject to the same laws and regulations”, the three main asset classes being equities (stocks), fixed-income (bonds) and cash equivalents . The art sector is poorly regulated. For example, the authentication procedure of works of art is devoid of clear processes and art authenticators are, up to now, largely protected against lawsuits. Their immunity in this regard raises question about their responsibility in the case of a market downturn.

Furthermore, paintings do not qualify as equities nor fixed-income as they do not generate any type of cash flows (fixed or floating). As a result, it is impossible to value paintings based on discounted cash flows, a valuation method by which the current value of an asset is the sum of its future discounted cash flows. Art is of course no cash or cash equivalent as it is highly illiquid. When a collector wishes to sell a painting, it can take months for experts to value the painting and other additional months to find a buyer, notwithstanding cases of failure to find a buyer. This lack of liquidity is precisely the cause of paintings being used as collaterals for loans often come with higher interest rates and higher “haircuts” (which means that a painting worth $ 1 Mio, for instance, could be eligible as collateral for only 40% of its value, i.e. $400,000). The art market is also unhedgeable to the degree that derivatives on paintings cannot be designed because of lack of standardization and valuation difficulties. Such derivatives cannot be replicated directly in the market. Above all this, the art market involves high transaction costs, a large proportion of which being the costs associated with art advisors and art authenticators, making the market very inefficient and difficult to grasp.

Art performance and art funds

Notwithstanding these aforementioned obstacles, the growing demand in the art sector is real and can be explained largely by wealth increase in emerging countries. After the crisis of 2008, auctions sales have been going up again and they accounted for around $56 Billion in 2013, $3.5 Billion of which having been from the post-war and contemporary art market only (See illustration). Since art is primarily a luxury good, increase in demand does not only stimulate the existing market but also, theoretically, pushes prices upward.

Source: ArtTactic

Performance of the art market during the last ten years has been mixed at best. The Mei Moses World All Art Index (All Art-W), the most commonly used index to assess the performance of the art market, has reported negative performance between 2012 and 2013 and stood at 7% between 2003 and 2013,  whereas the return on the S&P500 was at 7.4%. Over the years from 1999 to 2004 though, the index outperformed the S&P 500.

Nonetheless, the main strength of art as an investment lies in the fact that it is not correlated (or has a low correlation) with returns on shares and bonds. In this way, art can offer appealing diversification opportunities in a balanced portfolio strategy and improve the tradeoff between risk and return. On top of that, funds dedicated to art have appeared recently, such as the Fine Art Fund in 2001, spreading risk by buying large amounts of works of arts without obligations to sell at a loss. The art market is still at a very young stage and only the future will reveal how it will evolve.

For more information about Art finance, see the Deloitte report:

Photo credit: Thomas Hawk


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