Beauty is in the eye of the beholder. But who holds the cash?

We all know what art is. Many have probably been to galleries and museums and seen the works of the greats. But have you ever thought of investing in art? Owning art is perhaps just a distant dream, let alone thinking through the mechanics of how to invest in it successfully. So I took a look into the market of art and collectables to see what was behind it and could/ should I get involved. From a 2020 Art Basel report the value of sales in art and collectables (this includes watches, cars, antiques, books and more) was valued at $64.1 billion. A decline from 2018 but up significantly over the last decade. The more I've read about the art market and the ways people invest the more similarities it has to the stock market, and in some ways, it's a more simplified model for supply and demand than financial markets. Art is considered an excellent long term investment as a way to diversify a portfolio and hedge against inflation risk as well as provide a return down the line. I suppose it can also be pleasant to look at if you put it on show. So should we all go out and buy a painting to put 5% of our portfolio into something different? Well, no. 

Firstly, let's look at the returns of the art market so we can compare them to that of more conventional investments. The obscureness of this market makes even this difficult. Obscurity will be a theme throughout. A Yale study concluded that taking an index of art sales between 1972-2010, you could expect an annual return of around 6.5%. Similarly, a Citi bank report put there figure for 1985-2018 at 5.3%. Both good performances, and when compared to the S&P500 annual return of roughly 8% between 1957-2018 looks like it could be a good investment with potentially less risk, putting this investment on a level with perhaps government bonds. Now obviously the lack of returns compared to stocks isn't a valid reason to not buy art as we've seen people buy negatively yielding bonds, so the return is just a part of the question when investing. 

The most obvious differentiation between art and other investments is the lack of cash flow they provide. Unless you have a museum and paying customers regularly to view your Constable or Gainsborough, unfortunately, they won't print money every quarter. Therefore, no returns are experienced unless resold, something I'll cover later. Investment in art is purely speculative that the price will increase and the main driving force in this rising price was explained in Thinking Fast and Slow by Daniel Kahnemann (shameless plug again to check out my reading list for more about this book). The basic principle is that you value what you have more than what you don't have. In the book, he uses the example of mugs and pens, but we're here to talk about art so let's use the Mona Lisa. Suppose, you own the Mona Lisa and someone offers you $10 million. You'd, hopefully, not want to sell it. The painting is worth far more than that. Now theoretically, let's say there's another Mona Lisa or a portrait of her sister he did. It costs $10 million. Would you buy it? Maybe not. Rationality would say of course, if you didn't sell something at X price you'd buy the same object at said price. But you may not have the cash or not want another miserable woman on your walls (I'm assuming the sister was as miserable). The additional value you give to the painting you own drives the value up, and this fundamental principle can be used to explain a lot of the reasoning behind art prices rising, along with many other speculative asset bubbles. As people buy a piece speculating they can sell it for more and then purely due to the fact they own it inflates the price. 

Now we know about this mechanism in play, let's go back to looking at the returns the art market provides. Yes, the returns are good, but the volatility is not. This can be viewed from a few viewpoints, the first being the illiquidity of the market. Not many people are buying paintings compared to other assets, and this can lead to the price shifting rapidly. If there is no one to buy your art at $10 million then the price and therefore return has got to fall. Paintings can be compared to the sale of houses in some capacity. You need a dealer, intermediaries, to find the right buyer, arrange transport and storage and much more, so it's not that quick. Compare that to stocks which I can buy and sell with the touch of a button on my phone almost instantly. This illiquidity creates more volatility due to the ease for the price to shift quickly up and down, a common factor of virtually all financial markets. The Citi bank report mentioned earlier estimated the volatility of the art market at around 14.9%, in comparison the US 10 year treasury reached 14.3% volatility at the height of the financial crisis and is generally at about 4%. Another factor is the changing fashions and trends in the art world. Something you bought 20 years ago may no longer be desirable, and now you have a problem. Either sell it at a discount or wait another 20 years and hope it comes back into fashion. Some art is considered timeless and will always sell for high prices, but as with anything of higher investment quality, you'll be paying a premium to own it. 

You may be reading thinking after all that why do the Nahmad brothers have a collection of $3 billion then if they could make more with less risk in the stock market? Its' time to look at the benefits of owning art and how to use obscurity to your advantage. 

I don't want to ruin art for people, it's truly a beautiful thing, but I can't get past the ease in which the system can be used by the ultra-wealthy and the complicity of all players as it benefits almost everyone. So who is buying art and why? Luckily UBS and Art Basel did an excellent, very long, report on the art market and covered this in incredible detail. The report looks at those who are the most prominent and most active players in the market by surveying high net worth individuals (HNWI) that have spent more than $10,000 in the past two years. This doesn't look at a growing sector of the market, fractionalised investing for the masses, but I think that deserves a separate article. The most significant art market is the USA followed by the UK/ EU (EU market is predominately the UK, France and Germany) and finally China. In 2019, France was the only one of these regions that bucked the trend of decline with 7% growth with the UK seeing a 9% decline much of which is believed to be due to Brexit uncertainty. The US boasts 44% market share with the whole market responding strongly since 2009. The market is very correlated to broader macro trends and geopolitical risk. This makes perfect sense considering who the buyers are. Likely are the chances that those buying art have investments all across the economy and therefore impacts to their other investments will lead to a decline in their art passion projects. Anything that distracts these people from art can lead to a decrease in sales. Some claim that you can predict a recession by looking at the peak of the highest art sale and then waiting around 16 months. The Salvator Mundi sold at the end of 2017, approximately 20 months before the coronavirus recession? Despite the three previous downturns also lining up, I think more evidence is needed. 

The median number of works owned by those surveyed was 24, so it goes without saying that these are the wealthiest in society. In terms of the demographics of those buying this has been shifting over recent years. Millenial collectors bought the most out of any age group with female billionaires being the fastest growing sector of buyers and spending more on average than any other. Further, those buying art are new to the game. Due to globalisation and the subsequent wealth creation of new markets and buyers are emerging around the world, dealers reported 34% of their clients as new. This is incredible for the industry as it increases the diversity of work that is being shared, bought and sold. Also, this spreads the job creation of the industry with current estimates putting around 3 million jobs and 310,000 businesses being related to the industry. This younger money brings with it change that is reshaping the operations of the industry. Of those prominent spending Millenials, only 8% had never bought online, and 36% of them spending over $50,000 online. The online purchasing of art is estimated to be worth $5.9bn, comprising around 9% of global sales although small compared to industries such as retail that have grown exponentially online when considering the value of purchases and the history of auctions this is a significant shift. The move online has also bought about the democratisation of art buying allowing individuals like you or me to purchase fractions of artworks and then be entitled to a share of the profits when sold—a far more cost-effective way to get a stake in the fine art market. 

An interesting shift is seen in the high-end millenial art buyers, which leads me to think many don't buy for the beauty is the resale rate. On average of those surveyed, the average time to resell a piece was just two years. Not long to own something that you valued enough to pay millions for. This isn't just isolated to the younger buyers. Most collectors across all demographics resold within five years, driving my feeling further that something else is at play. To be fair to those surveyed, 93% said the most important factor and motivation in purchasing was the passion. I believe that to an extent however many also said diversification, inflation hedges and expected returns were also of importance in the buying process along with the costs involved in storage. 

Storage. This is where I have further issues with the passion for art reasoning behind purchases. Just 8% of the artwork held is available for the public to view with as much as half of the value of a collection out of sight for even the owners. This explains why storage is such consideration for many as where on earth are you going to keep millions of dollars of art somewhere secure where it can appreciate for five years. Freeports. The epitome of using the obscurity of the art world. Freeports are hyper-secure locations that allow for the storage of whatever you want. They have no government intervention as they don't belong to any nation. No one knows what's in them and you cant visit without an appointment. They are the equivalent to a Swiss bank account but for objects. These essentially offshore locations allow owners to store, buy and sell art and due to existing outside any jurisdiction are temporarily exempt from taxes for an unlimited amount of time. These allow art just to sit and wait almost cost-free while speculators wait for the price to increase. No one knows how much is held in these freeports, one estimate of the Geneva and Zurich freeports was $10bn, but honestly its anyone's guess. The globalisation that has bought diversity to the art market has also allowed for arbitrage between markets globally, and these freeports help facilitate the movement of art and therefore, capital globally. Art transactions are also commonly wholly private, making the tracing of whos buying what. Look at many of the most significant sales in recent years, and it's to a private buyer. 

Trying to value something as subjective as art is a tough task. There's no P/E ratio or sales revenue to go off, but it's essential to be able to invest. Sotheby's have a video series on their 10 part process, but there's three I want to focus on. One mentioned earlier is fashion; the other is rarity and finally comparables. Rarity is quite self-explanatory if there's only one of something it's going to be expensive if it's desired. This makes sense when you see a lost master come up for sale when there's only a handful of others. But how do you create rarity if an artist had a lot of works? Buy as many as you can. What better way to starve the supply to a market then owning all the product, a monopoly of sorts. So when you come to sell one of your works the likes of which hasn't been seen in 20 years that suddenly becomes a lot more valuable. Next fashion, what's trending matters and you want to be at the height of fashion when you come to sell your work. But changing fashions at the whims of arty folk that wear berets is a far too greater risk to be vulnerable to so how can you make your collection the height of fashion for you to sell? As a prominent collector chances are you have several works by famous individual artists. Let's say you suddenly decide to let the Guggenheim or MoMA or any other world-famous institute display never seen before work from your private collection you know people are going to be all over that. So the hype builds. Then the end of the exhibition comes around your artist is the talk of the town and one of their works comes up for sale at record prices. You get a high return, and the cycle continues.

The Young British Artists (YBAs) I think are a great example of this. A group of artists that came around during the beginning of Thatcherism in the UK, doing work about the working class with exhibitions in derelict buildings, bringing art to the people. The likes of Damien Hirst and Tracey Emin benefitted hugely from this becoming both incredibly successful artists and exceptionally well off. A lot of the success can be linked back to Charles Saatchi, a business owner and super collecter who despite the anti-institution approach of the artists and mixed feelings around their work, displayed it in galleries and then the success and money followed. This leads me to a term called cultural capital which is defined as non-financial assets that enable social mobility, those who have it are responsible for setting 'good' taste. For many galleries, the owners of such art are not only generic billionaires but also hold much of this cultural capital. What is a gallery without art?

The use of this cultural capital to artificially raise the prices of works in a collection that can then be bought by the same collector acting as a private buyer. All of a sudden has a perfectly donatable asset that they paid far less for which can be used as a tax-deductible. Now I may be approaching this sceptically, and I'm sure people buy art for the passion, but it just seems like a perfect set of institutions where the only party not to benefit is the taxpayer. The rich avoid taxes, the galleries get work to display, young artists get their work funded, the public get art to view, and the auction houses get commissions from the sale of works—a perfect circle. 

So what do I think about investing in art? If you love it and want to get into it for the feeling of owning history and being able to look at it daily, do so. Chances are it'll appreciate and could prove to be a prudent investment. If you're an ultra-wealthy individual again, it could prove to be very useful. You may never look at it or only look at a fraction of your collection, but not many investments offer the privacy art can. What about me? It's a no from me. At this point, an investment in art doesn't fit any of my needs, and there are far more products that can prove far more beneficial and flexible.