Fiddich Review Centre
Alternative Investment

Art, and Art Funds, as Alternative Investments

Deloitte has come out with its Art and Finance Report 2021; and, at 313 pages, the seventh annual report is quite a read, but there are several interesting observations:

  1. The rise in wealth in 2020 will likely bleed over into the art market.
  2. The volatility in the stock and other traditional markets is driving a demand for diversification into alternative investments, including into art-related assets.
  3. The ultra-high-net-worth (UHNW) population now holds an estimated $1.481 trillion in art.
  4. The art market has transformed itself during and after the pandemic, becoming more resilient.
  5. Although New York remains the dominant geographical location for auctions, Hong Kong is a strong rival for auction locations.
  6. The online art sales by auction houses, spurred by the lockdowns during the pandemic, are now firmly established at the major auction houses; and,
  7. Nonfungible tokens (NFTs) are a legitimate alternative art market channel. 

So, are art and art-related assets an alternative investment? If so, how should you get access to this asset class?

Is Art an Alternative Investment Class?  

Art is an investment, but it is a unique one. Much of the popular material on art investing is potentially misleading in its ebullient optimism, especially in the realm of modern art. The popular press extols the giant winners in the game, and some of the UHNW creators of new collections can dominate the market and return hundreds of times the initial investment. The giants are an integral part of the mystique of art collecting, but Saatchis are few and far between.

Some art investments have outperformed the stock market in the postwar years and, in many cases, quite handsomely. There have been periods when 25% compounded rates of return have been available to the investors; indeed, substantially higher rates have been achieved by many contemporary art collectors, and over long periods of time. In order to achieve these returns, however, you need access to expertise and experience in the specific market. The most critical expertise needed is in the areas of taxes, legal title, recognition, liquidity and premiums. 

Taxes. Income from transacting tangible assets is taxed differently from investment or ordinary income. How you handle the ownership of the collection will control the subsequent income tax treatment of your buying or selling tangible assets. The IRS recognizes four distinct types of taxpayers based on the role that the taxpayer plays prior to a transaction: collector, investor, business investor and dealer. Although the IRS will assume you are a collector (thus imposing the highest capital gains tax and allowing the fewest deductions), in reality you may qualify for the more advantageous tax status of investor, where more deductions are allowed. Qualifying as an investor is not as simple as a declaration and requires a well-documented pattern of behavior; but an expert can help you to qualify for a desirable tax status.

Recognition. The value of some of your collection will be much more susceptible to market forces than other pieces. This may be because of the general standards of taste, critical acclaim, the vagaries of provenance and authenticity, the role the item plays in the culture and changes in laws banning the sale or purchase of certain items. It may also be because, when it comes to the ownership of tangible assets, people become, in the words of Dan Ariely, “Predictably Irrational.” Artwork that is easily recognized often has more stable pricing, and those pieces that are less well known have a volatile pricing, especially if there is a questionable title, or provenance, to the ownership of the item. 

Liquidity. The ease with which you can sell an item also factors into the risk calculation. Rare, or unique, items by themselves may not have enough demand to provide liquidity: Any art must not only be offered for sale, but it must also be sought after by those willing to pay a premium for the ownership and control of the item. A highly sought-after item can easily be sold at auction or private sale, even if poorly executed or heavily damaged, while a well-executed and flawless item may languish for months or years. You may own a few highly liquid items and many illiquid items in a collection. By selling the highly liquid items without the more illiquid items, you may lack the leverage on negotiating fees, commissions and other costs on the sale. 

Family Offices. Surprisingly, large commercial family offices rarely acquire an expertise in artwork. I recently spoke to the CEO of a family office with assets in excess of $1 billion. One client was a well-known collector and philanthropist of arts organizations, but when I discussed what expertise or experience the family office had in managing or planning for the artwork the answer was, basically, there is none. In his opinion, “you could go to a dozen other families of similar wealth and interests and the answer would be the same.” Family office clients who are collectors or investors in art require bespoken service, something that does not fit the mass customization model of most commercial family offices. 

Indirect Ownership of Art

Many individuals would like to invest in art, but lack the skills or resources to own art directly. The alternative is to invest in art indirectly. Since the last publicly traded art auction house, Sotheby’s, was taken private in 2019, indirect art investment is now based on a private equity or hedge fund model.               . 

The hedge fund model has a number of options, including the fund put together by Artory, the online art registry; and Winston Art Group, the art appraisal firm that joins such established funds as Artemundi, Anthea Art Investments and the Fine Art Group, as well as platforms such as Yieldstreet and Masterworks

Whether it is a fund or a platform, all are:

  • Long-term (five to seven) investments that may not generate a cash return during the course of the investment;
  • The investments are illiquid with restrictions on being able to sell the interest for one or more years;
  • Much less disclosure than the disclosures required of regulated investment companies;
  • The minimum investment amount may be high ($10,000 or more); and,
  • The art investments in the fund are intended to be sold, not owned.  

When you invest in art funds, you are investing in access to the expertise and experience of the managers of the fund, and their processes 1) to determine the title to artwork; 2) the nature of the specific segment of the market; 3) the governance of the fund, and 4) the added cost of securing and preserving the artwork. Whether it is an experienced art investor and collector like Javier Lumbreras, the founder of Artemundi, or longtime industry experts like Elizabeth von Habsburg and Nanne Dekking, the founders of Artory/Winston. The success or failure of an art fund depends on the quality of its managers and the quality of the management.

Art investments, whether directly or indirectly, are only for investors who have an established portfolio of stocks, bonds, cash or cash equivalents that are not investing in art. Investors need to have a higher risk tolerance than most investors and a willingness to accept quite high levels of fees, costs and expenses. This is no different from investing in any other alternative asset class. Art also requires a certain passion that investing in, say, oil and gas partnerships does not.

Another thing to keep in mind is that art, whether owned directly or indirectly through an art fund, is a difficult asset to fit into a conventional estate plan, especially those that use trusts or other fiduciary relationships. These fiduciary relationships use Modern Portfolio Theory for both allocation and diversification of assets in the portfolio. Holding an illiquid asset like art will not meet all of those criteria, so requires drafting in specific exemptions to this fiduciary duty. When the trust distributes assets to the beneficiaries, the illiquid assets may not be easily divided among the beneficiaries; and, in cases where it can be divided, the individual beneficiary may not be a qualified purchaser or accredited investor under the terms of the SEC regulations; or, in the case of a charitable beneficiary, the illiquid asset is a jeopardizing investment; or, the sale of which is unrelated business income, both of which cause tax problems for the charity. The result is, more often than not, a fiduciary, especially a corporate fiduciary, will force the sale of the artwork or art fund regardless of the timing on the sale, before accepting the position. 

Conclusion

High interest rates, high inflation rates, and political and financial uncertainty have roiled the stock market. Many clients now seek alternative investments in general and artwork and art-related funds in particular. The glamour of owning art, and the stories of the extraordinary returns over time can mask the challenges of investing in art as an alternative investment. If you have the risk tolerance, the willingness to be charged higher fees and costs, and you have an established liquid investment portfolio that can provide financial security if the art investment requires a longer period to reach the returns desired, then investing in art is a viable option.

 

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