Art as an asset class

In this article, Nakul PANJABI (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2024) talks about the Art as an asset class.

Before delving into the economics of the art market and art’s significance as an asset class, let us first recollect the definition of an asset and an asset class. An asset broadly refers to a resource from which future economic benefits are expected to flow. An asset class is a group of assets that have similar characteristics and related risk and return behavior. Common examples of asset class would be equities, fixed-income investments, and real estate.

Why have you not invested in art yet?

Although an age-old investment, art as an investment has been available to only a minority of investors most of whom are high-net-worth individuals (HNWI) or even ultra-high-net-worth individuals (UHNWI). The prime reason is that the market faces an inelastic supply. In simple terms, there are very few goods in market to be traded which leads to higher prices of each item and therefore, at equilibrium, only few people with such means could afford the good. This economic explanation of the art market would be enough if there were very few art items available to buy. However, as intuition might suggest, that is not the case. The world is filled with pieces of art and people who own it. Does this fact weaken our previous argument? The answer is simply No. Even though there are lots of art item and anyone with some spare money can buy a piece of art, almost none of those items would be classified as an asset. Art as an Asset class has an extremely limited supply. Only a few pieces of art are purchased as Asset.

Features of the Art Market

Besides limited supply and consequently higher prices, there are few other factors as well that makes art an interesting asset class. Firstly, the investable art items are highly illiquid. Selling a collectible art item is a time-consuming complex process. It requires dealers, auctions and most importantly potential buyers who could afford such an expensive item that provides no economic benefits except capital appreciation. As one might guess, there are only a handful of individuals in the world who own a 50-million-dollar painting.

Secondly, the supply of this asset class is not closely related to the cost of producing it. Most goods’ supply is based on the cost of producing them. For example, it is cheap to produce toothpaste, so it has an elastic supply. If there is a strike at a toothpaste factory, then there would be less people to make the toothpaste. This will increase the wages (cost of production) paid to them. Now fewer toothpastes would be produced at a higher price. This will make the supply of toothpaste relatively inelastic. However, this economic phenomenon seems to be missing in the art market. The supply of this asset class is highly inelastic but the goods that represent investable art are very cheap to produce. The low cost of production does not dictate the supply of collectible art. It is the rarity of these goods that cause such an inelastic supply. A lot of Investable art items are works of deceased artists. Although they probably were very cheap to produce, it is impossible to create more of them. The rarity of such items makes them so valuable.

Art has a very high maintenance cost and most of the art do not provide any recurring cashflows. One source of art cashflows is the income generated from renting art to museums. Because there is a limit to the number of paintings that can be displayed in museums, most of the return from art investments is generated through capital appreciation. However, as we discussed before, it is not so easy to sell a piece of art. Then, why would anyone, let alone the most sophisticated of investors, buy such an asset? Well, there are a lot of reason why one might invest in art.

Reasons to invest in the art market

Low correlation

Art has a low correlation with traditional asset class. Fluctuations in Apple’s stock price would probably have little effect on the price of an authentic Picasso painting. Thanks to this low correlation, a collectible painting can act as a hedge against inflation and market crashes. According to a 2022 Citibank report, art has either a weak positive correlation or zero correlation with other asset classes.

Tax Benefits

Given the fact that the value of investable art does not derive from either its future cashflows or its cost of production, it is relatively easier to manipulate its price than it is for other assets. Manipulating the price of an asset is extremely useful to manipulate income and consequently taxes.

Money laundering

Art Investments have also been used for money laundering. The logic is straightforward. A 50-million-dollar painting can be much easily hidden than cash or gold of similar value.

Status Symbol

Art is a very efficient status symbol. The rarity of the collectible art items makes owning them a source of prestige. If your friend owns one of the only five paintings created by a famous renaissance painter, you don’t need to be an expert in art to judge the economic worth of the painting or of your friend.

What Future looks like for the art market

According to the annual report by Art Basel and UBS Global Art, the worldwide art sales crossed $65.1 billion in 2021. This reflects a 29% increase from the previous year.

Moreover, with increase in the trend of NFT trading, millennials are more interested in (digital) art than ever. According to 2021 study by Art Basel and UBS Global Art, millennials were the highest spenders on fine art in 2020.

Now, with an increase in art investing funds, the barriers for art investing have also been reduced tremendously. People, who could not invest in art because of high capital requirement and lack of expertise, can now do so by investing in an art fund.

Why should I be interested in this post?

As an (wealthy) investor, art represents an asset class which is not highly correlated with traditional assets. It then can be useful for asset allocation in terms of diversification. When you think of your personal portfolio, you may think of art.

About the author

The article was written in November 2022 by Nakul PANJABI (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2024).

About the Charging Bull sculpture

In mid of December 1989, a bronze sculpture of a bull in its charging position was dropped outside of the New York Stock Exchange. The Bull is a symbol of booming stock prices. Arturo Di Modica, an Italian-American artist, was responsible for this stunt. During the economically depressive period of late 80s, he intended to encourage optimism and hope for a prosperous future among the American Citizens. Anticlimactically, the sculpture was removed just after few hours but was placed just two blocks away from its original place.

Charging Bull sculpture on Wall Street.
Charging Bull sculpture on Wall Street

Source: Arturo Di Modica.

Although the Charging Bull has already become a global symbol for an upward stock price movements and prosperity, understanding the basics of Bull and Bear markets can be useful for Investment Management. Bull market represents the time period where asset and security prices are rising, and it reflects the heightened investor confidence in the financial markets. Conversely, Bear market represents a downward movement in security prices and an increased investor pessimism. The terminology evolves from the behaviour of the animals. Bull market derives its name from the upward attacking technique of a bull and the bear market from the downward attacking technique of a bear.

Price trends

Generally, fundamental investing deals with the fundamental value of the security rather than the movement of its price. However, it does not mean that price movements are completely irrelevant in investment decisions of an individual. It is useful to know whether the market is bullish or bearish. If the security is currently overvalued according to your fundamental analysis, then the ideal action would be to sell the security while it is overvalued. But if the price is expected to rise even higher in the near future, then the rational behaviour would be to sell the Security later at that higher price and to sell it now if the price is expected to dip. Judging the market trends is an important skill to maximise returns on investment.

The price trend approach and market efficiency

Classifying a market as bull or bear derives from studying the trends in prices of assets. The method to identify patterns in price movements and forecasting the direction of price using past market data is known as technical analysis’. Profiting from technical analysis requires the market to be inefficient. It simply means that the current stock price does not reflect all the information represented in the past price points as well as all the public and private information in the market. However, it is widely assumed that developed markets are usually efficient in the semi-strong sense. This means that the prices of the assets reflect all the information from past price points and all the information publicly available. Theoretically, in such a situation an investor cannot benefit (have abnormal returns) by using technical or fundamental analysis.

However, this does not mean that studying price trends is completely useless. In markets which are inefficient, using technical analysis might be even more profitable than fundamental analysis. Generally, the developing economies such as Africa have inefficient markets. In those markets analyzing the past price points might give a reasonable edge to forecast short-term asset prices. Using fundamental analysis can also be tricky in this case. If a stock is undervalued, then the rational behavior would be to buy the stock and wait for its price to increase. However, since the market is inefficient, it is very uncertain when the prices will reflect the public information and, consequently, whether the investor will make a profit or not. In such a case, technical analysis might still work as it relies on market sentiment.