Add Picassos to your portfolio?
Investing in art is becoming an increasingly popular diversification tool but it can be risky and costly.
NEW YORK (CNNMoney.com) - A good piece of art can mean much more than just a pretty picture on a wall.
In recent years, investors with a taste for the finer things in life have turned to art as an alternate asset class to diversify their portfolios beyond traditional stocks, bonds and real estate.
While the classic Dogs Playing Poker painting is unlikely to draw in the big bucks, high-profile auctions of paintings such Pablo Picasso's "Boy With a Pipe" -- which was bought in 1950 for $30,000 and sold at Sotheby's in 2004 for a whopping $104 million -- have piqued investor interest.
Investors can either buy individual works of art on their own by scouring galleries and auctions. For those that are looking for more guidance, a number of private banks, such as JPMorgan Chase (Research) and Citigroup (Research) offer services to help buyers gather a portfolio of art.
The surging interest has also spawned a number of art-investment funds --such as Fernwood Art Investments or the London-based Fine Art Fund -- and advisory firms in the U.S. and abroad. These entities are specifically designed to help investors create a portfolio of artwork to use as a hedge against stock-market volatility.
An alternative asset class
"In the past, people didn't consider the value of the things hanging on the wall in their homes," said Paul Provost, senior vice president and director of trusts, estates and appraisals at Christie's. "As people are becoming more sophisticated in their financial planning and estate planning, they are beginning to view art as an investment."
And if you look at the numbers, it can be a profitable endeavor.
The Mei/Moses Fine Art Index, the creation of NYU Stern School of Business finance professors Jiangping Mei and Michael Moses, tracks 9,000 pieces of art that were auctioned by Sotheby's and Christie's since 1950.
The index measures the value of the art market by analyzing repeat sales of the different pieces of art that comprise the index. While it is generally considered a fair benchmark for art valuation, critics say it doesn't show the whole picture because it excludes transaction fees, works that fail to sell at auction and certain styles of art, including photography and prints.
Still, for many art investors, it's the closest measure that a person can find to determine valuation in the subjective art market -- and what it shows is encouraging.
In 2005, the Mei/Moses Fine Art Index showed compound annual returns of 14.52 percent, while total returns for the S&P 500 were 4.9 percent and the U.S. Treasury's 10-year notes returned 2.68 percent, according to an analysis provided by the indexes' co-founder Moses.
The lack of correlation between the stock market and the art market makes it an attractive diversification tool, Moses said. But investors should be wary of looking for sharp returns in the near-term.
"Art should be considered a risk-reducing strategy, rather than a return producing strategy," he said. "The average holding period for a piece of art is about 28 years in our portfolio."
While 28 years may seem like a lifetime to hold an investment, experts say those interested in art are usually motivated by an aesthetic appreciation for the investment that makes the wait palatable. After all, hanging a beloved Lichtenstein on the wall can be much more satisfying than storing your shares of IBM (Research) in a lock-box.
A pricey play
But while art can hedge against some of the movements in the market, it can be a risky play and, for most individuals, a pricey one as well. Funds such as the popular London-based Fine Art Fund require investors to hand over a minimum of $250,000 in order to play the art market. Those investors will have to be willing to wait at least three years before they can cash out of their investment.
And, given the subjective preferences, there are no guarantees that a piece of art will grow in value over a set amount of time.
"Potentially interested investors need to keep in mind that the art market is a nominal marketplace, not a real one," said David Kusin, president of Kusin & Co, an institutional economic research firm specializing in the fine art, decorative art and antiquities. "These assets don't pay dividends and there are no current returns. Concepts such as inflation-adjusted rate of returns don't apply and the holding costs are high."
For one thing, investors should make sure that their art is properly insured. Many homeowner's policies have limitations on the amount they will cover and contain exclusions that may leave an art owner with a hefty loss if something goes wrong.
Dorit Straus, vice president and worldwide specialty fine art manager for Chubb Group, said buying special fine art insurance varies in price but overall, it's only "a fraction of the cost of the art" and should be considered a necessity for any art owner.
She added that savvy art holders should update their insurance coverage every three to five years and, if collecting pieces from a young artist, it would be wise to reassess their value even more frequently as there could be more rapid appreciation.
Aside from the cost of insurance, there are some other financial costs associated with buying and selling art. Selling a piece of art can trigger taxes as high as 40 percent of any profit, and transaction costs of about 20 percent of the value of the piece, according to a client newsletter from Bank of New York, which advises high net-worth clients on art investment.
Hot today, gone tomorrow
And what's hot one decade could be considered passe in the next, which could result in some pretty significant losses on the investment. Traditional old master paintings from the likes of Monet were market darlings in the 1970s and 1980s. In the last decade, however, that same genre has seen a decline in interest and, by extension, in value.
Currently, post-war and contemporary art is all the rage, said Christie's Provost. At Christie's November auction, Mark Rothko's 1954 piece Homage to Matisse sold for over $22 million, setting a world auction record for the period.
"Buying art is not as easy as buying stock," said Chubb's Straus. "Times change and fashions change... as an investor in art you have to be in tune with what's going on."
As a rule of thumb, Kusin said that art buyers specifically looking at art as an investment shouldn't put more than 3 percent to 5 percent of their liquid net assets into this special asset class.
Still, Straus said that art lovers shouldn't be deterred by the complexities of buying art or scared off by the large price tags reported by the auction houses. She said investors can find good deals among up-and-coming artists that could potentially surge in price as the artist begins to get noticed.
She advised potential investors to do their research and ultimately buy pieces that they truly love.
"Even if it doesn't appreciate at the end of the day, you still have the aesthetic value," she said.
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