The art market is on a very interesting trend. From a relatively esoteric beginning in which transactions were relationship based between few, established buyers and sellers, the globalization of the art world has produced a more structure marketplace with greater transparency, liquidity, and visibility in the eyes of the investing public. Art funds, in theory, are in a unique position to profit from the appreciation of art and the current bull market, as they possess several distinct advantages to dealers: they are capable of lower costs and overhead, as they don't require large exhibition spaces, they can employ a broad selection of expertise (unlike dealers who often specialize), the large capital bases provide unprecedented purchasing power, and longer, buy and hold investment horizons are possibly the ideal way to invest in art. Art is very unique, in that it a superior good (meaning as wealth increases, demand for the product increases) yet it is highly uncorrelated with other popular investment vehicles. The fluctuations of the stock market has little connection wit hthe art market, and demand has often been sustained in times of economic recessions. The primary factor behind this sustained bull market is the prestige element in art investing, in that art carries a significant value in its signaling of wealth and status, factors that don't disappear with the economy. The wealthiest portion of the consumer base will always have a very strong desire to signal their status, and won't be as susceptible to market volatility, creating a very stable and sustained demand base. As a result, many high-profile, high-price transactions have produced widespread public interest in the art market -- while these sales may not be indicative of the larger market, their volatility creates consumer confidence and interest, which is ultimately the largest and most significant driver of value in an industry in which the product -- art -- produces no actual cash flows to its owner. Many of the costs are sunk, and lie in transaction, storage, shipping, and insurance expenses -- these expenses are no doubt inflated, as there are many inefficiencies in the relatively young art investment market, such as conflicts of interests in transactions and large information asymmetries. Moreover, the only real opportunity to realize an investment lies in its resale. While the resale value is a relatively riskless investment, often the investment horizons required to fully ensure this value are much longer than time periods investors are comfortable with, especially as holding art during the time period can be cash flow negative. Prices are opaque, hard to predict and quantify, and subject to buyer's preferences, which further makes resale value difficult to ensure. The combination of these factors represent significant obstacles for an investment fund concentrated on art. One can infer that art, as part of a diversified portfolio of assets, works best when it is used as a hedge against other facets such as debt or equity, due to its low correlation with these investment vehicles and its ability to weather bearish markets. What seems fascinating is that most investment theses concern products that carry inherent monetary value, have easily agreed upon valuations due to concrete monetary cash flows and discounted cash flow analyses, and are traded in a market with sufficient liquidity to ensure resale and consumer confidence. Not only does art fail to satisfy these requirements, but its very value depends in its uniqueness and scarcity. If art funds and investment strategies succeed in becoming mainstream and ubiquitous, the result will be the commercialization of art, the mass increase in its production to meet the rise in demand, and its eventual homogeneity as arbitrage and mass scrutiny eliminate inefficiences and equalize differences in value. This very process of commercialization will ultimately destroy the scarcity and uniqueness of art, and thus its value; as art funds experience success, they will proliferate, and art will become homogeneous, and thus diminish in value as a signal of prestige and an aesthetic decorative piece, and thus the very investment funds which seek to profit off art's value will ultimately destroy it. In short, the process of the commercialization of the art market can ultimately lead to its demise -- art cannot function as a consumer product, as it provides no cash flow and has no truly functional value. For it to continue is success, it must maintain lower levels of supply and scarcity, which will be difficult to ensure as its popularity as an investment grows.
I don't think I would create a purely art-focused investment fund. I think there are inefficiencies to be exploited in art, but the time horizons required to fully maximize returns are prohibitive. Even in the past, when art funds have taken fully advantage of bull markets, their inflation-adjusted annualized returns and IRR's have been marginal, and may not offset opportunity costs. It is difficult to fully gauge market trends, and opportunity-based strategies would be subject to higher volatility. Middlemen such as auction houses take large cuts of returns, and there are many instances of conflicts of interest in the marketplace prohibiting a fully competitive or efficient market. Art in and of itself provides no cash flows to buffer market downturns, and sunk costs are considerable and unavoidable. Some firms have opted to vertically integrate, identifying good artists at young, cheap stages in their careers in the hopes of value appreciation, or investing in one medium in one geographic setting at all stages of production, but even this strategy poses fundamental problems, as art ultimately acquires value through its increase in public perception, eye-catching sales prices, and inclusion in art magazines and critical analyses -- a buy and hold strategy effectively takes art off the market, and thus prohibits it from acquiring reputation and marketing capital through public acknowledgement. Furthermore, any success is likely to produce many copycat funds and entrants to the market, which will further reduce returns. If I had to include art as an investment -- I do think it is valuable, as there are inefficiencies to exploit, strong recent upward market trends, and negative correlations leading to high hedge value in portfolios -- it will be as a part of the diversification process in a larger fund that includes equity, fixed-income investments, and other investment vehicles.