Art funds

In short

A friend of mine once bought a share in a painting the way some folks buy a ticket to the county fair, mostly because it sounded like fun. If you are holding a brochure for an art fund, you may feel the same pull. An art fund pools money from many people and uses it to buy artworks, which the fund then holds and later sells. Your slice of the fund is a share, and the share does not give you a painting to hang over the couch. Read the fund's offering document, called a private placement memorandum, before you send a dime. Look hard at the fees, the holding period, and how the fund will value the art. Then ask how and when you could get your money out. Take your time.

The whole of it

What it is

I once watched a neighbor pour his savings into a barn full of old tractors, and he loved every one of them. Art funds work a bit like that barn, only the tractors are paintings and sculptures, and a manager runs the barn. If you are weighing one, you are likely drawn to the idea that art can hold its worth when other things wobble. That is a fair thing to hope for, and you are not foolish for hoping it.

An art fund is a pooled investment. Many people put in money, and a manager uses it to buy works of art. The manager stores them, insures them, and sells them when the plan calls for it. Investors own shares in the fund, not the art itself. That difference matters, because you cannot walk in and claim a canvas.

Most of these funds are sold privately, to people the law calls accredited investors. That term means a person who meets income or net worth tests set by the Securities and Exchange Commission, which you can read on its own website at sec.gov. The income test is the current figure, which the official source publishes each year and the net worth test is the current figure, which the official source publishes each year. A private fund does not face the same reporting duties as a mutual fund. So the document the manager hands you does a lot of the work, and you will want to read it slowly.

How it works

A friend of mine who sells farm equipment says every deal comes down to who gets paid first. That is a good habit here too. A buyer who joins an art fund pays money in and gets shares. The manager then buys works, and the fund pays costs along the way.

Those costs are where many folks get surprised. Art is heavy, fragile, and costly to keep. The fund pays for storage, insurance, shipping, and appraisals. It also pays the manager. A common setup is a yearly management fee, charged as a percent of the money in the fund, plus a cut of the profit when works are sold, often called carried interest. Each fund sets its own terms, so the offering document is where the real figures live.

Then comes the waiting. Art does not trade on a screen like a stock does. A piece sells when a buyer shows up at an acceptable price, and that can take years. Because of this, an art fund often locks your money up for a set term, sometimes many years. During that term, you may have no way to sell your shares at all.

Valuation is the last piece. A stock has a price every second. A painting has an opinion. The fund must estimate what its works are worth, often with appraisers. Until a work is actually sold, the value on your statement is an estimate, and honest people can differ on it. Keep that in mind.

The numbers, and where to find yours

If you are reading a fund's papers tonight, you probably want to know which numbers matter. Start with the fees. The offering document should list the management fee, the profit share, and any other charges for storage and insurance. Add them up across the whole holding period, not just year one.

Next, find the lock up period, which is how long the money stays put. Then find the redemption terms, which say if and when you can cash out. Find out how the fund values its art and who does the valuing. Ask whether that person is independent of the manager.

You can also check the fund itself. Private funds that raise money under certain exemptions file a short notice called Form D with the Securities and Exchange Commission. You can search for it on the agency's EDGAR database at sec.gov. A manager who advises such funds may also file Form ADV, which lists fees and any past trouble. The SEC has published an investor bulletin on alternative investments, and the Financial Industry Regulatory Authority, at finra.org, offers plain guidance on private placements. For your own tax picture, the IRS covers how it treats collectibles on irs.gov. The IRS publishes its rules for collectibles, and a tax professional can say how those rules reach a share in a fund, since the answer depends on how the fund is built.

A worked example

I like to tell this one about a made up woman named Ruth, a retired schoolteacher in Ohio who had $200,000 saved. She heard about an art fund and thought about putting $20,000 into it. That is 10 percent of her savings, and she wanted to know what it would cost her.

The fund charged a management fee of 2 percent a year. On $20,000, that is $20,000 times 0.02, which is $400 a year. Over a ten year lock up, the fee alone comes to $400 times 10, which is $4,000. The fund also took 20 percent of profits when works sold.

Say the fund did well and the art sold for a gain. Ruth's $20,000 grew to $30,000 before the profit share. The gain is $30,000 minus $20,000, or $10,000. The manager's cut is 20 percent of $10,000, which is $2,000. That leaves Ruth with $28,000. Then the $4,000 in management fees comes out, so $28,000 minus $4,000 is $24,000, though the exact figure depends on how the fund charges fees.

Her result would be better or worse depending on the sales. Ruth saw something plain and useful, though. Fees took a real bite even in a good outcome. She also saw that $20,000 would be out of reach for ten years. Ruth asked herself if she could live without that money for a decade. That question mattered more to her than the brochure's glossy pictures.

Where it goes wrong

A fellow I know bought a rare coin once and learned that finding a buyer was harder than finding the coin. Art funds can have the same trouble, and it helps to know the usual ways things go sideways.

The first is getting stuck. If the fund locks up your money, you cannot leave when you wish. The second is the price of a share. Since art is valued by estimate, a share may look healthy on paper while the real sale price comes in lower. The third is stacked fees, which can eat a good part of a modest gain.

There is also the risk of one wrong call. A fund may own only a few works, and if the taste for one artist fades, the whole fund feels it. Fraud and weak oversight are real concerns in private markets, which is why checking the manager's filings matters. The SEC does not approve or vouch for private offerings. Authenticity is another worry, since a fake or a work with unclear ownership history can lose its value fast.

Taxes can also surprise people. The IRS has its own rules for collectibles, and how those rules apply to a fund share depends on how the fund is set up. Costs of storing and insuring art never stop, even in a year when nothing sells.

Questions to answer before you leave this page

Have you asked yourself whether you could leave this money alone for the whole lock up period, even if you needed it in year three? Do you know every fee the fund charges, and have you added them up over the full term? Who decides what the art is worth, and are they independent of the manager? Can you read the offering document without feeling rushed, and does anyone in the room seem to be hurrying you? Have you looked up the manager on the SEC's EDGAR database and checked Form D and Form ADV? Would you still be comfortable if the fund lost value and you could not sell? And have you talked with a tax professional about how gains from a fund like this would reach your return?