The collapse of Fernwood Art Investments last summer because of "irreconcilable differences" rocked not only the art world, but also the mother of all potential patrons: Wall Street. Could personalities alone ruin such a tantalizing market opportunity, or are we missing something? For aspiring art fund managers, wearing art indices and market measurement tools on their sleeves can do more harm than good.

Imaginations had strained for nearly two years to understand why the self-proclaimed Merrill Lynch of art investments had not closed on at least one smallish art fund, despite Fernwood’s avowal that it had not shifted into fundraising mode. However, few would have guessed that internal discord would, or could, end this high-profile and unabashedly expensive American effort to tout art as the latest and greatest alternative asset among wealth managers and institutional investors.

Art had finally made it on the Wall Street radar screen as the darling new alternative asset class; last June, a single Gustav Klimt painting fetched a record $135 million.

In explaining the art industry from both a curatorial and financial perspective, no group exceeded Fernwood, which packaged its products accordingly. Masterful presentations to institutions and wealthy investors, integrating Nobel laureate Harry Markowitz’s efficient frontier model, showed how fine art reduces risk and increases expected return in a statistically measured investment portfolio. Like ABN Amro before it, Fernwood wore the mantel of the popular Mei Moses All Art Index on an as-needed basis to add impact. Proprietary stress testing in Fernwood presentations showed that art performs well during times of inflation, rising interest rates and even during down markets and periods of weaker economic growth.

Once convinced that art risk was quantifiable, investors could choose the Sector Fund or the Opportunity Fund, each capped at a proposed $100 million. Fernwood would manage the former vehicle from the viewpoint of an art collector, diversifying among the major collector categories while also providing a modicum of liquidity through structural gymnastics. The Opportunity Fund would operate as an art dealer, with an additional risk/return element and clearance to engage in other investment activities—such as short- and long-term lending and assisting with consignor guarantees. This product line is quite ingenious, as it suggests an insider’s understanding of the art industry articulated in the seemingly unassailable language of modern portfolio theory.

Personalities aside, why would any sane business organization blow such a story at a time when the white-hot art industry was enjoying its third year of a bull market? Art had finally made it on the Wall Street radar screen as the darling new alternative asset class; last June, a single Gustav Klimt painting fetched a record $135 million. One possibility concerns the dual impact of the questionable relevance of art data as an input for efficient frontier models, combined with the movement away from relative return portfolio management strategies among professional asset managers.

Relative Problems
Many believe that the art market is highly inefficient, thereby offering a window of opportunity to find undervalued situations. Reflecting this condition, art market data used as input for efficient frontier models intuitively suggests an oxymoron from the start. But let us dig deeper. Markowitz developed modern portfolio theory and the efficient frontier model in the 1950s. The latter uses advanced statistical techniques to measure the effect on portfolio risk and return of different securities, or asset categories, having different price movement correlations. For example, asset categories that have a relatively low level of correlation, such as real estate and stocks, can improve the level of expected return for a given level of risk when included in a diversified portfolio. The efficient frontier is the graphical curve representing the optimal mix of assets that will produce the highest return for each level of risk.