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Buyer Beware: the dangers of viewing art as an investment

The more I own the more I want to own. Therefore, the more I own the more I lack.

Art collectors can be a determined bunch. Their obsessive drive to research, source, and capture the object of their desire can result in school fees and retirement funds being sacrificed in pursuit of ‘the collection’.

As guilt often accompanies such acquisitions, a rationalisation process invariably begins – and the most powerful argument is that a recently acquired work will serve as a wonderful investment. Never mind that many collectors will not sell any part of their collection, merely reframing it in this context is enough to temporarily soothe the guilt-ridden mind.

Though understandable, this can be a dangerous line to take. The number of collectors who buy art not just for enjoyment, but with an eye on investment is growing and is of concern. Allocations to art and other “passion assets” within the portfolios of Ultra-High Net Worth individuals are expected to increase over the next ten years, according to Deloitte’s Art & Finance Report (2017). Following a slowdown in the global art market throughout 2016, total auction sales at Sotheby’s, Christie’s and Phillips were up 18% in the first half of 2017, compared to the same period the previous year.

However, new art collectors should be reminded of the risks inherent in “investing” in art, as well as the more deep-rooted risk of regarding art as a traditional investment asset. Those who treat art as an investment may very well lose money.

It may come as a surprise, but investing in art is not an historically trodden path. It is a relatively recent concept, christened perhaps with the sale of seven paintings belonging to Erwin Goldschmidt at Sotheby’s in October 1958 for £781,000, the highest price ever achieved at the time by a single sale. A meagre sum compared to the sale, for example, of one painting, “When Will You Marry?” by Paul Gaugin for $210million in February 2015, fifty-seven years later.

To invest in art is to speculate. Would-be investors will buy with their ears and therefore often buy fashion; whereas true collectors buy with their eyes and such collections stand a far greater chance of holding their value. True collectors are likewise not driven solely by the desire to acquire objects, but also by a desire to acquire knowledge. However, even a collection thoughtfully assembled that holds its value must still be distinguished from a good investment that outpaces inflation.

Owning and managing an art collection is a complex business requiring frequent advice from a variety of experts. Many of these experts will have their own agendas and, unlike investment management, the art world is largely unregulated. This means that it is one of the most manipulated markets in the world. A conservative estimate of forged or misattributed art in circulation is 40% and, even if you do happen to own a genuine work of art, due to the unreliability of art market indices you will only know the actual value once it is sold. This is a sobering thought when one considers the money involved. Art collecting requires dedication and passion.

Investing in art is therefore not so much about making, as it is about not losing money. Much art will not appreciate in value and the contemporary art market exhibits elements of a Ponzi scheme, with a large proportion of such works of art having little value a short period of time after purchase. Some buy art because they are seduced by the luxury goods lifestyle. This explains why prolific contemporary artists with highly recognisable art fetch high prices, which is at odds with normal demand / supply dynamics and an expectation that rare works might be more valuable. Waiting lists to buy fashionable art are often followed by waiting lists to sell.

Real consideration must therefore be given towards the illiquidity of the art market, the substantial fees involved in both buying and selling a work, ongoing costs towards the insurance, storage and conservation of a collection, and the risk that the artist may well drop out of favour.

It is extremely rare for an individual to become wealthy from their art collection – the very best collections sold return an average of 10% a year. This is not much different to that of the S&P 500 over an equivalent period and yet is achieved with a great deal more work and risk. Though one cannot quantify the visual dividend, it is possible to calculate foregone yield or opportunity cost of this capital, which is significant over time.

In recent years a predictable “art fund” market has sprung up, but it remains very small for the very good reason that art is not an investment asset class. Art funds generate neither appropriate investment returns nor enjoyment. Owning only a small share of a work denies the owner its most obvious utility – aesthetic pleasure. Moreover, the performance numbers are poor and the attractiveness of art as a collective investment vehicle is reduced when lack of liquidity and the inherent volatility of the art market is factored in. Collectors and investors alike increasingly prefer buying art directly.

For this reason, Stonehage Fleming clearly distinguishes between investment portfolios and art collections. In addition to a substantial investment business, a separate team of six art professionals assists clients with the management of over twenty global art collections acquired over the past one hundred years. As we enter 2018, my advice to novice and experienced collectors alike remains unchanged: buy the best art that you both enjoy and can afford. Buy less often and ideally try to choose works that have been tested by history – unless you wish to speculate. All good things come to those who wait and a disciplined and patient approach to building a collection over many decades will yield a collection of substance.

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Inter-Vivos Trusts: Nebulous Creatures of Immense Pedigree with a Glorious Past & Promising Future

With all the negative publicity surrounding offshore trusts, it would be easy to think that the days of the trust are over, that the risks and costs now outweigh the benefits and that wealthy families will be looking for alternative ways of holding their assets.

At this stage, however, the evidence is the contrary. The trust is a unique structure for holding assets developed in England around 1200 AD and adopted in practically all jurisdictions which have a legal system based on the principles of English Law. Nowadays the trust is increasingly recognised internationally even in Civil Law Jurisdictions (including, for example, Switzerland and most recently Hungary) and is extensively used in both China and Japan, despite their very different legal systems.

The trust has survived many previous attacks, mainly because it has numerous legitimate uses and is a superb vehicle for family succession planning. It is obviously true that increased regulation has added to costs, that the demand for transparency has diminished financial privacy and that increasingly determined tax authorities are curbing the ability of offshore structures to avoid tax. However, there remain many legitimate and compelling reasons for settling assets into a trust, which have perhaps been temporarily obscured by the highly negative and illinformed press, associating all offshore trusts with money laundering and tax evasion.

The reality is that a small number of participants have helped to give the whole sector a bad press, by taking on clients whom most would regard as unacceptable.

Trusts under Attack

Regulators

The number of international regulatory changes in the past two years is unprecedented, with new AML regulations, EU Directives, transparency initiatives, exchange of information and the ability of foreign tax authorities to learn the identity of beneficiaries. These include the US Foreign Account Tax Compliance Act (FACTA) and the OECD’s Common Reporting Standard (CRS), both of which are threatening the privacy we have taken for granted for so long. The cost implications of these new initiatives are substantial, with all the obligations for enhanced due diligence, disclosure and reporting.

Tax Authorities

With government budgets under pressure all round the world, the rich are an obvious target:

• Increased transparency and exchange of information, combined with greater vigilance by the authorities will make it more difficult to use secrecy for illegal tax evasion.
• Opportunities for legal tax avoidance are being reduced by legislation designed to levy taxation on the basis of substance over form.

Media

The often deliberately misleading media campaigns will continue, increasing pressure on politicians to take action against so called ‘tax havens’ and raising concerns that data theft will cause breaches of confidentiality.

The combination of loss of privacy, increased costs, reduced tax benefits and now the potential reputational risks of being associated with offshore structures obviously prompts the question:

“What is the future for offshore trusts?”

The short answer, is that once the current furore has subsided, it will be recognised that Trusts are needed today just as much as they have been in the past.

The Lessons Of History: Trusts Are Resilient

Whilst implementation of FATCA and CRS is a challenge, there were similar concerns over the introduction by the US of the Qualified Intermediary Regime (QI) in 2001, but it was business as usual, following implementation. Similarly, despite current concerns, the reality is that trust laws continue to be recognised or promulgated on both sides of the Atlantic as well as in Russia, Eastern Europe, Asia and the Middle East, in response to growing international demand.

For the vast majority of individuals and families using Trusts, their tax planning is perfectly legitimate and not based on secrecy or tax evasion. That demand has not waned attests to the durability, versatility and inherent ability of trusts to preserve, manage and develop wealth as “part of the social and economic fabric of society.“1 Foundations, limited partnerships and corporations simply cannot compare with the benefits and flexibility trusts provide.

Legitimate Trusts For Legitimate Purposes

The many legitimate uses for trusts include: succession and estate planning (thereby alleviating the need for probate); tax planning during life and upon decease; continuity of family businesses; provision for heirs unable to take care of their financial affairs (spendthrifts, minors and the like); for testamentary freedom and protection against forced heirship claims; vehicles for charitable giving; and last, but by no means least, asset protection.

With increasing accumulation of wealth across the Globe and unprecedented numbers of businesses established over the last thirty years, families obviously require holding structures which promote effective succession and protect the assets they have built, especially in countries which are politically unstable.

And what better vehicle than a Trust, which can protect wealth for future generations, while simultaneously allowing families to retain enjoyment during their lives?

The essential element of a Trust, that distinguishes it entirely from other legal vehicles, is the gratuitous transfer of property from the settlor to the trustee, which results in the assets no longer belonging to the settlor. Following the transfer, the assets legally belong to the trustee and creditors will only gain access to these assets if it can be shown that the Trust was made with the intention of defeating legitimate creditor claims or is otherwise technically invalid. This will not be easy if the Trust has been established with appropriate legal advice and properly administered by an independent trustee.

The selection of a “real trustee,” who is independent and fully competent, is crucially important. A trustee who fails to act independently and takes instructions from the settlor and/or a beneficiary, can subject a trust to possible attack by creditors. They may argue that he was not a legitimate trustee of an Inter Vivos Trust but rather a mere nominee custodian holding the assets on bare trust for the settlor. The reality is that responsibility of the trustee is to all the trust beneficiaries and not to the settlor.

In many cases settlors wish to retain a degree of influence and certain jurisdictions have made specific legal provisions to enable this. The Hague Trust Convention² makes it clear that “the reservation by the settlor of certain rights and powers…are not necessarily inconsistent with the existence of a trust.” However, the less powers the settlor reserves, the stronger the trust. Under certain circumstances it may also be advisable to delegate some powers on to protector committees, family councils and investment committees. The latter may provide family members a forum for discussion, without the risks created by settlor retention of powers.

Even where the validity of a Trust is not questioned, the residence of the Trust for tax purposes might be challenged³. Offshore Trust laws allowing settlor reserved powers will not help protect a Trust if it is pulled onshore because key decisions are made by individual’s resident onshore. The precise definitions vary significantly according to the jurisdictions involved but the conduct of the trustee and the extent of proper trust administration (or lack thereof) by the trustee, will be the evidence principally relied upon by the tax authorities in such cases.

Ease and Continuity of Succession Without Probate

Many wealthy families prefer to hold assets in trust structures to preserve continuity of purpose, to involve trusted family advisers in key decisions, to help avoid family disputes and to prevent the assets being threatened by poor decisions on the part of individual family members.

Frequently settlors come from jurisdictions that limit testamentary freedom (so called ‘forced heirship’). Thus if the wish of the settlor is to ensure that the fortune he/she generated is managed after death pursuant to their wishes, a trust is an obvious solution. Many financial centres have passed legislation that specifically provides for the trust to be governed by the laws of that jurisdiction, irrespective of the law of the settlor’s domicile.

Another benefit of an Inter Vivos Trust is that it is wholly private and avoids the complexity, costs and time that probate takes for international families with assets located in many jurisdictions. There is no requirement for court orders to enable the trustee to continue to act after the death of the settlor or subsequent beneficiaries. The management of the trust assets continues smoothly and these assets can ultimately be distributed, without any public process, quietly and privately.

Holding A Family Business

Families with family businesses need to address the issue of succession, coupled with responsible ownership. Shares directly held by individual family members can give rise to significant problems on death, divorce, bankruptcy, changing financial circumstances or differences of view. Trusts, on the other hand, can offer continuity of ownership from one generation to the next. It is not unusual for differences of opinion to arise between members of the family directly involved in the management of the business and those who are merely shareholders. Such differences can develop into unpleasant and destructive disputes, which often result in enormous legal costs, potentially serious damage to the business and, worst of all, long lasting feuds between family members.

Settling family business shares onto a Trust can assist tremendously. Whilst conflicts cannot be entirely avoided, setting out clear rules to govern the family business in a structured fashion, under the stewardship of appointed trustees, can help mitigate family disputes. It will also increase the chances of the family staying together and keeping control of the business. A trust can provide a mechanism for consolidation and reservation of voting powers, which will limit conflicts arising.⁴

This presupposes a genuine Trust with a trustee who has a close relationship with all beneficiaries, who can negotiate a course which will be accepted by all parties, in line with the requirements of the trust deed. Without these relationships across generations, a trustee is little more than an administrator.

Where possible, the trustee will try to ensure his or her efforts are supported by a family constitution which addresses and defines the family values and the purpose of the wealth.

Providing for Spendthrifts

Most HNW families will face the probable dissipation of their wealth over three generations unless protective measures, such as a trust, are put in place. This process is called wealth entropy. Trusts can be used to protect the family from their inheritance and the inheritance from the family.

Similarly, many wealthy families do not want their children to inherit family wealth in a lump sum at a relatively young age. They want to ensure their children will receive the assets only if and when it is determined they have the maturity to properly handle such wealth. Placing the assets into trust, with specific tailored provisions, will allow the settlor’s objectives to be achieved, whilst protecting the children from themselves and from others.

Asset Protection

Trusts properly implemented with a bespoke, irrevocable, discretionary trust deed, can offer protection against third party creditors but also against liability arising from direct ownership of assets and the claims of divorcing spouses, or disgruntled heirs. However, a Trust can only provide asset protection (AP) if it is established in an appropriate jurisdiction and the settlor relinquishes beneficial ownership, dominion and control to an experienced and competent trustee. This must be done at a time when there are no existing or foreseeable claims against him/her, as alternatively the trust may be viewed by the courts as an attempt to defraud creditors. UK courts, in particular, are extremely alert to any possibility that the trust might have been created to defeat the settlor’s own creditors, even if the settlor was clearly solvent at the time.

However, a trust created by a solvent settlor for the benefit of beneficiaries such as children should prevent their creditors from collecting against the assets in contrast to a direct gift of the same assets.

Additionally, it is important to remember that whilst AP Trusts are subject to the basic principles and laws applicable to Trusts generally, they require specific planning by experienced professionals. Thus whilst such Trusts may always be subject to challenge, a well-planned Trust with a “real trustee” is the best tool available to protect a family’s wealth from unjustified or unexpected claims.

A Trust is not always a silver bullet in divorce cases instituted in the UK courts, but they do provide another layer of protection. The enforcement of an English court order granted in matrimonial proceedings in the Trust’s offshore jurisdiction will be a major hurdle, which the spouse will have significant difficulty overcoming. Furthermore, not all the cases are bad, as the particularly poignant choice of words used by the court in the A v.A divorce case⁵ (which upheld the husband’s two trusts noting that the trustees had conscientiously performed their fiduciary duties), reflects:

“...even in the Family Division, a spouse who seeks to extend her claim for ancillary relief to assets which appear to be in the hands of someone other than her husband must identify, and by reference to established principle, some proper basis for doing so.”

Tax and Regulatory Neutrality

In a global world it is increasingly common for assets to be owned by a variety of investors from different jurisdictions, whether or not they are of the same family. Each of those jurisdictions will have different tax and regulatory systems, such that it is difficult not to disadvantage some investors or beneficiaries by comparison to others. Holding the assets through an offshore structure is often designed to achieve tax and regulatory neutrality between all investors - i.e. a fair playing field. In general the beneficiaries will be fully taxed in their own jurisdictions but will not be subject to unnecessary complications arising from an unsuitable ownership structure.

Charitable Trusts

Most wealthy families make significant contributions to charitable causes, frequently through charitable trusts. This takes the ownership of the assets outside the family, whilst allowing the family some continuing influence over the way the assets are managed and the causes which they support.

So What is the Future of the Trust

Despite the bad publicity, the trust is a highly useful device which plays a very important and legitimate role in our society. Moreover, it is highly debatable whether criminals and tax evaders make use of offshore centres and trusts any more than they do mainstream bank accounts in major international cities like London and New York.

Gone are the days when commoditised trusts were sold by unskilled salesmen and the demand was for trustees who would acquiesce to every whim of the settlor/beneficiaries. And good riddance to them too because these were the very trusts that created the prejudices of journalists condemning the trust industry today.

HNW families that have trusts for legitimate goals need trusts that will stand up to scrutiny when stress tested, which calls for reputable, knowledgeable trustees who are accountable. Such families understand the price that needs to be paid, in terms of passing control over their assets to the professional trustee, so they will seek out trustees who have real business acumen, knowledge of trust law, independence and the skill to manage family trust relationships. Similarly, in the new world of transparency, companies offering trust services must worry about their reputation and can no longer afford to offer trustee services to families who still want to “have their cake and eat it”, appointing trustees who act according to their wishes and who perceive the settlor and his or her family as “clients”, rather than potential beneficiaries in accordance with the terms of the trust.

Given the myriad of potential issues HNW families face, they have never needed trusts more than they do today. But they require trusts that will stand up to attacks from creditors and tax authorities and this will only be the case if the trustees exercise their discretion and are not afraid to say, on appropriate occasion, “No.” Similarly, those families who understand the old Jersey Law adage ‘donner et retenir ne vaut’ (it is impossible both to give away yet retain) will be less equivocal about passing the necessary degree of control to their trustees, a fundamental requirement for a valid trust. And, undoubtedly, their trusts, like good ports in a storm, will be the ones most likely to pass the stress test.

1 Hon. Justice David Hayton, Reflections on the Hague Convention After Thirty years
2 Article 2 of the Hague Convention on the law Applicable to Trusts and on their Recognition, most of the provisions of which have been incorporated into English law, (by the (English) Recognition of Trusts Act 1987).
3 Garron Family Trust V Her Majesty the Queen [2009] TCC 450
4 See: Trust Ownership of the Family Owned Business: Towards a wider Perspective, Christian Stewart, Family Legacy, Asia
5 Av. A. 2007 EWHC 99(Fam)

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View from the CIO: Markets are getting wise to Trump’s rhetoric

​Over the last quarter, it felt like some of the concerns around the US/China trade war had started to subside somewhat. There were signs of a little ground-giving on both sides as Presidents Xi and Trump began to realise it is in everyone’s interests to reach some sort of agreement. Or perhaps the Chinese - like the markets - were simply wising up to Trump’s bluster.

Trump still seems determined to bolster his domestic image and his electoral prospects for 2020 by bashing China, essentially. Only last week, the US blacklisted 28 Chinese organisations for their alleged involvement in abuses against ethnic Uighurs in China’s Xinjiang province. But he also realises that going too far could result in a significant slowdown in the global economy. This would have a knock-on effect on the US stock market, which in turn would upset his election prospects. So he has to tread carefully.

The market, for its part, has cottoned on. The style that President Trump has adopted over the last couple of years has been to delve into things, put in place various red lines and non-negotiables, cry wolf on the ensuing crisis, retreat, wait a while, remove the very thing that created the crisis, then swoop in and ‘save’ the day.

This pattern is characteristic of his foreign policy, including, his current dealings with the Chinese. Initially spooked by the bouts of volatility it created in the past, the markets now appear to ‘understand’ the US President’s modus operandi and seem less affected by the potentially corrosive fallouts, safe in the knowledge they may never actually happen.

One result is that, despite increased volatility, the stock market has continued to be very strong over recent months. The idea that it will just continue with the pace and enthusiasm seen in previous years, though, is taking on less and less probability.

It might not be a bad time to take a pause from the market, to reduce some risk and selectively allocate it to long short equity managers - those able to both take advantage of stocks which they think have good long-term prospects while ‘shorting’ or borrowing stocks whose prognosis is negative. In this way, we think that portfolios will be better positioned to handle any volatility that may come our way.

Disclaimer: This article has been prepared for information only. The opinions and views expressed on any third party are for information purposes only, and are subject to change without notice. It is not intended as promotional material, an offer to sell nor a solicitation to buy investments or services. We do not intend for this information to constitute advice and it should not be relied on as such to enter into a transaction or for any investment decision. Whilst every effort is made to ensure that the information provided is accurate and up to date, some of the information may be rendered inaccurate in the future due to any changes. © Copyright Stonehage Fleming Investment Management 2019. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission.

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