Last year an investment banker approached one of the world's largest fund management companies with an unusual proposition. His bank had devised a new form of investment for the company's pension fund clients. It was, he said, planning to go around buying up rare and valuable violins, pool them, and issue paper securities against the pool in much the same way as a gold fund issues shares against its holdings of bullion. Historically, the banker explained, rare violins had been a fantastic investment, generating massive capital gains. And best of all, they represented a completely new asset class, uncorrelated with the pension funds' other holdings of stocks, bonds and real estate investments, and so offered perfect diversification. At that point, recalls one of the fund manager's senior executives, some of the company's brightest brains sat down to consider the proposal. Certainly the investment banker had been absolutely right when he said that violins have returned handsome capital gains over the years. The chart below shows prices paid at auction for violins made by the 18th century Italian master luthier Antonio Stradivari. From what was then an eye-popping record of US$200,000 in 1971, auction prices soared to hit an all-time high in May 2006, when an anonymous buyer paid US$3.5 million for the 1707 Stradivari violin known as the Hammer. That equates to a gain of 1,650 per cent, better than the 1,290 per cent rise in the Dow Jones Industrial Average over the same period, and superior even to the 1,360 per cent return from gold. But after due consideration, the fund managers rejected the proposal. For one thing, they decided that because there is no obvious risk premium for holding violins, buying them would not be an investment but speculation. Whereas bonds pay a coupon, stocks carry a dividend and real estate earns a rental yield, violins generate no income for investors. Buying them is a pure bet on market direction. (Actually it is possible to lease your violins to musicians, but it is a high risk business; Stradivarius violins have been lost at sea, stolen, left in taxis and in one case even run over by a bus.) Secondly, the managers were not convinced by the diversification argument. If violins have been uncorrelated with other investments over history, it is because they have been purchased by violinists rather than fund managers. If pension funds were to begin buying them up, they would soon come to dominate the market, and violin prices would start to fluctuate in line with other assets owned by the funds, like stocks or real estate. Any benefits from diversification would rapidly evaporate. What applies to violins applies equally to other commodities like gold, copper, oil or rice. Because they generate no income, buying them counts not as investment but as pure speculation; an activity usually considered inappropriate for pension funds. And as funds have bought into commodities on the basis that they are uncorrelated with other assets, the diversification has vanished. Like other commodities, violins are just an expensive fiddle.
