Fine returns from fine wine

Andrew della Casa and Chris Smith from the Wine Investment Fund, discuss the benefits of investing in fine wines

With market volatility hitting other asset classes hard, an investment in fine wine holds several specific advantages. The Wine Investment Fund, the granddaddy of the publicly offered wine investment funds, has been successfully managing wine assets since 2003. Here is how and why...

Risk

Investment is all about risk and good investment choices are made when risks taken are clearly understood. Risk is best expressed in terms of price volatility, with greater volatility bringing higher exposure to risk. Measuring a combination of absolute performance with price volatility, therefore, is useful for those looking to assess and maximise return on risk. The Sharpe ratio does exactly this: fine wine outperforms other asset classes - recording not only attractive average annual returns (14%+ per annum), but doing so with lower price volatility than most investments.

Supply/demand

The underlying supply and demand dynamics reinforce the attractive qualities of wine as an investment.

We consider only fine wine from Bordeaux as 'investment grade'. That is primarily because Bordeaux is a finite geographical area in which only a finite number of wine producers are to be found. Therefore, the wine produced by these producers, the 'Ch√¢teaux', is also finite. This contrasts with, say, Champagne, where a large Champagne house buys in additional grapes to make more Dom Perignon, for example.

The quantity of any given wine from any given vintage can only decrease over time as it is consumed. Moreover, and uniquely, while supply is decreasing, demand is increasing because as fine wine matures its quality actually improves.

Demand for fine wine is now global, encompassing both the traditional markets of Europe and North America, and the newer markets such as Russia and the Far East. As the emerging economies become wealthier, the number of consumers grows.

With the decreasing supply of each given wine and the increasing demand as both the quality improves and the number of consumers increases, prices should rise. This is borne out in practice: the long-run growth rate of wine prices has been around 15.5% per annum. Despite recessions and economic downturns, the very top end of the fine wine market has never fallen dramatically in value (even in 2008, the market as measured by the Liv-ex 100 index fell 'only' 14.6%, and has recovered virtually all of that fall since).

What to buy?

Of all the world's wine, only some 2% comes from Bordeaux. Only the top 40 or so of the 4,000 Ch√¢teaux in Bordeaux, however, achieve the standards required for their production to be considered investment grade - less than 0.1% of the world's wine stock, and worth in total about £6bn.

The key issues for any wine investor are 'what to buy?' and 'how much to pay?' In deciding what to buy, concentration on any single producer or vintage should be avoided, and a decision made on whether to buy en primeur (i.e. wines at the pre-bottling stage of their life) and/or small production 'trophy' wines. In our case, we do not buy en primeur as historical data shows that, since 2001 at least, en primeur wines have provided lower returns - and with higher levels of risk - than established vintages. Neither do we buy 'trophy' wines as both demand and supply are restricted, making prices volatile and liquidity low.

Selecting ch√¢teaux and vintages is key. During their period of aging, many great wines have quick short bursts of price increases, interrupted by price plateaux of varying lengths. The trick is to judge which wines and vintages are nearing a significant rise in value at the end of a plateau. The key factor is the state of maturity of the wine, which determines when larger quantities of it will start being consumed.

Another factor is the relative price of each wine (say Ch√¢teau Lafite 2000) in the wider market. This is complex as Lafite generally commands a premium compared to most other Ch√¢teaux, and the 2000 vintage also has a particular standing. Finally, there is the issue of critic's ratings - most famously the American writer Robert Parker. A wine with a higher score will typically trade at a higher price. In our analysis we strip out all of these factors to estimate a 'raw' price for the wine, which we can compare across potential purchases.

Once the difficult 'what to buy?' issue has been resolved, there's the 'how much to pay?' question. Key here is the ability to look across the whole market, including London and Bordeaux, for the cheapest price (for stock in excellent condition and with sound provenance). This is a critical advantage of wine investment funds over brokers or merchants, as the latter will generally use their own stock at the price they themselves set - an inherent conflict of interest.

Top tips

Here are some things to consider when selecting a portfolio of fine wine where the emphasis is on managing an investment portfolio (rather than laying down a wine cellar for drinking). First, pick stock predominantly from the most famous wines of Bordeaux and from the best vintages. As well as maximising the supply and demand dynamics (as discussed above), concentrating on Bordeaux minimises liquidity risk, as these wines are regularly traded on a mature secondary market. In addition, data is available to allow analysis of trends and price fluctuations. Again, this is in contrast to an area such as Champagne where production figures are unclear, historical data is weak and liquidity is poor.

Second, remember to take into account the impact of storage and insurance costs. For wines below the top tier, these can be high. We maintain an average cost of around £2,500 per dozen bottles, meaning annual storage and insurance costs are less than 0.2% per year.

Third, price differentials, or bid/offer spreads, of a given fine wine may be as much as 30% in what is still an imperfect market. This can make private investment hazardous, whereas professionals can use multiple sources to ensure purchasing only at the lowest prices.

Fourth, the spread of prices in the market means that when selling it is vital to get as close as possible to the end consumer, who pays the highest price. Commissions on selling might be between 10% (the minimum at most merchants) and 25% (for example at an auction, including the buyer's and seller's premiums). Just as we buy from across the market, we also use a variety of sources to sell wines to maximise returns.

Fifth, provenance is an essential consideration when buying and selling fine wine. Buying 'under bond' offers reasonable security that the wine has been correctly stored since original shipment from the Ch√¢teau to the bonded warehouse. Wines that have additional ('strip') labels may have endured lengthy journeys and should be avoided - perfect storage is in dark, cool cellars, not on ships or planes or indeed in most private homes.

The bonded warehouse system also provides a low risk, secure storage facility, reflected in the very low premiums paid for all risks insurance at full replacement value (see 'Second' above). By contrast try taking home five cases of Chateau Petrus 1990 (current value £25,000 each) and asking for an insurance quote!

Potential returns

Getting all these things right can lead to impressive returns. Since launch in 2003, The Wine Investment Fund has on average returned over 1% per month after all fees and expenses and even after the market downturn of late 2008 - the equivalent of over 14% per annum. This equates to real returns (i.e. after allowing for inflation) of 11.9% pa or 10.3% pa in excess of the FTSE 100.