Art investment funds are a bit like the Wild West. They're unpredictable, largely unregulated and dominated by speculators. Still a tiny fraction of the overall fund market—a $1.3 billion niche—the sector has been getting attention by the well-heeled from all parts of the world.
Such funds, which are structured like hedge funds and marketed exclusively to the very rich, pool investor capital to buy and sell fine art. Managed by a professional manager or advisory firm, they seek to deliver returns through the appreciation and ultimate sale of their underlying assets, which includes paintings, sculpture, photography, video or print.
Some art investment funds focus on investing in art from a certain region, a particular style period as well as a specific medium.
Read MoreThe 5 keys to picking the right funds: Jack Bogle
Fund managers must be diligent at trend and market analysis—tracking auction houses, curators and galleries—since their role is to predict when a certain work will peak in value in order to sell for a profit.
Art funds hold growing appeal to those who have enjoyed a net-worth surge and are looking for ways to diversify their portfolios, especially in new growth markets such as Asia, the Middle East and Latin America. They can carry a high price tag. London's The Fine Art Fund Group, the largest player in the market, with more than $500 million in assets under contract, requires a minimum investment of $500,000 to $1 million.
Where individual works by the most important artists are increasingly out of reach, art funds provide a means of entry— and a shot at partial ownership.
The series of funds managed by The Fine Art Fund Group allows investors to borrow works of art from the fund and hang them in their homes and offices.
Read MoreSecond-home real estate play is hot—for now
Based on assets sold and the estimated value of works that have not yet been sold, fund founder and CEO Philip Hoffman said his funds have produced an average return of 9 percent before fees. (Most art funds, including those offered by The Fine Art Fund Group, charge a 1 percent to 3 percent management fee, plus a 20 percent cut of profits. The Fine Art Fund Group collects its share only after clients have earned at least 6 percent.)
"We have seen huge interest from clients who are interested in having their eggs in 20 baskets as opposed to three," said Hoffman, noting most of his clients allocate roughly 5 percent of their wealth to art, but some allocate 20 percent or more. "After 2008, investors got burned [by being underdiversified], so they are delving in with smaller amounts to start with."
None of its funds are open to new investors.
In its 2014 Art & Finance report, Deloitte Luxembourg and market research firm ArtTactic found that 76 percent of art buyers and collectors were acquiring art and collectibles for investment purposes, up dramatically from 53 percent in 2012.
Read MoreThe strong dollar and your portfolio
At the same time, some 88 percent of family offices and 64 percent of the private banks surveyed said estate planning around art and collectibles is a strategic focus in the coming 12 months. Roughly half of the family offices surveyed also indicated that one of the most important motivations for including art and collectibles in their service offering was the potential role it could play in a balanced portfolio and asset diversification strategy.
Indeed, multimillionaires have a disproportionately high allocation to cash, according to a 2014 survey by U.S. Trust, which found 60 percent of those with at least $3 million in investable assets held between 10 percent and 25 percent of their money in cash.
While all art funds utilize a traditional "buy and hold" strategy, individual funds differ in their size, duration, investment focus, investment strategies and portfolio restrictions, according to the Art Fund Association. Most charge 1 percent to 3 percent of assets in annual management fees and take a cut of profits at the end of the fund's life, some as much as 20 percent.
Apart from The Fine Art Fund Group, the largest art funds globally include The Collectors Fund in Kansas City, Missouri, which reports an 11.3 percent internal rate of return on assets sold since its inception in 2007, and Artemundi Global Fund in London.
Artemundi reports its book value per share has grown from an initial value of $500 in 2009 to nearly $950 at the end of 2014, an accumulated 90 percent return. (Book value is an accounting term that refers to the value of the shares if the company were to liquidate its assets and pay off all its debt obligations.) The real return per share will only be attained at the end of the fund's life.
How art funds work
By design, art funds allow only a small number of "accredited" (wealthy) investors to purchase shares, which ensures they are not subject to the same regulatory oversight as stocks, bonds and mutual funds.
Proponents suggest the lack of regulation, deficient price discovery mechanisms, non-transparency of the market, subjective value and illiquid nature of fine art enables them to generate arbitrage opportunities that seasoned art professionals can exploit for the benefit of their investors.
Read MoreThese hot funds are leaving the S&P in the dust
They note, too, that as a non-correlated asset class, art provides portfolio diversification benefits, stores value and can help hedge inflation.
Ironically, though, it's the lack of transparency that has also been the art fund industry's undoing over the last 12 months.
To protect investors from unrealistic promises of double-digit returns on the resale of artworks by some funds, France, China and the U.K. have all imposed stricter regulations on unregulated collective investment schemes.
A shakeout under way
The 2014 Art & Finance report indicated that such measures have created a temporary crisis of confidence among would-be investors, especially in China, which, due to its size and appetite for tangible assets, serves as a bellwether for the global art fund market.
Assets under management in art funds have declined nearly 40 percent to an estimated $1.3 billion since 2012, according to the report.
As of last summer, 72 art funds existed globally, with 55 in China and the remainder based in either Europe or the U.S. By comparison, art funds totaled 115 in 2012—a record, when 90 such funds were open in China.
Read MoreWant a stock windfall? Bet on these big brands
"The Chinese government is putting the clamp down and trying in a more robust way to regulate the shadow-banking system, which has had the effect of contraction in the art fund space," said Evan Beard, head of Deloitte's U.S. art and finance group. Shadow banking refers to the network of informal lenders, such as trust companies, leasing firms, and money market funds that lend to riskier projects where conventional lenders will not.
Over the long term, however, the current contraction brought on by tighter oversight could be positive for investors, he said.
Know the risks
When you start commoditizing art, people start to think they can do it on a large scale and be successful, but there's a lot of risk.Kemp Stickney, chief fiduciary officerWilmington Trust
"If China can maintain their growth story, if their regulatory environment allows for these trust structures and if the infrastructure continues to develop on this path, I think you'll see continued growth in this space in China, which because of its size could fuel the art fund market," said Beard.
In the meantime, wealthy investors who are looking to diversify their portfolio amid the stock market's soaring returns must decide if art, or art funds, provide value in their portfolios.
"We don't promulgate a certain percentage of assets being in art," said Kemp Stickney, head of family wealth and chief fiduciary officer for Wilmington Trust. "When you start commoditizing art, people start to think they can do it on a large scale and be successful, but there's a lot of risk."
Many of Stickney's high-net-worth clients have 20 percent or more of their wealth invested in tangible assets, primarily art and vintage-car collections.
Liquidity is the biggest challenge, said Stickney. Not just for collectors but for art fund investors, too.
Read MoreInvestors flock to this unlikely $11B yield haven
Investors in art funds are generally required to lock their money up long-term, committing capital contributions from three to five years, which are not subject to return for between five and seven years or longer at the discretion of the fund manager.
The Deloitte report, however, suggests that larger, online art marketplaces are likely to increase liquidity going forward, broaden the collector base, reduce transaction costs and increase transparency.
Unpredictable returns are the other negative. Art funds may estimate on a yearly basis what their assets are worth, but until the works are sold at auction, there's no way to know their true market value. Indeed, demand for genres, artists and geographic regions is as fickle as the wind.
While the various art indices would suggest investors can reasonably expect an average annual return of nearly 9 percent on long-term holdings of investment-grade art, such data is fatally flawed, said Arthur Korteweg, a financial economist with the University of Southern California Marshall School of Business and the lead author of a 2015 report called "Does It Pay to Invest in Art?"
Market cycle 3.0
The most popular indices, including the Mei Moses Index, are based on repeat sales of artwork that has already demonstrated marketplace demand, said Korteweg.
"Sample selection bias has a first-order impact on art indices, lowering the average annual return by 28 percent, from 8.7 percent for a standard repeat sales index to 6.3 percent for selection-corrected indices," he writes, noting the risk-adjusted return, or Sharpe Ratio, also drops nearly 60 percent. "The implications are that an investor would not find it attractive to invest in a portfolio that is representative for the broad art market, unless she derives substantial non-monetary utility from owning and enjoying art."
Read MoreGoing to cash has never looked so good
Hoffman said investors who opt for large, diversified art funds would be "very lucky" to get 10 percent to 15 percent returns. "Somewhere in the 6 percent to 8 percent range is achievable with a well-managed, diversified fund. You can potentially earn double digits, but you would need to take on higher risk."
New art fund business models, however, may offer a different advantage—tax efficiency, said Beard.
"Art funds as a sector of the investment market have had a challenged history," he said, citing the 1970s proliferation, when a group of art funds that were structured like mutual funds and led by the British Rail Pension Fund launched primarily as a way to hedge inflation. By and large, the experiment failed. Virtually no such funds exist today.
The next wave of art funds was established in the late 1990s, when modern portfolio theory redefined diversification. Pension funds and endowments with infinite time horizons started allocating a sliver of their portfolio to art funds with some success, until the credit crisis revealed that art funds are more correlated with alternative asset classes than investors were led to believe.
"Now we're in cycle 3.0," said Beard, noting art funds have evolved into private equity structures that are either closely held or private syndicates that allow a small group of investors to build a collection with tax efficiency in mind.
Still others are billing themselves as full advisory art funds, mostly started by former executives of the leading auction houses who can use their networking and institutional knowledge to source promising work, create distribution channels, bypass auction houses (and thus avoid the costly transaction fees) and partner with or advise hedge funds. "That's a fairly sizeable trend," said Beard.
"Whether this is a good way to capture diversification really gets back to your objective," said Beard. "If you really want to diversity into art in a tax-efficient way, art funds can be quite beneficial."
—by Shelly K. Schwartz, special to CNBC.com