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Journal of Wine Economics, Volume 5, Number 1, 2010, Pages 119-131

Wine Investment and Portfolio Diversification Gains*


James J. Fogarty" Abstract
The existing literature on the return to wine is mixed. Some studies have found wine to be an unattractive investment option and others have found wine to be an investment class that provides excess risk adjusted returns. However, provided the return to wine does not have a strong positive correlation with standard financial assets, even if the return to wine is low, it is possible that including wine in an investment portfolio will provide a diversification benefit. Here the repeat sales regression methodology is used to estimate the return to Australian wine, and the return is shown to be lower than for standard financial assets. Several measures are then used to show that despite the return to Australian wine being lower than the return to standard financial assets, wine does provide a modest diversification benefit. (JEL Classification: Gl 1, G12)

I. Introduction
Although there is now a reasonably established literature that investigates the return to storing fine wine, the potential for wine to provide a diversification gain to an already well diversified investment portfolio is an issue that has not yet been fully investigated. The potential for wine to provide a diversification gain is explored in the remainder of this paper, and the structure of the discussion is as follows. Section II presents a brief overview of the return to wine literature. Section III describes the data, explains the method used to estimate the return to wine, and presents estimates of the return to storing Australian fine wine. Section IV demonstrates that there is a diversification gain from holding fine wine, and concluding comments are presented in Section V.

* The author would like to thank Gin Parameswaran and an anonymous referee for several suggestions that helped improve the paper. * School of Agricultural and Resource Economics, University of Western Australia, 35 Stirling Hwy, Crawley 6009, email: James.Fogarty@uwa.edu.au

The American Association of Wine Economists, 2010

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II. Literature Review


The first published study of the return to wine was Krasker (1979). To test whether the return to wine was greater than the return to Treasury bills Krasker considered post 1950 vintages of California Cabernet Sauvignon and Red Bordeaux sold at auction over the period 1973 to 1977. There were 137 observations for the study, although, as the regression approach used requires there to be observations for wine / in adjacent periods, many sales observations would have been excluded from the sample. The estimate of the premium to wine over Treasury bills was not statistically different from zero, and the conclusion drawn was that wine is not an especially good investment. Krasker did however note that the effect of taxes on investment income makes storing wine a viable proposition for those consumers faced with a high marginal tax rate and purchasing only wine they intend to drink. Jaeger (1981) takes as her starting point the Krasker (1979) data set and approach, and then extends the time series back to 1969 so that there are 199 observations. Using an approach similar to Krasker where storage costs are estimated from the data, the estimated risk premium to wine over Treasury bills for the period 1969 to 1977 was 8.5 percent, and was statistically significant. However, Jaeger argues the estimate for storage costs generated by the approach ($16.60 per case) is implausibly high, and that the model specification is inappropriate. As an alternative, Jaeger hypothesises that the return to wine can be decomposed into two parts; a return that accrues to all wine regardless of price, and a return that is a function of price. Reformulating the model to allow for returns to vary with price, Jaeger finds that the risk premium over Treasury bills for an average bottle of wine in the sample (price $410) was 12.4 percent. Jaeger concludes by using price to separate the sample into thirds and shows that the return to wine in the bottom third of the sample is greater than the return to wine in the top third of the sample. As the risk measure for expensive wine is lower, and statistically different to the risk measure for less expensive wine, the idea that the higher returns to cheaper wine represent compensation for higher risk appears reasonable. Whether the return to wine was greater than the return to other risky financial assets was not considered as part of the study. Rather than estimating a period by period return to wine calculated from aggregate sales data, Weil (1993) considers the case of an actual wine investor. The 68 transactions evaluated cover a 16 year period, where the earliest wine purchases were in 1976 and the most recent wine sales were in 1992. Wines were held for varying lengths of time, and the size of each investment varied. As such, the actual return the investor achieved was determined via an internal rate of return calculation. For comparison purposes the return to an equity portfolio was also calculated. So that the return to equities would be directly comparable with the return to wine, it was assumed that whenever a wine buy or sell action was initiated by the investor a matching investment or disinvestment in equities was made. For wine, the actual pre-transaction and storage cost annual return achieved was ten percent. As the return to the matching equities portfolio was 15 percent, the conclusion drawn was that the investor would have been better off holding equities. The regression approach used by Krasker (1979) and Jaeger (1981) is generalised in Burton and Jacobsen (2001) where the semi-annual return to wine for the period 1986 to

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1996 is calculated using the repeat sales regression price index methodology due to Bailey et al. (1963). The advantage of the Bailey et al. method over the approach of Krasker and Jaeger is that it is not necessary to have adjacent period repeat sales. As long as there is a repeat sale, regardless of the amount of time that has passed between the first sale and the second sale, the information can be used in the analysis. The approach therefore permits a substantial increase in the proportion of total wine sales information that can be used to estimate returns. The data used by Burton and Jacobsen to estimate the semi-annual return to wine was restricted to post 1960 vintages of leading Red Bordeaux wines and included 10,558 observations. In the study the return to wine and the return to wine sub-market portfolios of the best wines (first growths), and select high quality vintages (1961 and 1982), were compared to the return of equities and one year Treasury bills. The results showed that the risk-return profile of wine is such that it is dominated by equities in terms of risky investments, and an unattractive alternative to low risk debt. The adjacent period hedonic price regression approach was used by Fogarty (2006) to estimate the return to post 1965 vintages of Australian premium wine for the period 1989 to 2000. The hedonic literature is substantial, but modern applications generally attribute the approach to Rosen (1974). The quarterly return to premium Australian wine was estimated from 14,102 observations and compared to the return of Australian equities and three month Treasury bills. The return to wine was found to be lower than equities, but wine was also found to be slightly less risky than equities. Given previous findings that wine returns vary with price, the sample was then split into approximately half and the return to more expensive wine compared to the return to less expensive wine. Unlike the findings of Jaeger (1981), the quarterly return to the most expensive Australian wine (3.17 percent) was higher than the return to less expensive wine (1.92 percent), and somewhat surprisingly, the risk to the most expensive wine (S.D. 4.74 percent) was lower than the risk to the less expensive wine (S.D. 5.35 percent). Using data for the period 1996 to 2003 Sanning et al. (2008) use the repeat sales methodology to estimate the return to holding red Bordeaux. Rather than pooling the data to estimate a market return, Sanning et al. (2008) estimate monthly returns for individual vintage-producer combinations, and individual vintage-classification combinations, where classification refers to the five classifications recognised in the classic Bordeaux wine ranking, plus all unclassified wines as a sixth group. There are 276 unique vintage-producer combinations and so 276 vintage-producer repeat sales regressions. Averaging across all months and all 276 regressions, the monthly return to wine was found to be .51 percent, with standard deviation 6.05 percent. Restricting the sample to just the producers recognised in the classic Bordeaux classification the average monthly return was found to be .78 percent, with standard deviation 7.20 percent. There are 83 unique vintage-classification combinations and the average monthly return across all months and all 83 vintage-classification repeat sales regressions was .88 percent, with standard deviation 7.08 percent. Restricting the sample to just the producers recognised in the classic Bordeaux classification the average monthly return was found to be 1.03 percent, with standard deviation 7.29 percent. The Capital Asset Pricing Model (CAPM) and the Fama-French Three Factor Model (TFM), which are both standard tools used to study equity returns, are then used to further

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investigate the return to wine. For the vintage-producer analysis, although average excess returns are found to be positive, most estimates are not statistically significant. The result is somewhat stronger for the vintage-classification regressions. Average excess returns are shown to be positive, with approximately one quarter of the excess return estimates being statistically significant, and of the statistically significant excess returns most are positive. The finding of excess risk adjusted returns is important; however, arguable the most important finding presented in Sanning et al. (2008) is that models that do a good job of explaining the return to equities, such as the CAPM and TFM, do an extremely poor job of explaining the return to wine. The finding is important because if wine returns are not explained by equity market risk factors, wine may be able to play a risk diversification role in a balanced investment portfolio. Masset and Henderson (2010) use an approach that is conceptually similar to the approach used to construct a stock market index to show that for the period 1996 to 2007 the cumulative return to red Bordeaux wine (145 percent) was greater than the cumulative return to the Dow Jones (127 percent). The risk to holding wine, measured as the annualised standard deviation of returns, was also shown to be lower (8 percent) than the risk associated with holding equities (15 percent). The data set used included 77,014 wine sale observations, and so the authors were also able to estimate a variety of sub indices based on vintage and wine classification. The results show that in general vintages of higher quality, along with first growth and second growth wines, provide the highest returns, and also have a risk profile at least as favourable as wines from lesser vintages and lower classifications. The mean-variance framework is then used to show that including art and wine in an equity portfolio reduces portfolio risk, and a polynomial goal programming model is used to show that the optimal allocation to wine and art varies if investors care about the skewness and kurtosis of their investment portfolio as well as risk. The ability of wine to provide a diversification gain to an investment portfolio during a downturn is considered in Masset and Weisskopf (2010). The authors use data covering the period 1996 to January 2009 and the repeat sales methodology to estimate a fine wine price index, as well as individual price indices for wines from Bordeaux, Burgundy, Rhone Valley, Italy, and the US. Wine is shown to outperform equities during a downturn, and including wine in a diverse mix of investment portfolios, from conservative to aggressive, is shown to reduce portfolio risk. The CAPM and the conditional CAPM are then used to show that although wine returns are not related to systematic market risk, returns are impacted by general economic conditions.

III. Data and Wine Return Estimates


To investigate the potential for there to be a diversification gain from holding wine requires risk and return information for several asset classes. For standard financial assets it is possible to download data from a commercial service provider such as datastream. For wine it is necessary to obtain raw auction data and then estimate returns. For the current study wine sales data were obtained from the Langton's auction house for sales in Melbourne and Sydney, and

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the data allow returns to be estimated for the period 1990Q1 to 2000Q4. For each sale Langton's recorded only the highest and lowest sale price for each item, and information on the quantity associated with each lot sold was unavailable. If several lots of an identical wine were presented for sale at a particular auction, the mean of the highest and lowest hammer price has been used as the sale price. The sample of wines considered was restricted to the post 1965 vintages of the wine brands listed in the Caillard and Langton (2001) classification of Australian investment quality wines and included 12,180 observations. Observations were recorded for 84 individual wine brands, and while most of the observations were for either Shiraz based or Cabernet based wines, this was not exclusively the case. The specific distribution of observations by dominant grape variety was: Cabernet 43 percent, Shiraz 37 percent, Chardonnay ten percent, Pinot Noir four percent, Riesling two percent, and Semillon, Merlot, and Botrytis affected wines approximately one percent each. Not all wine brands appeared in the sample with equal frequency, and the most traded wine, Penfold's Grange Shiraz, accounted for almost nine percent of the sample. Details on the top eight wine brands by sales volume - along with the price range recorded for sales across all vintages at any point in 2000 - are shown in Table 1, and as can be seen, the top eight wine brands account for more than 36 percent of the total number of observations. Reflecting the development of the Australian wine investment market, sales observations increase in frequency steadily through time. Specifically, there were 624 sales observations in 1990, followed by 639 sales observations in 1991, then 689 sales observations in 1992, ..., and 2,483 sales observations in 2000.
Table 1 Summary Details for the Top Eight Wine Brands by Volume of Sales
Observations 1990-2000 (no.) (2) 1,071 652 481 467 461 453 421 386 Vintage range sold in 2000 (years) (3) 1965-95 1965-96 1965-97 1965-97 1965-95 1966-95 1976-95 1967-98 Distinct vintages sold in 2000 (no.) (4) 31 31 23 31 31 23 18 27 Max price all vintages in 2000 ($)(4) 426 100 151 86 85 281 226 60 Min price all vintages in 2000 ($)(5) 159 29 72 19 20 100 95 20

Wine Brand (1) Penfold's Bin 95 Grange Shiraz Penfold's St Henri Shiraz-Cabernet Penfold's Bin 707 Cabernet Sauvignon Wynn's Cabernet Sauvignon Penfold's Bin 389 Shiraz Henschke Hill of Grace Shiraz Mount Mary Quintet Cabernet Blend Lake's Folly White Label Cabernets

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When considering wines from a specific region it has been shown that it is possible to forecast the vintages that outperform the average by modelling the weather during the growing season (Ashenfelter et al., 1995; Byron and Ashenfelter, 1995; Wood and Anderson, 2006; Lecocq and Visser, 2006; Ashenfelter, 2008). However, in the Australian context, where investment grade wines are drawn from across the country rather than from a single region, such an approach is difficult to implement. As such, for the Australian context it could be argued that an index based on the return achieved from holding wines from all vintages is the most appropriate index to consider. It is however also true that climatic variation in most Australian premium wine growing regions is less pronounced than in Bordeaux, and so the variation in price across wines from different vintages is also less pronounced. The most commonly used approach to estimating the return to wine has been the repeat sales regression approach, and that is the approach used here. The original application of the repeat sales price index methodology was in the area of house price index construction, and there is now a vast literature that has used the approach to estimate the return to real estate. The approach is however well suited to estimating returns in any market characterised by infrequently traded heterogeneous assets. For example, the approach has also been used extensively to estimate the return to art, and in their review of the art auction process, Ashenfelter and Graddy (2003, p. 769) list nine studies that have used the repeat sales regression approach to estimate the return to art. The exposition of the repeat sales regressions approach presented in Bailey et al. (1963) is timeless, and as such the following outline of the approach draws heavily on the original presentation. Let weW=[l,...,W] be the set of all observed wine sales, and let /er={0,l,...,r} be the set of time periods under consideration. Now, separate the set W into the subset of wines that sell only once during the sample period, i el- {1,...,/} c= W and the subset of wines that transact more than once over the sample period, j e J- {l,...,y)cff. The repeat sales approach considers only the observations in the set J. In some applications the proportion of the data discarded can be significant, and this is a criticism of the approach. For Australian wine, individual wine brand-vintage combinations generally trade more than once in a relatively short period of time and so the requirement for there to be a repeat sale is not especially onerous. Now, let the second sale for wine) occur in time period t and let the first sale occur in time period s, where t>s. Let the sale observations be denoted Pj and Pj, respectively, with the price relative (Pj/Pj) denoted Rf. Following Bailey et al. (1963, p. 934) and using B' and Bs to denote the true but unknown price index numbers for periods t and s, the repeat sales model can be written as Rf - (B'/Bs) x Uf, or if lower case letters are used to denote logs, as rf -b' -bs + uf, where in log form the errors have zero mean and constant variance. If xT takes the value minus one when r=s, the value one when T=f, and the value zero otherwise, the regression model can then be expressed as rf - [=1 BTx] + uf, where the return to wine is found by taking first differences of the least squares estimates of the P coefficients. The actual regression point estimates, with robust standard errors, associated quarterly percentage returns, and regression R2 value are reported in Table 2. Although the R2 value

James J. Fogarty Table 2 Return to Wine Estimates


All Wine Vintages

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Period (1)
1990Q1 1990Q2 1990Q3 1990Q4 1991Q1 1991Q2 1991Q3 1991Q4 1992Q1 1992Q2 1992Q3 1992Q4 1993Q1 1993Q2 1993Q3 1993Q4 1994Q1 1994Q2 1994Q3 1994Q4 1995Q1 1995Q2 1995Q3 1995Q4 1996Q1 1996Q2 1996Q3 1996Q4 1997Q1 1997Q2 1997Q3 1997Q4 1998Q1 1998Q2 1998Q3 1998Q4 1999Q1 1999Q2 1999Q3 1999Q4 2000Q1 2000Q2 2000Q3 2000Q4 Observations R2

Estimate (2) -.045* -.031 -.024 -.034 -.042 -.057 -.026 .008 .000 .011 -.011 .043 .036 .096** .111** .106** .201** .220** .196** .177** .229** .322** .355** .372** .491** .541** .512** .540** .615** .699** .704** .752** .814** .834** .859** .823** .862** .836** .874** .885** .891** .886** .873** .861**

S.E. (3) (.025) (.031) (.032) (.031) (.035) (.035) (.037) (.035) (.036) (.038) (.039) (.041) (.038) (.038) (.039) (.040) (.039) (.039) (.039) (.040) (.042) (.043) (-041) (.042) (.042) (.043) (.042) (.043) (043) (.044) (.044) (.044) (045) (.045) (.045) (.045) (.046) (.046) (.046) (.046) (.047) (.047) (.047) (.048) 12,180 .192

Return (4) ^t.397 1.449 0.660 -1.009 -0.749 -1.499 3.102 3.503 -0.783 1.069 -2.179 5.537 -0.723 6.221 1.515 -0.540 9.990 1.946 -2.394 -1.899 5.409 9.664 3.365 1.747 12.620 5.163 -2.897 2.907 7.778 8.757 0.449 4.947 6.419 1.956 2.528 -3.528 4.015 -2.527 3.859 1.109 0.612 -0.524 -1.341 -1.206

* Significant at the 10 percent level. ** Significant at the 5 percent level or greater.

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for the regression is low, it is consistent with that reported in Burton and Jabcosen (2001, p. 343) of .17 for all wine, and not that far below the values reported in Jaeger (1981, p. 589) of between .29 and .41 for a vastly smaller data set. The maximum quarterly return over the period was 12.62 percent, and the minimum quarterly return was -4.40 percent. The average quarterly return was 2.05 percent, and the standard deviation of returns was 3.93 percent.

IV. Diversification Gains


To place the return information in context, Table 3 provides summary details on the return to Australian wine, Australian shares, Australian bonds, and unhedged Australian dollar returns to US shares and US bonds from the first quarter of 1990 to the fourth quarter of 2000. The second column of Table 3 provides total return information, and as can be seen, the return to Australian wine is lower than the return to each of the other four asset classes. There are several measures of risk, and many financial applications focus on systematic risk. Here, details are reported for total risk, measured as the standard deviation of total returns to each asset class, and as can be seen by considering the information in column three of Table 3, higher returns are generally associated with higher risk. When using total risk rather than systematic risk, a standard measure that can be used to compare the risk adjusted performance of each asset class is the Sharpe ratio. The Sharpe ratio is a measure of excess return per unit of risk and is calculated as the asset return minus the risk free return divided by the asset standard deviation.1 Here the 90-day Treasury bill return has been used as the risk free return, and by considering the detail in column four of Table 3 it can be seen that of the five asset classes wine has the lowest Sharpe ratio.
Table 3 Individual Asset Summary Return Information: 1990Q1-2000Q4
Asset class (1) Australian Wine Australian Shares Australian Bonds US Shares US Bonds Quarterly Return (%)(2) 2.05 2.67 2.84 4.79 2.91 Standard Deviation (%) (3) 3.93 5.80 3.15 8.14 6.07 Sharpe ratio (3) .061 .150 .327 .366 .181 Correlation coefficient (4) 1.00 .136 -.106 .131 .003 S. ratio x Corr. coef. (5) .061 .020 -.034 .048 .001 Diversification gain (6) Yes Yes Yes Yes

In an investment portfolio context both asset returns and asset correlations are important, and as can be seen by considering the correlation coefficient information in the fifth column of Table 3, the return to Australian wine is not strongly correlated with the return to other assets. So, despite the relatively poor performance of wine in both risk adjusted terms and raw return terms, wine could still be a valuable addition to an investment portfolio. The potential for there to be a diversification gain from holding wine can be tested
' If using systematic risk rather than total risk the comparable metric is the Treynor measure.

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using several different approaches. The first approach considered is based on the ideas outlined in slightly different ways in both Blume (1984) and Elton et al. (1987) that there would be an incremental diversification benefit from adding wine to an existing asset if the Sharpe ratio for wine is greater than the Sharpe ratio of the existing asset multiplied by the correlation coefficient between wine and the existing asset. As can be seen by considering the final column of Table 3, based on the Blume/Elton et al. measure, there is a diversification gain from adding wine to each of the four broad asset classes considered. One way to visualise the diversification gain from adding wine to an existing asset is to follow Polwitoon and Tawatnuntachai (2008) and form a sequence of portfolios consisting of the benchmark asset and the asset wine, where the allocation to wine starts at zero and increases in small steps; and then plot the change in the Sharpe ratio. As for the sample period the return to Australian bonds was higher than the return to Australian wine and the risk lower, portfolio combinations comprising these two assets provide a good example to focus on when studying diversification gains in a two asset portfolio setting. Figure 1 plots excess portfolio return, portfolio risk, and the net gain in the Sharpe ratio compared to a pure Australian bond portfolio, where a sequence of Australian wine and Australian bond portfolios are constructed with the weight to wine gradually increasing from zero percent to 100 percent. In the figure risk and excess return information is read off the left axis, and as can be seen, excess portfolio return falls from 1.03 percent with zero allocation to wine, down to .24 percent with 100 percent allocation to wine. It can also be seen from Figure 1 that portfolio risk traces a quadratic. The rate of decrease in portfolio risk is equal to the rate of decrease in portfolio return when the allocation to wine is 14 percent, and it is this point that defines the maximum net gain in the Sharpe ratio from adding Australian wine to an Australian bond portfolio. The plots for pair-wise
Figure 1 Australian Wine and Bond Portfolio Combinations
Portfolio risk and excess return 5.0 T Gain in Sharpe ratio (RH axis) Portfolio Return (LH axis) Portfolio Risk (LH axis) Change in Sharpe ratio -rO.l

Maximum gain in Sharpe ratio (allocation to wine 14 percent)

2.0 1.0 0.0

Minimum risk portfolio (allocation to wine 35 percent) Falling return as weight to wine increases -0.4 30 40 50 60 70 Percentage allocation to wine 80 90 100

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asset portfolios formed using wine and the other asset classes shown in Table 3 look broadly similar to the result shown in Figure 1. It is however true that an investor is likely to hold a diversified portfolio of assets rather than a single asset class. As such, it is necessary to consider a more general test of the potential for there to be a diversification gain from holding wine. Mean-variance spanning tests can be used to answer the question of whether or not an investor that currently holds K assets in their portfolio would benefit by adding another asset, or set of assets, to their existing investment portfolio. The Huberman and Kandel (1987) regression based spanning test is a joint test that the intercept equals zero, and that the sum of the /? coefficients equal one, in the linear regression r, = a + X, Alv + M > where rt denotes the return to the test < asset at time t, r.f denotes the return to the benchmark assets at time t, and ut is a constant variance zero mean error term. If the Huberman and Kandel spanning test restrictions hold, it means the return to the test asset can be written as a linear combination of the existing benchmark assets, plus a zero mean error term. In the current application this would imply that adding wine to the portfolio of existing assets could not raise expected portfolio return, but could only add to portfolio risk. As such, if the restrictions oc=O and Zjl, p = 1 hold, the investor would not add wine to their investment portfolio, and it can be said that wine is dominated, or spanned, by the test assets. The Huberman and Kandel mean-variance spanning regression was estimated using quarterly return information for the period 1990 to 2000 where Australian wine was the test asset and the benchmark assets were Australian shares, Australian bonds, US shares, and US bonds. The Wald test statistic for the joint restriction that a = 0 and Zf=i P = 1 was 14.3, and strongly significant. The null hypothesis of spanning is therefore rejected. Although the above result suggests wine provides a diversification benefit, before reaching a definitive conclusion there is one further aspect to consider. Unlike standard financial assets, the return to wine has to be estimated, and there is uncertainty surrounding these estimates. The situation is illustrated in Figure 2 where the actual estimated index values for 2000Q3 and 2000Q4 are shown, along with estimates of the maximum and minimum plausible range for the change in the index value. Although using estimated returns is unlikely to have a significant impact on the estimated average return, it does mean that the volatility of the return to wine is likely to be understated. Given this issue, as a final test of the robustness of the result that wine provides a diversification benefit, new wine return estimates were generated as /, = / , + (S(/,)x (px(-l)') where /, denotes the least squares estimate of the wine price index at time t, SE(I,) denotes the associated standard error, and qjis set at the maximum value consistent with rejecting the hypothesis of mean-variance spanning. The null hypothesis of spanning can be rejected at the 95 percent confidence level for (p=A5, and with <p=A5 the return to wine is approximately the same as shown in Table 3, but the implied level of risk is 35 percent higher (5.29 percent) than reported in Table 3. On balance, it therefore appears reasonable to conclude that in an Australian context, adding wine to an already well diversified investment portfolio provides a further diversification benefit. This finding is consistent with that reported in Masset and Weisskopf (2010) for the US market.

James J. Fogarty Figure 2 Uncertainty Surrounding Wine Return Estimates


Log Index i
L

129

Point estimate

8727-

V
Return I estimate j used I

T *
i
1
2000 Q3

> 95 percent confidence interval ! Minimum j plausible irange


f 9-

r
Maximum plausible range

8606-

95 percent confidence interval <

^.^

i
^

Point estimate
1

2000 Q4

To make tractable the diversification gain attributable to wine where the benchmark portfolio contains several assets, it is helpful to consider only portfolios on the meanvariance efficient frontier. Approaches to finding the mean-variance efficient frontier have evolved substantially since the concept was proposed by Markowitz (1952), but here the classic approach that uses the covariance matrix and mean return vector with asset weights restricted to non-negative values has been used.2 The efficient frontier and individual asset risk-return details are shown in Figure 3. The reference portfolio used to calculate the potential diversification gain available from holding wine is the portfolio that generated the highest level of return per unit of risk when wine was not allowed as an investment option. This measure was selected as it is a utility free measure of an optimal portfolio. When wine was excluded from the set of investment options the portfolio that provided the highest return per unit of risk had a quarterly return of 3.10 percent and risk of 3.15 percent. The inclusion of wine in the portfolio allowed this same level of return to be achieved with a risk of only 2.94 percent. So, despite having a relatively low return, including wine as an investment option shifts the efficient frontier to the left.3

Alternative approaches include replacing the estimated return vector or covariance matrix with a weighted average of two estimates, where the weights are determined by the data. See Jorion (1985) for an example of the approach applied to expected returns, and Ledoit and Wolf (2003) for a general approach to finding a shrinkage covariance matrix. 3 Transaction and storage costs when trading wine are much higher than when trading standard financial assets. However, in Australia the profits on the sale of wine are generally tax free. These two effects largely cancel each other out so that when considering after tax and transaction cost return information for the above assets the diversification gain from holding wine is of approximately the same order of magnitude.

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Wine Investment and Portfolio Diversification Gains Figure 3 Mean-Variance Efficient Frontier with Wine as an Investment Option Portfolio Return (%) 5.0! Efficient portfolios 4.0 3.02.0Australian Wine 1.0
0.0

US Shares

US Bonds Australian Shares

Inefficient portfolios

0.0

1.5

3.0

4.5 Portfolio Risk (%)

6.0

7.5

9.0

V. Conclusion
Over the sample period both the return to Australian wine and the risk adjusted excess return to Australian wine were lower than for standard financial assets. It had previously been proposed that for the investor that wished to drink the wine they store, even when the return to wine is lower than the return to standard financial assets, tax impacts may be such that wine investment remains an attractive option. Given the return information shown in Table 3, and provided the investor has other income such that they face a positive marginal tax rate, this proposition is also true in Australia. Additionally, for the investor that does not intend to drink the wine they hold, the mean-variance spanning test results show that wine investment can provide a diversification benefit that means a positive allocation to wine is worthwhile even if they already have a well diversified investment portfolio. Using the return from the portfolio that provided the highest return per unit of total risk when wine was not allowed as an investment possibility as the reference level of return, a positive allocation to wine was shown to reduce portfolio risk by approximately 6.7 percent.

References
Ashenfelter, O. and Graddy, K. (2003). Auctions and the price of art. Journal of Economic Literature, 151,763-786. Ashenfelter, O., Ashmore, D. and Lalonde, R. (1995). Bordeaux wine vintage quality and the weather. Chance, 8, 7-14. Ashenfelter, O. (2008). Predicting the quality and prices of Bordeaux wine. The Economic Journal, 118(529), F174-184, reprinted in this issue.

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