Art Investing is $1.7T+ Asset Class. Should It Be In Your Portfolio?

Ever considered investing in art as an alternative asset class? Allen Sukholitsky, CFA, joins us to discuss his role at Masterworks — an asset management firm that specializes in art as an investment vehicle. From how the concept of fractional shares of art really works to why it can be a great inflation hedge, this episode is a fascinating look into an often mysterious asset class.

 

00;00;05;19 - 00;00;29;07

Mike Wallberg

Hello and welcome to Guiding Assets, the flagship investment podcast for CFA Institute. I'm Mike Walberg. And in this episode I'm joined by Alan Sokolowski. Alan is the chief investment officer for Masterworks, a firm that develops and syndicates funds that invest directly in art. He came to the role with a wealth of experience in market strategy and portfolio construction, including a few years at Citi and nearly nine at Goldman Sachs.

 

He's also a CFA charterholder. The market's shown a remarkable appetite for alternative assets. In an article that I worked on recently, I learned that private asset funds have been pegged at growing from two to about $6 trillion in this century alone and aren't investing while historically, a single transaction type activity has come a long way toward being made available to everyday investors.

 

We're going to talk today about how that's come to be and what investors should be thinking about when considering including art in their portfolios. Welcome, Alan.

 

00;01;00;28 - 00;01;02;21

Allen Sukholitsky

Great. Thanks a lot, Mike. I appreciate it.

 

00;01;03;06 - 00;01;17;28

Mike Wallberg

To start us off, Alan, can you tell us what led you to leave your career in more traditional capital markets to help build masterworks? And in that, can you please just include a definition off the top of what fractionalized art is and cover what appealed to you about masterworks approach?

 

00;01;18;10 - 00;01;51;08

Allen Sukholitsky

Sure. So Masterworks started in 2017 with the goal of making blue chip multimillion dollar works of art investible to the broad, self-directed investor community. And we do this with a process that seems pretty straightforward today, but it was quite revolutionary at the time. And the way it works is we buy a painting outright with balance sheet capital. We set up an LLC.

 

We move the painting into that LLC. Then we qualify that LLC with the SCC, which makes it a public vehicle and that allows investors to buy shares in the LLC. So since the LLC owns one asset, which is the painting, when investors are buying shares in the LLC, they are effectively buying shares in the painting. And so the securitization process is it's exactly what allows us to fractionalized these works of art for investors.

 

In terms of what appealed to me about what Masterworks is doing, you know, that's as you noted in your question, I spent the entirety of my career in traditional investment management, in a variety of roles that generally kind of revolved around macroeconomic research searches, strategic and tactical asset allocation modeling. And I thought I had

researched every major asset class until I came across a company called Masterworks that invests in art.

 

And I'm not exaggerating. Exaggerating when I say that it was kind of a light bulb moment for me. What I couldn't believe about art as an asset class is that it combines essentially three characteristics simultaneously that I had not seen in any other asset class. So, number one, it's an enormous asset class. Number two, it has existed for centuries, predating most other asset classes.

 

And three, 99.9% of investors had probably never thought about investing in it. So what got me interested in joining Masterworks is that it would kind of give me an opportunity to do something I never really thought I would do in my career, which is introducing both a new and old asset class to the investor community.

 

00;03;45;29 - 00;03;52;18

Mike Wallberg

So you mentioned the size of the market. How big is the art market and how is that industry characterized in terms of the players in it?

 

00;03;53;07 - 00;04;20;25

Allen Sukholitsky

Yep. So yes, I mentioned the asset classes, enormous in terms of numbers. It's estimated to be about $1.7 trillion in size. As a point of comparison of the private equity industry in the U.S., which is considered to be a very large asset class, is about $3.4 trillion in size, and it's got more than 9000 firms that operate in that space.

 

So arts is half the size of private equity. And I would argue that anything that's half the size of something as large as private equity is still probably going to qualify as being very large in terms of players. There are, of course, individuals, families and institutions around the world that do invest in art in some capacity. But to my knowledge, we are the only player investing in the art market whose investment approach is basically split evenly between quantitative analytics.

 

With a team of data scientists, and also qualitative analytics with experts from the art market backgrounds in the auction houses, galleries, dealers. And so, to my knowledge, again, we're pretty much the only firm that's doing that for this $1.7 trillion asset class. Other asset classes that I think are probably worth mentioning here, too, are private credit that's under $1 trillion in size, private real assets.

 

That's about $1.6 trillion in size. The reason why I think those asset classes are worth mentioning is because many investors have either been already evaluating those asset classes or actually already investing in them, and yet they are both actually smaller than the art market. And if you think about the evolution of asset classes over time that investors have invested in, they've typically started first with the biggest and most familiar asset classes like

stocks and bonds before, eventually after long enough period of time, moving into smaller, more alternative asset classes.

 

And since art is actually bigger than private credit and private real assets, yet most investors have never thought about investing in it. It's kind of as if art has sort of been inexplicably passed over as an investment opportunity. And so, you know, much, much of my role, it basically revolves around researching and bringing awareness to an asset class whose characteristics I think should have made it worthy of investment a long time ago.

 

00;06;27;28 - 00;06;48;01

Mike Wallberg

So so let's talk about those characteristics a bit here, Alan. So if you can put your a Goldman Market strategist hat on for a second, take us through the case for investment in art, including, you know, talk about the risk and return, return and risk profile, the correlations, the diversification benefits and how does it compare to these other private assets that you're talking about?

 

00;06;48;14 - 00;07;14;21

Allen Sukholitsky

Sure. So I'm going to start with a handy equation. I mean, not literally equation, but sort of that I like to use for art investing. And then I'll kind of unpack some of the details. So first, you take the performance characteristics of private equity in terms of returns and vol you remove the use of leverage because art investing doesn't involve any unlike private equity.

 

And finally, you add a truly unique low correlation profile. Those three elements put together basically sum up investing in art as an asset class. So just to unpack that a little bit, the segment of the art market that we invest in is contemporary art. That segment has been appreciate going for decades now at about 14% annualized. As a point of comparison, S&P 500 has been appreciating at about 10% annualized.

 

And in terms of volatility, arts has seen a trend that's remarkably similar to that seen in private equity and venture capital over time, which is to say that a few decades ago, those volatilities for private equity and venture capital were north of 20%. In fact, if I had to be specific, I would say that venture capital's volatility several decades ago was significantly more so than even 20%.

 

But in recent history, that volatility in private equity and venture capital has actually come down little by little to the low teens. And contemporary art has seen the same exact type of trend, which I actually find fascinating, because as a private market asset class art should behave like other private markets. And indeed it does in several ways, except that most private market investors have never actually thought about investing in the art market.

 

And yet it shares some of those similar characteristics. And then the last bit on on correlation that you asked about, I have to say that art's correlation profile is the most unique that I have

seen in my career, and it is what I believe to be art's most attractive attribute as an asset class. When you think about the correlation profile of just about any major asset class stocks, bonds, commodities, real estate, private, I mean, you can go down the list.

 

You typically see the same type of pattern, which is to say each asset class might have a low correlation to at least one other asset class, but it will also have a higher correlation to other asset classes. It's just kind of a description of the world we live in from a practical perspective, investors simply don't come across tons of asset classes that all have low correlations to each other across the board.

 

It's just not the world we live in. But Art is actually one of those few asset classes that has near zero correlation to at least 15 major asset classes. And like I said, that correlation at zero near zero consistently across the board, no matter what you measure it up against. So the takeaway here is that art has the potential to give a portfolio diversification benefits no matter what might already be in that portfolio.

 

00;10;14;00 - 00;10;33;10

Mike Wallberg

And I guess one of the other sort of complaints about correlations at times is that, you know, they tend to be diversified when you don't need them to be. And then in times of market stress, they all go to one. So do we do we have a long enough track record of of seeing how art performs through market corrections?

 

00;10;33;26 - 00;10;57;18

Allen Sukholitsky

Yes. So we went back and we took a look at several years when the equity markets had negative performance and most of those years, the art market was actually in positive territory. In fact, if memory serves me right, I believe the average return in those negative years was roughly ten or 11%. And so it seems like it's attractive.

 

Zero correlation profile does continue to hold. We've actually you know, we're in the process of writing a paper on the question of how does correlation for not just art but frankly several other asset classes look when compared to equities. If you specifically first measure it in down equity markets and then measure correlation specifically only in upper equity markets, just to kind of break the two different environments apart.

 

And what we've seen so far is, as you kind of mentioned with correlations going to one with many other asset classes, those correlation numbers do seem to creep up in down equity markets. But surprisingly for the art market, it does actually still stay close to zero, both in down equity markets and in equity markets.

 

00;11;43;25 - 00;12;05;12

Mike Wallberg

So I'm going to play devil's advocate for a second here, Alan, and talk about pricing. So without a transparent pricing mechanism, many investors first question will be how are these assets marked? I mean, is it even possible to arrive at an objective consensus on the value of something as subjective as as art before it's sold? Of course.

 

00;12;05;25 - 00;12;33;21

Allen Sukholitsky

Sure. Well, so the evaluation process for art is not dissimilar from that of private equity or real estate in which you use a comparables approach. This kind of reminds me one of the first project that we had at Masterworks. This goes back to the very early days was building an enormous proprietary database of art market transaction history that goes back almost 70 years in time.

 

It's got hundreds of thousands of transactions in it, and we're constantly adding data to that database in real time. You know, in fact, I often kind of refer to this database as a Bloomberg for the art market. We basically built it and it's proprietary. So we've got the only license to that terminal. And we use that data not only to analyze different segments of the art market to find investment opportunities, but it also gives us a robust lens into the valuation process because we have so many transactions and comparable data in that database to use when we're engaging in the valuation process.

 

And, you know, in terms of accuracy for the process itself, you know, I'll mention that our sales of paintings so far have taken place at prices that were just about right in line with what we expected the paintings to ultimately sell for. So we would consider our valuation approach to be quite accurate for the paintings we hold.

 

00;13;29;05 - 00;13;38;15

Mike Wallberg

So we've got a solid return profile, low correlations. When you talk to clients, what allocation do you advise them? And, and why?

 

00;13;39;01 - 00;14;10;19

Allen Sukholitsky

So I'm going to start my answer here by actually citing external research. First City has actually been very forward thinking in terms of their asset allocation modeling with art as an asset class in the modeling process. They've created hypothetical asset allocations that include art in the portfolios precisely because many of their clients own art and they want to think of it as a component of their portfolio.

 

So for clients with the ability to have a portion of their portfolio in illiquid asset classes like private equity, real estate and of course, Art City has referenced an art allocation of up to 4%. So that's the external research. Now, in terms of our own asset allocation work that we've done, we actually took a slightly different approach in answering that question because and I'm going to be candid here.

 

We knew that if we optimized or ran simulations and arrived at probably any allocation to art, the result might not necessarily be perceived by investors as the most perfectly objective conclusion, since, after all, we are a firm that invests in art. So what we actually decided to do was simply to measure how frequently does a portfolio with a small 5% allocation to art do better than the same portfolio without art?

 

And just to reiterate here, there is nothing special about that 5% number. These aren't optimized. There are no simulations. It's just a small number and a round number. And that is what I wanted to do on purpose. And what we found is that whether your baseline portfolio is, let's say, a basic 6040, or if it's a diversified portfolio with a dozen or more asset classes in it, or even if your portfolio is an endowment portfolio with very healthy allocations to illiquid asset classes, by adding that small 5% allocation to art history has shown an improvement in your portfolio Sharpe ratio in 100% of ten year periods.

 

And if you break down those results into specific weekly, let's say, frequency of just higher returns or frequency of just lower vol, or if you wanted to run those scenarios over shorter time frames, the results are still very high, not as high as 100%, but they're also not very far from that either. And, you know, the driver of these impressive results, it just kind of goes back to the correlation profile that I talked about earlier.

 

If you add an asset class with close to zero correlation to just about anything else and that asset class has been appreciating in the mid-teens over time, it has the potential to be an attractive diversifier.

 

00;16;41;01 - 00;17;00;20

Mike Wallberg

Now, Al and I want to turn and talk about digital in a second here, but before we go there, I think it's probably worthwhile just revisiting the the profile of what Masterworks is actually offering so that investors can kind of understand that. Because the example you took us through was describing an LLC with a single piece of art in it.

 

But can you sort of describe more broadly what the funds are that you guys provide short?

 

00;17;05;27 - 00;17;53;13

Allen Sukholitsky

So the diversified art portfolio, we actually just recently launched it. It is going to be an evergreen, lean tender offer structure. And the idea is that that portfolio over time is going to have, call it, 100 plus works of art and it that come in and out of the portfolio as time goes on. But it's basically it's a way for an investor to make one allocation to art, get diversified exposure to many, many different types of paintings that are diversified across different types of artists, different nationalities, pretty much all the types of diversification that, you know, I find myself in this funny position when I used to talk about diversification, that's traditional investment management world.

 

You're talking about, you know, sectors and industry. And here I am talking about artists and and where the artists are are from. But, you know, in the world of art, that's sort of the equivalence when you talk about diversification. So you get diversified exposure across many different paintings. You make one allocation and again, it's going to be an evergreen tender offer structure.

 

00;18;15;17 - 00;18;27;21

Mike Wallberg

So one area that art is being syndicated and sold is via NON-FUNGIBLE tokens or Nfts is art masterworks in this area. And and what are your thoughts on Nfts as a medium of exchange?

 

00;18;28;04 - 00;19;05;01

Allen Sukholitsky

Sure. So masterworks, the short answer is masterworks is not currently in this area, although your question is one that comes up very, very frequently. Since we are the go to firm for art investing and so as far as NFT is are often considered as a form of art, we seem to be a natural fit except, you know, other than the word art in the phrase digital art, there isn't a lot in common between that and blue chip, multimillion dollar paintings whose artists and works have stood the test of time.

 

You know, NFT is have only kind of come around over the last couple of years. I certainly would not write off the possibility that down the line we uncover a way to, you know, incorporate Nfts into our business model. But at the moment, what we're focused on is bringing a centuries old, sizable asset class to the investor community that we think investors should have considered quite some time ago.

 

00;19;31;05 - 00;19;43;24

Mike Wallberg

So we're down to our final question here, Alan, and it's a two parter. What was your first job in the industry? And if you could go back and take yourself for coffee on your first day, what key piece of advice would you offer yourself?

 

00;19;44;28 - 00;20;18;12

Allen Sukholitsky

Well, most importantly, I would say that there's probably no shortage of advice that I would give myself. And and all of it would be along the lines of general career advice rather than anything particular to a specific role. My first job, it was in wealth management in a manager selection and asset allocation capacity. And but the advice I would give myself would definitely be to speak up and have confidence in what you think.

 

Especially very early on in any decision making process when expressing your opinion, frankly, doesn't have much downside other than maybe to be told that someone thinks you're wrong. And what I'm saying holds no matter where you might stand in an organization hierarchically. I

actually you know, I remember I remember very distinctly this was before the global financial crisis.

 

I was talking to my peers about how I thought the housing market was going to bring down the economy and the equity markets with it laid out the process step by step. But ultimately, my big mistake was not raising any of those concerns or thoughts beyond my peer group. Now, this isn't to say that I would have automatically gotten buy in from everyone in an organization to, you know, change strategy in favor of what was an extremely contrarian view at the time.

 

But I should have tried to at least make the case based on the level of conviction that I had. I mean, at the very least, it would have gotten me sort of in the habit of challenging the status quo a lot earlier in my career. So fast forward to today. You know, everyone always kind of does their best to learn from their prior mistakes.

 

I make it abundantly clear to everyone on my team that I want nothing more than to be told all the time why I might be wrong. I certainly do not have a monopoly on good ideas and nobody else does either. And so by being in an environment where I'm constantly being told why I might be wrong as often as possible, it kind of forces me to consider lots of different views that I might not have otherwise thought about before.

 

And, you know, the the funny, funny thing is, I honestly think about it quite similarly to how I think about asset allocation. You know, you want low correlation asset classes in your portfolio because if all your investments acted the same way. There would be no reason to own all of them. And kind of along the same lines, if all of my colleagues think the same way that I do, what's the point in having so many of the same point of view?

 

So, you know, I can't believe I'm going to say this, but it's it's almost like I aim to have low correlation colleagues precisely because they're diversification. Benefits lead to better outcomes. You know, it's just like building an investment portfolio.

 

00;22;44;25 - 00;22;52;21

Mike Wallberg

I've been speaking today with Alan Sokolowski, CIO of Masterworks. Thanks so much for sharing your insights on the art investment market today, Alan.

 

00;22;53;07 - 00;22;53;20

Allen Sukholitsky

Thank you.

 

00;22;53;29 - 00;23;10;10

Mike Wallberg

I'm Mike Walberg and this is me guiding assets.