Art: A Viable Alternative?

Author: Frederik Gieschen

In a subplot of the movie Tenet, the protagonist visits a so-called Freeport storage facility to retrieve a forged Goya painting. He enters a high security warehouse filled with art seemingly frozen in time: protected, preserved for the future, and remote from taxation and prying eyes.

Unlike the film’s mind-twisting time travel plot, freeports (and the occasional forgery) are a real feature of the opaque world of fine art. Prominent freeports house vast collections of art, collectibles, and luxury goods in places like Geneva, Luxembourg, and Singapore. The Geneva Freeport has been called the world's largest art warehouse and wine cellar. Behind armored doors in temperature-controlled rooms it houses works by artists like Picasso, Warhol, and even da Vinci’s “Salvator Mundi” (before it was sold for a record-breaking $450 million in 2017).

While freeports may provide a backdrop for secretive deals, money laundering and tax evasion, Adam Georgina writes in The Dark Side of the Boom that “operators protest that freeports are completely above board.” Their most common use is mundane: safe storage, privacy, trading, and the avoidance of sales taxes. “Richer collectors don’t ever pay,” one dealer told Georgina. “Works that they buy are shipped directly to a freeport; no tax. It’s legal.’”

Much less exciting than the movie Tenet: The Geneva Freeport (Ports Francs et Entrepôts de Genève SA). 

‍From status symbol to asset class

Dating back to the Medici family, the wealthy have channeled capital into the arts to gain status and access. Buying a famous painting and transforming into a patron of the arts creates more favorable headlines than yet another oversized yacht. Fine art is the original Bored Ape Yacht Club, offering preferential access to art fairs and auctions. But things have changed. Art has turned from being the playground of wealthy collectors to being pitched as an alternative asset class.

“In the early days, about 80 percent of [buyers] were collectors. Some bought paintings to keep up with the Joneses and others bought them as investments. Today it’s the complete opposite. 85 percent of people buy for investment and very few people buy for social reasons.” Art Dealer Bill Acquavella on the David Novak podcast

Private art funds and startups like Masterworks suggest that art offers both attractive returns and a low correlation to other markets. Is art really such a no-brainer? Does it deserve its status as a viable alternative investment? What drives this market and how does it work?

Art is a surprisingly large market. Deloitte estimated the global value of art and collectibles held by ultra-high net worth individuals at $1.5 trillion. By comparison, McKinsey estimated the value of total private markets assets under management at $9.8 trillion. Art would be half as large as private equity ($3 trillion), nearly as big as venture capital ($1.8 trillion), but larger than private debt ($1.2 trillion). However, only a small share of the art market trades every year: $65 billion in 2021, according to UBS.

Despite its size, art remains opaque and dominated by individual investors. It has characteristics that venture inventors might recognize: the market is shaped by small groups of connected insiders who act as gatekeepers. As one study found, the performance of a small number of works dominates portfolios’ returns. Investors navigate an illiquid market, information asymmetries, and high transaction costs. Unlike venture however, art offers incurs a cost to store, transport, and insure. Similar to gold or crypto, it offers no cash flow-based intrinsic value. Lastly, there is no investable art index and headline returns are impacted by several biases that might be overestimating returns.

‍The challenge of tracking performance

To provide an apples-to-apples comparison, art market indices track repeat sales of the same work (similar to the Case-Shiller Home Price Index as Morgan Stanley explains here). For example, Masterworks created an index based on “all live and online auction sales at Sotheby’s, Christie’s and Phillips for artworks that previously sold at public auction, going back roughly 200 years.”

This approach can lead to a few biases. First, it only captures the performance of relatively valuable art which is sold at auction. Second, it can incorporate survivorship bias: if an artist falls out of fashion or a work that declined in value is never resold, the decline is not captured. The index might also exhibit a positive bias if pieces are resold more frequently because they increased in value, that is if sales are not independent of price. Don Thompson writes in The $12 Million Stuffed Shark about another quirk: sometimes auction houses buy back artwork at a guaranteed price if the auction fails. Seeing this price reflected in the index, he notes, is “technically correct, but hardly reflects a work’s real market value.”

One popular index is the Mei Moses Index All Art Index published by auction house Sotheby’s. It boasts an annualized return of 8.5% from 1950 to 2021:

Masterworks offers multiple sub-indices, such as contemporary art, which it claims has outperformed the S&P 500 since 1995 with a return of 13.8% (compared to 10.2%; as of December 31, 2021). Citi occasionally publishes other Masterworks index returns, including the All Art Index which delivered annualized appreciation of 9% since 1962. In 2019, Citi noted annualized returns of 5.3% for the “art market as a whole,” 5.0% for Impressionists, and 7.5% for Post-war and Contemporary Art from 1985 and 2018.

However, returns since the 1980s reflect mostly one macro regime: declining rates and increasing wealth inequality in the United States as well as increasing globalization and growing numbers of ultra-wealthy globally who could join the ranks of collectors.

Researchers William Goetzmann, Luc Renneboog, and Christophe Spaenjers took a longer term view in their 2010 paper Art and Money. They examined “mostly British art-market data compiled since 1765.” Their index shows a long bull market since the 1950s but also significant periods of stagnation and decline.

The 1980s boom in impressionist and modern art, in part driven by the entrance of Japanese collectors, was followed by a painful bust in the early 1990s during which the Masterworks All Art Index dropped 56%. “The art bubble … exploded,” Thompson writes. “At Sotheby’s Impressionist sale in May 1991, 41 per cent of the lots went unsold.” A New York art critic recounted dealers “sitting atop dozens of unsaleable Warhols and Basquiats, praying for a bail-out from somewhere.” Something to keep in mind when the rise of contemporary looks unstoppable.

Driving factors behind art’s returns

The structure and returns of the art market have been driven by a unique imbalance of supply and demand. Non-contemporary art by definition does not increase in supply and so the prices are determined by demand. But more than that, “the best examples of other schools of art are disappearing from the market,” Thompson writes and “are never again likely to appear for sale.”

“There are many buyers and not so many paintings of the quality everybody wants. The competition to get those paintings is very difficult. … Most of them [trophy paintings] end up in museums. And the people that have bought them in the last 30 years have been extremely wealthy and they don’t sell.” Art Dealer Bill Acquavella on the David Novak podcast

One factor reducing the supply of investable art has been the estate tax. Art that has been held for decades can lead to a surprising tax bill based on its fair value which creates an incentive to donate collections. Private collections are also being turned into museums. Examples include the Guggenheim, Whitney, and Frick in New York, the Getty and Broad in Los Angeles, the Louis Vuitton Foundation in Paris. Once owned by a museum, a high-profile work is less likely to change hands again. For example, Ronald Lauder acquired Gustav Klimt’s 1907 Portrait of Adele Bloch-Bauer I in 2006 for $135 million for his Neue Galerie in New York.

As a result Thompson notes that “the masterpieces become staggeringly expensive because the number of museums grows while the number of masterpieces is constant.”

“When I started out, 30 years ago, millionaires had boats and jets—but didn’t necessarily have any art at all. That has changed, for the very wealthy today, it’s not fine not to be interested in art.” Thomas Seydoux of Connery, Pissarro, Seydoux

Demand on the other hand has exploded. Not only are today’s wealthy broadly more interested in art, there are also a lot more of them. And, unfortunately, rising inequality seems to be a key driver of prices. In their 2010 paper Art and Money three researchers concluded that “we can expect art booms whenever income inequality rises quickly.” Looking at prices from 1908 to 2005, one of their models suggested a  staggering increase in art prices of about 14 percent for every “percentage point increase in the share of total income earned by the top 0.1.” Though the data is limited, it is intuitive that rising inequality and spending power of the ultra wealthy disproportionately drives the art market and particularly the upper end.

As a result of these forces, the art market has been changing its composition. It has become more concentrated: 90% of transactions occurred at the low end in 2021 (prices below $50,000), but 60% of the value transacted at the high end (price in excess of $10 million). 

The art market mirrored the bull market in stocks with its increasing concentration:

And because of the dynamics described earlier, the market has been increasingly defined by the performance of contemporary art which accounted for the majority of value at auction over the past few years.

“The single most surprising change in the art market is the relative increase in the value of recent art.” David Galenson, University of Chicago

Because the supply of contemporary art is technically unlimited, dealers act as tastemakers and gatekeepers. They invest in select artists, carefully control the supply of new work, and strive to keep sales prices a secret.

“The market for fine art is…controlled by galleries and dealers who commit with astonishing discipline to keeping artwork prices predictable and pegged to signals of quality like the prestigiousness of the gallery selling the artist’s work,” Alex Mayyasi writes in Why Is Art Expensive. “You could say the market for art is “rigged”; a more charitable explanation is that galleries and dealers act as tastemakers, deciding which art is good and therefore expensive.”  He points out that aspiring collectors have to play by the rules, such as the resale through a gallery or risk being blackballed in the art industry.

The value of art is signaled by factors such as provenance (which is a list of facts “concerning the background of the work, such as notable former owners and the exhibition of the work at prestigious venues”). Thompson writes that having a show at a “major museum” can increase an artist’s value by “50–100 per cent.” The market’s lack of transparency occasionally spawns schemes in which overvalued art (established by appraisal) is being donated to gain charitable tax deductions.

One notable newcomer to the world of contemporary art has been the rise of non-fungible tokens (NFTs). NFTs hold the promise of making digital art monetizable and allowing artists to redefine the relationship with their audiences by disrupting the existing layers of intermediaries. NFTs rapidly gained popularity in 2021 with $40 billion sent to NFT marketplaces in 2021 alone according to Chainalysis.

However, the potential democratization of digital art creates thorny questions for collectors around the supply of new work, limited history, and the importance of new tastemakers among online communities and influencers. Not surprisingly, existing players are also looking to play a role in this new ecosystem. Citi noted that the auction houses possibly “carved out their position as the bridge between the old and the new art value system, adding their own “brand premium” and validation to the nascent NFT market.” Though per UBS and Art Basel the volume of NFTs sold by “the top-tier [auction] houses of Sotheby’s and Christie’s” amounted to only $230 million in 2021. With crypto markets undergoing a steep bear market, the extent and pace at which NFTs could be accepted as valuable art by mainstream culture still appears to be an open question.

Investors are faced with a clubby world and significant information asymmetries. Market structure dictates that contemporary will likely dominate new collections. If the indices are flawed, perhaps a look at real portfolios can be instructive in assessing art as an alternative asset.

Examples of successful collectors: Keynes, British Rail Pension Fund, Sally and Victor Ganz

It is rare for collections and their transaction records to be available for study by academics. However, some examples exist including from John Maynard Keynes who was not only an economist and active investor but also an avid art collector. He purchased works between 1917 and 1945 which he bequeathed to King’s College, Cambridge. His returns were studied in the paper Art as an Asset: Evidence from Keynes the Collector.

“While Keynes’ total expenditures amounted to less than 13,000 British pounds, the collection had an estimated market value of more than 76 million pounds in early 2019.”

This amounted to a “nominal internal rate of return of 10.4%.” He underperformed the stock market by merely 0.2% annualized.

Keynes purchased art through a variety of channels and proved to be a shrewd investor. In early 1918, he attended the sale of the private collection of Edgar Degas in Paris to purchase works for the British treasury. The German army was conducting its final offensive of WW1 and the mood was dire. For his own collection Keynes reportedly acquired “27 drawings and paintings, works now worth millions, for next to nothing.”

The paper examined Keynes and several other collections and found that, much like in venture capital, a small number of outlier investments dominated returns. “Fewer than 10% of all works,” the authors note, “account for over 75% of the total value.”

One other example was the British Rail Pension Fund which invested about £40 million in art from 1974–1980 in an effort to protect against inflation and diversify from a weak stock market. The final item was sold in 2003 and the net IRR turned out to be 11.3%. The performance highlighted the impact of transaction and advisory costs as “half the total gain was spent over the life of the fund in advisor and auction fees.”

There are also rare examples of the art market’s equivalent of successful angel investors. For example, Victor and Sally Ganz were self-taught collectors who traveled extensively and fell in love with Picasso. They bought Le Rêve for $7,000 in 1941 which was later purchased by Steven Cohen for $155 million (after Steve Wynn, the seller, first poked a six inch hole in it while showing it to guests). The Ganz’s collection was sold for more than $200 million and, according to William Landes, from 1948-1997 “earned real rates of return ranging from 12 to over 21%.”

Finally, there were Dorothy and Herbert Vogel, postal employees in New York City, who collected over 4,000 works of contemporary art on modest salaries. The Wall Street Journal noted that “her salary paid the rent; his salary went for art.”

Should you invest in art?

Art is not a silver bullet for the portfolio. While the shrinking supply of older work is attractive during times of high inflation, the investable universe increasingly consists of contemporary art. And the attractive headline returns not only reflect some bias but have also been driven by rising inequality and growth of the ultra-wealthy globally - trends that could moderate or even reverse going forward.

Without an investable index and portfolio returns driven by outliers, investors have to accept the risk of missing out on a small number of winners. And because insiders have an information advantage, success may depend on building a network and working with the right advisors.

Much like an aspiring angel investor, an investor should expect to invest time and effort to establish a baseline from which to make judgements. This might be more challenging in art than other asset classes because its value is intangible. Its resale value hinges on the future demand and taste of other collectors. And it has become fashionable to call taste entirely subjective. And why not? Contemporary art does not strive to be aesthetically appealing. “A lot of contemporary art is aggressively ugly,” according to professor David Galenson who researches the art market at the University of Chicago. “That doesn’t matter in terms of its value. Art and money have always been joined by an umbilical cord of gold.”

However, if there is no such thing as good taste then any skill in art investing would amount to excelling at the Keynesian beauty contest: instead of relying on one’s own judgment of value, decisions would be made entirely based on beliefs about the future actions and beliefs of other market participants. Value is what others perceive as valuable.

For a different take I recommend two pieces by Paul Graham. He acknowledges that “for the average person, brand dominates all other factors in the judgment of art.” In How Art Can Be Good he writes that “seeing a painting they recognize from reproductions is so overwhelming that their response to it as a painting is drowned out.”

However, Graham argues in Is There Such a Thing as Good Taste? that because there is an objective qualitative difference between a master painter and the completely inept, it must be possible to recognize this quality and develop good taste. To do so, he recommends to “travel widely, in both time and space. If you go and see all the different kinds of things people like in other cultures, and learn about all the different things people have liked in the past, you'll probably find it changes what you like.”

Thompson agrees, pointing out that “you have to see hundreds of works you don’t like before you begin to understand what you do like.”

“When you enter an art fair or gallery room,” he advises, “look around and think ‘If I were going to steal one, which would it be?’”

Would you steal Art Basel’s infamous $120,000 banana?

The question of whether to purchase art becomes easier once it is reframed from investing to collecting. Because collecting can be fun, a bonding activity, and have a real impact.

When David Geffen was an upcoming record executive, his mentor introduced him to the world of art by arranging a sweetheart deal with one of his dealers. Geffen later sold his friend Steven Spielberg a Magritte at a bargain price. “Why did you make such a bad deal for yourself,” Spielberg asked him. “It’s a good deal,” Geffen replied. “You are going to become a fanatic as an art collector. And I’m going to be able to sit on the sidelines and enjoy watching you build your collection.”

And Graham’s take on taste has a wider implication: “One of the reasons artists in fifteenth-century Florence made such great things was that they believed you could make great things. The most important consequence of realizing there can be good art is that it frees artists to try to make it.”

And good art by emerging artists needs support. Which is why collectors like Jim O’Shaughnessy put their focus on the work of living artists: it is where their money can have the greatest impact. It is where the collector can support a creative process whose output they enjoy. Even Keynes occasionally purchased pieces of his artist friends whom he sought to “keep going over a period of years at very large cost to my own income.”

In other words: collecting art can be a worthwhile pursuit even if its returns don’t keep up with the stock market.

Note: if you’re interested in investing in art or other alternatives (and are an accredited investor), Compound can help. Access curated alternative investments to drive investment returns, manage risk, and generate income through Compound.