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112 The Art of Investing with Scott Lynn of Masterworks

"You have this asset class which has been around for hundreds of years, but up until recently I think people haven't fully appreciated the characteristics." - Scott Lynn (Tweet)

Scott Lynn is the Founder and CEO of Masterworks. He began his career as a serial entrepreneur, starting tech companies focused on casual gaming, online advertising and financial technology. All along the way he collected art, and after seeing the data available in the last twenty years thanks to the Internet, Scott decided to pursue art as an investment. Art as an asset class has been around for hundreds of years, but only recently has been seen as a viable investment opportunity - made possible by Masterworks. Listen in on today's episode to find out why art is becoming more popular as an asset class among investors, what the key macro drivers are for art, and how Masterworks is making art an accessible investment opportunity.
Thanks for listening and please welcome our guest Scott Lynn.

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In This Episode, You'll Learn:

  • How the art market is different today than it was twenty five years ago
  • How old art is as an asset class
  • How analyzing art is different from analyzing other asset classes
  • When did art as an asset class begin to be studied
  • How art returns are related to the growth of the top 1%

"There's so much opportunity in the art market compared to other asset classes." - Scott Lynn (Tweet)

  • How art prices are driven by a decreasing supply of new works
  • How should an art collector think about risk
  • What is a bad environment for art investment
  • How Masterworks invests in art
  • What is a standard commission when buying a piece of art
  • What are the trends among art investors

Connect with Masterworks:

Visit the Website: Masterworks

Call Masterworks: +1 203-518-5172

E-Mail Masterworks: support@masterworks.io

Follow Scott Lynn on LinkedIn

 

"The thing that amazes me about the art market is how it's still very much in its infancy." - Scott Lynn (Tweet)

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Full Transcript

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Scott

You think about the art market, art as an asset class is 1.7 trillion dollars. That's a number that's published by Deloitte and has been (more or less) confirmed by Sotheby's. Last year 68 billion dollars in art sold, so think it as a couple of percent turnover every year.

Compare that to venture and private equity, which is 3.5 trillion dollars. There are six thousand firms that operate in venture, private equity, late-stage buyout, whatever, that help people allocate to the asset class. In the art market, there is nobody.

Introduction

Imagine spending an hour with the world's greatest traders, imaging learning from their experiences, their successes, and their failures. Imagine no more, welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation remember to keep two things in mind: all the discussion that we’ll have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks, from the investment manager, about their products before you make investment decisions.

Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

Niels

Hey everyone and welcome to another edition of Top Traders Unplugged where today I'm joined by Scott Lynn, who is the founder and CEO of Masterworks. Today we are really going to talk alternative investments. So, first off, Scott, thanks so much for coming on the podcast. I'm excited about our conversation today because it's a new asset class for me, and I think for many of our listeners, but I have a feeling that once we get started it will be surprising to most of us how similarly you can think about investing in art compared to more traditional assets.

So, I want to kick off by framing what we are going to talk about today and better understand your journey into the world of investing and, specifically, how you came about choosing art as your focus area. So, perhaps we can go back for a little bit and see how it all began and how you got to where you are today.

Scott

Sure, yes, so, thanks for having me. I guess my journey into the art market is a little bit unique. So, I have been starting technology companies for the past twenty years, originally, beginning in casual gaming and then moving into online advertising and then FinTech.

Also, throughout that period of time, I have been collecting art. The art market in the, I guess the mid to late nineties was very different than it is today. The primary difference between the market back then, compared to today, is that the internet didn't really exist, so there wasn't good data to analyze.

So, I guess qualitatively, when I think about the market back in the mid-1990s, you had this core group of collectors who were passionate about the artists. They were passionate about cultural significance. While those things still exist today, I think every collector who is buying multi-million dollar paintings is doing it with some lens of investment. That's probably the difference that has occurred over the past twenty years.

We always get questions from people like, "Aren't ultra-wealthy people just buying these paintings to hang on their wall because they like them and there's no focus on investment. I would say I know very few people that are ultra-wealthy and have spent their entire life working very hard and buy one million dollar, or ten million dollar, or fifty million dollar paintings without thinking about it from an investment perspective.

Niels

Sure, we're going to get into a lot of the weeds of investing in art, but I want to explore the asset class itself for a little while. So, maybe you can tell us about the history of art as an asset class and how it has grown over the years, and perhaps why it seems to be becoming more popular with investors these days.

Scott

So, the history of art is, obviously, one of the oldest asset classes there is. I use the statistic a lot with people and I think they don't totally recognize it until I say it. But Sotheby's, which just recently went private, was the oldest company on the New York Stock Exchange - two hundred and seventy-five years old. Christie's is roughly the same age. So, there are two companies in America that are two of the oldest companies that there are. Art has been traded between ultra-wealthy families for, literally, centuries.

So, you have this asset class which has been around for hundreds of years, but up until recently, I think people haven't fully appreciated the characteristics.

Niels

Yeah, why do you think it's becoming more popular now?

Scott

That's a good question. I think that we believe, and we have our research team working on this question, but we do believe that art prices are correlated to the growth of the top 1%. So, when you're investing in art today, you're sort of buying a call option on the ultra-wealthy. So, if you believe that the top 1% are getting wealthier I think you believe that art prices are going up. So, I think that dynamic alone has created more activity in the art market.

Then, I also think that, since roughly half of the art market trades at public auction, you now, today, have a data set, which you can go back decades and analyze the performance of the asset class and really conclude that it is a strategic asset class. To be honest, a strategic asset class just very simply means an asset class that beats inflation, or an asset class that is uncorrelated. I think up until the last ten years there probably hasn't been sufficient data or maybe just sufficient research to conclude that.

Niels

Yeah, we may come back to that point a little bit later as well. I also wanted to, again, big picture stuff and before we get into the nitty-gritty of things, is just in terms of the experience of returns and risk in this asset class. How do people get their head around that when they start thinking about art as an investment opportunity?

Scott

I think that the way that we analyze the market is very similar to how many investors would think about real estate. So, we've done a lot of work to understand how particular assets are performed over time. Some of your listeners may be familiar with how Case-Shiller was constructed for real estate.

So, we look at individual paintings that have been purchased and then subsequently sold in the art market and how much money was made or lost on each of those transactions. We use that to construct indexes on the art market overall, or on particular segments of the art market. Then we use those indexes to inform how we think about returns or how we think about correlation.

So, it's, frankly, when we think about analyzing the asset class, it's very typical of how you would analyze any other asset class.

Niels

Since you come from the tech world, I can't help not asking you, when you've met investors from that world and now you meet investors looking to invest in art, are they (in a weird way) looking for the same things?

Scott

Our investors at Masterworks are prototypical investors. They're looking for uncorrelated returns. I would love to say that most of our investors care about cultural significance but they really don't. They're really just looking for another way to diversify a portfolio and generate returns.

Niels

OK, let's talk a little bit more about art as an asset class. You mentioned a little bit about the data side of things. How long can you actually go back and find what, let's call it, reliable data to make sense of these returns and the characteristics of that market?

Scott

You can go back, probably, close to a hundred years. Obviously, the reliability of that data is questionable the further you go back in time. Most of our data sets begin in the 50s and 60s.

When you think about the market high level, last year 68 billion dollars in art sold. Half of that 68 billion was at public auction and then half of it sold privately. So, we really only have good, reliable data on half of the market. The private market data is very unreliable.

So, the public auction segment is controlled, at least in the U.S. and Western Europe, by three major auction houses. So, it's not that difficult to collect. There haven't been that many firms that have done it, historically, but the data is there if you want to analyze it.

Niels

Yeah, and I think you already mentioned that you actually have to, then, go and build your own indices to track that data. No one else offers that as a service?

Scott

It's really crazy. The thing that amazes me about the art market is just how it's still very much in its infancy. There haven't been a lot of research groups formed to analyze the asset class. Frankly, our research team is the best, by far, at understanding returns in the art market. There have been a bunch of research projects to understand total transaction volume; total size of the asset class; how many galleries operate in the art market; how many artists constitute a certain portion of the market, but there really hasn't been research teams formed to understand returns. I think that the very first person to analyze it is a guy named Mike Moses, who was an advisor of ours.

Mike started analyzing returns in the art market in the 1990s which is crazy, right? You have an asset class that has been around for hundreds of years and the first time that anyone has really studied returns was in the 1990s.

Niels

Yeah, absolutely, what about when you look back on the history of the data that you have access to, what does the growth look like? As you say, some asset classes are really just coming into the frame now and starting to take off even though they might be old. What about art in itself? What's the growth of that? Has it been steady, or is it...?

Scott

It depends on the segment that you analyze, like any other asset class. So, if you look at the top 100 artists by transaction volume, and these are household name artists like Picasso, Basquiat, Warhol, etc., that top 100 segment (which constitutes 64% of the art market, by the way - we can talk about that separately) has outperformed the S&P by roughly 180% from 2000 through 2019. So, from a returns perspective, it's very interesting.

We did the first correlation analysis with City Group, on the asset class, at the end of 2019 and concluded that, essentially, it's an uncorrelated asset class. I think the highest correlation, interestingly, is between art and cash at roughly 0.3. The correlation between art and the S&P is roughly 0.14.

The challenge with art, I think, for most investors is that it's an illiquid asset class. So, you have to be comfortable with holding that investment for some period of time to really realize returns.

Niels

Yeah, well, luckily most investors tell us when they invest, "Oh yeah, we're long-term." And that is, of course, until the day they decide, "No, we're not long-term anymore." (laughter) But there we are.

I want you to describe, and I think you touched upon it a little bit with the ultra-high-net-worth individuals, but I actually want you to describe what you see as the key macro drivers for art as an asset class.

Scott

Yeah, there are two things that I think are very interesting. So, one is, as I mentioned, I would think of investing in art as a call option on the ultra-wealthy. So, if you believe, globally, that the top one percent are getting wealthier then you can probably believe that art prices are going up. When I say globally it is important to understand that the biggest concentration in the art market today is the United States with roughly 25% of the market.

So, art is somewhat of a currency-neutral asset. You can buy a painting in the U.S., you can take it to China and you can sell it. So, it is, we believe, correlated to growth in the global top 1%. The second thing that's really fascinating, and I think this is unique to art compared to any other asset class, is that you have a continuously shrinking supply. So, when an artist makes a number of paintings in their lifetime, at some point they pass away, and those paintings go into collectors' hands or they go into institutions or museums. As collectors pass away they usually donate those works.

So, the best example, qualitatively, that I like to use is Jackson Pollock. So, many of your listeners are probably familiar with his drip paintings that he did in the 1940s, 1950s which are icons of American Art History. Some of those paintings have sold in excess of $100,000,000. But what's happened in today's world is that most of those paintings are now in institutions. There are twenty-three drip paintings left in private collections. Out of those twenty-three, there are only a couple that we, frankly, would consider "A" examples. Most of them are "B" examples or "C" examples. But they still sell for twenty or thirty million dollars simply because there's nothing else left. So, that continuously decreasing supply of available work from, what is regarded as, culturally significant or historically important artists definitely continues to drive price pressure over time.

Niels

Now, you talked a little bit about the return profile. You mentioned that in comparison to, say, the S&P, so the flip side of the returns, of course, is risk. How do you even think about risk associated with the returns of art?

Scott

We think about risk as you would think about risk in any other asset class, which is simply standard deviation of return. So, when we're bringing offerings, under the Masterworks platform, we're generally looking at the individual artist's market. What is the artist's market return, historically? What has been the standard deviation in return for that artist's market? And, effectively, what is the risk-adjusted return (or what your listeners would think of as a Sharpe ratio)?

What you see is that different artists have very different standard deviations and returns. So, one of the best or the lowest standard deviations on return is actually Claude Monet. Monet, I think, last year sold something around $400,000,000 in art. So, if you assume that 3% or 4% of his total market sold last year, you can think of him as a multi-billion dollar market cap artist. His standard deviation on return was, roughly, 6% (if I recall correctly). So, his risk-adjusted return is very good because his overall returns are very predictable.

Now, Monet actually has one of the lowest returns of any artist we track. I think his absolute return is something like 7% a year from an artist market perspective. But his risk-adjusted return is very good because it's just so predictable. Monet has been selling work for over 100 years now.

Niels

Yeah, I love the way that you take this non-traditional asset class and you have turned it into the speak that we like on this podcast. (laughter) So, I'm going to stick with that a little while longer and I'm going to talk about something that comes up quite a lot and that is the word "Crisis Alpha," meaning something where - how does this asset class perform when the rest of the world is having a difficult time, mainly an equity crisis? So, what's your experience when it comes to... I know it plays to part of the correlation argument, of course, but what do the actual hard facts look like when we look at the crisis period that we all know and how art handles those?

Scott

Yeah, so this is a fun story. So, for the past couple of years, we've been touting this idea that art is an uncorrelated asset class and we have pressure tested that by analyzing prior financial crisis' beginning with the dot.com bubble bursting in 2000, and then the '08, '09 crisis. Interestingly, the art market declined in 2016. The best guess as to why is Brexit and capital controls in China. So those are the three periods that we looked at. What we found is that when the dot.com bubble burst in 2000 our prices actually increased. In '08, '09 it had the biggest correlation ever to the S&P. I think that correlation was something like 0.4. Then in 2016, when public equities did very well, the art market actually declined for those reasons I mentioned.

So, we concluded, effective, that looking at the correlation data and also looking at those three periods of time, that it was an uncorrelated asset class. Now, this is after 2016 and we didn't really have a proof point yet. So, we published research on this and we thought it was right and we hoped it was right and then Corona happened. So, Corona was a good test of that. I continue to say that it was an uncorrelated asset class, we believed that it was uncorrelated, but the truth is I was sort of sitting in the back room hoping that when auction sales started happening again, the prices didn't collapse. What we found, thankfully, is that prices didn't collapse.

So, what we saw in June of this year, right in the middle of Corona, is that things started happening again, was that twenty-two artists set price records, prices continue to go up. There is no impact on the market what-so-ever (that we could tell). I think, for better or for worse, that just continues to speak to the growth in the top 1%. While we are living in a world today where it feels like there are two different economies: public equities and then the real economy, we don't see the top 1% really experiencing that. So, the behavior hasn't changed, from what we can tell.

Niels

Sure, so you might be one of few business owners who actually wouldn't mind a second wave, even though it's politically completely incorrect to say that.

Scott

I can't comment on that.

Niels

No, that's right, that's right.

So, we talked a little bit about returns in general, some risk associated with it, obviously, it should be a core part of any portfolio based on these attributions, but, if we just stick with this point about environments. All investments go through different environments. What would you say would be a bad environment for art, as an investment?

Scott

The risk that we see... It's interesting, when we talked about this risk, three years ago, people didn't really think it was a risk. I think it's more of a risk today. But it's just anything that targets that top 1%. We're seeing governments, globally, start to refocus policies on the top 1%. In New York City there's a proposed billionaire tax right now. Things like that could, potentially, hurt the art market.

Niels

Yeah, well, we have a U.S. election shortly, so that might be an interesting time to watch for a change in how billionaires are treated, I guess.

Scott

You know, it's interesting, there was... Many of your listeners who invest in real estate are probably familiar (at least in the U.S.) with 1031 exchanges. That was the biggest policy change that happened to the art market when the Trump tax laws went into effect, and they basically eliminated 1031 exchanges from the art market.

1031s are this way to effectively take gain in a particular painting and then roll it into another purchase without actually paying tax. So, you can effectively just roll forward your gain indefinitely. We thought that would have had an impact on the art market, and a lot of art lawyers who work in the market (that do these 1031 exchanges) thought the same. We didn't really see any impact on prices, so it didn't impact people buying and it didn't impact people selling which I think is a good sign. Maybe that just speaks to the fact that there is so much money in the top 1% it's just not impacting behavior.

Niels

True, another thing that I think a lot of people have been surprised about is just the reaction in the real estate market. I'm not a specialist in that, but what I have noticed is that has not had any significant price decrease despite the fact that there has been a lot of uncertainty, a lot of unemployment showing up. So, you're right, we see these oddities from time to time.

I also wanted to ask you... I guess in our industry ( the hedge fund world) where suddenly one strategy or a manager becomes the flavor of the month, do you see the same in the art world with an artist or a type of art where everybody runs towards the same?

Scott

That's an excellent question. So, the short answer is, yes, depending on the segment of the market. So, we definitely see a lot of artists that are selling in the sub $100,000 per painting range that come into favor, fall out of favor. That segment of the market, we feel, is very volatile. We risk rate that segment of the market as a "C" risk rating without getting into risk profiles. We almost entirely avoid it, today, for investors.

If you look at the top 100 artists and I mentioned earlier that the top 100 artists constitute 64% of the market overall, interestingly, in the past twenty years there have only been three artists that have fallen out of favor. When I say, "Out of favor," I just simply mean generated negative returns. Those artists are Damien Hirst, Jeff Kunz, and Murakami. There are different reasons for each of those markets, why they have declined, but in short, we would say that they were effectively fabricated. They were propped up by a handful of investors, they couldn't sustain the prices, and it collapsed.

Art is a very interesting store of value. We just, also, subsequently, after our correlation study with City Group, published a report on art versus gold and how we think about store of value characteristics between those two. What we found is that, when we look at loss rate, loss rate measured as loss rate on a trailing three-year average and the magnitude of loss, when a loss does occur, art compares favorably to gold.

We continue to think it's this really interesting asset class, again, that the main drawback is just the lack of liquidity.

Niels

Manipulating a market in art is not that different from what we see in the stock market or any other financial markets, to be frank. I think that comes with the territory. So, I want to shift gears a bit and I want to talk about how you, at Masterworks, actually make investments in art and what kind of art do you focus on, and, of course, how your investors participate in these investments. But before I do that I can't help thinking of something that we often say to our own investors when it comes to the benefit of running a rules-based investment strategy that I represent, and that is that you should never fall in love with your own positions. So, now how can you avoid that in your side of the industry?

Scott

Well, I think if you talk to any prior girlfriend that I have ever had she would just say that that's my personality. Yeah, we're a very data-driven team. When we think about acquiring a painting I guess there's a two-step process that we go through. One is that we analyze the data that I referred to. By the way, for your investors that really want to get hands-on with data, you can actually go to the Masterworks.io website and click on price database. We publish all the data that we have on the market to anyone on the Masterwork's platform. So, we're big believers in collecting data on the asset class and then just publishing it for free because we think that's what's really required to get people to buy into allocating to art.

So, the first thing that we do is we look at data on the art market overall and we really decide, on an annual basis, which artists do we think are most investable. When I say most investable, I'm really talking about absolute return and risk-adjusted return.

There are two different buckets that we guide people to, in terms of absolute return. One is what we refer to as our "A" risk bucket. It tends to be high single-digit kind of low double-digit returns. These are artists like Basquiat, Warhol, etc. Then the other bucket is what we refer to as our "B" risk bucket and these are mid-teen returns but more volatility.

Now, interestingly, when you look at the Sharpe ratio between those two buckets it's basically the same. So, there's not a right or a wrong answer, but we do have investors that just have absolute return preferences based on their portfolio. So, we, this year, have come up with, I think 44 artists that we think are most investable out of several hundred if not thousands of artists.

We then take that list from our research team and hand it off to our acquisitions team who goes out and finds, basically, every example by those artists that they can. So, I think, as of today, we were actively tracking something like eleven hundred paintings from those 44 artists that we have been in negotiation on and then we're purchasing now, roughly, one $1,000,000 to $10,000,000 painting every week and that's, effectively, how we think about sourcing works.

Niels

Sure, obviously the auction houses, as you mentioned earlier, where you can get very easy data from, I was just curious, in terms of anyone buying a painting as a private collector from a gallery, does that transaction ever become public or?

Scott

It doesn't, it doesn't. It's so interesting, galleries sell work in a very different way than we talk about art. How we're talking about art right now never happens in the art market, ever. You walk into a gallery, you stand in front of a $10,000,000 painting, and the gallery will talk about the cultural significance of the artists; they'll talk about what other paintings similar to that painting are selling for today, but they never talk about returns, which we think is strange.

Niels

I mentioned to you before we pressed record today, that I wanted to talk about art in as much as the same kind of... Using the same terminology that we do when it comes to investing. This is, obviously, from pure ignorance on my side, but we talked about the liquidity and how that comes from auction houses and so on and so forth, but what does it actually cost? The one thing that we think a lot about is commissions, right? Is there a standard commission for when art is traded? How do we even think about that?

Scott

So if you go to an auction house, Christie's is actually having an evening sale tonight, in New York City, where hundreds of millions of dollars in art will sell. The average commission, today, for paintings (I think over $4,000,000 is 21%, 22%) is shockingly high. Now the crazy thing about that is that if you are Masterworks, or if you're a well-known collector, you can effectively work with the auction house to negotiate most of those commissions away. So, we more or less pay flat fee commissions now, a couple of hundred thousand dollars per painting, that we're bidding on. It works out to be 1% or 2% in most cases. So, I guess it is significant, but it's not as significant as if you were an individual navigating the market on your own.

Niels

Sure, but it's a massive benefit, really, for the people who buy paintings or art, or invest in art through your platform. That in itself I think is quite interesting. By the way, if you were not buying through Masterworks, is it only the buyer who pays, or is it the buyer and the seller (again, I have no idea)?

Scott

It's generally the buyer who pays. In lower dollar lots, if you're selling a twenty-five thousand dollar painting, the seller may pay a fee as well, but generally, it's the buyer. One of the great things about working with Masterworks is that we obviously do negotiate away those commissions and we also have tax advantage structures where you're not paying sales tax or use tax. So, that in itself winds up being a big number.

Niels

Yeah, now you mentioned you have a research team, and if you want to feel free to talk a little bit about that. You mentioned you have an acquisition team, etc., etc. The question I wanted to get to was actually... So, you sit down and you look for the next year, these are the artists you're interested in, these might be the specific paintings you're interested in, do you try to work out, in advance, say, "We're willing to pay this amount for the painting." So that you don't get too excited and pay too much during the actual auction for that piece of art?

Scott

Yeah, the reality is that we're just seeing so many more paintings, today, than we're buying. So, if we take a particular artist that we like, like Basquiat, we're tracking 30 Basquiat and we're buying one every four months. So, we're very selective about what we buy and at what price we buy. Like any asset class, the entry price does dictate returns. How much you pay for something obviously matters.

Niels

Yeah, absolutely, you also... This is what I, again, liked about some of the things that I read up on before our conversation today. You use a lot of the terminology also, generally, that is used in the investment world. I think you talk about emerging artists, I don't know if you used the word "developed artist" but that's, of course, what we would think about as markets. Maybe even blue-chip versus startup. I'm not sure whether that applies but, talk a little bit about how you look at the... The market must be vast and very different, but then you want to categorize it I imagine.

Scott

Yeah, we try to categorize in terms that people relate to. These are more or less our terms, right? So, there's not really anyone else in the art market doing this. So, when we refer to blue-chip we are basically talking about art created by the top 100 artists. So, these are the household names that constitute 64% of the art market. Those are artists that have the high single-digit returns, low double-digit returns but have a lower standard deviation in return. So those are our "A" artists.

Then when we talk about "B" risk artists we're generally talking about what is referred to in the art market as mid to late-career artists. So, they're generally living artists, sometimes they're 90 years old but they're generally living artists. They have markets where they generally sell $50,000,000 a year or more. Those are what we consider riskier. They're still not... People in the art market would still regard many of these artists as very established and not risky but they're riskier. Their standard deviations in returns are higher. Those are the mid-teen return artists. Those are the two segments that we focus on.

There are these emerging segments which, under our risk classification, we would classify as a "C". That would mean that we don't have enough data to conclude, one way or another, exactly where they fall on the risk spectrum. Those are artists that, today, we stay away from. We get requests for these artists all the time. I think the typical investor that likes this segment is someone who is like a venture investor. They want to make 100 bets and hope that one bet has a 100X return or a 25X return. I struggle with that because we have a lot of people investing from IRAs. We have a lot of people who are... We don't have super speculative investors so we haven't really moved into that segment yet, but it's maybe interesting in the future.

Niels

Sure, sure, sure, I think you mentioned, also, that the Sharpe ratio doesn't necessarily change a lot between established artists. What about styles, and again, I'm no expert here but you have, maybe, a category like post-war and contemporary art versus (I don't know), modern art or impressionist. Does that change anything or...?

Scott

Yeah, so this is actually really interesting. What we found is that returns follow recency. So, at a very high level, the way to think about returns in the art market is that if you invest or if you purchase a Rembrandt today, for example, a good Rembrandt self-portrait costs, roughly, $10,000,000. You will basically sell that painting twenty years from now for $10,000,000 plus inflation maybe. So, it's a good store of value but it's not really going to generate returns.

Now, what we do see is that art in today's world, after World War II, is primarily the most investable segment of the art market. That art that was created after World War II, right now, we see returns that are decelerating. So, returns follow recency but in very wide increments. Sort of think of the acceleration is a bell curve and then you hit a midpoint and then it decelerates over time. That entire bell curve effectively is something like 80 years. So, it's a very wide increment and you'll see acceleration from whatever. Right now we're seeing acceleration from art created in the 90s or early 2000s, kind of into that bell curve and will continue to accelerate, and then at some point, it will peak out and it will start decelerating.

So, there's no question that you definitely, in the art market today, do not want to be investing in art created in the 1700s. There's just not a market for that. It's not fashionable. The demand is far less. But the good news is that fashion just changes over very long periods of time. It doesn't change in five years or three years.

Niels

Yeah, sure, so, again, inside your firm do you operate with something like an investment committee, or is it really you as the... I don't know if portfolio manager is the right word, but that says no, this is it, and here is the price we're going to pay or...

Scott

Yeah, we operate with an investment committee- like framework. Now, it's interesting, so, each of these offerings is technically a public offering. So, very similar to how a company in the U.S. goes public through and S1, we literally purchase a painting, put it into a vehicle, file it with the SEC, and then have the painting qualified so that our governing structure and everything from risk factors, etc., is a much higher standard than what you would typically see in private offerings. So, we disclose to investors all the risks, we disclose everything about the painting, we disclose any fees or anything else. It's a pretty transparent structure.

Niels

And do you consider yourself as a kind of a value investor or is there even a thing called momentum in your world?

Scott

Yeah, so, I would actually say that the crazy thing about the art market, today, is you can be both. The art market is such in its infancy that there's just not people like us that are operating in the market today. There are collectors.

Like tonight, for example, if you go to this Christie's evening sale that will sell several hundreds of millions of dollars in art, you'll sit next to collectors who have a particular... Tonight's sale is mainly post-war art, so you'll have post-war collectors there that own paintings like Pollock and Rothko and someone is trying to buy a de Kooning and they've wanted a de Kooning for fifteen years and the de Kooning that they want is up for sale tonight.

There are not people like us sitting in the audience that are happy buying anything at a certain price depending on the artist market and the return profile. So, we believe that... I mean everything that we're bringing to investors, today, we think is a great value. In many cases, we think there's movement to buy in the artist. There are certainly artists that we have brought to the platform. Like we have brought a Claude Monet where there's not momentum behind his market. It's very predictable. Even someone like Basquiat, I would say, is not accelerating in returns but he has generated 17% or 18% returns for twenty or twenty-five years now. So, very predictable, not accelerating but still pretty incredible. So yeah, there's just so much opportunity in the art market compared to other asset classes.

Niels

Sure, in my world I come from what's called the trend following world where we just look at data and we just invest according to the data and I'm waiting for the day when there is actually a trend follow in the art market. Maybe some of the listeners, today, will take you up on starting to analyzing all the data that you put up on your website and come out with some good rules for investing in some of these artists. Another thing which is super important in the world of investing, of course, time horizon. I don't know what you typically advise or talk to your clients about when it comes to time horizon in terms of art.

Scott

Yeah, I mean, look, it takes a while to generate returns in the art market today. So, we tell people to think of holding an investment somewhere between three and seven years. It's highly unlikely that we buy a painting and we sell a painting in a year. It's just how the art market works, it's very difficult to do for a whole bunch of reasons. So, at a minimum, I would think of these as three-year liquid holds. It can go up to seven years and then we have, essentially, a feature where if we can't sell at seven years we can extend that sale process by another two years.

Now, all of that being said, one of the things that we have focused on heavily as a team and as an organization is building out trading markets for these securities. So, we did launch secondary markets for these securities something like four or five months ago. So, while those markets are still relatively early, we do fundamentally believe in a world where investors can trade securities in these underlying assets just like they trade shares in a public company.

Niels

Yeah, I think that's very interesting and, obviously, you're in the forefront of all of that and I guess that's why your tech background is very useful. You mentioned earlier that Damien Hirst had been, in my speak, in a bit of a downtrend recently. Do you ever use the concept of a stop loss, where you say, "OK, I bought this painting, but actually, um, it's going below what I think is comfortable and so I just want to get out?" Is that even a concept in your world?

Scott

You know, luckily, we haven't (knock on wood) we haven't had that issue yet. In the art market, I mentioned before, out of the top 100 artists, there have only been three, over the past twenty years, that have generated negative returns. So, unless you make a mistake, and I would just really describe that as an error, unless you make an error buying - you buy something that, for whatever reason, you just massively overpay for it, it's hard to lose significant amounts of principal.

What I tell investors is that I would think about the return profile as riskier than the principal. We don't see a lot of people buy Monet paintings for $20,000,000 and turn around and sell them for $5,000,000. It just doesn't really happen.

Niels

Now, I want to be respectful of your time, but I know we have a few more minutes left, so I do want to turn the spotlight towards more specifics in terms of how people can become an investor in art. Of course, you're obviously offering one opportunity. But I think one of the first questions, when people here, "Oh, should I invest in art?" The first thing they obviously think of (I'm sure) is that, "It's going to set me back $100,000,000 dollars plus." That will preclude a lot of people. But just describe a little bit more about how you have overcome that. How are you actually making this a very accessible investment opportunity for many people? Even, maybe you want to touch upon the fact of whether or not you need to be an accredited investor to participate.

Scott

Sure, so we made a very deliberate decision, starting Masterworks, to make all of these investment opportunities as public offerings, meaning that both retail investors as well as accredited investors can invest. So, anyone both in the U.S. or abroad can invest in these offerings. In addition to that, another benefit of having these offerings be qualified public offerings is that we can run trading markets where people can trade securities in them. So, that was a deliberate decision.

In terms of minimums, we always get the question, what is the minimum investment, we really work with any investors. So, we require that every investor, before investing, have a call with our membership team; talk about their investment objectives; talk about their portfolio; we'll walk them through how to think about allocation, how to think about what segment of the market is right based on their portfolio and their objectives. But ultimately we work with any investor. Our goal is to really democratize this asset class and make it investable by anyone.

Niels

Sure, sure, now, in order to get to that point, of course, you will have gone through an SEC registration (I imagine). I can't help but imagine that there have not been many firms, like you, before, that they have had to deal with at the SEC in this area. So, I'm just curious, what were the main challenges, so to speak, from their side, but maybe also from your side too in order to tick all the boxes.

Scott: There are no challenges, we love regulators. (laughter)

Niels

Of course.

Scott

So, the very first offering that we filed with the SEC was a long process. So, it took, I think, something like fifteen months to get the investment vehicle through the SEC. There were lots of different rounds of commenting. Part of that was our fault. We didn't exactly know the ideal structure and kept trying to fine-tune it over time. But I would say, today, that the cadence of these offerings and working with the SEC has been much improved.

So, now we're getting one offering qualified approximately every week. We're one of the largest filers of small-cap public offerings that there are. So, cadence has definitely improved. That being said, government agencies are not (at least in the U.S., and I think probably most everywhere), they're not set up to handle really, what someone like Masterworks is doing. They're not set up to process one public offering a week from one issuer. So, we're definitely pushing the envelope there. But I think, over time, we'll see that improve as alternative assets, in general, become more securitized at an individual underlying level, more tradable, and so on.

Niels

Yeah, now, on my side, I spend a lot of time, if not the majority of my time, doing what I would say investor education on systematic investment strategy. I know how overwhelming that can be when you enter a new asset class. It's difficult to know where to start, or maybe where to end and who to trust. How can investors take a few steps to filter out some of that noise? Are there any resources or anything that you would point in a direction, that you would point them at?

Scott

Yeah, so we publish a quarterly report from our research team on how we think about the art market, generally. We partner with a lot of private banks to do third party research as well. So, we have links on our website to those different research pieces.

Then, I would also say that we try to present offerings in a standardized way that makes sense to investors. We risk rate them. We publish historical returns. They can see a third party appraisal on every single painting. They can decide, based on very simple data, how they feel about that investment. So, we try to make it as easy as possible. So, you can either spend a lot of time diving in or you can spend very little time diving in. It's really up to the investor.

Niels

Yeah, and of course the investors, in your case, would, at the moment at least, have to commit to one specific painting, but have you ever thought about doing a fund where you would say, "OK, I'm going to diversify the risk for all of these investors and have ten or twenty painting." I can imagine it might be a little bit difficult for people to decide on a specific painting unless they know a lot about art.

Scott: The short answer is yes, we like the idea of fund-like offerings over time. Today, I think most people are approaching portfolio construction simply by looking at the return profile, looking at the risk profile, and then essentially just diversifying amongst paintings. But I think there is no question that for more sophisticated investors, and particularly... Maybe not even more sophisticated, maybe investors that just want to be more hands-off, that fund offerings make sense.

Niels

In terms of once you have all these paintings and as you grow you are going to get more and more paintings, you are going to have to store them, I don't know if this is even a concept, but instead of having to store them away from everyone, would there even be an opportunity to say, "We're going to rent the paintings out to a museum so that the investors could earn a little bit of a carry or interest?

Scott

It's a great question. We had a lot of interest pre-Covid from real estate development firms that would typically buy paintings as part of a luxury condo project, who were interested, instead, in just renting paintings. You know, it's very hard, today, to figure out how scalable that is, or how much demand there is for that. So, I think right now it's not really an opportunity for us, but it could be in the future.

Museums or institutions are very difficult to work with. We think it's unlikely that they would ever pay to rent paintings just because they don't have an allocation in their budget for it. One of the unique things that has happened during Covid, which we didn't expect, is that we actually now have institutions reaching out to us who are interested in de-accessioning.

So, a lot of museums have been hurt because they don't have the ticket revenue that they used to have due to Covid. So, now they're trying to figure out ways to fund their operating budgets, and the most rational way is to sell paintings. There is a unique structure where we could have a museum effectively sell us a painting. We could have investors invest in the painting, then the painting could stay on the museum's wall until it eventually sells, which maybe is a more friendly way for institutions to think about de-accessioning than what they thought about it in the past.

Niels

Yeah, absolutely, now Masterworks, obviously, I'm sure is growing a lot. Capacity is a question that we get a lot of in our industry. Is there anything that, capacity wise, where you can see people like Masterworks, but even, maybe, if you get a little bit of competition at some point becoming too large to operate in a market, as you say, that is not, obviously, as liquid as you see in other public markets?

Scott

The best analogy that I love to make that I make at least once a day is that you think about the art market, art as an asset class is 1.7 trillion dollars. That's a number that's published by Deloitte and has been (more or less) confirmed by Sotheby's. Last year 68 billion dollars in art sold, so think it as a couple of percent turnover every year.

Compare that to venture and private equity, which is 3.5 trillion dollars. There are six thousand firms that operate in venture, private equity, late-stage buyout, whatever, that help people allocate to the asset class. I the art market there is nobody. There is Masterworks, right? So, you have an asset class that's literally half as large as venture private equity and there is no way to invest in it. It's very easy for us to continue buying billions of dollars in art, over time, just based on the size of the asset class. We don't see any capacity constraint issues.

Niels

Sure, I have one final question of the more business-like questions. I have got a few personal and fun questions for you before I let you go.

Scott

(Laughter) Great!

Niels

Just to keep you on your toes here. Just out of curiosity, when you look at your investor base and where you see, generally, demand coming from, what type of investors and, geographically, are there any trends in what you see?

Scott

You know it's interesting. Today most of our investors are from the U.S. although we spend an enormous amount of time and energy making sure that all these vehicles are tax-efficient for people outside of the U.S. So, each artwork actually sits in a Cayman entity, and whenever it's sold it's 100% passed through to anyone living outside of the U.S. It's a perfectly tax-efficient way for non-U.S. persons to invest. I would say that most people are in the U.S.

The average investor is investing something like six or seven thousand dollars per painting and may in five or six paintings now. A lot of our cohorts are still maturing, so, it's difficult for us to tell how those investor profiles mature over time, but it's something like that. The average investor is investing $25,000, $35,000 as a part of their portfolio. We have investors who are investing $250,000. We have investors who are investing $2,500 but that's kind of the average profile.

Niels

Sure, OK, very interesting. As I said, I just wanted to finish off with a couple of more personal and fun questions. The first one I would love to know is what was the first painting that you ever bought and at what age was that?

Scott

(Laughter) You know, I was successful really young with the whole dot.com internet boom so my very first painting... Well, I've actually written a blog post on this. There were multiple things that I collected at a young age, many of which were not what I would consider good investments today. But the very first important painting is this artist names Marc Chagall, the title of the painting was Le Pont-Neuf. You know, I probably paid, back then, something like $250,000 for the painting when I was nineteen years old. I thought it was a great painting back then. I think my taste has evolved since then. I'm collecting different things today.

Niels

Sure, of course, it's nice to know where it all got started. Now, another thing that certainly in the traditional world is something that comes up and that is: is there anything that keeps you up at night? Is there any risk or event, business-wise, or market-wise that you worry about?

Scott

You know it's really sort of the talk, at least in the U.S., of a lot of these wealth taxes. That's not anything specific to the art market but it does concern me on multiple levels without going into politics. We do have a lot of, what I would consider, very extreme proposals now that, essentially, take away a lot of the wealth or a lot of the gain from anyone that has a net worth above X.

I can see that hurting lots of industries. Even the current proposal in the U.S., the current Democratic tax proposal where cap gain rates match ordinary income rates, I don't know what happens if that passes. Do people just stop selling assets for the next four years? I don't know. So, some of that, at least in today's market...

Niels

Yeah, political risk, that's a tough one. Yeah, I agree with that. Now, I also wanted to ask you what are the questions that you think potential investors should be asking your team - things that may not come up so often but that you actually think are really important?

Scott

I think the most important thing... There are two questions, really, when you're investing in art, at least through Masterworks. One is what should your overall allocation be? That allocation number, we've run asset allocation models internally and we also did it with City Group as a part of that correlation report that I mentioned. The allocation range is huge. On the very low end, for people that have a low tolerance for illiquid assets, it's roughly 1.8%. On the very high end, it's roughly 8%. So, a key question is what is your tolerance for illiquidity?

Then the second question is, once you decide what the overall allocation should be, which of the two risk buckets makes the most sense? Is it risk bucket "A" or is it risk bucket "B"? As I mentioned, the Sharpe ratios are basically the same, so there's not a right decision or a wrong decision it's just what sort of risk are you willing to take and what kinds of returns are you aiming for as part of your overall portfolio?

Niels

Sure, I think that's super important. Now, the final one, it's a little bit different Scott, so bear with me here because I want you to finish this statement for me. OK? So here we go.

Scott

(Laughter) Uh oh.

Niels

I know I'm being successful when...

Scott

I know I'm being successful when everyone has an allocation to art.

Niels

Yeah, that's a pretty good answer. Now we've come to the end of my long list of questions, but I want to make sure we covered all of the important points. So, let me just ask you if there is something that I missed and that I should have asked you today, Scott?

Scott

No, I think we covered everything. I mentioned briefly that we do have secondary markets now that are available to investors so, for those people that aren't necessarily interested in focusing on allocating a portion of their portfolio to art overall, you can always just go in the secondary market, buy shares, play around with that as well. As a company, we're very excited about that because we obviously recognize that if you look at just the characteristics, as an asset class, you can pretty easily conclude that everyone should allocate to it but the number one objection continues to be liquidity - people that just aren't able to wait a handful of years to recognize a return. So, a big focus is on how do we build out trading markets for interim liquidity?

Niels

Yeah, that's very important. Now, Scott, this has been quite a fascinating journey into the world of art. Before we finish, of course, do tell the audience where they can learn more about Masterworks and the investment opportunities that you offer and also any suggestions of places that they can go and educate themselves if it not on your own website?

Scott

Yeah, so I think in terms of third party research, obviously you can look at the research that we've done with other third parties on our website www.Masterworks.io but you can also look at other third party sources. So, we like a firm called Artprice that we think is a great third party resource that publishes lots of research on the art market.

Then if you're interested in getting started, I would just encourage everyone to come to the website, schedule a call with our membership team, which is almost always available sometime in the next three or four days, speak about your portfolio, speak about your investment objectives and just get started investing in one offering and then grow it from there.

Niels

Fantastic, on that note, let's wrap up this fascinating conversation. Scott, thanks so much for being on the podcast and for sharing your thoughts and experience with me. It has been fascinating to hear your story. As I often say, it's so important to have practitioners like you share these ideas because when ideas become conversations that lead to action that's when real change happens.

To all of you listening today, I hope that you were able to take something away from today's conversation onto your own investment journey and if you did, please share these episodes with your friends and colleagues and send us a comment to let us know what topics you want us to bring up in the upcoming conversations with industry leaders in the world of finance and investing. From me, Niels Kaastrup-Larsen, thanks for listening and I look forward to being back with you on the next episode of Top Traders Unplugged. In the meantime, go check out the show notes for this episode and all the other resources that you can find on our website.

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