Updated on August 24th, 2021
This is a continuation of my alternative investment introduction and my general criticism for the space of hoodwinking investors with a great marketing pitch.
Masterworks, Investing in Fractional Art Pieces
You’ve probably seen the Masterworks ads all over social media: invest in works of art! Diversify your portfolio! Invest in blue chip art shares! We’re the place for buying fine art online! Not only do they do heavy promotion on Instagram, Facebook and Twitter, there is also a personal finance army that is pushing affiliate sales of how to invest in fine art, using Masterworks.
Masterworks is one of the newer alternative investment platforms that have sprung up in the last couple of years, picking up gobs of non-discerning capital flowing through the economy with the stock market at records highs and a non-stop spigot of stimulus checks. Their message is that you can buy art as an investment and they advertise that you can invest in “shares” of fine art, $20 at a time. This is the first and only art crowdfunding site in existence.
In this article I lay out my various concerns with this alternative investment in art company including the marketing of returns, the business model, concerns with the company founder, tax implications and marketing tactics.
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I attempt to answer: is art a good investment? What are the pros and cons of investing in art with Masterworks?
Historical Art Returns
My first gripe is their misleading promotion of historical returns. Right on the front of their homepage, they display this performance chart of contemporary art versus the S&P 500.
This chart led me to two questions. Is their platform only for investing in contemporary art or are they just picking the best performing style?
I was also wondering why the starting period was only from 1995. I already suspected the answer and confirmed it when I managed to dig up another one of their return plots for the same asset class. Their performance chart still looks good, but looks a lot better when you omit that 1990-1995 dip.
Ultimately I would like to see an even longer price history than this, but it is hard to come up with sources since it’s a very fragmented market without a central repository for pricing data.
The problem with charts like these is that is that they suffer from selection bias and academic research confirms that the long term returns are less than half of what Masterworks and others are suggesting. Only the pieces of art that get sold are included in the performance figures. This is very different than looking at a performance chart of the S&P 500 because you have fungible shares trading every day, which can be aggregated to up to an index level.
What happens to art that is purchased but then isn’t sold because its value dropped? What if the reserve price isn’t met at the auction? What if the art owner never even bothers to bring it to auction because their art expert consultant said that it wouldn’t fetch enough at auction to make it worth the fees? What if a piece of artwork is sold privately?
Not every piece of art appreciates. In fact, the data show that the best returns come from just 2% of artists that have the most resale volume. If you’ve ever been to an art museum, you’ll surely be familiar with the names that do well.
Furthermore, I’m always skeptical of outperformance claims made about an asset class that not only produces no internal cashflow but actually has costs associated with holding it. Possible for some collectibles, but unlikely for an entire asset class.
A different source looks at its mean annual return, which is like a speedometer through time. This chart shows that art has had spurts of growth, coinciding with the same time periods of other asset and stock market bubbles, and that mean annual return has been declining over the last ten years.
And even the ArtPrice100 art investment index shows that the top 100 artists did very well but the remaining artists fared much worse.
Frankly, there doesn’t appear to be a consistent source for historical investment artwork returns, but picking a basket of the top performing artists isn’t likely to represent the returns that an individual investor will get on the Masterworks platform.
You Can’t Get The Index Returns
This business has only existed since 2018 so the first clue is that these are not THEIR historical returns, but some collection of art pieces that have sold since 1995, or 1985, or 2000, whichever performance chart you prefer. You would have had to have owned a representative slice in each of those paintings to match that return, which you couldn’t even do before a firm like Masterworks even existed. There is no ETF in the art world.
And it’s not easy to get that diversified art exposure.
On the Masterworks platform, you not only have to choose which paintings you want to invest in, which requires art selection skill, if you want to invest in a lot of paintings, creating your own sort of index, good luck with that. They’ve not only purchased about 75 paintings since their firm’s inception, but they also require minimums well above what they advertise (more on that later). Furthermore, to gain exposure to the works they purchased years ago, you would have to buy those ‘shares’ from their secondary market, which consists of existing owners who want out but likely suffer from the endowment effect.
And there is no automation for buying a collection of works on their platform either. You will have to run around their site and scoop up shares from current offerings and past offerings as they become available.
Illiquidity is not necessarily a bad thing as it can force you to hold through the ups and downs of investing. But there is still an implicit cost since you can’t get your money out as you please. An investor would demand a higher rate of return to compensate him or her for that inconvenience.
Each fractional art ownership interest is supposed to be held for around 5-10 years and as mentioned before, there is only an internal secondary marketplace with limited sales volume to sell before then.
The biggest problem with illiquidity is a lack of price discovery. You could hold an investment for ten years and not have a clue what your investment is actually worth. When you invest in the S&P500, you can find out every day what your investment is worth and cash out on the spot if you want to.
This makes retirement planning very difficult to project and whether you are on track or not if you hold a lot of artwork in your portfolio. And if a big expense comes up where you need to cash out early, it’s going to cost you to get out.
Macroeconomic Asset Inflation
Pretty much everything appreciates well in low interest rate environments: Real estate, stocks, baseball cards, and art. The opportunity cost of capital has been nil for ten years, so you have to wonder how art will perform if real interest rates start climbing over the next ten years. Notice none of those art performance charts that I managed to dig up show what happened in the 1970s when interest rates were skyrocketing. I don’t think that is a data omission coincidence.
Art isn’t a capital driver in that it doesn’t produce business activity or increase the GDP. The capital is just locked away for a time while hoping that there will be a bigger fish to come and take it off your hands later.
This is highly dependent on how the economy is doing and the level of asset inflation. If the roaring 20’s bubble pops, will art fare better or worse?
If you’ve ever had to deal with a K-1 tax form, you’ll know the pain that comes with including one in your tax return. Now for solid businesses that are generating cashflow and paying it out quarterly, it can be very much worth the hassle and can end up paying for itself, depending on the investment.
Unfortunately each piece of artwork on the Masterworks platform is bundled into an LLC and you are sent a K-1 tax form at the end of each year. Presumably, you won’t owe any taxes until the painting is sold because it will only be racking up expenses for storage, cleaning, maintenance, and related fees, but you will have to add them to your tax return. You also have to keep track of each of these for each year and perform the necessary cost basis calculations to net out the losses from the gains upon the final sale.
If you have an accountant, be prepared to shell out $100 per K-1 form and if you don’t, be prepared to spend extra time doing your tax preparation. Because of this fact, really think twice before creating your own “art index” and scooping up 30 issues, because your accountant might charge you an extra $3,000 to prepare your taxes.
Furthermore on the tax topic, art is a collectible and has a higher long term capital gains treatment (28% + 3.8% net investment income tax) than stocks do.
Masterworks Business Concerns
Massive Fee Grab
The biggest reason why you’ll never get the advertised performance chart figures is because of their hefty platform fees. They run their business almost at the same cost as a hedge fund: they charge 1.5% annual expenses plus 20% of all future profits from the art sales.
Try to understand the hurdle you have to jump over to beat the S&P 500 here.
When they go to sell the art at auction, the auction house takes 10% of the sales price, Masterworks takes 20% of the profit, and then there is the 1.5% fee for 10 years (assuming the fee doesn’t increase linearly with the projected sales price and stays constant from initial investment).
So let’s do some math on what your net return would be after fees and taxes if the investment doubled in value over ten years. Let’s say you invested $10,000 and the final sales price after 10 years was $20,000. The auction house would get $2,000 and Masterworks would get $3,500 ($2000 20% sales profit+$1,500 annualized total) leaving you with $4,500 in profit, which you would then have to pay a fixed 28% collectible tax rate on ($1,260). So the net profit would end up being $3,240. That’s an after-tax compounded return of 2.85% per year. Not stellar.
Compare that to the after-tax return of 6.3% if stocks double over ten years.
Say things really go well and the investment in the painting triples in value to $30,000 over ten years. The art house will get $3,000, Masterworks gets $5,500 ($4,000 profits + $1,500 annualized total) and you pay $3,220 in collectible taxes, leaving you with $8,280 in profit, for an after-tax compounded return of 6.2%. Again, it still would have been better to invest in stocks.
And if your chosen painting quadruples in value over ten years, corresponding to a gross annualized compounded return of 14.9% similar to their marketing rates? Your net return would be 8.8%. Stocks only need a gross return of 9.8% to earn an after-tax net return of 8.8%.
You could make an argument for diversification with a reduced portfolio correlation, but the the Masterworks investment fee structure is heavily weighted against you.
But that’s not all.
Read any of the offering statements and you will find out that you lose 15-20% of your investment immediately to an upfront load fee (they call it a “true-up”). They sell shares worth $20, but then only use $18 of that to buy the painting. And then they keep the rest net of any extra acquisition fees. The painting has to appreciate at least 11% just to break even.
Founder and CEO’s Past Business Ventures
The marketing gimmickry described in the next section won’t be much of a surprise when you find out that Scott Lynn has founded some pretty shady marketing businesses in the past (Virtumundo) that were involved in spamming and sleazy banner ads (he proudly states on his Linkedin profile that he invented the “punch the monkey” ads).
None of this necessarily means that the art business won’t be successful, but you have to wonder about what corners will be cut with your money when the founder has created not one, but two businesses with questionable ethical practices in the past.
Cherry Picking Results
When you peruse their website, they show pieces of artwork that have appreciated 50, 100, or even 500 times since purchase. So what? Did you know that if you had invested $1,000 into Amazon at their IPO, you’d have $1,200,000 today? Should we jump in our time machine now or later to plunk down some money?
Masterworks originally was going to sell their artwork on the Ethereum blockchain. Or at least that is what they said there were going to do. I suspect it was all marketing hype attempting to capitalize on the Blockchain momentum in 2018.
On their signup page they mention there is a 160,000 person wait list (faux demand) and they have a special link for affiliate promoters that claims their readers get to skip the wait list (special treatment). Does a velvet rope part when you click the link too?
“Invitation to Invest“
With most online platforms you just sign up, fill out the typical investment waivers and forms, deposit some money and off you go. This platform requires you to apply to the platform which requires a “screening call.” Except that it’s a giant sales push to get you to invest in 3 different art pieces the day of the call.
Misleading Minimum Investment Amounts
Their website talks a lot about buying $20 worth of art but a dozen of their offering statements state that minimum investment amounts per investor is $10,000-$15,000, per offering. I’ve also read countless personal accounts where people said that their interviewer told them they had to invest at least $10,000 to start. Doesn’t sound as “democratized” now, does it?
I think the pushy sales call is designed to tease out who the wealthy investors are and fast track them into the signup process. It’s cheaper to manage your platform with a smaller subset of people as there will be fewer customer service staff to maintain. That’s fine, but why not just state that the minimum is $10,000 then?
Key Man Risk
Inside their disclosure they share “Masterworks relies on a single investor, Scott Lynn, for substantially all of its capital and liquidity. If Scott Lynn were to cease funding Masterworks for any reason, Masterworks may not be able to identify additional sources of capital.”
I’m not sure what happens to the business and your existing investments if the Scott gets hit by a bus. Key man risk in any business is a major red flag for institutional investors and they usually won’t go anywhere near it. This is not a common risk that a typical investor faces and the ramifications of its realization are hard to value.
Their Lack Of Experience In This Business
How many paintings have they sold since they bought their first painting in July 2018? One. They’ve sold a single painting, which was the Banksy’s “Mona Lisa” sold in 2020 after only holding it for a year and a half, interestingly enough. Investors reportedly got 32% return, so it was a good first start, but can it continue? Only time will tell.
I suspect they unloaded that painting for a quick return to use in marketing materials and draw in more investors.
They prominently display on their signup page “Exceptional historical returns: Our single realized investment returned 32% annualized.”
Storage Of The Artwork
The Observer reported that Scott stores the artwork with his own personal collection. So Scott gets to enjoy some multi-million dollar pieces of art in his own personal museum with a crowd funded collection, what a nice deal for him.
Possible Conflicts of Interest
Scott Lynn personally owns $100 million in artwork. It is conceivable that he will sell some of his own artwork to Masterworks clients at an unfair price through a private sale, which they have stated they do in their disclosures.
There are no rules that say they can’t.
Furthermore, since they have purchased works of art through private sales, how can the value of the painting be accurately determined?
Art Itself Has Unique Risks
One of a kind anything’s are such an illiquid market that really cater to the eye of the beholder. Paintings that sell for millions of dollars have a very limited buyer pool and when people have millions of dollars to spend on an item for enjoyment, they have a lot of options as it comes to homes, boats, cars and planes. Tastes change over time. A painting that appreciated 10x over the previous ten years may not appreciate at all for the next ten. It’s a gamble.
Counterfeit works of art have plagued the art world for decades and you have to put a lot of trust into their art professionals that they are skilled at their job.
Since most of these paintings won’t be sold for 7-10 years later, you might not find out your investment is completely worthless for a long time. Or your LLC could get sued after a sale and the sales proceeds clawed back years afterwards.
Fakes can even fool professional art dealers, and sometimes they are even willing participants to get sales flow from commissions. It’s a business that requires a lot of trust and provenance but Masterworks incentives are not aligned with yours since they don’t hold a minimum ownership interest in each painting.
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Theft or Damage
As long as Masterworks doesn’t invite Steve Wynn over to the art room, the paintings will hopefully be safe from elbow damage. All kidding aside, one glaring omission from their website is how the artwork is secured. As already mentioned, the Observer stated that the art is kept with Scott’s personal collection. Is it an art vault? Is it his home? Usually firms like to advertise their state-of-the-art security as part of their marketing, so it is telling that they don’t say anything about it at all.
And if there is an art heist, the insurance will only cover the value of the purchase price, not the theoretical appreciated value. So if the cat-burglars come to Scott’s home, hope they steal the newest pieces of artwork, not the examples that have been appreciating for ten years on your dime.
There aren’t many art investment companies, and Masterworks.io is one of the only options for individual investors to buy fractional pieces of artwork.
If you can get beyond the shady business practices, marketing, founder’s past business activities, fee grab where they act as an art hedge fund, and unique art risks, then Masterworks investing offers the opportunity to buy a fractional ownership in fine art.
For me, I think there is just too many red flags and ultimately Masterworks is a business that has a business model that overwhelming favors their interests. If you do well, then they do well, but if you don’t do well, they still do okay based on their fee structure.
Fractional art investing is a revolutionary concept, but ultimately any time a firm securitizes a product, they buy wholesale and sell retail. You drive up the price of the product because you make it more affordable for people who couldn’t afford it before. There’s nothing to stop them from being the top bidder in every auction that they participate in because they are buying the painting with your money (or flatly overpaying in private sales).
It is in their interests to rope in as many investors as possible and accumulate as much art as possible to puff up the assets under management for fees.
If you want to buy art as an investment or learn how to invest in art online, using Masterworks will likely lead to a disappointment in outcomes.
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