Art exhibited little to no correlation with any other major asset class from 1997 through 2021, making it a potentially attractive diversifier. Consistently low correlation across asset classes appears a characteristic unique to art.
Correlations are close to zero across the board compared with other asset classes, potentially implying that art may help to diversify a portfolio no matter what might already be in it. In contrast, other asset classes have proven to be a mixed bag in terms of their correlation benefits — having low correlations to some asset classes, but higher correlations to others.
For example, private equity has low correlations to bonds, but higher correlations to public equities. Or commodities, which have lower correlations to bonds, but higher correlations to hedge funds.
None of the aforementioned is intended to imply that some asset classes have no place in a portfolio. Rather, while there are no guarantees, it is important for investors to understand the magnitude of the diversification benefits that they might experience by including different asset classes. Because of art’s correlation profile, we would argue that its benefits are significant.
OUTPERFORMANCE AND TIMING
Diversification cannot ensure a profit or protect against loss in a declining market. It is a strategy used to help mitigate risk. We believe that a portfolio’s frequency of outperformance from allocating to a new asset class is among the most important considerations when deciding whether to allocate to that new asset class. If a new allocation to an asset class frequently improves a portfolio’s performance, then the question of when to allocate to that new asset class becomes less relevant.
Let’s take an example. A portfolio has two asset classes in it, asset class “X” and asset class “Y”. An investor is considering adding asset class “Z”. If the portfolio with asset class “Z” has outperformed the portfolio without “Z” most of the time, then it matters significantly less when the investor decides to allocate to asset class “Z”. After all, the outperformance happens frequently. In fact, frequency of outperformance may also be more important than magnitude of outperformance.
Let’s stick with the example in the prior paragraph. If the portfolio with asset class “Z” in it only outperforms a small percentage of the time — but by a significant amount during that small percentage of the time — then the investor would only benefit from that sizable gain by allocating specifically during the times when asset class “Z” outperforms. Since that outperformance does not happen frequently, it may be challenging to invest at precisely the times when the outperformance will take place. We believe investors would prefer to benefit from time in the market more so than timing the market.
ADDING ART TO THE 60/40
We created several hypothetical portfolios, including a 60/40 and an endowment model, to measure how frequently a small allocation to art has benefited those portfolios, historically.
Despite having a basic asset allocation strategy, the baseline 60/40 portfolio has performed well, historically, on the back of both bull markets in equities and fixed income. We funded the small allocation to art out of equities rather than fixed income because the former is a return-generating, while the latter is risk-managing. Prudence would therefore suggest funding art out of equities. Nevertheless, the portfolio with a small allocation to art frequently improved on its baseline 60/40 counterpart. For example, in 62 percent of 5-year periods and 100 percent of 10-year periods, the portfolio with art had a higher Sharpe ratio than the portfolio without art.
The endowment-like portfolio owes a lot of its success to the illiquidity premiums found in private markets, such as private equity, real estate, and infrastructure. Not surprisingly this has often made it challenging to improve upon. Here, we funded the small allocation to art out of equities 1) for similar reasons outlined in the 60/40 portfolio section and 2) because it is not always easy to reallocate from illiquid asset classes.
The endowment-like portfolio with art demonstrated frequent improvement over its non-art counterpart, in line with the improvement seen over the 60/40 portfolio. Here, the portfolio with art had a higher Sharpe ratio in 70 percent of five-year periods and 100 percent of 10-year periods.
Allen Sukholitsky is CIO of Masterworks.