Bet on Bling, But Not With Diamond ETFs

The gemstone isn't lacking in value, but falls short on fungibility

   
Bet on Bling, But Not With Diamond ETFs

In response to the global financial crisis, investors have taken a real shine to physical assets and precious metals. As the various fiscal, monetary and growing public debt pressures have taken hold of the economy, gold has become the de-facto safe-haven holding in many portfolios.

The yellow metal — along with others such as platinum and silver — have seen their prices rise exponentially over the past few years as more attention has been placed on holding these sorts of assets. With more than $65 billion under management, the physically-backed SPDR Gold Shares (NYSE:GLD) is one of the largest funds of any kind currently on the market.

Given hard assets and precious metals new-found popularity with investors, it’s easy to see why Wall Street is willing to comply with these portfolio demands. The latest moves suggest that fund companies think there is still an appetite for investments other than precious metals that will hold their value in times of great uncertainty.

And in this case, we’re talking diamonds and precious gemstones.

Plans are currently in the works to bring two ETFs to market that will hold the physical gemstones a la SPDR Gold Shares. While it may seem at first blush like a good idea to hold some exposure to these alternative assets, investors may not get everything they bargained for.

Popularity Isn’t Everything

According to British investment bank Barclays (NYSE:BCS) latest wealth survey, diamonds and other precious stones make up a sizable portion of many people’s fortunes. More than 70% of rich investors around the world own precious jewelry — i.e. the kind you rarely wear and keep locked up in a vault. That’s up from 57% just five years ago.

On average, these investors have roughly 5% of their holdings in the asset class — on par with their stakes in physical gold. At the same time, diamond consortium De Beers expects growth in the global demand for rough diamonds to reach a new record this year, based on robust demand from China, India and other Asian emerging markets. So clearly, retail investors should jump in with both feet, right?

Well, not exactly.

While the two ETFs — by IndexIQ and GemShares — are interesting concepts, they fall flat on a number of factors, with perhaps the biggest being the idiosyncratic nature and lack of fungibility of diamonds. Almost anybody who has purchased an engagement ring knows about the gems “four C’s” of carat, color, clarity and cut.

Therein lies the problem. Each stone is different, with the diamond industry allowing for a margin of error — called “tolerance” — when it comes to grading. As such, different diamond dealers may put different prices on the same stone and that gap between what a dealer will buy a stone for and what he is willing charge to sell it can be very wide. Important and large stones — think like the Hope Diamond — can take years to sell and find the right buyer.

All of this is due to a major key characteristic of all commodities — fungibility. While most investors aren’t familiar with the word, they understand its concept. Fungibility basically means there’s little differentiation between one unit of a given commodity and another unit.

While there is some difference between where a natural resource is produced, all of the same type of commodity is priced the same. A barrel of Brent-priced crude oil is the same across the world, and we can easily look up the price for a bushel of corn. That’s a key point into making the commodity markets work.

But this doesn’t hold true with physical diamonds as so much of their pricing is subjective based on an individual grader. The GemShares fund will try to create a benchmark basket that arranges diamonds in ten layers of comparable quality and value. By defining the attributes of each layer, GemShares hopes to ensure that it can create as many tradable units as possible and make diamonds “fungible” for the first time. However, those efforts may fall flat, based on investor interest and who is doing the grading.

The IndexIQ fund plans to “receive and deliver diamonds in Diamond Parcels, which are fungible aggregations of diamonds, through creation and redemptions.” Again pricing on these parcels is subjective to the individual grader.

Buy Some Earrings Instead

There is no doubt that the two physical diamond funds are an interesting concept, but I’m still skeptical on just how they plan to determine values on their underlying holdings — and that could spell trouble for investors trying to view diamonds as a commodity rather than a luxury good. To that end, those who want to hold physical diamonds are probably better off buying a pair of earrings or an individual parcel of stones.

An even healthier bet may be on the companies that dig up the gemstones. Like gold miners with gold prices, producers can act as a leveraged play on diamond pricing. While Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP) have announced their plans to shut some of the largest diamonds mines on the planet, mega-miner Anglo-American (PINK:AAUKY) has recently upped its stake in the industry, completing its acquisition of the Oppenhiemer family’s stake in De Beers. This acquisition boosts Anglo American’s ownership of De Beers to 85%, and De Beers controls roughly 40% of the entire diamond market.

Given all the headwinds facing the global economy, there certainly is appeal to investing in diamonds. The problem is that the two physically-backed ETFs in registration fail to alleviate the gemstone’s pricing issues. So for investors, the best choice for a diamond investment is either buying physical jewelry or shares of a miner.

As of this writing, Aaron Levitt did not own a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2012/08/bet-on-bling-but-not-with-diamond-etfs/.

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