Diamond ETFs: For Dragons Or Portfolios?

IndexUniverse.com

 

If you think that either of the physical diamond ETFs proposed by IndexIQ or GemShares are good ideas, I have one question for you:Are you a dragon?

IndexIQ filed in March to market a physical diamond ETF , while GemShares recently applied for a patent to create a diamond “basket” index as a benchmark for ETFs. Each filing, to my mind, is trying to cash in on the returns of physical gold funds like the SPDR Gold Shares (GLD), the world’s second-biggest ETF.

These companies are trying to channel the mentality of an aristocrat during a revolution:Run with your gems and jewelry—they’re portable money. That’s true to some extent in the case of gold, but diamonds are not gold, and they’re not money either.

Diamonds don't have the financial history of gold. The idea of a fund based on keeping a physical hoard of gem-quality diamonds sounds more like a dragon's hoard than a growing pile of assets. Diamonds will never be a hedge against a falling currency.

But that doesn't mean diamonds can't be a sound investment. You just need to go synthetic.

Faking It

Synthetic diamonds make for an excellent investment because they’re not exclusively luxury items, like the gem quality diamonds that any ETF from either IndexIQ or GemShares proposes to hold.

According to the World Diamond Council, only 30 percent of mined diamonds are of gem quality, so as an investor, you’re already missing 70 percent of the market with these proposed funds.

Industrial diamonds’ uses in cutting and as abrasives is unquestionable, but they also have four times the conductivity of copper, are heat resistant enough to be used on space probes, and there’s currently research under way to use them for microchips.

As part of its synthetic diamond production, Scio Diamond Technology Corp (SCIO) has been researching applications in everything from lasers to high-voltage power switching to water purification and treatment. Harvard University has even been doing research into using diamonds for nanostructured devices for quantum communication and computing.

Natural diamonds are used industrially, but 90 percent of the U.S. industrial diamond demand is already for synthetics, according to Antwerp Facets, the newsletter of the industry trade group Antwerp World Diamond Centre.

Synthetic diamonds can be customized for specific purposes, and are preferred since their creation in a controlled lab leaves them relatively free of impurities. The fact that these are a producible item available in infinite amounts helps stabilize prices, too.

With that kind of diversification, synthetic diamonds seem like a much better bet than some dragon’s hoard of gem-grade diamonds of uncertain value, like the offerings proposed by Gem Shares and IndexIQ.

 

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Here we have the correlations of a few ETFs to stand in for some of the big industries of a synthetic diamond play, with an index of the Average Price of 1 Carat Top Quality Diamonds (NYSE:DIAM1CRT) for the jewelry market. It’s worth remembering that theoretically, that index also represents type of diamonds that IndexIQ proposes to hold.

With surprisingly low correlations, synthetics sure look like a smart play to me.

So do the proposed diamond ETFs make sense for capturing the jewelry market if you were only interested in a luxury play? After all, the IndexIQ Physical Diamond Trust would only hold stones over 1 carat, a size synthetic diamonds rarely match.

Well, dig into its prospectus and you’ll see that IndexIQ warns investors that “diamond mining and production is largely controlled by a small number of miners and producers who have had and continue to have the ability to influence the supply and demand for diamonds throughout the production phase, which market impact could materially adversely affect an investment in the Shares.”

Well, that's concerning.

By including synthetic diamonds in its  patent application , GemShares had the potential to offset that problem. Instead, it chose to build a methodology that allows the trust to substitute “diamonds that meet all the requirements of the method of the present invention, but that can appear slightly different due to its intrinsic color because its monetary value is equivalent to others in the unit.”

This methodology loophole is a big red warning flag. And underlying both statements is another serious problem:Diamonds are not considered a “fungible” commodity because two diamonds of similar price are not equal.

When measured against a fund of synthetic diamond producers, the ideas put forth by IndexIQ and GemShares stand on shaky ground.

An Investor's Best Friend?

If the jewelry and gems market is your goal, remember that true synthetic diamonds are just as real as their mined counterparts on a chemical and crystalline level. Synthetic diamonds are rarely larger than one carat, excluding them from comparison to IndexIQ’s proposed fund holdings. However, lab creation means virtually no inclusions, so a cutter won’t need to take them into account during faceting, leading to consistent, high-quality cuts.

Carat, clarity and cut:that’s three of the four “C's” clearly addressed by synthetic diamonds. The fourth “C” is color. Synthetic diamonds can easily be produced in “fancy” colors—pinks, blues, greens, yellows, oranges and browns. While natural diamonds in these colors are rare and expensive, synthetic versions cost around the same as a comparable colorless mined diamond. So as an investor in synthetic diamonds, you’d have wider access to growing trends in, say, in colored diamond engagement rings.

Natural diamonds still dominate the market, but eco-conscious consumers are turning their eyes to how the world of diamond mining works. Synthetic diamonds, in contrast, are created in-lab by a process that has less social and environmental impact than mining.

Companies like Brilliant Earth specialize in ethical engagement rings using synthetics along with mined diamonds from Canada, and two highly vetted operations in Namibia and Botswana. After all, no woman likes being told that her ring may still have had child slavery and environmental devastation in its past.

 

 

Just Fake It

A synthetic diamond ETF would have two major plays:luxury jewelry gems, and industrial diamonds allowing access to industries ranging from semiconductors and microchips to ceramics for aeronautics, coatings for the auto industry, water treatment and even space exploration.

You’d have a unique country exposure too, since the largest producers of synthetic diamonds are China, the U.S., Russia, Ireland and South Africa.

To top it all off, a synthetic diamond fund would be more socially and environmentally responsible holding only conflict-free diamonds with none of the social or environmental drawbacks of diamond mining. If you wanted exposure to diamond mining itself, you’d still have it via the use of diamond coatings on equipment such as drill bits.

Bottom line:A fund focused on synthetic diamond producers would be a well-diversified play with a unique combination of countries and industries that hedges against itself.

Funds offered by either IndexIQ or GemShares will restrict you to less than 30 percent of the entire diamond market, while leaving you so highly dependent on the supply willing to be released at any given time by a handful of mining companies like DeBeers to the point that the index methodology may even change in GemShares’ case.

Also, a natural diamond fund will have 65 percent of its geographical exposure in Africa, making your investment dependent on mining processes that are environmentally damaging and can include slavery and murder—Kimberley Process-checked or not.

In the end, all you would own is a stake in a physically held collection of unique stones that are at their core nonfungible.

Personal aesthetics have no place in financial instruments, so if I’m going to have diamonds in my portfolio, I want them to work for me. A physical hoard of gems is not a solid investment. It’s an attempt to cash in on the success of physical gold ETFs while being first to market with something new.

New in this case isn’t better; it’s uncertain in worrying ways.

Since I’m not a dragon intent on sitting on a trove of precious stones, I’ll hold out until an issuer files for that synthetic diamond ETF.


Contact S.M. Brorup at sbrorup@indexuniverse.com .

 

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