Diamond ETF In The Rough?

March 19, 2012

The proposed IndexIQ Physical Diamond Trust strikes me as nonsense, and I’ll tell you why.

First, the idea of a diamond ETF has been floating around for years, and it wasn’t until earlier this month that anything came of it. It’s no surprise it took so long, but it is a surprise that it came at all.

And, by the way, I’m not the first analyst to belittle this idea at IndexUniverse. A little background is in order.

A key characteristic of commodities—such as crude oil, precious metals and grains—is fungibility. It’s a funny word with a clear definition. Fungibility simply means there’s little differentiation between one unit of a given commodity and another unit. Think ears of corn.

And therein lies the rub—diamonds are not fungible, although the IndexIQ Physical Diamond Trust prospectus might have you believe otherwise. Each diamond is unique, and its appraisal is thus subjective.

IndexIQ plans to “receive and deliver diamonds in Diamond Parcels, which are fungible aggregations of diamonds, through creation and redemptions.”

According to the prospectus, these “fungible” diamond parcels are divided into fixed subcategories with characteristic variations generally reflective of the variations in the market supply of one carat, gem-quality diamonds.

If that isn’t an oxymoron, I don’t know what is.

After all, gemstone grading is hardly a science, and is subject to interpretation. The diamond industry allows for a margin of error when it comes to grading, called “tolerance.” Yet, appraisals that determine how much stones will go for on the marketplace are based on such grading.

Small differences in opinion on any of the so-called four C’s—carat, cut, clarity and color—matters a lot and can swing the price $1,000 or more either way, depending on the type of diamond. Could the diamonds in your physically backed ETF be unfairly priced? All signs point to yes.

Perhaps what’s even more worrisome are the proposed logistics of the creation and redemptions process. The fund plans to “verify the specifications and GIA Certification of each diamond prior to its receipt or transfer as part of a creation or redemption order.”

This seems like a lot of work, especially for large block orders—most likely making it an expensive fund to hold.

Hoodwinked

What’s especially worrying is the degree of ambiguity in the prospectus. Important information on the custodian, the trustee and the provider of diamond spot prices is absent.

Even more troubling is the effort that’s required to figure out whether the fund plans on investing in rough or polished diamonds.

Eventually, I decided that the investment was in polished diamonds, but I’m still not 100 percent certain. Why does it matter, you may ask? Well, polishing and cutting rough diamonds into gem-quality stones nearly doubles its value. However, half of the diamond is lost during this process and one stone may be broken into two smaller ones.

For example, a one-carat rough diamond would only yield about two polished diamonds, a quarter carat each. As of right now, it’s not entirely clear what the fund is investing in aside from nonindustrial, gem-quality rocks.

For a diamond fund, I would expect a little more clarity.

To make a long story short, I’m not sufficiently convinced that physically backed diamond ETFs are a good idea. The prospectus failed to explain to investors why diamonds should be viewed as a commodity rather than luxury goods that behave like commodities.

Until I see a more thorough prospectus, I’ll put diamonds on my ears, not in my portfolio.

 

 

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