Tuesday, October 16, 2012

Diamond ETFs Seen Riskier Than Other Commodity Funds

Plans are afoot to create exchange-traded funds specializing in diamonds, but advisers are warning that such investments are fraught with challenges and risks.

Diamonds are more difficult to package and price in fund portfolios than other types of commodities such as gold and silver, portfolio managers point out.

"Unlike gold, diamonds trade in a very fractured private marketplace that is highly opaque and ripe with opportunities for pricing markups," says Greg Peterson, investment research director at Ballentine Partners in Waltham, Mass., which manages $4 billion in assets.

While a diamond ETF hasn't arrived in the U.S. yet, Mr. Peterson is suggesting that investors prepare for a host of new funds. More than likely, he believes that ETF sponsors are trying to capitalize on the success of other popular commodity funds, such as the $76.1 billion SPDR Gold Shares Trust (GLD).

"This is typical of the ETF industry--someone takes an interesting financially engineered product like GLD and then tries to copy it. But not everything fits so neatly into an ETF wrapper," Mr. Peterson says.

Several different fund developers are looking to move into the field, including IndexIQ, known for its ETFs that replicate benchmarks for hedge funds. It has filed for approval from regulators to create an ETF that would buy diamonds and physically store them in a vault for investors.

While global pricing information on diamonds is still difficult to formulate, enough trades are now being done online to make tracking such moves much more practical, says Abraham Stern, chief executive at industry researcher IDEX Online in New York.

"We believe enough information is now available to set an objective statistical base to build transparent pricing structures for an ETF," Mr. Stern says, pointing out that IDEX has been benchmarking such markets since 2004.

Last month, Chicago financial services provider GemShares was granted a patent for its own benchmarking process that could serve as the basis for an ETF. A leading driver behind the effort is Andrew Feldman, a financial adviser inspired by a desire to see diamonds made more accessible to investors.

"The natural users are industry players, just like airlines are for oil and miners are with gold," Mr. Feldman says.

But just building a diamond ETF doesn't guarantee professional traders will come, notes Stephen Hammers, chief investment officer at Compass EMP Funds, a registered investment adviser that runs $1 billion in separate accounts and mutual funds using ETFs. The firm in Brentwood, Tenn., includes commodities strategies as one of its areas of expertise.

Mr. Hammers views efforts to bring out diamond ETFs more along the lines of trading in lumber than gold. "Even though it's traded on exchanges, lumber hasn't attracted enough institutional investors to gain much in the way of liquidity," he says. "Diamonds could easily run into the same issues."

Unless a new ETF takes off in a big way, Mr. Hammers warns that investors might wind up shouldering higher costs related to storage, insurance and other transactional expenses than they're used to paying in more popular parts of the commodities marketplace.

Despite such possible structural flaws, a new diamond ETF is likely to draw at least some initial investor interest, says Andrew Ahrens, an adviser in Lafayette, La.

His advisory firm, which manages about $900 million in assets, has been informally asking affluent investors who own diamonds and favor alternative investments what they think about a diamond ETF.

Almost everyone questioned has found the idea appealing--at least at first, Mr. Ahrens says. As discussions advanced, however, he found that most expressed concern about widely perceived discrepancies in the market related to categorizing and pricing different grades of diamonds.

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