Lynn Strongin Dodds reviews attempts to create investible indices.

At first glance, diamonds have all the right ingredients for a commodity investment. They are tradable, liquid and there is a supply/demand imbalance. The only problem is that there is no institutional investment vehicle in the marketplace. Industry participants are trying to rectify this but at the moment the gem is likely to remain just a girl's best friend.

There have been attempts over the past 30 years to commoditise the product via a futures exchange, derivatives contract and straightforward fund and each has been beset by problems. One of the main stumbling blocks has been that while the gems act like other commodities, in that prices are impacted by economic factors, they are difficult to price. Each diamond is unique, is in contrast to, for example, gold bullion which has standardised quantities and purity.

There is a huge variation in value between different stones as diamonds come in different sizes, weights and cuts. For example, larger stones tend to be more expensive than the lower carat gems, while red stones, which are rare, cost more than the yellow, pink or brown variety. Currently, the most popular venues to buy the gems are either a jeweller or at an auction house such as Christie or Sotheby.

Investors can also gain exposure through listed mining stocks such as Rio Tinto or BHP Billiton, which between them produce $1.65bn (€1.16bn) in rough or uncut diamonds a year. Fund managers can also buy shares of Anglo American, which has a 40% holding in DeBeer's, the largest diamond company in the world. Over the past year, though, as other commodity prices soared, institutions and industry participants once again explored the different options to access the gems.

One of the main attractions is that diamonds may sparkle, but they have not enjoyed the spectacular price runs of other commodities. For example, the Goldman Sachs Industrial Metals index soared by 180% in the three years to end-2006 while precious metals were up an impressive 56%. Diamonds, meanwhile, only managed a 34% hike over the same period, according to industry figures.

"Diamonds lagged behind other precious metals such as gold, silver and platinum," says Richard Platt, director and statistician at diamond price and information platform PolishedPrices.com. "However, there is no reason why they can't catch up in the future due to the supply and demand issues. We predict reasonably flat growth against increasing demand, particularly from wealthier populations in the emerging markets. Many of the world's diamond mines - which are located in Botswana, Russia, South Africa, Canada and Angola - are past their most productive years. Although producers are busy exploring, so far there has been little to show for it and if a new mine is found, it could take between five to seven years to come into production."

 

While there are concerns that the current credit crunch could put a dent in consumers' appetite for the gem, industry participants believe it will not have that much of an impact because there will still be enough wealthy people around who enjoy the finer things in life. The recent Wealth Report conducted by Merrill Lynch and Capgemini, revealed the wealth of the world's high net worth individuals jumped 11.4% to $37.2trn in 2006, with India and Russia showing the fastest growth.

As Platt puts it: "The rich will always be rich and the bread and butter sales such as wedding rings tend to remain stable. For example, during the 2001 downturn the diamond market only shrunk by a couple of percentage points in the US. Also, we expect significant growth from countries such as India and China." In fact, according to figures from De Beers, the size of the diamond consuming market in these two countries is expected to grow at 7% compound every year - from 33m consumers today to 65m by 2015.

Against this promising background, it is easy to see why there has been a flurry of activity this past year. The results so far have been disappointing but all agree that it is still early days and it is likely that the participants will continue to forge their own path.

For example, in the summer, Diapason Commodities Management, a Swiss based asset manager, was poised to launch the first diamond fund on the London Stock Exchange. It formed a new company, Diamond Circle Capital, to invest in large polished diamonds worth over $1m each but the $400m flotation was pulled due to volatile market conditions. It was also believed that investors were reluctant to put cash into such an unknown vehicle. Diapason may try again when markets stabilise.

This uncertainty may also explain why Deutsche Bank and PowerShares decided to think again about adding a diamond exchange traded fund to its precious metal ETF range.

 

Attempts at laying the foundation for a futures exchange also had a shaky start. If successful, the market could be worth over $200bn, according to industry experts. In September, the Rapaport Group, a New York based diamond price and information provider, held its first monthly internet auction of one carat or more Geological Institute of America (GIA)-graded diamonds. The aim is create an index of prices which could form the basis of liquid trading contracts. However, only 27 of the 210 lots included in the auction were sold, for a total of $223,840.

Martin Rapaport, chairman of the group and an industry veteran, is not deterred. He believes one of the reasons for the poor showing was that the auction did not disclose reserve or the minimum price. "The bids started at $2,000 and increased from there," he says. "But that is going to change in the future. We plan to disclose the reserve prices because the idea was for people to be able to build momentum in the bidding like they do at Christies, Sotheby's and the other large auction houses. However, this was the internet and I think people found it very frustrating because they did not know what the reserve price was. Going forward, we plan to publish all the prices."

Rapaport has been down this road before. In 1982 he filed a contract proposal to the New York Commodities Exchange for a diamond derivative to create a diamond commodity market. At the time he claimed that the effort failed because the industry did not want price transparency. Winding the clock back even further, 194 diamond contracts were traded on the West Coast Commodities Exchange over a two-week period in 1972 but prices collapsed and that put an end to the exchange.

Today's environment is different, says Rapaport. "We are moving from the monopolistic, manipulative control of diamond prices to a more free market. Also, legislation in the US and Europe to stop the trade in conflict diamonds has added to the need for transparency. Finally, a market in diamonds enables investors to capture the growth in global wealth. Diamond derivatives would not only allow lenders, retailers and manufacturers to hedge against future needs, but it would also enable institutions to gain access."

Rapaport is thought to be talking to the US Commodity Futures Trading Commission about forming a diamond futures market in New York, rather than London or Antwerp, because he reckons New York is an important hub for high-quality graded diamonds. This is not only because 50% of diamonds are sold to the US but also because he believes the regulatory regime is more conducive to transparent diamond trading.

He is not alone in his attempts. PolishedPrices is also thought to be in talks with the Chicago Board of Trade about developing a derivative contract. While few details have been divulged, Charles Wyndham, the company's founder, has admitted that the group was talking to an exchange. PolishedPrices' role is to be a supplier of a wholesale cut diamond price list based on multi-source priced transactions that could be used to create an index. In 2002 it developed a weighting mechanism that allows a platform for other players to create derivatives.

"I am not sure what form the derivative will take as I am not an expert," Wyndham says. "Our goal is to create a tool. However, I think there is going to be some form of derivative contract within 12 months."

Wyndham has been critical of Rapaport's auctions. "The problem with the auction is that is only offers a narrow range of stones - those of one carat in size and certain grades. This will not allow extrapolation of prices for all stones. Also, tenders can be open to blatant manipulation."

Rapaport argues that tender offers are good ways to create an index for a futures market because they involve multiple buyers and sellers that are not under any pressure. "The auctions will provide spot cash transaction prices, not just asking prices," he says. "They are a clear, crispy, crunchy vehicle to observe and it is easy to spot a distortion. We know who the buyers and sellers are and they are for real."

Rapaport does concede, though, that his system does not solve all the problems. "The bottom line is that we are trying to create new vehicles. It is like the first aeroplane that the Wright brothers flew. It may have crashed but no one forgot the concept and eventually it took off."

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