Should Diamonds be in Your Portfolio?

Should Diamonds be in Your Portfolio?

February 6, 2013 Academic Research Recap, Architect Academic Insights
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The Return Characteristics of Diamonds

  • Kenneth Small, Jeffrey Smith, and Erika Engel Small
  • A version of the paper can be found here.
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Abstract:

We outline the ethical considerations surrounding the trading of diamonds, the metrics used to value diamonds, the history of diamond trading, and the current market structure. We provide an analysis of the underlying risk and return characteristics of several individual diamond types. We show that diamonds exhibit low CAPM and Fama-French betas and exhibit low correlations with gold, the S&P 500, long-term U.S. bond prices, and U.S. inflation.

Data Sources:

Diamond price index from Datastream (polishedprices.com). 2002-2011.

Alpha Highlight:
alpha.empiricalfinancellc.comsystemfloads310originalssrn-id2195728
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
Strategy Summary:
  1.  Identify the 6 diamond price series listed in the paper
    1. Diamond Index (includes both commercial and fine diamonds)
    2. One-Carat Fine Index
    3. One-Carat G-VS
    4. One-Carat H-VS
    5. One-Carat I-VS
    6. One-Carat D Flawless
  2. The diamond returns are much higher than the market from 2002-2011 with the highest return being the One-Carat D Flawless series.
  3. The diamond returns exhibit low correlations with the SP500, inflation, gold, and U.S. long-term bond returns.
  4. The diamond returns are not explained by the CAPM or 3-factor models.
Commentary:
  • Although there are low correlations between diamonds and the SP500 between 2002-2006, and negative correlations between 2007-2009, the correlation in 2010-2011 become significantly higher (around 30%).
    • Will this trend continue?
  • The four one-carat price series (G-VS, H-VS, I-VS, and D Flawless) have higher returns than the market, but much higher standard deviations.
  • The One-Carat Fine Index has lower returns than the One-Carat D Flawless series, but has a much lower standard deviation.
  • An interesting finding is that the diamond returns are in general negatively correlated with gold returns.
  • Only a 10 year period of study, so results must be interpreted accordingly.
  • What are the true transaction costs and liquidity constraints on diamonds?
  • Personally, the only $ I’d waste on diamonds is the one you have to put on your wife’s finger…but that’s just me.
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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.