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.



About the Author

Wesley R. Gray, Ph.D.

Dr. Gray has been an active participant in financial markets for over 15 years. His experience includes positions as a Captain in the United States Marine Corps, as a finance professor at Drexel University, and as a portfolio manager for a special-situations hedge fund. Education and entrepreneurship has been the focus of his professional endeavors and his research interests are focused on the performance of portfolio managers and behavioral finance. Dr. Gray is currently the Executive Managing Member of Alpha Architect, an SEC-Registered Investment Advisor. Dr. Gray has published two books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army and QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors. His work has been highlighted on 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.


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  • Nathan

    Thanks for the article. Is there a way to invest in diamonds without actually buying them? My friend sells jewelry and is looking for a way to hedge his inventory.

  • http://welcometotheadventure.com/ Wesley R. Gray, Ph.D.

    http://finance.yahoo.com/q?s=gems&ql=1
    The ETF is the only thing I know of…
    You could also buy one of the machines that makes them in a lab…or maybe purchase a plot of land in Africa…
    The biggest value play is going on Ebay and buying diamonds from bitter ex-wives, and the flip them to the GEMS etf. Ha!