Tuesday, May 24, 2011

Diamonds are a Hedge Fund Managers Best Friend?

In this Bloomberg story, the manager of an Oklahoma City based hedge fund claims he's a buyer of diamonds as an inflation hedge.  According to the story, individuals are selling diamonds at 50 to 60 cents on the dollar.  Sounds like a bargain.

First question: Why aren't they returning the diamonds to the store from which they bought them?  As I wrote some time ago, many jewelry stores give ridiculous buy back guarantees that they cannot possibly cover.  At least you ought to try!  If they don't take 'em back, sue 'em for their "unregulated insurance contracts"!

Second question: Doesn't this guy know that he can save half on diamonds any day of the week from these guys, high in the Empire State Building, or has he never listened to Bloomberg radio?  "Dial-a-Diamond and Save Half!"

In all seriousness, diamonds worked really well as an inflation hedge historically.  Where's my data?  I don't need any.  Historically, DeBeers held a monopoly on diamonds.  When you have a monopoly, you can maintain your real return substantially above the rate of inflation.

However, several years ago, DeBeers released (or lost?) their complete strangle-hold on the diamond market.  Roughly speaking, Russia and Canada had enough diamonds so that DeBeers could no longer effectively maintain their monopoly.  That's why DeBeers can (sort of) do business in the United States now, an its executives no longer risk arrest. 

(You'll note that's a link to a glorified jewelry store, which is a JV of DeBeers Group SA and LVMH.  Also, prior to settling anti-trust charges with the United States, DeBeers executives faced arrest here.  Shortly before the settlement, a senior executive flying to Canada was diverted to the U.S. due to bad weather.  The Feds pulled him off the plane.)

While historical prices look like diamonds hedged inflation, I doubt they did it effectively in practice.  Why?  That would mean DeBeers allowed someone to join their monopoly.  A monopolist doesn't do that!

Controlling supply means controlling production, but also resale.  So, DeBeers killed the secondary market for diamonds as well.  First, they did it psychologically. Diamonds are Forever after all!  You're emotionally attached to a rock.  You can't sell the family jewels. 

If nothing else, grandma says they always go up in value faster than inflation.  Just get it appraised, the jeweler will confirm it.  Just don't try to actually sell it!  The jeweler won't transact at the appraised price!  And good luck selling it yourself even with Ebay and GIA certification. 

Worse, as a jeweler buying from an individual, you risked retaliation from DeBeers, who might cut off your reliable supply of stones. Now you're out of business.  So, that purchase of grandma's ring had better be at a very low price.

Mr. Shafer, of Covenant Financial, will retort that he buys large, rare diamonds that are less susceptible to manipulation.  First, he has no idea how rare they are.  Only DeBeers knows how rare they are.  Second, he faces insane transaction costs.  Yes, his problems are not as extreme a those hedging disasters with gold, but let's see him auction his diamonds at Christie's.

One more thought for Covenant Financial investors: You better make sure Mr. Shafer's wife doesn't custody the fund assets.  Insuring diamonds is incredibly expensive, and will eat those returns very quickly.