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.

 

Nickel Mania

In 1980, when I was eleven, the U.S. Mint announced pennies would no longer contain 100% copper, starting in 1982.  I started hoarding pennies.  I saw certain wealth in my future. Being the sentimental sort, the first roll I sealed into a plastic tube, inscribed with "Donot Open Until 2000".  That roll appears in the image above.  My wife says this proves I was a lunatic at a very early age.

Before I went to college in 1987, I schlepped approximately $800 worth of pennies to my local bank.  That's a lot of copper.  And, a surprised bank teller.  I gave up on my copper trade: I had hoarded copper through some ridiculously high interest rates, most certainly losing money.

Yesterday, I had lunch with a friend thrilled with the nickel trade.  In case you are unaware, the metal value of a nickel is now about seven cents.  He explained that an unnamed hedge fund manager is out marketing with a picture of a vault full of nickels.  This is his actual strategy.

Aside from the legality of melting down US currency, let's think about expense.  If my brother the chemistry PhD student kept reasonable hours, I'd have the exact answer already as to how much energy is required to melt a nickel coin, separate the copper and nickel, etc.  (I know, specific heat, melting point, yada yada yada...I'll miss some detail in scaling it up and wasting energy in the process...I'll follow up with relevant details later.)

Clearly, you're better off reconstructing my 1980 penny hoard.  Those pennies are worth almost three cents today.  Pure copper will be easier to work with than the copper-nickel alloy of nickels, so I'm guessing the melt down expense may actually cover for the substantially higher storage cost of nickels versus pennies.

You want a better trade?  All donations to the strategy will be accepted via Paypal.  [This is not an offering to sell securities!  You will lose money, but I'm happy to accept your contributions!]

I have completely secure storage (in a safe deposit box) and clean title (I purchased direct from the issuer!) to U.S. government backed inflation indexed securities in small denominations.  Not only are they indexed to inflation, they carry an accrued premium above inflation based on the implied inefficiencies of one of the worst functioning government programs.  Equally importantly, storage costs are a mere fraction of coinage storage.  In the space required for a roll of nickels, I can hold almost $200 face value of these securities.

Want more information?  Here you go...Forever Stamps good for 1oz of first class postage, well, forever.  The best part of the current "Forever" stamps, truly appropriate for gambling on inflation?  The image is not Lady Liberty, but the Las Vegas replica!  (Note: not worth 1 of your 20 if you're counting.)

Should You Pay Off Your Mortgage?

In my last post, I note that there's some really bad advice out there about a difficult decision: Do you or do you not pay off your mortgage.  "Ordinary Bob" asked for more help.  I'll try.

Disclaimers: This is a complicated question.  I do not give financial advice, I am not qualified to give financial advice.  I don't know you or your circumstances.  I'm going to highlight my personal concerns, which could be very different from yours.

Before I begin, an apology: I referred to Kelly Campbell as a woman.  Kelly Campbell is male.

Campbell states the obvious, and he says nothing particularly unique about a mortgage: If you can borrow money at a rate below the rate at which you think assets will appreciate, you can expect to make more money by borrowing to invest than if you didn't borrow.  Note the word expect.  This strategy involves leverage and more risk around uncertain outcomes.

He assumes that your house and investment portfolio increase in value by 5% and 8%, respectively.  I'll go out on a limb and assume he told his clients more or less the same thing in 2006.  Unclear if those people remain his clients.

In other words, he forgot to mention that investment returns are not guaranteed.  (Interesting that a Certified Financial Planner who touts his clean FINRA record on his website can make statements in a U.S. News column he cannot legally make in a client conversation.  If you're curious about that one, ask him to mail you a re-print of the article.  I'll bet $1 the re-print he sends has multiple disclaimers!)

Buying a house with a mortgage is just a leveraged investment. Yes, you live in it, enjoy it, yada yada yada.  But, you can borrow cheaply against stocks and mutual funds too.  It's called a margin loan, and that interest is also tax deductible.

So, you have to ask yourself if you can stomach the risk of more leveraged investing.  Most people cannot.  You probably could not cope with the volatility of your house price if you watched it.  (Check Zillow's monthly marks on your house.  I'll be you another $1 you rationalize that Zillow is just wrong, that they don't know your house.)  

For me, liquidity is the next issue to consider when thinking about paying off a mortgage.  Liquidity provides financial flexibility.  A pile of cash that could pay off your mortgage provides liquidity.  Pay off your mortgage, your liquidity disappears with your loan.  Suppose after you pay off your mortgage, you lose your job, so you can't get a new loan and your short cash.  Or, you want to move to a great new job, and you can't sell the old house.  You have no cash to buy another.  Heck, what if the stock market really crashes, and all of a sudden Campbell's risky 8% becomes a not so risky 20% and you have no cash to invest??

Lastly, I think about inflation.  Everyone's talking about inflation these days.  Did you buy gold for the end of the world yet?!?  Seems pricey, right?  Many logical inflation hedges seem uncomfortably priced.  I hold a relatively large amount of TIPS.  But even they aren't perfect.  If you own a house, you're already "long" a real asset, albeit in a completely undiversified and illiquid way.  With a 30 year mortgage, however, you're short a long duration bond.  That's very convenient if you think interest rates are going to rise dramatically due to inflation.  That's right, you pay off the mortgage with depreciated dollars after inflation strikes. 

So you ask, have I paid off my mortgage?  Not yet.  But, my circumstances are very different from yours!

86 The 529

A story in the Education section of the Journal discusses pre-paid tuition plans, a special case of 529 college savings plans. (For those without children and therefore not up on the details of college funding, these plans allow savers to invest tax free, as long as the proceeds go toward college tuition.) It turns out most investors in pre-paid tuition plans didn't read the fine print: Counterparty credit risk. They turned their cash over to state controlled entities that blew their money, and can't make good on their commitments.  There's a shock.

Add incompetent state oversight to the list of bad management, lousy investment options and absurd add-on fees.

Buy a House? The "Best Leading Indicator" Says Yes!

I've owned three houses in my life.  They've all been terrible "investments", including the one I'm sitting in right now, and I haven't a clue when I'll sell it.

Think about a house as an investment.  Historically, residential real estate returns maybe two or three percent annually, after inflation.  That's actually not terrible, especially if you don't owe taxes on the sale.  But it will cost you at least five percent in various transaction costs.  We're not selling IBM shares, after all. While you own this "investment" you risk fast depreciation, (it burns down,) and slow depreciation, (the roof wears out.) Those are real dollars to keep the investment "working for you," as they say.

More abstractly, you severely limit your career.  You can't move cross country with this asset.  You also can't inexpensively change your child's school.  I know, you bought the house for the good schools.  That was ten years ago.  They had a great kindergarten!  The high school is full of hoodlums.