Diamonds were once a girl's best friend. Now they're also an asset class.

Growing numbers of the world's ultra wealthy are investing in high-end, colored diamonds and gemstones as a hedge against global economic uncertainty and an opportunity for appreciation. The market for these tangible assets is being driven by nervous high-net-worth Westerners and newly affluent Asians, especially in India and China, where colored stones have long been seen as status symbols and good-luck charms.  

"Diamonds offer a very attractive alternative to traditional asset classes. They are highly uncorrelated to equities and exhibit extremely low volatility, while at the same time offering very good potential for positive returns," says Alan Landau, CEO of Novel Asset Management. The Novel Diamond Fund I, a private fund incorporated in the Cayman Islands, launched in October 2011, and it is the first in a planned series of funds from Novel aimed at the colored diamond market.

Colored diamonds are some of the priciest and rarest gems in the world. Experts say only one carat of colored diamond is found for every 10,000 carats of colorless or white diamonds mined.  (A carat is a unit of weight equivalent to 200 milligrams).  Colored diamonds come in a range of hues, including red, purple, green, pink, blue, orange and yellow, as well as a variety of mixed hues. Like other precious colored gemstones, the purer, more intense colors are more rare and thus more valuable.   

Landau says his fund operates as a trading vehicle for buying wholesale and selling retail, through the network of Novel Asset Management's parent company, Novel Collection, a colored diamond trader and manufacturer (it cuts and polishes rough diamonds) with offices in the U.S., Europe and Asia.  Although the fund can purchase colorless diamonds, Landau says it's extremely unlikely to do so.  "The profit margins in trading are higher in color diamonds," he says.

Based on fund returns through January 2011 and the recent trading activity of Novel Collection, Landau expects net returns of 20% per year on average. The fund is closed-end and the minimum investment is $250,000.

The fund targets wealthy individuals and single-family offices, in part because, in Landau's experience, institutional investors find diamonds too "exotic." But that attitude could be changing. Recent news reports indicate that hedge funds, private banks and even pension funds are showing increased interest in this niche asset.    
Even funds that invest primarily or exclusively in colorless diamonds are popular with some investors. White diamond funds typically buy and sell high-quality stones from 1 to 10 carats.  Last year, Malta-based Diamond Capital Fund, Zurich-based Diamond Asset Advisors and London-based Fusion Alternatives all started new funds. 

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In an April 2011 paper, "Hard Assets: The Returns on Rare Diamonds and Gems," Luc Renneboorg and Christophe Spaenjers of Tilburg University in the Netherlands, examined the recent performance in U.S. dollars of investment-grade white diamonds, colored diamonds and other gems (rubies, sapphires and emeralds), using worldwide auction transaction data from Sotheby's and Christie's.

From 1999 to 2010, the annualized real returns for white and colored diamonds were 6.4% and 2.9%, respectively, compared with -0.1% for global stocks, 3.3% for global government bonds and 11.6% for gold. Negative real returns occurred during two sub-periods: the dot-com bust and the recent financial crisis. But subsequent price rebounds more than compensated for the dips.

The authors used post-2003 data to calculate annualized real returns for white diamonds, colored diamonds and other gemstones-10.0%, 5.5% and 6.8%, respectively.