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. 

Hot Rocks  
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.

Advisors should note that reported returns were gross, not net. Transaction costs for gemstone auctions, such as auction house commissions, average 10% each way, much higher than fees for buying and selling stocks, bonds or gold. In addition, the authors found that gem returns for the study period were positively correlated with the stock market, suggesting the existence of a stock market "wealth effect."

Although the potential for gains can be substantial, the downside to investing in gemstones is the relative lack of short-term liquidity. To avoid having to sell at a steep discount, experts recommend allowing three to six months to find an appropriate buyer who will pay what the stone is actually worth.

With adequate lead-time, clients who want to exit their positions can sell to dealers, jewelers, auction houses or private buyers. For truly exceptional collections, donation to a museum could provide tax benefits. 

Besides higher transaction costs and lower liquidity than for diamonds and gems, the costs of storage and insurance for them can reduce profits, which are, meanwhile, subject to capital gains taxes. However, clients can make tax-free exchanges, if they trade their gems for stones of equal value, or defer taxes if they trade up.

In addition, advisors must caution their clients to avoid "conflict stones"-those that are traded to fund a war. For example, the U.S. currently bans imports of rubies and jade from junta-ruled Myanmar (Burma), although there's no prohibition on buying or selling stones that are already in the U.S.              
            
Gem Hounds
Colored diamonds, Burma or Kashmir sapphires, Burma rubies and Colombian emeralds are currently the most popular with sophisticated investors, according to Robert Genis, president of National Gemstone and editor of The Gemstone Forecaster, a quarterly newsletter for gem collectors and investors. Genis calls these the "Big Four." "These are stones that have a long history of being traded. They're the Rolls Royces of the gem world," he says. 

A 30-year industry veteran, Genis has traveled extensively in search of rare gemstones for clients. He says few wealthy individuals purchase white diamonds, as most of these stones are not actually rare. Those who do buy colorless diamonds seek out one carat or larger "D-Flawless" gems, the highest quality available. 

Genis says most connoisseurs invest in colored diamonds, the rarest of which are red. Approximately 30 of these magnificent stones are known to exist in gem qualities, and they almost never become available for purchase. When they do, they can command over $3 million a carat. Next in rarity are blue, pink, green, orange and purple, which sell for millions of dollars per carat at auction. Yellow and brown diamonds are considered second tier, although Genis likes the outlook for yellow diamonds. "Yellows can look like the sun. They're just gorgeous. There's more upside potential. Browns violate the first precept of high-end gems. They should be beautiful, but they're ugly," he says.

Serious collectors and investors buy only natural gems and avoid stones that are treated in any way, Genis says. He says 95% to 99% of all gemstones are treated through heating, irradiating, oiling and fracture-filling.

High-quality untreated Colombian emeralds can command $25,000 per carat or more. But they're not easy to find. Genis had one client who was "obsessed" with emeralds. "He loved green stones. Only green stones. For ten years, once a year, I went to Colombia to look through 10,000 stones to buy him one. Each stone took two weeks to find," he says.

Overall, the keys to successful gem investing are buying important stones below retail from primary dealers or wholesalers, holding them for three to five years, and in some cases ten years or more, and obtaining industry-recognized grading reports from major laboratories to ensure the stones are authentic and investment quality.
American Gemological Laboratories (AGL) reports are the gold standard for colored gemstones. The Gemological Institute of America (GIA) is the reigning authority on colored diamonds and white diamonds.

Because each gem is unique, grading reports provide important information on a stone's carat, color and tone, clarity and cut (the "4C's"). They also discuss any treatments applied as well as the stone's country of origin, which significantly impacts value.

While Genis doesn't think it's feasible for wealth advisors to become gemologists and buy the scientific equipment necessary to become experts in evaluating gems for their clients, he does believe they can learn to read AGL and GIA grading reports to gain a basic understanding of the qualities of a particular stone. He has posted a primer on how to read an AGL report at preciousgemstones.com. The site also has charts on retail gemstone price trends from 1975 to 2010.

Although recognized grading reports establish quality, they do not establish value. Prices for polished white diamonds can be compared to benchmarks like the RapNet Diamond Index (RAPI) and the PolishedPrices.com index. By contrast, colored diamond and gemstone prices are generally set by sales at major auction houses.

Buying Bling
Besides investing in a fund or buying loose gems, those of means can always invest in high-end finished jewelry made by big-name jewelers such as Van Cleef & Arpels, Bulgari, Cartier and Tiffany's. The more expensive and exclusive-pieces produced in quantities of no more than a few hundred-the more likely the items are to grow in value, the so-called "masterpiece effect."

The best bet on jewelry appreciation might just be to collect like film star Elizabeth Taylor. Her iconic handcrafted bespoke jewels, with exceptionally rare gemstones and pearls, all in exquisitely designed settings, established a world record for the sale of a private collection. Christie's December 2011 auction was estimated to bring in at least $30 million. It ultimately grossed a staggering $137 million, topping the 1987 record for the auction of the Duchess of Windsor's jewels. The fact that they were owned by a Hollywood legend and the unusually large size of some of the stones and pearls were undoubtedly factors in the fantastic success of the auction.
   
Ensure Insurance
In August 2011, a dozen thieves posing as maintenance workers broke into 170 safe deposit boxes at Banco Itaú in São Paulo, in the heart of Brazil's financial district, making off with over $50 million in cash, gemstones, jewelry and gold bullion. Banks typically provide very little insurance on deposit boxes without an appraisal of the contents. The majority of customers in this unfortunate case had neither obtained appraisals nor adequate insurance. 

"Many affluent people are underinsured," says Eric Gordon, a principal with Denver Agency Company, a Denver-based independent insurance brokerage that provides commercial and personal insurance to the wealthy. As part of a client's overall insurance program, Gordon recommends a few specifics when it comes to jewelry and gemstones: having the items valued by a reputable appraiser; purchasing an insurance policy that includes a reasonable inflation guard (e.g., 4% to 6% annually); and reviewing the client's insurance needs yearly to update values, add items purchased since the last review and delete items the client no longer owns.

Because of the difficulty of valuing rare gems and high-end jewelry, Gordon says the final safeguard is to choose an insurance company that will pay more than the insured amount for the items. His firm works frequently with the Chubb Group of Insurance Companies, which offers a 150% valuable articles replacement clause for scheduled items in its policies. "We can't be completely certain that we're going to get the value of the piece absolutely correct because it's based on perception, market value and other variables. If there's a loss and we're underinsured, at least we have an increased market value clause," he says.