PureFunds’ Paul Zimnisky talks diamond ETF investing

DIN: What led you to create the PureFunds ISE Diamond/Gemstone ETF? How does it fit into the overall ETF picture?

PZ: GEMS is the first ETF to provide direct exposure to the diamond industry, and the idea was to create an easier way to invest in the space. Physical diamonds tend to be difficult to invest in; there’s no futures or spot market, and that is because diamonds lack fungibility, meaning they all have different characteristics that lead to different values. Each stone needs to be individually graded, and that really reduces liquidity.

The ETF provides an easier way to track diamonds via the companies in the industry. The fund includes mostly pure-play companies involved in the production of rough and the sale of polished stones. We believe that as demand for diamonds increases, these companies and the fund will benefit.

DIN: Since it’s not a physically backed fund and there are no futures contracts or other forms of trade, how does your ETF account for the qualitative nature of valuing gems? How is it priced?

PZ: All of the companies in the fund are exposed to diamonds or other gemstones in one way or another, so fluctuations in the price of diamonds should directly affect these companies’ cash flows.

As far as how the fund is priced, the fund’s index is based on a market cap-weighted methodology across a basket of about 25 stocks. The fund is passively managed, attempting to mimic the stocks in the index as closely as possible, and the stocks are marked to net asset value every day, which is right around where the fund is usually priced.

DIN: It’s basically tracking those companies?

PZ: Correct. It’s a global ETF, so it includes companies from all over the world that are traded on major national exchanges. All of the companies are exposed to the diamond or gemstone industry, whether it’s upstream or downstream. Given that they’re all publicly traded companies, there is transparent pricing for each of the stocks in the index. The ETF and the market makers trade based on the net asset value, which is fairly easy to calculate because these are all publicly traded companies.

DIN: How did you select the companies that are being tracked? What were the parameters for choosing them?

PZ: It was relatively easy, because there are so few publicly traded pure-play companies in the diamond industry. In the US and Canada, for example, there are less than ten companies that are big enough or liquid enough to even qualify for inclusion in a SEC-regulated investment vehicle such as this. But as we took the fund global, we found a few more companies that fit the criteria, expanding to Europe and Asia. All in all, we were able to put about 25 symbols together.

It’s a market cap-weighted methodology, but the purest-play companies that derive almost all of their revenue from the diamond industry have the heaviest weight. Companies that are not as pure play — for instance, Anglo American (LSE:AAL), which is the majority owner of De Beers — have other businesses outside of the diamond industry. They are not pure-play companies, so their weight in the index and the fund is reduced accordingly. We wanted the fund to be as pure play as possible, but at the same time, we wanted to include a company like Anglo American because it is the majority owner of De Beers, and De Beers is obviously one of the most important names in the industry.

DIN: Right. Is it revised often?

PZ: Yes. It’s rebalanced on a semiannual basis, every six months.

DIN: How can non-US investors invest in the fund?

PZ: It’s a New York Stock Exchange-listed ETF, so anybody that has access to stocks that trade on the New York Stock Exchange would have access to the fund. At the current time, the fund is not listed in any other country, but at least the New York Stock Exchange is one of the easiest exchanges in the world to gain access to.

DIN: What kind of exposure to diamond and gemstone markets does it offer to hard-asset investors? How can they expect to benefit?

PZ: Investment in physical diamonds represents less than 1 percent of total diamond demand, whereas for gold, investment demand is 40 to 50 percent of total demand. Because of the complexities involved in investing in physical diamonds, hard-asset investors have not represented a large portion of demand. I think there is pent up demand for investing in physical diamonds, but right now, there’s not an easy or economic way to invest in physical.

We feel the best way to invest in diamonds is via exposure to the industry, and that’s why we created the fund that we did — investors want liquidity and transparency. There is very little liquidity [in investing in physical diamonds] and arguably less transparency as far as pricing for a nonprofessional as most of the transactions that take place are on a private market.

DIN: Some people believe that diamonds are a poor investment, in part because they’re difficult to resell and partially because of the perceived De Beers monopoly. How would you respond to someone with concerns like that?

PZ: I would say that up until recently, there was a structural flaw in the industry: De Beers controlled prices. However, the monopoly was dismantled early last decade. For the first time in 100 years, diamonds are being driven by market forces. I think most people don’t understand that, but if you actually look at the price of diamonds, De Beers liquidated its stockpile inventory from 2001 to 2004, and that put pressure on the market.  But when the stockpile liquidation was complete in 2004, the overhang had been lifted and diamond prices traded up and made a new high into 2008. They sold off during the financial crisis, but then rebounded, and in the summer of 2011 made another new high.

De Beers’ scheme was to create a very stable diamond price that gradually went up. As soon as its inventory was liquidated, there was unprecedented volatility in the diamond price, and I think that was an indication that the monopoly no longer exists; people can technically see this in the price action of diamonds. The point being that diamond prices, for the first time in 100 years, are being driven by market forces, not De Beers controlling supply, which is very attractive for investors, on top of the fact that the diamond industry is forecasting 6-percent annual growth in demand over the next 15 years, but only 3-percent growth in supply. I think that produces a pretty interesting investment thesis going forward.

DIN: Well, thank you very much for speaking with me, Paul.

PZ: Thank you for having me.

 By Charlotte McLeod

Securities Disclosure: I, Charlotte McLeod, hold no direct investment interest in any company mentioned in this article.