By almost any definition of either “hedge fund” or “Islam,” the two have never been quite compatible. Shari’a, the religious code that guides devout Muslims in all matters, financial and otherwise, prohibits certain practices that are generally taken for granted in the West: It explicitly forbids borrowing, for example, a restriction that would seem to preclude leverage and shorting, among the favorite tools of hedge fund managers everywhere.
This apparent contradiction hasn’t stopped people from trying to bridge the divide, however. Banks and entrepreneurs are well aware of the staggering wealth controlled by Islamic countries and the vast potential for introducing new investment products. Yet the conflict persists. “Hedge funds are among the most controversial areas in Islamic finance,” says Mohammed Amin, the London-based Islamic finance leader for accounting firm PricewaterhouseCoopers, who notes a broad reluctance to invest in something still being debated by Islamic scholars.
The relatively few, scattered funds and investment products tailored to Islamic rules on investing are finally beginning to move into the mainstream. Ernst & Young this year released a report on Islamic investing that counted about 500 shari’a-compliant funds of one kind or another at the end of 2007, up from 150 in 2000, and estimated there could be as many as 1,000 by 2010.
Shari’a-shaped fiscal conservatism has a clear upside, especially in these times. Funds tailored to Islam have had little or no exposure to the West’s subprime-loan-riddled, downward-spiraling banks and financial stocks. As a consequence a whole range of shari’a hedge funds and mutual funds have outperformed conventional holdings. An Islamic fund index maintained by Morningstar was down 29.34 percent over the 12 months ended November 3, compared with a 34.43 percent drop-off in the Standard & Poor’s 500 index. On the other hand, shari’a-compliant investment vehicles are vulnerable to precipitous declines in the prices of oil, natural gas and other commodities. In October, as oil prices plummeted, the index was down 16.75 percent, compared with a 16.79 drop in the S&P 500.
The opportunity for shari’a-compliant instruments is potentially enormous. The Islamic investment pool last year was $1.34 trillion, according to Ernst & Young. Understandably, international banks, asset management houses and a host of fund providers are now working feverishly to develop products for this possibly lucrative market.
Some critics wonder if shari’a offerings follow fewer standards than they should. At its core a shari’a- compliant investment cannot involve the accrual or collection of interest, and it must invest in tangible assets, such as real estate or equities. Within equities it cannot involve companies that deal in products or practices forbidden by Islamic law — alcohol, gambling, lending or tobacco, for instance.
Unlike investors of a generation ago, who had to pick from scant shari’a-compliant offerings, those who now seek such investments have a wide selection of Islamic bonds and mutual funds tied to index-linked portfolios, structured products and hedge funds from which to choose. But because the industry remains nascent, it still seems an open question as to which products actually work and which ones appeal to investors.
Hedge funds are at the leading edge of that debate. This summer, Barclays Capital said it would launch the world’s first truly shari’a-compliant hedge funds, and Deutsche Bank announced plans to sponsor a shari’a-compliant trading platform. Paris-based Fimat International Banque rolled out a shari’a-compliant platform in 2007, and in May of this year, the Singapore stock exchange introduced an exchange-traded fund for shari’a-minded investors.
Some experts, including PricewaterhouseCoopers’ Amin, remain skeptical about the level of interest among investors, let alone the likelihood that a true hedge fund can faithfully adhere to the law of shari’a. But Shaykh Yusuf Talal DeLorenzo, chief shari’a officer at New Canaan, Connecticut–based Sharia Capital, sees a boom in the making.
“Hedge funds provide Islamic banks and financial institutions with a number of advantages they currently lack,” notes DeLorenzo, whose firm launched Al Safi, a shari’a-compliant platform, with Barclays. DeLorenzo argues that the urge to diversify and better manage risk will inevitably drive such customers to hedge funds.
The push from outside the Muslim world seems to be growing. In response some banks and entrepreneurs are striving hard to hit the right notes.
Al Safi, for instance, has what it calls a shari’a supervisory board — a feature common to shari’a-sensitive funds — that screens holdings to ensure that they are shari’a-compliant and that offerings are not just palatable but also appealing to Islamic investors. Part of the attraction for Barclays is that — assuming enough shari’a-compliant hedge funds are created — it will eventually be able to create fund-linked derivatives that are acceptable within some interpretations of shari’a. Barclays and Al Safi are using a classic Islamic-finance structure known as an arboon, which sets up a derivatives contract to distance investors from short-selling.
Dubai-based Saqib Masood, head of Islamic-product development at London’s HSBC Saudi Arabia, says the modern Islamic finance industry is still developing, with significant growth seen only in the past five or six years, and that it remains in an experimental stage. But he notes that interest in shari’a-compliant funds has grown from about one third of retail investors in Saudi Arabia to about two thirds. “Critical mass is coming through,” Masood says, explaining that demand for modern shari’a-compliant offerings comes predominantly from high-net-worth individuals.
Richard Ho, head of derivatives at Barclays Capital, says investors in the Islamic Middle East and Far East are eager to use alternatives, but they are held back in part by tradition and in part by the dearth of offerings that are promoted as being at least shari’a-sensitive, if not fully compliant.
Masood adds that he expects the demand for attractive, international shari’a-compliant product offerings to filter soon into the institutional market in Islamic countries, as awareness of such products grows. And he says big pension funds in particular will begin to demand them. Already Islamic insurance companies — which are structured to reflect the concept of takaful, a broad Islamic notion of the common good — can invest only in shari’a products, and pension funds will likely be pressured by their members to abide by shari’a.
Sovereign wealth funds, the biggest institutional investors in the Middle East, Masood says, seem content, for the time being, to take stakes in noncompliant investments, mainly because so few alternatives exist. He doubts, however, that they will ever sign on full-bore to shari’a compliance since performance is paramount for most sovereign wealth funds; shari’a is a secondary, complicating consideration.
Estimates of the number of shari’a-tailored funds vary. Failaka Islamic Funds, a Chicago-based database on shari’a-compliant funds, counts 325 Islam-sensitive mutual funds alone. Kuwait-based Sabaek Leasing and Investment Co. projects that a universe of 700 such funds will exist before the end of this year and more than 950 by 2010, driven in part by strong financial liquidity in the oil-producing countries of the Persian Gulf and by the growing awareness of, and preference for, sophisticated shari’a-compliant products.
Hedge funds that are shari’a-compliant are much less common, numbering perhaps no more than a dozen. The essential problem is most likely a chicken-and-egg dilemma: Which comes first, the supply or the demand? A number of banks and firms are pushing the supply side, and Masood says they can be categorized roughly into three groups. First are those focused on alternatives — like Al Safi. Launched in June, Al Safi offers five New York–based commodity funds, including a BlackRock metals-and-minerals fund, a Lucas Capital Management energy/oil and gas fund, an Ospraie Management agriculture fund, a Tocqueville Asset Management gold portfolio and a Zweig-DiMenna Associates natural resources fund.
Though it is based in Connecticut, Al Safi has direct and official support from the Middle East: Each portfolio was seeded with $50 million from the Dubai Multi Commodities Centre, which is sponsored by the Dubai government.
Second are firms, like HSBC, that offer plain-vanilla global-equity mutual funds. These funds avoid bank stocks, breweries, casinos and tobacco companies. The third group includes those — like Deutsche Bank — involved in the creation of structured products, strategies meant to offer a guaranteed return on principal that are linked to a shari’a-compliant investable index.
Traditionally, most Islam-friendly investment products have been retail — bank accounts, mortgages and insurance. Then in the 1980s bondlike instruments called sukuk were introduced. These are medium- to long-term Islamically compatible trust certificates backed by shari’a-compliant assets, say those tied to real assets like property or commodities and that rely on rental income or appreciation for returns rather than on interest. Such products are meant to duplicate conventional fixed-income debt securities, and most have been issued by governments, though the private sector has shown interest in issuing them too. This year, Japan’s Toyota Corp. announced that it was considering issuing a shari’a-compliant bond for the first time (in a bid to expand its business in Malaysia), and Thailand said it would issue $600 million in shari’a-geared government bonds.
It’s easy to see why there is an interest in this market. Sukuk issues totaled $47.1 billion in 2007, up from $800 million in 2002, according to the Islamic Finance Information Service, a product of ISI Emerging Markets, which is owned by Alpha parent Euromoney Institutional Investor. This so-called Islamic bond market has led to the creation of investable indexes that are tracked by Dow Jones & Co. and Citigroup, seeking to offer exposure to the performance of global sukuk.
Sukuk aside, Muslim wealth is tied in large part to oil, which can see sharp price swings — witness the spike from $90 a barrel year ago to almost $150 in June and the subsequent drop to less than $60 in November — but whose worth is unmistakable and long term. This fact assures the potential for shari’a-sensitive investing.
“The trend of growth in Islamic financial products is still very much there,” Amin says. “The fall in oil has been big, but it does not change the big picture. It still leaves a situation where many of these countries are sitting on significant financial surpluses.”
HSBC’s Masoon is of the same mind. He says bankers and investment firms were already turning toward the markets of the Middle East before oil prices surged to record highs this year and notes that parts of the Middle East — like Dubai — have diversified and have rich real estate bases in particular.
Though global market turbulence in recent months seems to have dampened demand among most investors for alternative investments, Islamic ones included, conditions have forced adaptation. “It is very murky and muddy out there still, so a lot of asset managers are now focusing on products that are more ‘all weather,’” Masoon explains.
To that end he expects an uptick in interest for fixed-income products or simple equity-based funds that are shari’a-compliant. In fact, he predicts that shari’a-designed funds may find themselves with a broader audience than ever because their performance has held up better than that of more-conventional funds — thanks to their avoidance of lending-related holdings like the mortgage-backed securities at the root of the credit crisis.
Of course, other, more social than economic questions persist, like whether and how well investment vehicles that are promoted as shari’a-compliant will even be accepted in the Muslim world.
Dean Naumowicz, a London-based Islamic-finance partner at law firm Norton Rose, says the shari’a-tailored investment industry would be taking a big step toward more professionalism and perhaps a broader audience if it were to adopt uniform standards, especially for whatever derivative products are being offered. Naumowicz notes that in the conventional derivatives markets, the International Swaps and Derivatives Association offers commonly accepted standards and works to advance the understanding and acceptance of derivatives. The Islamic-finance world has yet to sanction any such group.
DeLorenzo calls for more clarity in every respect. He says he believes that a viable and practical balance can be found, and that religious tenets and investment returns can coexist.
“The industry must demonstrate its ability to regulate itself and insist on the Islamic authenticity of all that it does or allows to be done in its name,” he asserts. “In the past few years, modern Islamic finance has proved itself to be credible and, at the same time, both innovative and adaptable. The question it faces now is whether it can prove that it is moral and responsible.”
