Do not sell what you do not own, avoid uncertainty, interest payments, guarantees and undue risk and stay away from haram or forbidden investments in tobacco, pork or alcohol. These Koranic instructions, all of which must be followed in a Shariah -compliant product, appear to signal that Islamic fund managers and investors should steer clear of hedge funds.
But Gulf investors, having learnt the hard way this year that what goes up must come down in one of the steepest emerging market crashes, are now realizing that there is a serious need for products that mitigate investment risks. In Muslim communities, demand for more sophisticated Islamic investment products is increasing.
A small but determined cohort of financiers is on a quest to develop hedge funds in conjunction with Shariah scholars that meet the rigorous demands of Islamic investors. As one Riyadh banker puts it, “the prospect of blending hedge funds and Islamic finance gets all our imaginations going – if it can work it could generate huge fortunes.”
However, “the hedge fund project has faced many hurdles, and various partner organizations have come and gone,” says Volaw Trust and Corporate Services director Trevor Norman, an Islamic finance specialist.
Jersey-based Volaw started work in April 2004 on the Shariah -compliant Algo Al-Qayyim Fund Limited, which eventually won Jersey Financial Services Commission’s approval in February. “Finally, with the input of the scholars provided by the Shariah Supervisory Board of Yasaar Ltd, the skills of Algo Capital Management in devising appropriate screening techniques, and the support of Citibank who will act as prime broker, the fund is ready to be launched,” Norman says.
But even after this progress the fund still faces difficulties. Norman told Emerging Markets that “lawyers of one of the key participants are still commenting on draft documents and this has delayed the launch, much to our frustration.”
Historical perspective
The quest to find Shariah-compliant ways to buy stocks long when analysis suggests positive performance and sell stocks short when under-performance is anticipated reached its first milestone in 1997, when Kuwait-based The International Investor launched its Al-Khawarizmi Market Neutral Fund. This aimed to achieve long-term capital growth from securities and other financial instruments while managing risk through hedging and efficient portfolio management techniques.
In the same year, Saudi Economic and Development Company (Sedco) in Jeddah and New York-based Permal Group jointly launched Al-Fanar Hedge Fund. According to Sedco, its long/short strategy is Shariah -compliant because it is executed under a Salam contract, which provides the investor with a framework in which to sell short.
In the Salam framework, the seller agrees to supply a specific commodity to the buyer at a future date in exchange for a price fully paid at spot. The commodity’s quality and quantity must be specified exactly and be generally sourced in the market. This means the Salam contract is essentially a sale at a current price with deferred delivery of the asset; thus it replicates the economics of a short sale.
But there is no universal agreement over which contracts are acceptable under Islamic law. “Shariah Standard No 21 issued by the Accounting and Auditing Organization for Islamic Financial Institutions, Financial Papers (Shares and Bonds), has stated that shares ‘cannot essentially be the subject matter of the contract of Salam’,” Norman observes.
“The Algo Fund has used the Urbun contract at the core of its substitute for short-sale methodology, with other forms of Islamic contracts being used for other transactions between the various parties,” says Norman. “A Salam contract is in effect a sale at a current price with deferred delivery of the asset, whereas Urbun is a deferred sale with a down-payment, where should the buyer not complete the purchase the down-payment is forfeit”.
Risk
management tools
Another provider eager to grab a slice of the Islamic alternative investment market is Shariah Capital. This division of US-based Meyer Fund Management claims to have developed two Shariah -compliant hedge funds – the Shariah Long/Short Master Fund and Shariah Market Neutral Master Fund.
The former claims to be the first multi-manager, Shariah -compliant fund of separately managed accounts comprised of hedge fund managers following predominantly long/short equity strategies. It targets performance superior to conventional long/short funds’ returns.
The Shariah Market Neutral Master Fund is similar, but is comprised of underlying hedge fund managers who follow market neutral strategies. It targets performance that is superior to returns from short-term murabaha investments.
Shariah Capital says its proprietary risk management tools will enable institutional Islamic investors to participate in hedge fund strategies on a managed or private label basis. One of these tools, Shariah Screens, uses specially designed software to monitor listed companies for Shariah compliance in 52 securities markets around the world.
Offshore lead
The two most public upcoming hedge fund launches have been developed in Jersey and the United States, rather than in Muslim financial centres. This does not mean that there is no appetite for Shariah-compliant hedge funds in the Middle East, but it is apparent that Islamic financing structures are not the only attraction for local Gulf investors.
The UAE’s First Gulf Bank is marketing its Gulf-focused Al-Saqer hedge fund – a conventional fund aimed at achieving even, long-term returns and targeted at local investors. “Hedge funds currently marketed here are operated from Tokyo, London or the US,” says First Gulf Bank’s chief operating officer Andre Sayegh: “Al-Saqer is UAE based for the UAE investor, with eyes firmly focused on the impressive returns that can be recorded here with careful and deft management.” The fund was over-subscribed within weeks of launch.
Shariah-compliant hedge fund developers outside the Middle East remain optimistic that once they are able to launch, investors will be satisfied that their offering is Shariah compliant and will declare a healthy appetite for an Islamic tool for mitigating market risk. “I can only assess the amount of interest that we have had since the initial [January 2006] press release, which has been extremely encouraging,” Volaw’s Norman told Emerging Markets. “With a diverse panel of scholars we seem to have allayed the concerns of many potential investors.”