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Shariah compliance poses challenge to Middle East managers

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Leading institutional and private investors in the Middle East have long been an important source of capital for some of the world’s biggest and longest-established hedge fund managers, and the reg

Leading institutional and private investors in the Middle East have long been an important source of capital for some of the world’s biggest and longest-established hedge fund managers, and the region is also now home to a small but fast-growing pool of home-grown alternative asset management talent. But for both local and international managers, an important challenge now is to reproduce the performance and risk management benefits of hedge fund investing while meeting the constraints of Islamic law.

Compliance with the Shariah code, which bars the payment or receipt of interest, financial speculation, and the selling of property that the vendor does not legally own, and requires that financial returns are derived from physical assets, ostensibly bars the use of leverage, short-selling and derivatives, three of the staple techniques employed by hedge fund managers. These strictures effectively rule out investment in banks, conventional insurance companies and other financial services businesses, while other sectors barred to Shariah-compliant vehicles, less crucially, include companies involved in gambling, alcohol or tobacco.

A number of investment managers have worked with Islamic scholars to develop strategies that replicate hedge fund techniques through Shariah-compliant processes, but others are wary about their ability to deliver comparable levels of performance. Fund of hedge funds manager GAM, which recently opened an office in Dubai to meet the requirements of its growing client base in the region, is among the institutions that remain cautious about stepping into the Islamic hedge fund sector.

‘On the hedge fund side, it’s an exciting opportunity and we’ve been in discussion with Islamic institutions as well as with various underlying hedge funds,’ says Craig Wallis, GAM’s group head of institutional business and fund distribution. ‘But to create a product like that we would have to be absolutely comfortable that we could deliver the performance we would expect.

‘To do that we would have to go to some of the biggest and most successful names in the hedge fund industry, who don’t necessarily need the hassle of running a Shariah-compliant product. Because GAM is very prominent in early-stage investment, which is a major feature of our funds of hedge funds, we have relationships with managers with whom we can open this dialogue. But it’s a catch-22 – we wouldn’t want to open a dialogue unless we felt we could give them a significant sum of money. But there is certainly a big opportunity there. There are extremely successful funds of long-only funds that have raised billions.’

Much of the work to accommodate hedge funds within the strictures of Islam has been carried out at the behest of Greenwich, Connecticut-based Shariah Capital, its chairman and chief executive, Eric Meyer, and chief Shariah officer Shaykh Yusuf Talal DeLorenzo. In partnership with Barclays Capital, last September the firm launched Al Safi Trust, a Shariah-compliant investment platform designed to offer a framework in which managers can accommodate Islamic investors within their existing strategies.

Over the past year Shariah Capital has also launched a compliant separately managed account that follows a 130/30 quantitative strategy using an Islamic Arboon structure, which uses a down-payment transaction to replicate the effect of shorting. However, it is Fimat, the prime brokerage arm of France’s Société Générale, which is usually credited with having introduced the first Islamic hedge funds at the end of 2006. The Fimat-backed strategies employ the Salam contract, used to facilitate deferred sales for financing and hedging of commodities transactions, and which has been approved by authorities on Islamic law for equities.

‘Shariah-compliant techniques work much better on long/short strategies than on hub or turning strategies,’ Wallis says. ‘There are difficulties with various strategies involving leverage and certain types of instruments. There is a process you can go through to short equities, but derivatives are much harder. We haven’t really seen any macro manager trading currencies, commodities and fixed-income who’s cracked that to a satisfactory degree.’

Disagreements do arise between industry members and scholars on the acceptability of certain techniques used to create hedge fund-related products suitable for Islamic investors. For example, there was controversy over a Shariah-compliant fund launched last June by Dubai Islamic Bank in partnership with Deutsche Bank and Goldman Sachs that is linked to the performance of conventional, non-Shariah hedge funds, but not directly invested in them.

Instead the fund invests in capital-protected notes linked to a hedge fund index, with the return achieved through a total return swap. However, critics such as Shariah Capital’s DeLorenzo argue that the product is not compliant because its return is determined by the performance of funds that do not used Shariah investment techniques and may well invest in stocks forbidden under Islamic law.

‘Some of the innovative products that get around Shariah issues may be legally compliant but stretch the boundaries from a moral perspective,’ says Mark Weller, managing director for Europe, the Middle East, Africa and Asia with PerTrac Financial Solutions. ‘Fixed-income funds are certainly off their radar, but as has always been the case in the securities market, people find creative ways to get around that. There are funds that simulate the return exposures you get with fixed-income strategies.’

As a provider of portfolio management and investment analysis software, PerTrac offers the screening capabilities that can help managers and clients with the other key element of ensuring compliance, establishing the Shariah investment universe. Screening is required both for investors, to determine which funds meet Shariah requirements, and for fund managers, to ensure that the companies in which they invest are suitable for Islamic investment.

However, continuous monitoring of underlying stocks is necessary to ensure, for example, that investee companies have not subsequently launched operations involving proscribed activities, or increased borrowing levels to a degree considered unacceptable (Shariah-compliant funds may invest in companies that have low levels of borrowing or interest-bearing cash holdings; the share of dividends or other profit distribution derived from interest earnings are often donated to charity).

Says Weller: ‘In some respects investors seeking Shariah-compliant funds have even greater need for products like ours, because the screening process to determine the potential funds they can invest in has to be even more rigorous. And because their eventual universe of funds is smaller, it’s all the more important to identify those that offer the best levels of performance.’

There is no functionality currently available to screen funds specifically for Shariah compliance, but the PerTrac analytical software can be used to flag up problem areas of investment strategy. ‘Islamic investors will be looking out for certain sectors that they cannot accept exposure to,’ Weller says. ‘You can certainly use the PerTrac analytical tool to screen out funds that invest in tobacco or in financial services.’

As Islamic investment becomes a greater source of business in the global investment marketplace, he notes, Shariah compliance is increasingly a characteristic highlighted by fund databases. ‘As databases start to list funds that describe themselves as compliant, you can use the PerTrac analytical software to construct peer groups to ensure you are using the best of what’s available.’

Rasmala Investments, the multi-manager arm of a broad-based financial services group with headquarters in Dubai and offices in Egypt, Oman, Saudi Arabia and the UK, is steadily extending the range of its Islamic products. Over the past year it has launched Shariah-compliant versions of three of its funds of funds, something that chief executive Eric Swats says has been facilitated by the ongoing expansion in the range of compliant fund products offered by asset managers both inside and outside the Middle East.

As a fund of funds manager, Swats says Rasmala uses the same techniques to identify potential investments whether the fund is conventional or Islamic. ‘We use the same methodology in manager identification, selection and due diligence in each sphere,’ he says. ‘With regard to compliance, we rely upon the underlying funds having received a fatwa from their Shariah boards. We have fatwas for our own Shariah funds.

‘We are reliant upon each fund’s Shari’ah board monitoring its ongoing compliance. We don’t go in fund by fund and make sure they have done everything they said they would, but rely on the board to certify that they remain invested according to the terms and conditions under which they first received their fatwa.’

There is a sufficiently broad range of funds covering investment areas including the US, Europe, Asia and emerging markets, including funds that focus on style and market capitalisation, to enable Rasmala to implement effectively its global asset allocation strategy, either for Shariah-compliant or conventional managers. ‘We have strong demand from clients for Shari’ah-compliant products, and we’re also seeing increasingly high-quality asset management groups offering these funds,’ he says.

Swats argues that whatever their style or approach, all investment strategies involve some sort of filtering process, whether qualitative or quantitative or a blend of the two. ‘We’re looking at managers who can operate with an additional filter to exclude companies that are operating in prohibited industries or whose balance sheet income statements have too much interest earned or paid,’ he says.

‘When you strip it out, the biggest sector you lose is finance companies, so the US Shariah-compliant index looks almost exactly like the S&P 500 ex financials. Over time the two indices will deliver the same performance. Financials are the main difference, and there are times when they will outperform, just as there are times, like now, when they will underperform and the ex financials will offer better returns. That’s the cyclical nature of finance companies, but in the long term both approaches ought to do about the same.’

The growth of Islamic investment is also bringing new areas of business to markets such as the Dubai International Financial Exchange, which although just two years old is already positioning itself as a trailblazer for the region in new listing areas such as structured products. ‘In addition to our conventional bonds we also have some Sukuk, or Islamic bonds,’ says DIFX head of corporate communications Mark Fisher. ‘There’s also an Islamic element to our structured products business. Some of the new structured products launched over the past six months are Shari’ah-compliant, which is bringing in new investors.’

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