The ongoing evolution of Sharia compliant investing

Sharia compliant investing is based around concepts such as risk sharing, fairness, investment in real assets rather than debt, and the avoidance of riba (or interest in conventional finance). This has led to a variety of investment forms available to Islamic investors, which of course have evolved over time as the market and its understanding of Sharia compliant investing has grown. This means that a full range of Sharia compliant investments is now available to investors across the risk and return spectrum. Examples of well established Sharia compliant investments include the murabaha based deposit, Sharia compliant equity funds, and sukuk. The murabaha, or “cost plus” financing, is probably the best known form of Sharia compliant investment and is in many ways similar to a conventional deposit. The main differences are that an investment under a murabaha takes the form of delivery of a specified (set of) asset(s), and that the deferred profit rate associated with this sale is specified in advance. The assets underlying the transaction must themselves be Sharia compliant and are typically physical commodities or Sharia compliant equities. In a simple example, an investor wishing to invest $100 at a fixed profit rate of 5 per cent per annum, would source $100 worth of assets, deliver these to a bank, and receive a cash amount equal to $105 in payment for these assets after one year. For equity investors, more and more options are also becoming available. Sharia compliance of equities is generally determined by two layers of screening relating to the activities of the companies in question and the way in which those companies are financed. This means, for example, that companies may not derive a significant proportion of their sales or income from activities such as alcohol production, conventional finance and weapons manufacture. Equally, the extent to which companies are financed by debt of various forms, rather than equity, must be limited. This introduces a natural bias to non-leveraged companies. Many of the main index providers now also publish a range of Sharia compliant equity indices, with criteria determined by an independent Sharia advisory board. A variety of tracker funds linked to these indices as well as some actively managed Islamic equity funds are available to investors in most jurisdictions. Sukuk are the closest Sharia compliant equivalent to conventional bonds and can take many different formats. As with the murabaha, one of the main concerns here is that ownership in a sukuk must confer an interest in an underlying pool of assets and the risk associated with that pool. Sukuk are therefore typically issued by a special purpose vehicle, which then sources assets and enters into a variety of Sharia compliant agreements. Sharia Compliant Structured Products One of the main developments in Islamic investing has been the development of Sharia compliant structured product issuance platforms. These come in various shapes and sizes, but the more advanced platforms allow for issuance of a wide range of structured products and offer all the flexibility of a conventional note issuance programme. An example is Citi’s Oasis Certificate Programme, which allows for a comprehensive range of Sharia compliant investment solutions. Through this programme Citi, in co-operation with the Citi Islamic Investment Bank and its board of scholars, aims to deliver Sharia compliant investment solutions whilst preserving the efficiency and liquidity of traditional investments. Issuance is achieved through a special purpose vehicle, which enters into a series of Sharia compliant transactions. These transactions include the outright purchase of Sharia compliant assets, such as eligible equities or commodities, and entering into contractual arrangements allowable under Sharia. An example of this is the murabaha transaction as described above. UNILATERAL UNDERTAKINGS Crucial to the flexibility of these programmes is the use of unilateral undertakings (wa’ad). These undertakings have the economic effect of linking the sale or purchase price of a specified set of compliant assets to an often unrelated benchmark. This ensures that a range of pay-off variations is available under the certificates issued by the special purpose vehicle. The certificate issuance programme is certified as Sharia compliant by an independent board of Sharia scholars through a pronouncement (fatwa). The flexibility of these programmes in itself also poses challenges to structuring banks, as there have been ongoing discussions amongst scholars and practitioners about both the spirit and letter of the law. Although the infrastructure could in theory be used to simply give investors access to non-Sharia compliant assets, such as hedge funds or financial equities, a second layer of screening is imposed by most Sharia scholars, including Citi’s Sharia board, regarding the markets that investors are ultimately exposed to through the certificates. Recent trends Investors in the Middle East and Malaysia have understandably been driving the pace of Sharia compliant product development. There has however been a marked increase in interest from other regions such as Switzerland and the US as investor awareness and Islamic finance coverage increases. Regarding the popularity of different investment types, the risk aversion that is currently prevalent across markets seems to apply equally to the Islamic investor base. This means that full or partial capital protection and high levels of interim profit are sought after features. One of the most innovative Sharia compliant retail launches in recent months was a capital protected fund launched in major Asian retail market with assets structured by Citi, the first of its kind. The structure repays investors capital plus a fixed periodic profit rate, with additional upside potential dependent on the outperformance of the Citi Climate Change Opportunities Index over several other well known global equity indices. For investors willing to take some risk to capital and hoping to profit from a perceived bottom in equity and / or commodity markets, interim profit paying structures linked to these markets have been popular. These structures typically provide for high guaranteed or market dependent profit rates, and the possibility for early redemption in case of positive market performance. Capital is at risk in case of several market declines. Lastly, many investors are specifically interested in customised solutions to absorb liquidity, particularly since sukuk issuance has declined and secondary market liquidity is limited. These customised products range from simple floating profit rate certificates, where returns are linked to LIBOR, to capital protected strategies linked to quantitative commodity strategies. Conclusion Sharia compliant investing is an evolving area of business, both as investors and structuring banks gain sophistication in this field, and as the discussion regarding the permissibility of certain types of structures develops. Given the potential size of the investment base however, it is certain that this evolution will continue with a growing range of investment options available to investors. Marc Damoiseaux, CFA - CitiFirst, Structured Products Group