The journey towards absolute return

The period since the Malaysian government sold the first modern international sukuk (Islamic bond), in 2002, characterised by the rapid growth and rising sophistication of global Islamic finance, coincided with strong financial market performance worldwide. The shocks that have swept through the global financial system in 2007 and 2008 are, therefore, the first real test of whether Islamic finance can withstand a bear market and maintain its appeal to investors.

A central challenge for bankers in the field is that many of the conventional tools to achieve absolute return – such as swaps, options and short-selling – use techniques that contravene basic principles of Sharia law. Interest (riba) is forbidden, which rules out conventional foreign exchange (FX) forwards, or paying repo to borrow stock for shorting. However, Islamic scholars acknowledge the need for companies and long-term investors to manage their risks prudently, and are increasingly sympathetic to products that fulfil this purpose while adhering to Sharia technically.

Islamic structures cannot contain conventional interest rates so the basic building block, the murabaha, is a commodity sale transaction in which the commodities are paid for in advance at a fixed price plus an agreed profit rate. Sulaiman Moolla, head of Islamic treasury sales at HSBC Amanah in Dubai, says: “We use murabaha trades in a similar way that zero-coupon bonds are used to build conventional structured products. In a volatile market, capital-protected products have become more expensive, and that affects the pricing available for other Islamic derivatives.”

Under the principle of maisir, any speculative trading akin to gambling would also struggle to receive scholarly approval. This is an advantage in the current climate because it limits the potential for companies to take unnecessary derivatives positions that could result in heavy losses if the trade goes against them.

“Sharia principles have a natural tendency to protect companies from taking excessive risks,” says Mr Moolla.

With such difficulties in building corporate hedging techniques, the process of developing absolute return products for investors is more complex, given the Islamic disapproval of excessively speculative activity.

Nonetheless, a growing number of providers have built alternative investment platforms that allow Sharia-compliant investors to harness total return products equivalent to hedge funds. This approach could find favour with investors in a sustained market downturn. “It is always difficult to sell a hedge fund when a long-only position in the stock market is returning 40 per cent a year, but that has changed now,” says Philippe Teilhard de Chardin, global head of prime brokerage at Newedge.

Trading began on the Al-Safi Trust, a joint venture between Sharia Capital and Barclays Capital listed on the Dubai Multi-Commodities Centre (DMCC) in January, with a sizable $200m seed investment from DMCC. Deutsche Bank launched Al-Miyar, an open architecture platform for listing Islamic certificates, in the same month. BMB Group, the parent of BMB Islamic, aims to launch a new alternatives product entitled Share (Sharia Alternative Return Evolution) in the second quarter of 2009.

Knocked confidence

Although the natural conservatism of Islamic products has added appeal in current market conditions, the Madoff fund fraud has inevitably undermined investor confidence in hedge funds as an asset class. “We thought of including a number of hedge funds on the Share platform but now we have changed our composition to managed futures programmes that have performed well,” says Dr Humayon Dar, chief executive of BMB Islamic in London, who still hopes to roll out the platform on schedule.

Even so, there is agreement that the questions raised about highly leveraged banking and investment models will ultimately draw business towards Sharia-compliant products, especially given their emphasis on commodities exposure.

“DMCC is a longer-term investor committed both to Islamic finance and to building a commodity-backed asset management business,” says Ahmed Bin Sulayem, executive chairman of DMCC. “Irrespective of prevailing market conditions, we believe in the managers we have selected and the funds that have been built around them. Consequently, we’re confident in their ability to generate positive returns in both rising and declining markets.”

“The timing is excellent,” says Dan Rice, portfolio manager of the BlackRock Global Resources and Mining, which joined Al-Safi in November – one of four funds listed on the platform. “The darkest hour is always before the dawn. There is not so much visibility on the outlook at the moment, but markets will begin to discount renewed economic growth, which will lift the resources sector.”

This assessment is shared by Mr Hassan at Deutsche Bank, who is preparing to list the first certificate on Al-Miyar. “This is likely to be a simple, safe, commodity-linked product, as investors look to lock in at current low commodity prices,” he says. “Now we have put the resources into building the infrastructure, we will focus on the distribution to potential issuers on the platform, and to investors.”

HOW TO WIN INVESTORS

In contrast, Eric Meyer, chief executive of Sharia Capital, believes the distribution process needs to be built into the design, because of the challenges posed by the nature of the Islamic finance market. As scholars debate whether any of the available shorting and options mechanisms are strictly Sharia-compliant, some investment products failed to gain traction among investors. UBS folded its Islamic investment products subsidiary Noriba back into the rest of the bank in 2006, just four years after its creation.

Against this backdrop, Oracle Investment Management puts the total Islamic alternatives market at just $5bn, and some market participants believe this estimate is generous. This means the market is tiny compared with the $2000bn conventional hedge fund universe, or even the $70bn in outstanding sukuk issuance.

The reputation of scholars supporting a fund – often a three-member Sharia board – is vital to winning over the Islamic investing public. The Jeddah-based Organization of the Islamic Conference Fiqh Council, a religious body that carries de facto legal authority, has approved the use of the arbun mechanism for securities trading used by the Al-Safi Trust. The Sharia board behind Al-Miyar is much larger than Deutsche Bank’s usual oversight, and includes five scholars with which the bank has had no previous contact.

Moreover, given the fragmented nature of the Islamic finance market, Mr Meyer emphasises the importance of establishing clear support from the financial authorities in leading Islamic finance jurisdictions. In addition to the DMCC investment in Al-Safi, Barclays can bring to the table its own major shareholders in Qatar and Abu Dhabi.

Deutsche Bank is in talks with the Bahraini and Malaysian central banks to replicate country-specific versions of Al-Miyar, especially to improve the range and liquidity of short-term investment products for Islamic investors in those countries.

However, Mr Meyer also believes that the Islamic alternatives market as a whole has suffered from a lack of transparency among some participants. He is committed to making Al-Safi a good governance benchmark, asking: “Why should Islamic investors have to settle for lower standards of transparency, disclosure or reporting than everyone else?” In February, Al-Safi became the first Islamic alternative investment fund to publish its returns, and Mr Meyer is keen that investors should compare its performance to conventional as well as other Islamic hedge fund products. US law firm Skadden Arps carried out rigorous due diligence on Al-Safi, and custodial services are provided by Citco, one of the world’s largest fiduciary institutions.

Mr Suleyman emphasises that this combination was one of Al-Safi’s features that appealed to the DMCC. “There was a level of transparency and risk management we had not seen in another platform,” he says.

In the case of Deutsche Bank’s Al-Miyar, Allen & Overy built a structure that would allow listing in the UK and Luxembourg. “These products need to be robust enough to stand up under English and Luxembourg law principles. Then on top of that, Sharia is an additional layer of compliance that you need to build into the structure,” says Allen & Overy’s Ms Uberoi.

The cost of compliance

This preparation is inevitably expensive. Mr Meyer says the set-up costs for Al-Safi, which he estimates at $10m, far exceeded his initial expectations. From an investor perspective, this can also translate into a lower-end return because product fees are high. Mr Hassan says the high set-up costs for Islamic fund products are precisely what should draw business to Al-Miyar, due to its open architecture approach. Several international investment banks are already expressing interest in listing their products on the platform. “It is a win-win situation, we will be able to offer a broad range, and for the other banks, they save on the money we have spent to develop technology that incorporates the latest Sharia thinking.”

As the market develops and Islamic products become more standardised, fees should begin to converge with conventional markets, although the frictional costs will remain higher due to the structural complexity necessary to be Sharia compliant.

Philip Alexander is finance editor of The Banker

Sulaiman Moolla, HSBC Amanah