Alternative investments: New sharia-complaint products tap rising demand

14 September 2008
Alternative asset classes are widening the Islamic investment pool, but most new funds are likely to continue focusing on equities, leaving investment in cutting-edge products to the specialists.

Islamic funds are set to grow in both value and number as fund managers and product producers seek to tap into the emerging sharia-compliant alternative investment market. Finance houses are launching Islamic hedge funds, real estate funds, private equity funds and funds of funds for an increasingly sophisticated consumer base, dominated by GCC investors.

By 2010, the potential annual revenue pool for Islamic asset management will rise to $2bn, from $1.3bn in 2007, according to the 2008 Islamic Funds & Investments Report from analyst Ernst & Young.

Fund managers say the broader range of increasingly sophisticated and innovative Islamic products will encourage a wider take-up among investors, challenging the traditional dominance of equity funds in the Islamic investment sector.

“Islamically-compliant investment funds have gained traction in the past decade as investment businesses such as ours realise that economies of scale and profitability can be achieved in this space,” says Irfan Khan, head of global asset management at HSBC Amanah, which provides HSBC with sharia-compliant banking products.

Tax incentives

To date, sharia-compliant investment funds have had a mixed track record, with the majority being targeted at the region’s high net worth individuals and larger corporate institutions. In some instances, local investors are choosing to invest in sharia-compliant products for essentially defensive purposes, as a way of getting around paying the Islamic tax known as zakat.

The Islamic fund market remains small, with fewer than 500 sharia-compliant funds in existence in 2007, according to Ernst & Young. But by 2010, the analyst predicts the market will almost double in size to 950 funds, with 160 being launched each year.
In response to these growth predictions, regional authorities are forming alliances with Western fund managers, and it is these relationships that are driving the development of a fresh range of products.

One of the biggest of these alliances was launched in June when Barclays Capital teamed up with the Dubai Multi Commodities Centre Authority (DMCC) to launch five sharia-compliant hedge funds on the Al-Safi Trust alternative investment platform.

The Al-Safi platform was created to trade specifically in Islamic products in the alternative investment market, on the premise that it vets all investments for compliance with sharia rules. DMCC invested $50m in the five companies managing the Dubai-based sharia-compliant hedge funds.

Demand for alternative investments is growing, says Barclays Capital, which is developing products to open up the market. “If you look at sharia-compliant financial instruments, you find sukuk [Islamic bonds], long-only equity exposures, some real estate applications and a few private equity funds, but that is pretty much it,” says Frank Gerhard, head of fund-linked derivatives strategy at Barclays Capital. “What you do not see is a solution that provides a diversified, easy-to-tap-into source of alternative investment.”

The first sharia-compliant hedge fund was launched in early 2007 by international brokerage NewEdge, with seed investment by Saudi Arabia’s NCB Capital. The asset class is growing. Earlier this year, London-based fund manager Emiri Capital launched the Emiri Equity Alternative Strategies Fund, a sharia-compliant, global equity long-short fund of funds. Deutsche Bank and Bank Al-jazira are also preparing to launch Islamic derivative products.

Hedge funds

The structure of an Islamic hedge fund is not the same as its Western counterpart. Where Al-Safi invests in US equities, an additional layer of screening is undertaken to ensure investments meet sharia criteria. “Out of these individual funds you can put a fund of funds together, but really it goes beyond that,” says Gerhard. “It is a trading environment that appeals to blue-chip managers such as Black Rock and Ospraie, which are multi-billion-dollar outfits.”

Islamic hedge funds are still controversial in the Middle East, given Islam’s strictures against selling anything that is not owned. Fund managers are therefore being creative. London-based sharia adviser BMB Islamic claims to have a mechanism that allows sharia-compliant investors to participate in conventional hedge funds in the region. Under the mechanism, a separate sharia-compliant fund trades commodities and tracks an index of the conventional fund.

It is still early days, however, and Islamic hedge funds may struggle to match the success of more established sharia-compliant investment products. For example, there are 120 Islamic mutual funds in Saudi Arabia, accounting for 55 per cent of the total assets under management in the kingdom.

“Equity mutual funds dominate the Islamic investment space as investment in equities or equity mutual funds best fits the Islamic financial model of getting compensated for sharing the risks of a business,” says Khan.

Sector-specific Islamic funds, such as real estate, retain a strong appeal among regional investors. HSBC Amanah’s Global Properties Income Fund is the largest Islamic real estate fund. First launched in 2002, it has now raised $667m in investor equity, owning 83 properties, with a market value of $1.76bn.

Real estate will remain an active investment sector, as it helps diversify portfolios away form the energy sector. In August, Kuwait’s Global Investment House (GIH) launched the Global GCC Real Estate Fund II, a $500m sharia-compliant real estate fund.

Private equity funds are also increasingly important in Islamic investor portfolios. In June, GIH launched the $500m Islamic Buyout Fund, which is designed to give investors access to the asset class across the region.

Conventional funds

The Islamic Buyout Fund is an attempt at imitating a conventional fund. “These kinds of funds will emulate a conventional fund but use a filter to remove investments that do not meet sharia standards,” says Mark Stanley, assistant manager of Ernst & Young’s Islamic Financial Services Group. “The result is a private equity fund that complies with sharia principles and benefits from the expertise of a conventional fund manager. It reflects a growing realisation that liquidity in this region is sharia sensitive.”

Mainstream funds of funds are unlikely to face the obstacles encountered by, for example, Islamic hedge funds. Saudi Arabia’s Jadwa Investment launched three funds of funds in March, giving investors greater diversification of asset classes, markets, risks and managers. Fund of funds’ assets can be spread into equities, real estate, private equity, sukuk (Islamic bond) and murabaha (Islamic financing), offering a balanced investment.

But such funds do face challenges, notably bringing in the fixed-income element of conventional products. “It can be hard to place fixed-income funds largely due to the inflationary environment in the Gulf,” says Stanley. “With high inflation in many countries, it is difficult to offer products that target 5 or 6 per cent returns.”

HSBC Amanah’s Khan says difficulties in structuring economically viable and truly sharia-compliant fixed-income-oriented mutual funds has resulted in the Islamic investment market developing in a vastly different way to that in the US, where bond and equity funds follow the asset allocation model of a typical investor, in the range of 60/40 or 70/30.

Innovation is important for Islamic fund managers, but the simpler ideas are often more attractive for investors. Some features of conventional alternative investments, such as risk-adjusted returns, pose problems for Islamic product producers.

“We like to avoid such product innovation,” says Khan. “Our focus is achievement of the investment objectives of our investors, not product innovation.”

Other alternative investments include exchange-traded funds (ETFs), which are effectively shares that collectively behave as a fund.

Barclays Global Investors launched three Islamic ETFs in December last year, which are listed on the London Stock Exchange. It will be seeking to launch additional Islamic ETFs over the next 12 months. The key advantages of ETFs are the low costs and the ease of trade, making them more appealing to the retail market.

According to Khan, investors from the Gulf act as the anchor for Islamic funds, which can then be offered elsewhere, where economies of scale are not achievable independently.

In recognition of this, Gulf institutions are launching products with a wider geographic reach. The Bahrain-based Family Office as launched a fund trading on London’s Alternative Investment Market to serve Islamic clients in the Middle East who want to invest in a broad mix of strategies, providing investors with exposure to a variety of sharia-compliant investments largely outside the GCC.

Investment strategies

New Islamic funds are likely to remain focused on equities, despite the clamour for new asset classes. “There is some demand for esoteric strategies such as hedge funds and private equity funds among high net worth individuals, as these investors are generally more sophisticated than the average investor and have knowledge or investment exposure to these strategies in the traditional space,” says Khan. “However, this demand has not trickled down to the retail space, where the level of understanding and appreciation of these strategies is not very deep.”

The development of new products will be slow but steady. “We have seen a lot of insular investment strategies: individual fund managers pioneering solutions under their own efforts and then investors on the buy side invest into that solution,” says Gerhard. “Going forward, we will see more platform solutions such as Al-Safi, where the set-up is taken over by an investment bank and the investor only needs to vet the platform once.”

Key fact:

$2bn - Predicted annual revenue pool for Islamic asset management by 2010

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