An increase in cross-border transactions is one important manifestation of globalisation. In financial services, as in other fields, globalisation can be seen as a process that opens up national economies and markets, enabling knowledge, technology, ideas, services and capital to move more easily and quickly from country to country, and widening the extent and form of cross-border activities. In this respect, a distinction can be made between globalisation and internationalisation. Globalisation may be viewed as the catalyst for change, to which firms and institutions respond by becoming more international in their operations.
In Islamic financial services, a leading example of this process comes from the growth of cross-border transactions due to the expansion of Islamic investment funds. Fund management of this form has become a large growth segment for the Islamic financial sector; all the more so because Islamic investment banks, unlike their Western counterparts, do little M&A business or trading activity and have made wealth management and mutual funds a principal focus.
At a global level, as Alan Greenspan has argued, ‘home bias’ (the preference for geographically proximate investment opportunities) has been on the decline in the past two decades, and the increase in investment rates and cross-border activity in investment funds is consistent with diminishing risk compensation on overseas investments. This trend is indubitably derived from investors’ recognition of the importance of diversification in their investment portfolio to reduce risk for the purpose of increasing return.
Islamic investment funds as one of the asset classes also have the potential to generate capital from investors (both individuals and institutions) to be invested in different markets, with different market growth performance and financial instruments. In this way, the funds can promote ethical and moral values in the worldwide capital market. With their expansion in different regions including the Middle East, the Asia-Pacific, North America and Europe, Islamic investment funds demonstrate a prospect for investment across these regions and other global markets.
In expanding investment across the different countries, with different cultures, legal jurisdictions and financial market volatility, it is important that investment funds ascertain that the capital of their fund holders be well protected. The twin issues of the protection of the investment capital of these funds and gaining the confidence of the fund holders are among the challenges that must be faced by these funds to encourage the expansion of their investment.
Trends in the Growth of Worldwide Islamic Investment Funds
Islamic investment funds, unit trust funds and mutual funds based on the Islamic Financial Services Board (IFSB) are placed under the Islamic Collective Investment Scheme (ICIS). There are several types of Islamic investment funds including equity funds, Ijarah funds, commodity funds, real estate funds, Murabahah funds, money market funds and mixed funds. These various funds embody very different patterns of returns, a feature that is of considerable importance in times of financial turmoil.
Ijarah and Murabahah funds offer virtually fixed returns being based on fixed leasing charges on capital equipment on hire purchase and cost-plus profit rates respectively, while equities necessarily are exposed to greater market volatility in the short run and need to be seen as an investment for the long term. Funds which specialise in real estate development (many structured as private equity) offer a different balance between risks and returns again. Hedge funds are becoming one prospective fund category in the industry, though there are several arguments on their permissibility among the scholars.
Of the different types of Islamic investment funds, those involving equity investment comprise more than 50% of the total funds. The current market trend shows there has been expansion of these types of financial vehicles since their development in the 1980s. From 161 Islamic investment funds in 2006 (not including money market funds), this number in 2007 was estimated at 480 funds (including all types of Islamic investment funds) in the worldwide financial industry, showing great interest among the investors to be involved in the capital market.
This tremendous growth parallels that of the Islamic financial market generally. Assets under management of Islamic financial institutions were estimated at over US$360 billion in 2006. Furthermore, Islamic financial services are offered in 70 countries, including non-Muslim ones. Based on this current development, there is a possibility that their investment can be expanded to the global capital market, rather than only focusing on the local market, although current conditions in world equity markets are likely to interrupt this longer term trend path in the case of Islamic mutual funds.
Cross-border financial services between Muslim countries are not unknown in the Islamic financial industry. In Malaysia, for example, cross-border links can be seen with the opening of branches by Kuwait Finance House (Kuwait’s leading Islamic bank) and al-Rajhi Bank (the largest Islamic bank in Saudi Arabia) in 2005 and 2006 respectively. This trend can also be seen in cross-border investment by Islamic investment funds, in which these funds are investing in the international capital market.
The inter-government reciprocal agreement on cross-border investment highlighted the importance of the activities of the Islamic investment funds. There is an agreement between the Securities Commission Malaysia (SC) and Dubai Financial Services Authority (DFSA) to enhance the activities of the Islamic investment funds through distribution and investment transactions between both countries, with low regulatory bureaucracy. However, the aim to enhance the investment may not be achieved if the investors (fund holders) are not confident that their capital is well protected or that the investments comply with Islamic principles.
Such developments, especially among Muslim countries, have the potential to be expanded further. Islamic investment funds (through their fund managers) can play an active role in encouraging the growth of capital, and for monies to be invested in the international market. In this way, the large amount of capital from the rich Muslim countries can be transferred to other countries that can offer high profits, with the investments made following Islamic principles.
Challenges to Islamic Investment Funds
If Islamic investment funds, operating as separate entities from their fund managers and sponsors with their large stakes, are to play their roles to promote cross-border investment, and thus help the investors (fund holders) create wealth based on Islamic principles, one issue warranting attention is how these funds can gain the confidence of the investors who want to earn licit profit by making an investment based on Islamic principles.
Another is that these investors do not want their capital to be exposed to unwanted excessive risk. Lack of investor confidence can lead to the withdrawal of the invested capital by the investors, as in the financial crisis of 1997 and 1998, which saw a reduction in cross-border investment. A concern about investor confidence was reflected in government-led reforms, such as in Malaysia after the regional financial crisis of 1998.
Given that investments are made in a number of international geographical areas with which local investors are not familiar, these investors may be unwilling to place their capital in Islamic investment funds that operate under this purpose. They may prefer to invest in funds that only include local equity and other securities, to which they are more exposed. These challenges thus must be dealt with by the funds.
Gaining the investors’ confidence is needed to encourage their involvement in these diversified forms of funds, thus expanding these fund’s activities. The reluctance of investors to participate in cross-border investment can be overcome if Islamic investment funds (through the sponsor or fund managers) play their roles effectively, and this can be done for example through precise compliance with Islamic principles and reducing the information asymmetry between the investors and the funds.
Islamic investment funds as the fiduciaries accordingly must reflect their obligations towards their investors and thus must invest based on Islamic rules. These include the four main prohibitions on riba (interest), gharar (uncertainty), maysir (gambling), and in companies that produce certain haram goods, such as alcohol and pork. Building on these prohibitions, the roles of these funds must be strengthened in ensuring their investment portfolios comply with Islamic teachings. In this case, evaluation of the financial securities included in the investment portfolio must be made continuously to ensure that their investment does not violate the Islamic precepts. The roles to comply with the Islamic principles here are considered as accountability of funds towards their investors.
There are several ways by which the information asymmetry from Islamic investment funds to the investors can be further reduced to enhance investor confidence, notably improving the transparency and disclosure of Islamic investment funds’ information. In this context, Islamic investment funds as institutional investors must be open in their investment processes and thus show the investors actual and accurate information, so that they know how the funds are managed, and the potential and actual financial performance of their investment capital.
There is standard information provided by funds to the public or their investors related to investment objectives (depending on the type of funds), asset allocation, potential risk, financial performance, etc. However, the information supplied to the investors could be enhanced by including other elements such as the potential risk of investment in the different regional capital markets, and the mechanisms for dealing with those risks. Rather than just giving the information of the benefits of investment in different capital markets, information on current market situations, in which they made their transaction, should also be provided.
In this case, providing extensive information to the investors can reduce insecurity among the investors, and provide them with an understanding of the types of investment in which they are involving themselves. Muslims cannot be disinterested investors, and on moral and religious grounds need to familiarise themselves with the types of investments they are undertaking. This requirement puts commensurate obligations on those operating the investment funds to increase the flow of information that is provided to the investors.
Islamic investment funds need to be responsible and accountable fiduciaries towards their fund holders, and be transparent in their investment process. The disclosure of information, financial performance and market conditions in the capital markets in which they focus their investment can enhance investors’ confidence in these investment funds. In this case, the investors with insufficient information on different capital market situations can readily assess the information from their prospectus and fund management companies’ websites without necessarily searching for the information themselves.
The fulfilment of their fiduciary duties towards fund holders in preserving their fund holders’ investment objectives and disclosing sufficient information can promote and encourage the involvement of investors in these types of funds, while enabling the participants to meet their religious duties as involved Islamic investors.
This article first appeared in Islamic Finance news (Volume 5, Issue 41).