Alternative Construction

Devout Islamic investors have by and large kept themselves at bay from hedge funds. Consequently, most managers of full-fledged Islamic banks shy away from investing their proprietary money in hedge funds and get additionally nervous on the prospects of having to sell an Islamic hedge fund.

The performance of Islamic hedge funds has also not helped to change this negative attitude towards this asset class. The most widely publicised success story of Islamic hedge funds is related to the Al Fanar Islamic hedge funds, managed by the US fund management company Permal (and seeded by Saudi Development and Economic Company (SEDCO)). Their performance, however, remains at best mediocre. Although the four Islamic hedge funds launched by Dubai Shariah Asset Management (DSAM) – a joint venture between the US-based Shariah Capital and Dubai Multi Commodities Centre (DMCC) – have done fairly well since their launch last year, they have not been able to attract wider investments beyond the seed capital of $50 million each provided by the Government of Dubai. This is primarily due to some widely publicised failures and frauds in hedge fund industry in the West. Negative publicity of short-selling, following its suspension on a number of Western financial exchanges, and other similar factors that are deemed as responsible for accentuating the current financial crisis have also not helped the cause of Islamic hedge funds.

Private equity (PE), on the other hand, has flourished in the emerging markets, including the Middle East and North Africa (MENA) region, where Islamic investors have over the last two decades assumed significance and influence. Pioneering PE companies like Emerging Markets Partnership (EMP) and following its success, a number of other firms have emerged in the Middle East offering Islamic as well as non-Islamic PE.

Islamic PE is a recent phenomenon in the Islamic markets, especially in the Middle East in general and the Gulf Co-operation Council (GCC) area in particular. In Malaysia, another important Islamic financial market, the size and number of Islamic PE transactions remain small. However, there are now some serious players in the Islamic financial market in the East (Malaysia, Brunei and Singapore) who contemplate setting up Islamic PE platforms for the ASEAN region. In the GCC region, it is fast emerging as an important asset class, in line with a growing trend in favour of alternative investments in the region. According to some estimates, alternative investments by ultra high net worth individuals in the GCC region grew by over 22% in the last seven years. Islamic PE is rapidly assuming importance in this growing sector. Out of about 60 Middle Eastern institutions involved in private equity, at least 20% have in the recent past practised Islamic PE.

Although Islamic investment banks in the region have for some time been involved in PE deals, establishment of Islamic PE funds is very recent. Since 2006, there has been significant growth in Islamic PE funds in the region both in terms of number and size. The reason for this late entry of Islamic finance into PE is primarily explained by relative less exposure of the region to local PE deals. This is not to say that the region did not have exposure to the PE deals at all. In fact, until the mid-1990s Middle East was the second largest source of capital for the international PE funds. Most governments in the GCC area had significant investments in PE funds and deals in the West. It is, however, recent that the region has witnessed the growth of PE funds (conventional and Islamic) managed by the local management companies.

The third important alternative asset class is real estate. The current downturn in the real estate in the GCC countries (particularly in Dubai and Kuwait) has, however, confirmed Islamic finance's over-exposure to this asset class.

Among the three above-mentioned alternative asset classes, the latter two fit well in the Islamic culture. Hedge funds are at best misunderstood and mostly considered as an untamed horse. Many Islamic investors would like to be in love with it but would refrain from riding it, fearing injury and collapse.

It is interesting to note that Shariah concerns surrounding hedge funds have by now been resolved with the help of an increasing number of scholars. There are now more than one Shariah-compliant ways of short-selling, a technique crucial to long/short Islamic hedge funds. The days are gone when Shariah scholars would not understand the mechanics of short-selling and hence, would take the conservative stance of disallowing it. There is now a growing recognition that short-selling is not a Shariah concern, if done properly. It is deemed a regulatory issue. If the regulator is happy with Shariah-compliant short-selling, then it should also be acceptable by market players.

Islamic Structured Products

Nevertheless, many Islamic institutional investors and high net worth (HNW) families have shown to accept structured products offering economics of hedge funds, sometimes with principal protection and at times without it. Most of the successful offerings of Islamic structured products have been those offering exposure to commodities. Since 2005, when Deutsche Bank sold a commodity-linked Islamic structured product referenced to platinum, aluminium and crude oil to Abu Dhabi Commercial Bank, a number of similar products have emerged on the scene. Given excellent performance of some commodity futures programmes during the current economic downturn, Islamic structured products built around commodities must attract investment from the savvy Islamic investors who are used to earning high returns.

Islamic structured products in themselves are a growth area in Islamic alternatives domain. A number of Islamic as well as conventional banks now offer a variety of Islamic structured products, covering traditional and alternative asset classes. These Islamic products are being offered in three forms – structured deposits, structured notes and certificates, and hedging solutions. The structured deposits are primarily offered to premier clients of Islamic banks. The structured notes are sold as over-the-counter securities or through exchanges like Dubai International Financial Exchange (DIFX) and Luxembourg Stock Exchange. With the prospects of a fully-recognised Islamic derivatives market in Kuala Lumpur, exchange tradability of Islamic structured products is bound to improve. Islamic hedging solutions are being offered by a number of Western investment banks in the form of profit rate swaps, currency swaps and other Islamic derivatives.

An attractive feature of these structured products is that they offer principal protection – something highly desired when the general market trend is downward. They became immediately popular amongst HNW clients of banks like Dubai Islamic Bank (DIB) when it started distributing Islamic structured notes manufactured by Western banks.

Another more important reason for their popularity is that selling these products represents a natural progression to what Islamic banks have been doing for last three or four decades. Profit sharing investment accounts (PSIAs), especially unrestricted, offered by Islamic banks are very much in line with the underlying structures of Islamic structured products. Based on the principle of mudaraba (an investment management agreement that allows Islamic banks to offer variable returns deposits), PSIAs behave very much like principal-protected structured products.

Shariah Issues

There are two broad categories of Islamic structured products on offer in the market. First, the so-called A-Z Shariah-compliant structured products, with both the structure and the underlying fully Shariah–compliant, and second, the so-called Islamic bridge products with a Shariah-compliant structure exposing investors to economics of non-Shariah underlying assets.

There has been a steady rise in popularity of both these types in the recent past. Western banks tend to specialise in the Islamic bridge products while the likes of CIMB Islamic (and some other Islamic banks) prefer to favour the purer form. It is interesting to observe that the use of Islamic bridge products is on rise, despite their criticism by some Shariah scholars.

Some analysts have rather naively criticised the use of wa'd (undertakings) in Islamic structured products. Although Deutsche Bank was the first bank to explicitly base its Islamic structured products on wa'd, the use of this extremely useful concept has helped the Islamic financial services industry for long. In fact, almost all Islamic financial products have to rely on wa'd to make the underlying structures legally binding. From retail banking operations of murabaha, ijarah-wal-iqtina (hire purchase) based Islamic mortgages to sophisticated products like Islamic put-options, short-selling, swaps and other derivatives actually use wa'd to affect the economic outcomes these products aim at emulating.

Following the false controversy created over the use of wa'd in Islamic structured products, the use of wa'd in such products' structure has become implicit. The master murabaha agreements used in such products are indeed no more than unilateral and independent undertakings (ma'd) to buy and sell on the basis of murabaha by the transacting parties.

Islamic structured products are going to assume increased importance in future in wake of slowdown of sukuk issuance and their popularity. Since the start of 2008, the global sukuk issuance has witnessed a steady decline. This, along with some Shariah concerns around practices like tawarruq or commodity murabaha (a recent resolution by the International Fiqh Academy of the powerful Organisation of Islamic Conference (OIC)), is bound to pave the way for further development of Islamic structured products, which may effectively be used as liquidity management tools – something like an Achilles' heel for Islamic treasury operations. In fact, Deutsche Bank's Al Mi'yar platform (launched in January 2009) aims to address the core issue of Islamic liquidity management by offering tradable Islamic money market products/securities settling with short settlement cycles (T+0). This should enable the issuance of overnight products or other short-dated money market instruments and hence, enhance the liquidity of the Islamic money markets. Moreover, Islamic structured products listed on the DIFX TraX Platform offer a potentially excellent opportunity to develop a comprehensive framework for Islamic liquidity management. This will certainly diversify Islamic money market instruments, if it does not entirely replace the existing commodity murabaha practices.

The principal-protected Islamic structured products on global equities and other assets foreign to Islamic investors in different countries are attractive only when domestic or regional markets are not doing well. Once, for example, the GCC equity market is buoyant and the real estate has come out of current sickness, Islamic structured products with foreign underlying assets will get marginalised by the local structured products, even if they may not offer principal protection.

Islamic investors have a strong pecking order – invest locally, then regionally, and then either go eastward or to Africa, especially North Africa. If nothing interests them in these regions, they go for the Western assets and this is where they look for principal protection. Those institutions which are looking to use regional assets/indices as underlying of Islamic structured products may wish to try offering products that are not principal protected, as Islamic investors feel comfortable in taking local risks rather than venturing into foreign risky assets.

This article first appeared in Global Investors Magazine (July/August 2009 issue).