Islamic Funds: Characteristics and Shariah Compliance

Due to previous years' shortfall of information and the relative youth of the industry, Islamic funds are only now receiving substantial inflows, considering the vast wealth of their potential client base, as discussed in last month's edition. Disconnect between the consumer and the product can be attributed to structural deficiencies in the market and informational gaps, as well as the historically oblique nature of Islamic finance. More transparency, as with any developing industry, is needed to earn investors' confidence.

Despite the vague understanding the investing public has of Islamic funds, most follow a few basic precepts that should allow investors to dispose of hesitancy in positioning themselves with one of these instruments. These characteristics, as well as the general requirements of Shariah - the set of principles that governs all Islamic funds - are addressed briefly below.

Most funds target high net-worth clients because Middle Eastern countries, which form the industry's primary clientele, have large wealth gaps and therefore a relative minority of potential investors. The funds, which are concerned primarily with asset inflows cater to individuals who can help them grow into a globally competitive position, and thus have minimum investments of around US$10,000 initially (although the figure ranges from US$500 to US$1 million). Since Islamic funds target their local communities, the obvious choice for marketing is in the Middle East. It is this discrepancy of wealth between Arab and poorer Muslim countries that has resulted in the latter being overlooked by funds, which flock to oil magnates and wealthy inheritors for placements.

The market is young and does not boast a wide range of strategies or structured products. Most funds are simply invested long in global equities. A smaller percentage of these equity funds have positions in North American or European equities, while a still smaller portion maintain style (e.g. small cap) or sector specialisations (e.g. technology). Many equity funds focus on emerging markets, which seems intuitive when one considers the economic growth of many Islamic countries. Outside the Middle East, Malaysia has an aggressive campaign to emerge as a leading provider of Islamic investments and has turned out its fair share of products.

Outside equities, however, the market remains limited. The very nature of Shariah compliance precludes riba, or interest-base income; consequently, fixed income instruments are difficult to construct (let alone complex strategies such as short selling). Thus, only a few bond (Sukuk) funds exist. Going forward, Shariah regulations will limit the breadth of investment vehicles available; thus, diversification is likely to occur in equity funds, within sectors, styles and geographic markets, not in the structure of the instruments themselves. For instance, the first Shariah-compliant hedge fund opened last month, but only after two years of working around Shariah-compliance issues to achieve its desired strategy.

While these Shariah demands may seem obsolete or out of place in a world governed by the profit motive and a hindrance to an expanding industry, consider the following rather sensible and moral tenets of the requirements as they apply to investment managers:

The basic distinction Shariah makes is between haram and halal - forbidden and lawful practice. Economic innovation, competition and monetary gain, while all acceptable in their own right, should never come at the expense of society's welfare or basic moral obligations (a relevant and important demand given the recent corporate governance issues). An individual must not hoard wealth but instead distribute it or spend it in a conscientious fashion. Zakat, a form of charity applying to investment companies, requires Muslims to offer 2.5% of their annual salary to the poor.

In general, Shariah compliance requires mindfulness of a just and equitable society and is more a set of broad principles to guide Muslims than a detailed constitution preempting wrongdoers and specifying penalties. The discretion of adherence is turned over to the fund manager, and in return for this confidence requests ethical investment practice for the good of a larger social body.

Investing in its modern form is dominated by the world's western monetary epicentres that thrive on the concrete and the calculated, not an amorphous duty to a general code of ethics. An investing public inundated with such practices may struggle with the responsibility that Shariah requires, especially given the ease with which managers might circumvent hazy moral obligations. Shariah is therefore particularly important to understand for funds interested in this new investment frontier and in winning the trust of the investors who will precipitate its growth.