“Following corporate accounting scandals in the US and the string of rulings in the US and Europe that have made investment banks increasingly liable for corporate scandals, financial institutions too have been forced to take stock of their operations, accountability and compliance procedures.”
DUBAI, 3 March 2003 — The $600 billion conventional hedge funds industry has in the last two years retrenched significantly, with an increasing number of such funds — especially the popular long-shorts — either closing or merging due to a lack of performance and redemptions. A few years ago the then US President Bill Clinton had to bail out investors in US hedge funds to the tune of billions of dollars.
Following corporate accounting scandals in the US like Enron and WorldCom, and the string of rulings in the US and Europe that have made investment banks increasingly liable for corporate scandals, financial institutions too have been forced to take stock of their operations, accountability and compliance procedures.
But despite this, the pressure on bankers to engineer new and often highly-risky products especially in the fixed-income space, including derivatives such as options and futures, bonds and other issues, and securitization, continues to grow. Financial engineering over the last few decades has been synonymous with high risks and often high rewards, but also with spectacular collapses, scandals and fraud, fueled by a self-nurturing and inevitably self-destructive greed.
It therefore seems curious that the $200 billion or so Islamic finance industry is also trying to develop such products as Shariah-compliant hedge funds. Conventional derivatives such as options, futures, and short-selling are proscribed in Islamic banking because they involve riba (interest), gharar (uncertainty), and speculation. Of course, financial innovation or engineering is not the monopoly of the conventional banking sector. Islamic finance is only too aware that product innovation is currently a poor relation, and therefore many Islamic financial institutions are cooperating with conventional institutions in developing value-added products for liquidity management; bonds, project and structured finance, leasing, and investment funds.
But are Islamic hedge funds possible? Judging by recent announcements in the sector it seems so, although these revelations have either been long on hype and short on substance, or at best exploratory.
At a recent Islamic banking conference in Dubai, Dr. Mohammed Khalfan ibn Kharbash, the UAE minister of state for finance & industry who is also the chairman of the Dubai Islamic Bank, the oldest commercial Islamic bank in the world, warned that “highly engineered finance is not necessarily sound finance. Islamic financiers must be aware of the dangers of creative accounting, creative structuring and of over-engineering contracts for the sake of raising margins rather than efficiency gains. Innovation must be a genuine response to investor needs that reaches Shariah compliance and not simply unnecessary layering of products. If the Islamic finance industry is to embrace the new mind-set that has hit the global investment community, it must embrace the underlying investor needs that created it.” In January this year, Shariah Funds Inc., a division of Meyer Capital Partners, a US-based investment management firm, claimed that it is “the first Islamic fund of hedge funds.” The fund was to have been unveiled at the Dubai conference, but the promoters failed to show up. Shariah Funds Inc., according to the promoters, will allow hedge fund managers to use options and short selling in their portfolio management compliant with Shariah investment principles.
Shariah Funds Inc. CEO & President Eric Meyer is coy about how exactly this would work and which underlying Islamic financial structures it is based upon. More worryingly, Meyer’s assertion that the Islamic hedge fund market could be worth trillions of dollars is more to do with hype and betrays a fundamental misunderstanding of the global Islamic finance industry.
The fund hopes to raise $500 million of starting capital, with no cap on assets under management, and liquidity provisions will follow standard fund of fund restrictions. The aim is to run the Islamic hedge fund like an index, monitoring stocks which are Shariah-compliant and can therefore be included in the underlying funds’ portfolios on an on-going basis. How this will be done needs some explanation, and some say convincing. There are currently only two Islamic index funds and they have failed to make an impact in this niche sector.
Shariah Funds Inc. has one of the senior Shariah advisory boards in the business, including Sheikh Nizam Yaquby of Bahrain and Shaikh Yusuf Talal de Lorenzo of the US. A third advisor is from Saudi Arabia. Yet, Shariah Funds Inc. hitherto could not find a way in giving structural substance to its claims that it has perfected a Shariah-compliant hedge fund product. No-one expects Meyer and his colleagues to give proprietary information, but at least a basic outline of the product would have gone some way toward keeping the cynics at bay and enhancing the credibility of the product.
Contrast this approach to that of Yusuf Khayat, senior vice president at Jeddah-based SEDCO (Saudi Economic Development Company), who not only confirmed that the company — in conjunction with its investment advisor Permal Investment Management Services and its Shariah advisory board — is in the process of developing an Islamic hedge fund product, but also opened “the black box” by revealing how this might be possible by basically using the Salam contract to synthesize forwards and futures based on stocks where the price of the shares are determined and paid up-front, and the shares to be delivered at an agreed future date.
SEDCO, together with Worms & Co., promote a seven-strong Islamic investment fund family, Al-Fanar, whose Global Investment Holdings is the second largest Islamic equity fund in the world and last year was one of the best-performing, out-performing both the Dow Jones Islamic Market Index and other conventional benchmarks.
Although SEDCO’s approach is exploratory at this stage, compared with Shariah Funds Inc.’s supposed imminent launch, there are several factors that would need clarification regarding Islamic hedge funds. Islamic investors are notoriously short-term in their outlook. As such long “lock-in” periods for Islamic hedge funds would be difficult to sustain. Islamic investors also tend to be risk-averse but very price-conscious. With conventional hedge funds fees and share of profits averaging 2 percent and 20 percent respectively, will they be eager takers of these hedge fund products?
Shariah-compliant equity funds have restrictive investable stock universes because of stock screening and the various Shariah filters relating to proscribed industries and acceptable financial ratios.
