Samira Mensah, fund analyst for Standard & Poor's

Islamic funds performed well in the credit crunch and last year Islamic finance even gained the support of the Vatican. Politicans are now recognising that sharia-compliant principles could assist in avoiding another financial crisis. Writer Silvia Pavoni

Although difficult to measure, experts estimate that Islamic investments have to date attracted between $700bn and $1000bn globally. All agree, however, that the market has been growing fast, at a rate of between 5% and 7% a year over the past 10 years, thanks to a larger and richer investor pool.

Despite having become somehow fashionable - to the point where, in March last year, the Vatican not only paid notice to Islamic finance, it also applauded its ethical philosophy - sharia-compliant investments are still mostly of interest only to the Muslim communities, and the Gulf Co-operation Council (GCC) region and south-east Asia are home to the largest pools of Islamic investors.

These pools are growing fast, with assistance from higher oil prices that have increased the wealth of the GCC region. Such growing numbers have been good news for organisations that are keen to tap a new source of investor and diversify their funding. This has led to an interesting growth in sukuk issuances (sharia-compliant bonds) by a larger number of Western banks, companies and governments since the beginning of the credit crunch in 2007, while sukuk issuances globally increased by 40% in 2009, according to data provider Eurekahedge.

If Islamic finance offered some much-needed diversification during the tough times at the beginning of the financial crisis, what are the prospects for Islamic investments over the next, hopefully less disruptive, years?

The way forward

Traditionally oriented towards cash holdings, equities and real estate investments, Islamic investors have not resisted the appeal of more sophisticated sharia-compliant ways of channelling their savings. Sukuk and even convertible sukuk have become increasingly popular through the years, particularly thanks to the development of the financial engineering abilities of financial centres such as Dubai.

Investing in companies that are deemed ethical, with acceptable levels of leverage, and in instruments that are very close to the underlying assets - which constitute the philosophy of sharia investing - have contributed to the attraction of Islamic funds.

Further, high-profile sukuk carried out by issuers such as US multinational General Electric, combined with the fact that Islamic funds have outperformed conventional mutual funds during the financial crisis, have brought this area under the spotlight.

The positive correlation and overperformance of certain Islamic fund indices, such as Eurekahedge's, against the Dow Jones World Sustainability (DJWS) Index over the past decade shows that investing in sharia-compliant companies and products can be more profitable than investing in social development-related or climate change-related companies. Of course, one must also bear in mind that many Islamic funds are invested in the Middle East, a region that has outperformed the more developed markets to which the DJWS index constituents allocate investments.

Islamic funds by domicile

Islamic funds by domicile

Islamic challenge

Despite such successes, Islamic funds present their own challenges. If they scored relatively well during the credit crunch - limited use of leverage in their investments came in handy when there was a shortage of credit going around - these funds do not necessarily perform as well in more buoyant economic conditions, when higher levels of leverage amplify businesses' success. Also, although they suffered less than most, Islamic funds were still hit by the financial crisis, and while details are hard to find, some reports suggest there has been zero growth in assets under management for Islamic funds in recent months.

Although tapping on a growing investor pool, individual fund managers are still battling with growing their operations enough to reach scale and attract the many fragmented investments, which tend to come from the retail space.

"While there is always much talk about the 'potential' for sharia-compliant funds, the reality is that growing assets and reaching scale have been a big problem for managers," says Mark Smyth, head of the consultancy Failaka Advisors. "Many managers are readying new products and working on their distribution in the hope that prospects will improve in the fourth quarter and into 2011."

According to Mr Smyth, the market would benefit from a larger presence of institutional investors that could channel substantial amounts of money in specific products. "The biggest challenge [for Islamic funds] remains distribution; in short, finding clients," he says. "At present, the market is very retail oriented, which can be a strength for those willing to put resources behind their sales efforts; for those looking for quick big-ticket investments from institutions, launching a sharia-compliant fund can be a frustrating experience."

The effects of the financial crisis reached the Middle East with a very specific secondary contagion. Many Islamic investors, who tend to favour investing in their home region, got burned by the Dubai World debt slowdown due to the collapse in real estate prices. This has led to investors worrying about the creditworthiness of their Islamic investments, which, depending on the domicile of the fund, have very different reporting and transparency requirements.

Malaysian funds, and the handful of funds that are starting to appear in the Luxembourg and Irish markets targeting offshore Muslim investors, have more solid and stringent reporting requirements. The ones from GCC countries operate in a much less transparent and ad-hoc way, according to some experts.

"We have seen a number of investors asking their investment manager to have their fund rated after the [financial] crisis, especially after the troubles with Dubai World," says Samira Mensah, fund analyst for Standard & Poor's, which for the first time recently rated a Luxembourg-based sharia fund for Islamic investment bank European Finance House.

Steps have been taken also to increase harmonisation in those GCC countries, where in the past decisions on the admissibility of a product could vary according to the different sharia boards that each financial institution would refer to.

"Malaysia and some countries in south-east Asia have established a central sharia authority. You don't have this approach in the GCC countries," says Fares Mourad, head of Islamic finance at Switzerland's Bank Sarasin. "The GCC is trying however to find a general standard of supervision. If you ask the GCC for a banking licence, it would reply: 'Do you have a sharia board? What is its situation? How neutral is it? Where is it placed within the organisation? There is an increased observation on Islamic finance activities."

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Bassem Snaije, head of the Middle East and north Africa for HSBC Private Bank

Slow progress

Mr Smyth agrees that progress has been made, but highlights that the harmonisation process is only at the very beginning. "Transparency has improved," he says, "but as regulation remains a country-by-country issue, it will be decades before complex sharia-compliant structures will be efficiently regulated, taxed and accounted on a global basis."

So far, Islamic funds have not been encouraged to disclose a great deal of information. A lot of them have been trying to build up a track record but, from a regulatory point of view, they still do not have stringent guidelines or obligations to report their holdings. Standard & Poor's Ms Mensah says that another way to increase transparency and disclosure could be sought through a fund rating because to obtain it, the fund will have to adhere to standard reporting formalities.

Despite the important challenges that Islamic funds present, investors' interest continues to be strong, and this is mirrored by growing participation from non-Muslim issuers and financial centres, such as the UK, France and Germany.

As politicians continue to debate how to avoid future financial crises, Islamic finance experts put the case for sharia-compliant principles in the proposed solutions.

"The conventional finance space is being challenged on the use of leverage, and when you hear Angela Merkel or Nicolas Sarkozy talking about prohibiting short selling, this is not far from Islamic finance in a way," says Bassem Snaije, head of the Middle East and north Africa for HSBC Private Bank. "They're trying to direct capital towards industries that create value, away from financial deals relying on leverage."

This is probably one of the most effective investment sales pitches Islamic finance has to offer at the moment.

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