Innovative sharia-compliant products are sparking global interest, and in the constrained financial climate they are catering to customers' growing risk aversion. Writer James Gavin
Islamic investors have become used to a wider array of products to place their money over the past year, as fund managers attempt to penetrate an untapped market with some innovative new instruments.
Whether traditionally structured equity and real estate funds - still the most popular - or the more esoteric products that have emerged more recently from financial institutions, such as Islamic hedge funds, the choice is wider than ever.
The surge in interest from overseas institutions in the Islamic space is largely a by-product of the Middle East's huge spurt of wealth creation that followed the dramatic rise of oil prices from 2002 onwards.
Demand is set to grow, experts say. The market for Islamic investment products is growing by 15% to 20% a year and equity fund assets alone are forecast to jump from $15bn to $53bn by 2010, according to the FTSE Group.
Islamic communities across the globe have always preferred to save and invest their capital in an Islam-compliant manner, but this has not always been possible as sharia compliant avenues were not always available in which to channel them.
Once investment houses realised the possibilities offered by Islam-compliant investment funds, and the profitability that could be delivered, they moved with alacrity to fill the gap.
Product engineering
Sometimes providers have little alternative but to engineer their product slate in an Islamic fashion. "Certainly in Saudi Arabia, a lot of clients say it is now almost a necessity to provide products that are sharia compliant," says Mark Stanley, assistant manager of Ernst & Young's advisory services and part of the Islamic Financial Services Group in Bahrain.
The 120 sharia-compliant mutual funds in Saudi Arabia account for a majority of Saudi assets under management in the kingdom.
Then there are attempts to tap the Middle East's investor base. "A number of Western product providers have recently shown an interest in restructuring their existing products to become sharia-compliant, particularly when they are asset-backed types of instruments," says Mr Stanley.
The activity is not just the result of Western institutions in pursuit of quick profit. Islamic banks are also becoming more creative in their product offerings. They carry four main asset classes within their investment portfolios, property, equity, sukuk and managed funds.
The Islamic fund space has gradually expanded, starting in the Gulf region. According to an Ernst & Young study, there were fewer than 500 sharia-compliant funds two years ago, but this could double in number by 2010.
Most Islamic investment strategies are focused on equities, an emphasis that has left the fund universe skewed against fixed-income sectors. Difficulties in structuring economically viable and truly sharia-compliant fixed-income-oriented mutual funds has left the Islamic space vastly different than that of the US, where bond and equity funds follow an asset allocation model of in the ranges of 60/40 to 70/30.
Financial climate
The worsening financial climate of the past six months may cause interest in Islamic fixed-income funds to pick up. "Fixed income is an area that is under-represented in the sharia-compliant space. From an investor's perspective, it makes sense to have a balanced portfolio, with some money in equities, and some in fixed income," says Saqib Masood, Saudi-based head of Islamic product development for HSBC Asset Management.
Diversification is the watchword: "Asset managers at Western banks have long acknowledged that you have to diversify portfolios if you are going to ride out the tougher periods, and this current crisis has forced a reassessment of concentrations, particularly in real estate," adds Mr Stanley.
Structural obstacles need to be surmounted. For example, Islamic funds of funds have found it difficult to place fixed-income funds. The inflationary spike that afflicted the Middle East last year also eroded the appeal of products whose returns were typically about 5% to 6%, well below many Gulf states' consumer price indexes.
Sukuks also carry large minimum investment levels, which put off retail investors. With the sukuk market illiquid, Islamic banks found it difficult to attract buyers at satisfactory prices. This may stymie the take-up of this asset class, although income generator types of products may draw more interest from customers.
Whether fixed-income or equities, neither class is likely to witness significant new product innovation so long as investors are bent on being cautious. Simpler solutions may prove more attractive to the average investor.
Wider interest
High-net worth individuals (HNWIs) have shown some interest in hedge funds and private equity funds, given their greater investment exposure to these strategies in the conventional space, but this demand has yet to seep into the wider retail sector.
Last July, Barclays Capital and the Dubai Multi Commodities Centre Authority (DMCC), an agency of the Dubai government, announced the launch of sharia-compliant hedge funds on the Al Safi Trust, a comprehensive sharia-compliant platform comprised initially of single-strategy alternative investment managers.
The backers wanted to provide a turnkey solution that provided access to a diversified source of alternative investment. "Investors are seeking diversification and a reasonably straightforward access in a credible and transparent format. That's what Al Safi provides," says Frank Gerhard, Barclays Capital's head of fund-linked derivatives strategy.
The link-up with DMCC is critical in the current climate and Dubai has moved to shore up confidence in three new Al Safi hedge funds with commitments of $250m. Last November, DMCC and Shariah Capital - the adviser on the Al Safi platform - officially launched a joint fund, the DSAM Kauthar Global Resources and Mining Fund, an exclusive feeder fund with $200m of Dubai state funds committed as seed investment.
In a constrained financial climate, the Islamic fund pipeline is likely to cater to customers' growing risk aversion, rather than to the more esoteric HNWI market. Islamic funds have not escaped the global downturn. The main Islamic asset classes have all lost value in the past year, and the Dow Jones Islamic Market index at end-2008 was down by 26.5% on the start of the year.
According to Jahangir Aka of SEI Investments, while sharia investing continues to outperform conventional investing through the credit crisis, it cannot be immune to the problems, however much Islamic indices remain sheltered from the most extreme ups and downs.
"Most Islamic funds have performed better than their conventional peers, there's definitely a relative outperformance. But that's not to say that they have not lost value in absolute terms," says Mr Masood. He adds that the HSBC Amanah Global Properties Income Fund, a sharia-compliant, open-ended, global real estate investment fund that invests in commercial properties, is still in line with its promised return to clients.
The factors that have undergirded the better performance of Islamic funds compared with conventional peers should enable them to weather the worst of the economic storm ahead. The exclusion of the financial sector and Islamic finance's debt-aversion provide welcome insulation from the economic downturn.
"Islamic equity products are not exposed to the financial sector and any fund which doesn't have exposure to the financial sector has a chance to outperform," says Mr Masood.
The way that equities are screened for inclusion in Islamic funds, weeding out companies with high leverage - usually it is stipulated that it should not to exceed 33% - provides added protection. Islamic funds tend to focus on stocks offering value rather than growth, mainly underleveraged or niche companies, and this has helped their performance. On the downside, Islamic funds have higher exposure to commodities and energy, currently witnessing stark drops in international markets.
Investor conservatism
With a precarious global economic backdrop in mind, practitioners will seek to tap into investors' conservatism. This means less emphasis on hedge funds, already considered dubious on religious grounds due to Islam's strictures on short-selling of stocks, and more of a thrust on capital preservation.
HSBC's product pipeline for the next six months is informed by this conservative outlook. In February, it launched a capital protection fund linked to Saudi equities as an underlying asset class. "Saudi Arabia is sitting on a fairly large surplus so it has the ability to ride out storms better than most countries - it is a good thing to push given the risk-averse nature of clients right now," says Mr Masood.
In the short to medium-term, fixed income is also likely to see a revival of interest. "This might not be restricted to sukuks, but possibly include other income generating assets such as securitised leasing arrangements," says Mr Stanley. "Investors have taken a hit on equities and on real estate and may look to more stable returns from fixed-income-type structures."
