Balancing profit with religion

“Do not use your property for vanities,” warns the Koran in its second chapter or surah, ‘The Cow.’ “Neither seek to bribe the judges so that you may take the property of others by wrongful means.” From this modest verse comes most of Islam’s sharia law concerning financial relations. That law has a long history, but the Islamic finance industry only came into official existence with the profit-sharing mosharaka investments pioneered by Egypt’s Mit Ghamr Savings Banks in 1963. Since then it has grown into an insurance, banking, mortgage, capital-markets and asset-management business worth between $1,000bn and $1,500bn (E960bn), growing at an annual rate of 10-15 per cent. But investment techniques, strategies and products have not exactly been standing still since the 1970s. Has Islamic investment managed to keep up? Long-only equity investing does not present much of a hurdle. There are now well over 500 sharia-compliant long-only mutual funds and S&P’s Global Sharia Index Series alone offers exposure to more than $34,000bn of the world’s market capitalisation, spread across 52 markets. The prohibition of riba, or interest, means the banking sector is haram, or off-limits; and other ethical prohibitions exclude industries involving things like alcohol, arms, gambling, pornography, pork production and tobacco. That still leaves a lot to invest in - consider the industries it cuts out (financials and consumer cyclicals) - and it is not surprising that a typical Islamic certificate issued by ABN Amro on the LLB Top 20 Middle East Total Return Index returned more than 70 per cent during 2007, with lower volatility than the broader markets. Furthermore, increasing demand and sophistication, coupled with the Koran’s exhortations, have seen the sharia premium come down from perhaps 50-70 basis points a few years ago to around 15-35bps today. Some product providers will even absorb that extra cost themselves. Outside long-only equity, the picture is not so clear. Where there is no riba, there can be no bonds, for example. Sukuk were developed as an equivalent, but investors have not really taken them up. “Perhaps the only piece missing from the Islamic investment suite is fixed income,” says Ruggiero Lomonaco, head of Middle East & Islamic private investor products for ABN Amro Markets. “But these days a lot of private banking clients use hedge funds in place of fixed income anyway.” But how is it possible to hedge or trade on margin without riba? Or indeed employ leverage for a private equity buyout? And doesn’t the prohibition of gharar and maissar (ambiguity and speculating) effectively take options trading out of the equation, too? Apparently not. For leverage, traditional murabaha arrangements can be employed. And for hedge funds, the option-like Bei Al-Arboun has been used as the basis for synthetic prime-brokerage arrangements by pioneers like Newedge, ABN and, especially, the US’s Sharia Capital, which set up a managed account with Barclays Capital last March. ABN’s Mr Lomonaco says that around $50m in being managed using its in-house Islamic synthetic prime brokerage, “and we hope it’s going to be a big growth area for us”. Of course, this is not to say that there are suddenly 12,000 sharia-compliant hedge funds on the market, nor that these techniques are as simple as negative-screening equities. “When we look at Islamic alternative products we find that sharia-compliance almost always compromises return,” claims Dr Humayon Dar, CEO of advisory and product-structuring specialist BMB Islamic UK and a leading sharia finance academic. “This is one reason that we developed a technique here that allows exposure to conventional alternative asset classes without compromising sharia principles.” A variant on a technique developed by Dr Dar’s team at Duetsche Bank subsidiary Dar Al Istithmar, Sharia-Compliant Alternative Return Emulation (ShARE) involves the investor buying a derivative structure on a basket of sharia-compliant commodities managed to replicate the returns-stream of a chosen non-sharia compliant fund. This derivative is then priced off the change in NAV of the chosen fund. BMB swaps its return from the basket of commodities for the return of the target fund which it then pays to the end investor via the structured product, thereby assuming the risk that the basket of commodities underperforms the target fund. "Sharia principles are primarily focused on the object of sale, and in this case the underlying commodities are compliant, and the price is just a number," explains Dr Dar. “When the products came to market there were of course people who did not like them, but I would say that over the last three years their acceptability has increased a lot. Recently the central bank of Malaysia has come up with guidelines for the players in the local Islamic market which allows products very similar to these. But with the passage of time as Islamic finance develops this kind of product will phase out – it is only at this early stage of development that they are required.” The fact that alternative investment techniques differ qualitatively from traditional equity investing raises the question of whether or not these new structures merely disguise interest as profit via financial engineering. Indeed, in some recent private equity and real estate deals in the Middle East some of the more conservative voices have prevailed against murabaha arrangements, saying that standard loans, though not halal, are preferable to what they regard as hypocrisy. “There is a move towards more conservatism, towards having a much closer to look at the underlying transactions, alongside this trend from the banks for more innovation,” observes Kazi Hussain, director of Islamic finance at Europe Arab Bank, which has recently listed nine long-only funds in Guernsey. “It’s quite a conundrum when you’re establishing a board: if you go for the wisest interpretation of sharia, you’re not necessarily getting the best knowledge of banking and finance.” Although many institutions share board members, they nevertheless do all have different boards, so in a world where institutions like AAOFI have no enforceable powers, what guarantee is there that a product with a fatwa necessarily meets an individual investor’s strict religious requirements? Dr Dar believes that it should be enough to reassure investors. Although he points to small differences in interpretation between Middle Eastern and Far Eastern scholars, for example, Sunnis should feel comfortable with a fatwa on a finance product from a committee made up predominately of Shi’ites, and vice versa. Standardisation is key to both product manufacturing and distribution. Mr Lomonaco describes how, following the negotiation of a basic structure with ABN’s sharia board 18 months ago, that structure has supported the launch of more than 30 different products giving exposure to dozens of different underlyings. SWISS PRIVATE BANKING “I can issue a new Islamic product in about an hour,” he claims. “The second stage is the secondary market. Most of the Swiss private banks don’t require that a third-party product to get approval from their own sharia board, as long as they recognise my scholars. But the local Islamic banks are different – every product they distribute has to be re-approved, and it took me six months to get the rubber-stamp from all of them on my structure. So as an investor, your choice of bank makes a big difference. Use Saudi Hollandi Bank, for instance, and you get a good range of sharia-compliant products; use Dubai Islamic Bank, and you will have a much smaller range. That’s why they are stuck, and why the vast majority of Muslims use offshore banks.” That’s one way in which sharia-compliant products are creating revenue outside of the Middle East. But is there scope to take them to Muslim investors elsewhere – or even to non-Muslims? Faisal Private Bank declares itself “designed for all investors, whether Muslim or non-Muslim”, who want to create portfolios that “respect their ethical values”. Mr Lomonaco also notes that the majority of his clients are “not particularly religious” . “I have one Islamic product in Germany which invests in the Middle East, and people are buying this product for a very simple reason – the Middle East is going up,” he says. Opinion on whether demand can spread geographically is mixed. Although there is much speculation about the need for various elements of Islamic finance among European and North American Muslims (a mainly immigrant population requiring bank accounts and mortgages), a recent Moody’s report anticipates that 65 per cent of sharia-compliant fund investment will come from the Middle East (where the HNWs are). “Some demand is coming from the Far East, led by Malaysia – but fundamentally, this is primarily an Arab phenomenon and the real growth is in the GCC region,” agrees Dr Dar. “I would categorise South Asian Muslims as ‘emotional Muslims’ - when it comes to the actual, real practice of Islam, they are not so interested, and that includes the practice of Islamic financial doctrine.”

Some key terms arboun: The Islamic form of an option: a non-refundable deposit paid by the client (buyer) to the seller upon concluding a contract of sale, with the provision that the contract will be completed during the prescribed period gharar: Ambiguity halal: Permitted under shariah haram: Prohibited under shariah maissar: Speculating murabaha: Purchase and resale to avoid lending. The capital provider purchases the desired commodity from a third party and resells it at a predetermined higher price to the capital user over instalments riba: Interest sharia: Islamic law sukuk: The Islamic form of bonds. Certificates of equal value representing undivided shares in ownership of tangible assets