Issue 813, 21 September 2007

In search of Islamic hedge funds – high margin holy grail

We are at the inferface where faith meets financial engineering. Bankers of all persuasions are ever in search of higher margins of the sort that hedge funds have generated for some of the globes sharpest-witted investors, at least before this summer’s markets melt-down. But so far one of the globe’s boom financial sectors has missed out: the quest to create a sharia-compliant hedge fund has proved elusive and controversial – opinions remain polarised.

Several players over recent years have claimed to have created a product that will deliver returns comparable to a successful hedge fund in a sharia-compliant way. However, the fundamental sticking point apparently remains: whether the fund’s underlying asset is halal (allowed) or haram (forbidden).

Typical is the debate among Islamic scholars and bankers triggered by Dubai Islamic Bank (DIB)’s recent creation of a fund of funds, launched in partnership with Deutsche Bank (DB) and Goldman Sachs Hedge Fund Asset Management (GSAM). This employs five-year capital protected notes linked to the DB-GSAM Hedge Fund’s performance, using an underlying index that tracks the performance of a ‘B’ class fund share in the Goldman Sachs Alpha Limited Partners Strategies Fund (GSAM ALPS Fund) – a fund of hedge funds managed by Goldman Sachs Hedge Fund Strategies.

Critics say that because the underlying asset is not sharia-compliant, the whole scheme is haram because under sharia law the underlying asset must be halal. Dr Hassain Hamid Hassan, president of DIB’s Fatwa and Sharia Supervision Board, which approved the fund as sharia-compliant, sees things differently. He argues that although the fund profits indirectly from the performance of non-sharia hedge funds, it does not invest directly in them; therefore it is still sharia-compliant.Hassan argues the fund is halal because DIB and its partners used a technique based on a credit swap, which means an Islamic investor is exposed at a distance from non-sharia compliant assets but does not actually invest in them.

The arguments appear finely balanced, even for DIB employees. “You’ll have to read the terms of the fund yourself and determine for yourself whether the fund is sharia-compliant,” a senior DIB banker told GSN. Other critics are concerned that other aspects of the fund may not be sharia-compliant, such as whether its investments could be in prohibited items such as pork or alcohol.

Islamic bankers and the sharia scholars who determine what is halal and what is haram have for years been assiduously working to find Islamically compliant ways to mirror hedge funds’ risk-balancing properties. In the last decade, developers trying to fill the gap in Islamic markets for instruments that mirror conventional hedging tools have created a smattering of such funds. In 1997, Kuwait-based The International Investor (TII) launched its Al-Khawarizmi Market Neutral Fund. In the same year, Saudi Economic and Development Company (Sedco) in Jeddah and New York-based Permal Group launched the Al-Fanar Hedge Fund. In February 2006, the Jersey Financial Services Commission approved a sharia-compliant hedge fund known as Algo Al-Qayyim Fund Ltd developed by Jersey-based Volaw.

But after a decade of development, this year’s crop of Islamic finance conferences (of which there is no shortage) in Dubai, Bahrain, the United Kingdom and elsewhere have all produced people who take opposing views on whether the objective of creating a sharia-compliant hedge fund has been achieved. A substantial constituency, if not the bulk of Islamic financiers, say that common hedge fund strategies break Islamic law and cannot be accommodated within the sharia. Opponents say that to appeal to mature and sophisticated investors, Islamic finance must develop techniques to hedge investors against risk. One way to square that circle is to argue that a hedge against risk need not employ hedge funds. One banker canvassed by GSN drew the distinction between hedge funds, which remained haram, and Islamic derivatives used for hedging purposes, which he argued were not only halal but also desirable as a risk management tool.

Standard Chartered Bank believes its first Islamic Cross Currency Swap (ICCS) deal with Malaysia’s Bank Muamalat Malaysia Berhad is nothing short of a landmark. “The Islamic Cross Currency Swap is a trailblazer – combining the benefits of managing currency risks and rate differential returns with sharia-complaint principles,” Standard Chartered Bank Malaysia chief executive Berhad Shayne Nelson said. The ICCS is an arrangement between two parties to exchange a series of profit and/or principal payments denominated in one currency for and similar series denominated in another currency, based on a notional principal amount, over an agreed period. The arrangement uses commodity murabaha transactions as the underlying transactions.

In south-east Asia Standard Chartered has also launched a comprehensive Islamic Derivatives Solution based on techniques that it considers to be sharia-compliant, comprising Islamic Profit Rate Swap, ICCS and Islamic Forward Rate Agreement. StanChart claims these techniques ensure that customers have access to hedge profit rates risks while enhancing their balance sheet management. Banks are looking to tempt investors, but the overall uptake of the sharia-compliant hedge fund alternatives launched so far is said to be low, and for the time being a hardcore at least of Islamic financiers and sharia scholars still believe that even if a so-called Islamic product takes dozens of steps away from a conventional product in order to short sell, you simply cannot sell what you do not own.