"They seem like a gimmick," says the manager of one such fund. "But in fact they are not really any different from socially responsible or ethical investments, such as environment-friendly funds. And by setting a minimum investment requirement of only $15,000, the fund is available to lower-income Islamic investors."
Six such funds were launched last year and are performing satisfactorily. These include Robert Fleming's Oasis Fund, and PFM's Ibn Khaldun fund. "Islamic investors are delighted," says Thomas de Sausmarez, assistant to the managing director at PFM in Doha. "At last western finance is taking an interest in the needs of Islamic investors who have until now been restricted by their faith."
Even though these funds avoid buying stock of companies that pay substantial interest on debts, and eschew bonds, they are performing as well as many conventional western-style funds. In some cases, returns are even higher than their respective benchmarks. "Avoiding highly geared companies can be of benefit," says Dhaval Joshi, investment manager at Robert Fleming. "Since its launch there has been little difference in performance between the Islamic fund and the world index. But an Islamic equity fund that requires purification has a necessary penalty as it's difficult to avoid interest income totally. Inevitably there will be a difference, but not so large as to make it infeasible."
Privatization in developing Islamic countries offers the funds some attractive investment opportunities in companies that should not be alarmed by their appearance on the share register. Islamic fund managers may be well placed to influence their capital structure and behaviours.
Western fund managers are undeterred by the past failure of Islamic equity funds. Kleinwort Benson Investment management's Islamic fund collapsed shortly after the liberation of Kuwait in 1989. "We were vulnerable to changing circumstances," says Nick Haynes, head of portfolio management at Kleinwort Benson. This pioneering fund was launched into a trough in the stock market and was unable to include insurance companies, then the best performers, as they were deemed unacceptable. Although KBIM consulted Mohammed Iqbal, ombudsman to the Pakistani government at the time, the fund was not fully accepted by the sharia (Islamic law) committee. One lesson learnt is that the fate of an Islamic fund is wholly dependent on the approval of custodians of the sharia.
"One of the main starting points was putting in place our own sharia supervisory board with enough clout to make the fund a serious proposition," says Joshi. "It is the sharia board that gives the fund credibility and they establish the criteria for the inclusion of an acceptable list of companies."
The only way in which Islamic equity funds differ from a typical mutual fund is the screening process required to limit the targeting of stocks to those compatible with principles of Islamic finance. These prohibit the receipt or payment of interest, as well as other activities. "The whole universe of companies has 2,600 names," says Joshi. "In terms of company activity about 30% of these are unacceptable, including all the financial services, brewers or people involved in alcohol production as well as companies involved in the production of non-halal meat, gambling and pornography."
Strict enforcement of the screening process limits the fund to a small group of stocks. The modern corporate capital structure includes some debt on the balance sheet, and fixed-income liabilities. With such a small set of stocks, portfolio diversification is more difficult. The breakthrough came when the Islamic authorities accepted compromise to permit these funds.
"The problem in the past has been the fact that a lot of western companies had unacceptable activities even if that was only part of their overall business, like supermarkets. Airlines, for example, were excluded, as they served alcohol and sold duty-free," says Neil Honebon, investment director of Islamic products at Fleming Asset Management. "Sharia law in the past has been interpreted in a very strict fashion. Any company engaged in what the sharia deem to be pornographic advertising or display, however innocent, might not be accepted. The Mirror Group was judged to be unacceptable. They have now realized that the whole concept of equity is for the greater good of the Islamic community."
Investment in the shares of companies with negligible interest income and low debt ratios is considered acceptable, as long as profits are purified by taking a portion of the income earned through interest from fund profits and giving it to charities.
In order to discourage dealing in debt, a "black list" of highly geared companies is drawn up: only companies with relatively low debt ratios are targeted. "The justification for this is that the debt financing is only a fraction of the capital employed to conduct business, " says Honebon. "And by becoming shareholders, the investors are in a better position to influence the management to find substitutes for debt."
Fund managers set an acceptable tolerance level for the debt ratio, ranging from 10% to 60%, after a screening process. In reality the Islamic funds' ability to influence decisions by companies in which they invest is limited, not least by the funds' size. "The companies in our fund are sufficiently large that we have little effect on decisions," says Honebon. "At the moment the funds aren't big enough to appear on their radar. In years to come it's possible that decisions of companies will be affected by Islamic investment funds. But this is a very long way ahead."
The tension between performance and religious acceptance inevitably limits diversification and fund management is made more difficult by the constant need to rebalance the portfolio when a company falls short of the screening restrictions. Honebon says: "Managing the fund has not been difficult once we had agreement. We spent a lot of time on the design phase. You don't get second chances when you're dealing with religious authorities."
The market for Islamic funds has only just reached a size that makes launching them feasible. "Non-Muslims would not want to invest in this type of fund," said de Sausmarez. "It is geared towards Muslims and marketed entirely in the Gulf." The estimated potential market size is more than $1.5 billion.