INCREASINGLY, INSTITUTIONS DEVELOPING Shariah-compliant financial products are bringing sophistication and smart thinking to bear in their development of new products, whether for the individual retail investor or the corporate client. The challenge is in convincing the end investor that it’s legitimate to do so.
For the individual investor, the growth area is capital-protected products. For Middle Eastern investors bruised by choppy local stock markets, it’s understandable that there is a yearning for security.
HSBC, for example, launched its first Shariah-compliant capital-protected products four years ago and has built them based on different markets, for example, global equities or regional equities, and even specific sectors (a recent product focused on healthcare stocks).
Deutsche Bank sells an Islamic money market product, linked to the portfolio of a short-term dollar bond fund, with capital protection, and has built bespoke products with exposure to asset classes as diverse as gold, foreign currency pairs and Saudi Arabian equities. UBS sells capital protected structures linked to equities and commodities. And in Malaysia capital protection is the norm. “You won’t see a structured product, Islamic or conventional, available now that doesn’t have capital protection,” says Badlisyah Abdul Ghani, head of CIMB Islamic in Kuala Lumpur. His bank is about to launch a series of structured products itself.
On the face of it, this seems an obvious direction for Islamic investment to take: after all, with gambling (and anything that is more speculation than prudent investment) prohibited by the Shariah, capital protection links naturally with the objectives of Islamic finance. But it’s not quite that simple. “You cannot, under Islamic law, guarantee the return of the capital because that is not Islamic,” says Khalid Yousaf, managing director of Islamic finance at International Holdings Group, a private equity and advisory firm in Dubai. It’s the same principle, he says, as the one that applies to bank deposits: a depositor in an Islamic bank knows he is putting his money in the hands of the bank to invest elsewhere and that the return will be reliant on the success of that investment – not quite the same sense of protection as that afforded to the conventional depositor. In Yousaf’s eyes, an offer of capital protection is more a promise to do your best not to lose it.
This is one of the reasons why, in Islamic finance, the structuring of the capital protection is as innovative as the product itself. In conventional finance it’s common to use a zero coupon bond to provide protection but that’s not really workable within Shariah constraints. Instead, specific murabaha transactions (contracts of sale involving pre-agreed profits) are devised.
It’s an issue too if options are used to provide capital protection. An option is only legitimate in a Shariah context if the underlying securities are themselves Shariah compliant. “You have to make sure the institution underwriting the option has ownership of these securities when it contracts to sell it to the end customer,” says Javed Ahmad in Riyadh, general manager for Islamic business at Saudi British Bank, a joint venture with HSBC and the largest Islamic business within HSBC globally.
Dynamic methods
Ahmad says that capital protection has more recently moved on from its earliest murabaha incarnations towards the dynamic asset allocation methods common in conventional finance in developed markets such as Europe and Australia, where the allocation of funds to riskier assets can be increased or decreased in favour of more stable deposits according to outlook and performance. Here, too, there are Shariah complications: underlying investments must themselves be compliant, not just in terms of the industry they are invested in being halal but also in their level of gearing and investments in interest-bearing deposits.
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It’s becoming increasingly common to package these products not only with capital protection but also with insurance. These products have sold well in southeast Asia, giving people the promise of, say, a lump sum for permanent disability, with stock performance on top of it. “It makes sense from a regulatory perspective,” says Abdul Ghani at CIMB. “It’s easier for structured products to be introduced when they are linked with takaful [Islamic insurance].”
Another trend in structured products for individual investors is the push to devise structures related to a non-Shariah-compliant underlying asset class. Deutsche Bank, for example, sells a product linked to hedge funds – yet hedge funds, if they involve short selling, are not compatible with Islam (because they involve selling a security you don’t yet own).
So how is this done? “You have to make a distinction between being invested in hedge funds that are not Shariah compliant, and getting a payout that is linked to a hedge fund return,” says Geert Bossuyt, managing director for global markets and regional head of Middle East structuring for Deutsche Bank in Dubai. “Just as, for example, you have sukuks with periodic payments linked to Libor where it is very clear the cash is not used to invest in Libor deposits, similarly you can make a product linked to hedge fund returns where the money is not directly invested in hedge funds.”
Bossuyt also reports growing popularity for hybrid structures. These multi-asset-class products tend to be bought for income and often involve a high fixed coupon. Deutsche’s Momentum index option product, for example, a bespoke structure, allocates investments between gold, equities, bonds and cash; another hybrid uses an equally weighted arithmetic basket of LME aluminium, Comex platinum and Nymex WTI crude oil.
Building something that is technically compliant is not the problem. “The constraint we have is acceptance by the end investor, not the Shariah acceptance,” says Bossuyt. And this is where progress will always be slow: shifting innovation towards people who might naturally approach it with mistrust.