MODERN ISLAMIC FINANCE has developed rapidly since its inception in the 1970s. Most of the advances have been in banking, however, and Islamic asset management, which only started to take off in the mid-1990s, remains relatively underdeveloped. Substantial hurdles still inhibit growth but nearly everyone in the market is convinced that it will soon come into its own.
Industry sources estimate that there is $100 billion to $150 billion invested in a Shari’ah (Islamic law)-compliant fashion. This relatively small figure highlights the potential. The world’s 1.3 billion Muslims control vastly greater assets. Private assets in the Middle East alone are estimated at $800 billion but most of it is either salted away under mattresses or invested in conventional products.
A huge proportion of Muslims would, however, prefer to invest in Shari’ah compliant products given the opportunity. “There is a lot to be done in this area,” says Mohammad Toufic Kanafani, CEO of Noriba Bank, the new Islamic financial services institution started by UBS in September 2002. “Conventional investors demand a whole spectrum of products to diversify their portfolios. In Islamic asset management the spectrum of products is not yet there to structure diverse portfolios for investors with different risk profiles.”
UBS is the latest major international bank to establish a dedicated Islamic financial services unit. HSBC and Citigroup also have Islamic finance subsidiaries and several other international banks, including BNP Paribas, Deutsche Bank, Barclays, and Merrill Lynch, offer a limited selection of Islamic financial products.
Figures to quantify the size and growth of the entire Islamic asset management industry are hard to come by since many Islamic banks and funds, especially those in the Middle East, are reluctant to release figures. The picture is a little clearer in the equities sector where US-based research firm Failaka International keeps track of the number of equity funds and the amount under management.
According to Failaka, in 1996 there were 29 Shari’ah-compliant equity funds with $800 million of assets under management. By 2000 this had increased to 85 and assets under management to
$5 billion. Growth in the number of funds slowed with the collapse of global equity markets and the value of funds under management fell substantially, so that by January 2002 there were 105 funds with $3.3 billion of funds under management. Out of the 105, 33 are global equity funds. The average fund size is just $32.6 million, and it is estimated that the top 10% of funds account for 50% to 60% of total equity assets under management.
A common estimate for the proportion of Shari’ah-compliant investments that are in equities is between 3% and 5% but some Islamic asset managers believe that is an overly conservative figure.
Islamic investment funds are structured on the principle of shared risk. Returns from a fund must come from the profit or loss earned by the fund, so neither the principal nor the returns can be guaranteed. In addition to this, investments are restricted to companies whose businesses are Shari’ah compliant. This excludes investments in companies whose activities are haram (forbidden) such as those involved with pork, alcohol, entertainment (eg, gambling, cinema, music, pornography), tobacco and weapons. It also excludes those that either earn or pay large amounts of interest, so most conventional financial institutions are barred. Interest (riba) is strictly forbidden in Shari’ah, which regards it as usury.
There are additional conditions attached to equity investments. If a company’s business activity is halal (permissible) but it deposits surplus cash in an interest-bearing account or has loans for which interest is due, the Muslim shareholder must express his disapproval. In order to purify the investment, the investor must also donate to charity whatever proportion of the dividend he receives that is attributable to the interest income. Shari’ah also forbids equity investment in companies without illiquid assets. This is because if a firm’s assets consist solely of cash, its shares only represent money and so can only be purchased or sold at par by Muslims because they are forbidden to make money from money.
A major development in Shari’ah-compliant equity investment was Dow Jones’s launch in 1999 of the first Islamic equities index. Creating Islamic equity indices is not easy. As well as the initial screening to remove firms engaged in non-halal business, the rest must be screened according to financial ratios such as debt to market cap, cash and interest bearing securities to market cap, and accounts receivables to assets. The difficulty with the indices comes from the need to screen continuously – ratios can change rapidly as market caps fluctuate. Once a company ceases to be Shari’ah compliant the investor has six months to dispose of holdings.
In order to mitigate instability in such an index, Dow Jones uses a 12-month trailing average for the ratios to allow index constituents some leeway. Nevertheless the quarterly index reviews result in more frequent changes than is desirable, with implications for buy-and-sell activity on stocks ejected or included for the first time, as index-tracking funds are forced to follow their movements.
FTSE, which runs nine Islamic indices, tries to avoid the problem by opting for half-yearly reviews. This is problematic: if a fund has six months to dispose of haram stocks and an index constituent’s ratios were to change the day after a review, it would not show up until six months later, leaving little time to adjust its positions.
Tech-heavy takeoff
The impact of the screening for Shari’ah compliance on the composition of equity portfolios and their performance has been significant. In the late 1990s, when the sector took off, the Shari’ah financial ratio screens particularly favoured technology companies because they had inflated market caps, low debt levels, and because interest from profits was not an issue. As a result, Shari’ah-compliant funds outperformed during the tech boom. When the bubble burst this meant that they were hit particularly hard. The industry shrank 34% by assets between 2000 and 2002. Despite this, Shari’ah-compliant funds escaped three of the biggest investment debacles as the financial ratio screening ejected Enron, WorldCom, and Global Crossing about 18 months ago before they bombed.
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Murabaha funds soak up the greatest proportion of liquidity in Islamic asset management. Murabaha – cost-plus financing – is the most widely used instrument in Islamic finance. According to the Bahrain Monetary Authority, 75% of contracts are murabaha based. In a murabaha contract, the financial institution purchases goods for the client, who makes deferred payments totalling the cost, plus an additional profit margin to the financial institution.
Statistics on the performance of murabaha funds are difficult to obtain but anecdotal evidence suggests that they have generally been steady but not spectacular performers. “We had originally anticipated possible double-digit returns but found that we would have to go quite far down the credit curve to achieve that, and that was not in our investors’ interests,” says Chris Vermont, head of project and structured finance at ANZ Investment Bank in London, which runs an ijarah/ murabaha fund. “In the end murabaha products compete with Libor-based products, and with interest rates so low returns have not been exciting, even if they have significantly outperformed equities. The directors decided about 18 months ago to wind down the fund to seek alternative Islamic investment opportunities.” ANZ is developing new commodity-based structures both as funds and individual transactions and is also said to be considering property-related funds.
Purchasing property poses a particularly tricky problem for Muslims in non-Muslim countries because standard mortgages charge interest. HSBC Amanah is one of a few banks that offer Islamic mortgages in the US. A Shari’ah-compliant mortgage can be devised from an ijarah wa iqtina, a form of leasing. The bank buys the property and the client pays rent until he has covered the full price plus a profit margin, after which the title is passed on to him.
This simple method, however, may incur double stamp duty in many regulatory regimes. “The transfer of ownership of an asset is generally speaking a taxable event,” says Jane McCormack, head of KPMG’s investment management tax team in London. “This puts some Islamic structures in the unusual situation of having a tax liability at the start of the contract and possibly also at the end. There are no hard-and-fast rules for it. Unlike in traditional transactions where there is a framework, in Islamic products we have to look at each transaction on a case-by-case basis.” Additionally, in the UK, such lease arrangements have to be 100% risk weighted compared with 50% for normal mortgages.
An asset class that is rapidly gaining popularity is sukuk: essentially asset-backed bonds. The underlying asset has to be real and so is usually property. In a sukuk contract the issuer pays the holders of the sukuk rental income at defined intervals and agrees to repurchase the asset at the end of the rental contract at par.
The $600 million global sukuk issued by Malaysia in June, for which HSBC was the sole bookrunner, demonstrated that the contract could function like a conventional bond. The value of the rental income was set as a spread over dollar Libor, and repayments were divorced from the performance of the underlying property assets. “This was a landmark transaction for a number of reasons,” says Rushdi Siddiqui, director of the Islamic index group at Dow Jones Indexes. “It was the first global Islamic bond and it was also the first time that Middle Eastern Islamic investors had bought a Malaysian Islamic product”. It also achieved recognition with global conventional investors, proving that Islamic products could be put on a level footing internationally.
Several other Shari’ah-compliant products are being developed to fill gaps in product offerings. These include more capital-protected funds, derivative products, possible Islamic hedge funds and exchange-traded funds. Some are dubious about Islamic hedge funds – because financial speculation is forbidden in Shari’ah. Siddiqui takes a pragmatic view: “You can use a knife to cut a steak or to kill someone,” he says. “It’s up to you what you do with it.”
Central to the continued development of sophisticated Shari’ah-compliant products are the new breed of Shari’ah board members, who are well versed in both finance and Islamic law. Shari’ah boards are employed by all Islamic financial institutions to ensure compliance with Islamic finance principles. The recognition and respect of board members is crucial to the success of new products. Many early attempts to market Islamic finance products failed because Shari’ah board members were not known outside their own countries. Today there are a few internationally recognized Islamic finance scholars, including Shaykh Abdul Sattar Abu Ghuddah, Shaykh Justice Muhammad Taqi Usmani, Shaykh Nizam Yaquby, and Shaykh Dr Mohamed A Elgari, who sit on numerous Shari’ah boards.
A universal standardization of Shari’ah interpretations would boost Islamic finance. Malaysia’s highly developed Islamic finance and asset management industry had been shunned by many Middle Eastern institutions because of its allegedly more liberal interpretations. Over 60% of new domestic debt issues in Malaysia are now Shari’ah compatible and Islamic bonds made up about 43% of all private debt securities issued there last year, compared with 3% in 1998. According to Securities Commission Malaysia, the net asset value of Islamic funds in Malaysia rose from RM26 million in 1993 to RM 2.9 billion ($764 million) in June 2002. Islamic funds now account for 5.3% of the total NAV of funds in Malaysia.
Apart from a lack of products and standardization of Shari’ah interpretations there are other major impediments to the continued growth of Islamic asset management. High on the list is the lack of an interbank market, and tied to this a lack of secondary market liquidity. “A secondary market is severely needed,” says Stella Cox, managing director of Dawnay, Day Global Investment, a private investment and financial services group with specialist knowledge of the Middle East and Islamic finance products. “Most of the liquidity comes from the fund sponsor and investments tend to be buy, hold, and sell back. There is not much genuine secondary market activity.” Cox also points to the slowness of ratings agencies to rate Islamic products, which has held back their appeal.
A slow start in retail
A failure to market Islamic investment products effectively is a weakness. Islamic financial institutions were focused on banking and only began to look at asset management in the mid-1990s. Even then the funds were slow to tap retail investors, concentrating on institutions and high-net-worth individuals. “The initial Islamic equity funds had pretty hefty minimum requirements of about $100,000 plus,” says Cox. “They didn’t start targeting retail investors until the last couple of years.” Minimum levels have fallen in many funds to just $1,000 to $2,500 and the largest and most successful funds have tended to be those that have targeted the broadest range of investors and have the best distribution networks. Saudi Arabia’s National Commercial Bank is the largest fund sponsor by far, sponsoring equity funds worth up to $935 million.
Islamic funds have also failed to target non-Muslim investors even though there is no reason why the products, especially the equity funds, should not be attractive to those with ethical concerns about investing in armaments, gambling and alcohol.
In efforts to address these problems, Bahrain and Malaysia have again taken centre stage. In February 2002, the Liquidity Management Centre (LMC) was established in Bahrain, already home to the Accounting and Auditing Organization for Islamic Financial Institutions (Aaoifi). LMC is designed as an interbank market for Islamic financial institutions. The LMC has begun pooling assets acquired from governments, financial institutions, and corporates, with the objective of securitizing these and issuing tradeable sukuks. The hope is that Islamic financial institutions will then have an instrument in which they can invest surplus liquidity. Islamic banks are on average 40% more liquid than conventional counterparts largely because of a lack of short-term investment opportunities.
In November the Islamic Financial Services Board (IFSB) will begin operations in Kuala Lumpur. It will be primarily made up of central banks from the Muslim world and will help to develop and promulgate new standards on Shari’ah interpretations, and to promote effective regulation.
