Permal, part of French group Worms & Cie, announced last month that it had launched its first Islamic hedge fund.
The fund is part of the $528 million Alfanar family of Islamic funds it runs with investment management company Sedco, a vehicle of Saudi Arabia’s bin Mahfouz family.
The fund, called Alfanar US Equity Hedge Fund, is a growth fund managed by FLA Advisers, a New York-based hedge fund company with about $3.2 billion of assets under management.
Conventional methods of shorting are not allowed in Islamic finance because it is contrary to the Shariah to sell something that you do not own and because most derivative contracts are forbidden on the basis that they do not represent real assets, and involve interest and elements of uncertainty.
In order to circumvent these restrictions the fund has had to devise a Shariah-compliant mechanism to replicate the effects of conventional shorting. The solution is based on the salam contract, a traditional Islamic finance forward sale contract.
A reversed procedure
In Alfanar’s Shariah-compliant version, the prime broker buys stock from the hedge fund. The fund enters into a contract with the prime broker to deliver stock at a specified future date, which can be anywhere between t+30 and t+180, and receives the payment for the stock up front on t+0. The fund buys the stock once the price has fallen, making a profit on the difference between the amount it was paid on t+0 and the price paid on t+x.
The prime broker, JPMorgan, charges a 1% arrangement fee for its services.
The fund has to bear the risk if the stock price rises above the price at t+0 before the agreed settlement date, which could be substantial given the length of the contracts. The fund can, however, cover its position at any time before the settlement date but cannot physically deliver the stock until the settlement date.
The reason why the settlement date has to be so long is that the salam contract is traditionally used for forward sales of agricultural commodities.
Theoretically the credit exposure and operational costs between this salam method and the conventional stock borrowing method are similar. But the reluctance of many prime brokers to engage in such an unusual arrangement for a small fund means the fund is effectively tied to its prime broker, putting it in a weak negotiating position.
The fund has started with about $20 million, a good part of which has come from one principal investor, thought to be the bin Mahfouz family.
While there is obvious potential for the Islamic hedge fund industry to grow from its minute base, hedge funds have a small client base as it is and the subset of those who would like a specifically Shariah-compliant one is even smaller. Performance will therefore be crucial to whether or not they can take off.
The fund uses the DowJones Islamic Indexes screens to find Shariah-compliant companies in which it can invest. Out of a total universe of over 7,000 stocks in the US, this leaves roughly 500. This restricted universe could make stock selection more challenging for the fund manager and have implications for the fund’s performance.
