"The history of Shariah compliancy in finance is littered with bad stories. Up until fairly recently, a lot of initiatives were done to win business, or to tap into unaware investors and play on their feelings of trying to be good Muslims"
But with growing wealth among Muslim investors, an increasing number of hedge funds claim to be offering Shariah-compliant products. The legitimacy of their claims, however, is open to debate. All too often, Muslim investors money is put to work with non-Shariah-compliant managers but by wrapping several funds returns into a new product via a total-return swap, and having a well-paid board of scholars approve the structure, firms can claim to have produced a Shariah-compliant fund.
"It is like the form versus substance argument. You can call these funds what you like, but they are not Shariah-compliant," argues a manager who plans to launch a Shariah-compliant fund of hedge funds in the US.
The managers view is echoed by many Muslim investors. "These are not Shariah-compliant. It is insulting that these funds think they can pull the wool over Islamic investors eyes," says a Muslim investor in London.
The Newedge Group (formed by the merger of Calyon Financial and Fimat) has set up a platform to service hedge funds that it believes to be truly Shariah-compliant. Philippe Teilhard, global head of Newedge Prime Brokerage, says: "The history of Shariah compliancy in finance is littered with bad stories. Up until fairly recently, a lot of initiatives were done to win business, or to tap into unaware investors and play on their feelings of trying to be good Muslims."
Given its interest in servicing constraint-based asset management such as socially responsible investing, Newedge decided to attack the problem head on. "We wanted to bring alternatives to Islamic countries by being mindful and respectful," says Teilhard. Newedge provides Shariah-compliant prime brokerage services to the portfolio of a hedge fund that would have screened its investments thanks to the technology developed by Ratings Intelligence, a specialist Shariah advisory firm based in London and Kuwait. It results in a reduced stock universe that does not have an adverse effect on returns, says Teilhard, although it does increase volatility. "A third-party administrator makes sure all the rules have been met and those permissible assets are being traded in a permissible way."
Newedge uses a dedicated area of its prime brokerage platform which has also been granted a fatwa (a Shariah-compliant licence). The group has five hedge funds on its platform, based in Europe and the US, and hopes to add five more this year. "We only pick funds that have a solid reputation," says Teilhard. "Hopefully, with 10 funds on the platform it will be enough for private banks or product organizers to create a concentrated fund of hedge funds. It is completely different to the wrapper solution. Investors can see the underlying investments, and they know that all the ancillary services around the product are Shariah-compliant also."
Offering a holistic Shariah-compliant proposition and a transparent proposition is crucial, says a fund of hedge funds manager. "The custodian, prime broker and hedge fund manager need to all be operating in a Shariah-compliant framework. A holistic proposition is better for the investor."
That well-respected Islamic scholars are approving some wrapped funds that are not Shariah-compliant has raised concerns. "The problem is that there are no firm laws stating what can be allowed or not, so scholars are taken at their word. I dont want to say they are approving products because they are being paid to do so, although that is questionable. I think there is just too much confusion and the scholars are not comfortable with the responsibility so look to pass the products if they meet literal laws, rather than paying some mind to the morals underlying the investments. Shariah compliancy is still such a grey area," says one would-be Shariah-compliant hedge fund investor.
One manager, however, is confident that those offering products where Shariah compliancy is dubious will not survive for long. "It is growing pains. Unfortunately we have to go through these things but ultimately it is transparency that will lead to the downfall of these experiments."Teilhard agrees. "Islamic investors themselves will drive the transparency and methodology of Shariah-compliant hedge funds as they choose with whom to invest. It is a rapidly developing area, however. I expect we will see a few more truly compliant funds, and then a developing funds of Shariah-compliant hedge funds market."