CHAPTER 5
Broad Choices of Islamic Investment Funds
Can They Become Mainstream?
O mankind! Eat of that which is lawful and wholesome in the earth.
(Al Baqara: 168)13
Permissibility is the original state.
(Islamic legal maxim)13
INTRODUCTION
When Institutional Investors magazine conducted a 2010 survey of more than 50 global institutional investors and asset managers to find out the reasons why they do not invest in Islamic portfolios, one key feedback was the limited breadth of Islamic asset classes available to meet the investors’ varied appetites. However, this is more a product of unawareness and lack of education because there are already more than 700 Islamic funds offered internationally. With estimated assets under management (AUM) of USD60–65 billion,1 it continues to grow 15 percent globally. These Islamic funds cover a broad spectrum of asset classes, which have the ability to satisfy the diverse range of investors’ appetites.
During the 2010 Amanie-Failaka Symposium in Dubai, Islamic asset managers were given an opportunity to launch their funds. It was inspirational to see the announcement and briefings of an Islamic commodity and energy equity fund by a Swiss asset manager, an Islamic gold fund by a Canadian asset manager, an Islamic China equity fund by a Malaysian asset manager, and an Islamic Australian equity fund by an Australian asset manager. Islamic funds are now available from as far north as Canada to as far south as Australia.
The world’s oldest Islamic fund was a commodity fund established in Saudi Arabia in 1987. The Al Ahli International Trade Fund was created to provide retail clients with a Shariah-compliant alternative to a conventional savings account paying interest. The oldest equity fund, the Al Ahli Global Trading Equity Fund, was first offered in 1995 by the National Commercial Bank of Saudi Arabia. Its AUM has grown to USD255 million as of November 28, 2012.2 The range of Islamic asset classes now include equity, Sukuk, money market, gold, real estate, private equity, infrastructure, and other commodities. They are available via different types of Islamic funds, which have grown to include open-ended, close-ended, exchange-traded funds (ETFs), and hedge funds managed on relative and absolute returns bases.
Although Islamic funds compose only 1.1 percent of the estimated 63,000 conventional funds available, there is sufficient breadth and depth of Islamic asset classes available for investment. However, the investing public is not aware of the existence of all these funds, due to poor distribution by the fund managers who concentrate on domestic-centric marketing. Investors are not aware of the existence of these funds, let alone the benefits.
A much smaller percentage of Islamic funds are registered for international distribution in comparison to the number of internationally distributable conventional funds. However, it is worth noting that across the entire risk-return spectrum, all these funds are structured to meet domestic and international demand. Like its conventional counterpart, Islamic investment funds are also offered to the international investors based on the varied risk tolerance levels of investors. As younger Generation Y investors become sophisticated and conscious about investing ethically, this demand will grow to meet the available supply of Islamic funds. These funds will be able to meet varying investment agendas, from capital protection and appreciation to education and long-term retirement needs.
Capital protected Islamic funds were popular after the 2008–2009 financial crises. Even passively managed index-linked investment solutions are available in the form of Islamic ETFs, which have grown to a total of thirteen. Islamic funds have been shown to grant similar risk–return or slightly superior returns during a downtrending market, compared to their conventional counterparts over a long-term basis of at least five years. Islamic funds have also shown lower volatility versus their conventional counterparts. These similar performance and volatility characteristics are delivered via an investment process, which invests in a socially responsible and ethical manner.
This chapter therefore provides the broad choices of Islamic investment funds across the various asset classes. Each of the descriptions of the following fund categories will briefly touch on the features, the structures, and the availability in the market.
EQUITY FUNDS
Among the available Islamic funds, equity funds with market share of 46.9 percent hold the largest investment portion.3 This is due to the easy availability of broad Shariah indices offered by Dow Jones Islamic Markets, Standard & Poor’s, FTSE, MSCI, and Russell. The Shariah indices have established a transparent Shariah stock screening processes and are regularly reviewed.
Equity investing is a proven long-term investment solution that grants capital gain for institutional investors like pension houses and sovereign wealth funds. The demand for Islamic equity funds was initially created for retail and high-net-worth investors. Institutional investors need a minimum three-year track record in order for them to be convinced with regards to investment performance.
Islamic equity funds are widely available, from onshore funds to offshore funds registered in domiciles like Luxembourg, Ireland, and the Cayman Islands. The greatest challenge is to offer these funds internationally so that investors around the world are able to invest in various regions. For example, investors who are keen to invest internationally can look at Islamic global emerging markets, or can source for Islamic funds that invest in more specific emerging markets like Islamic Asia Pacific ex-Japan, which are registered on an offshore fund platform.
As an example, the top five holdings of the CIMB Islamic Asia Pacific ex-Japan Fund were Samsung Electronics, China Mobile, Taiwan Semiconductor Manufacturing, BHP Billiton, and Petro China Company (as of March 31, 2012). These stocks were also eligible for investment in a conventionally invested fund. The benchmark for this fund is the Dow Jones Islamic Markets Asia/Pacific ex-Japan Index. Since its inception in June 2006, the fund has outperformed the benchmark on a cumulative basis by 5.17 percent. Investors who want to invest more broadly can consider an Islamic global equity fund that exists in substantial quantity. One of the earliest Islamic global equity funds available on the Irish funds platform is the Oasis Crescent Global Equity Fund with an AUM of USD151.4 million as of March 31, 2012.
Islamic equity funds were initially led by Malaysia and Saudi Arabia, with domestic equity funds. However the range of available funds has grown to include more broad investment capabilities, from global equity to emerging market equity. In fact, the Irish funds platforms have been managed by investment managers from France, the United States, Germany, South Africa, and Malaysia. Analyzing the top 20 global Islamic equity funds based on total return, the majority of these funds were based in Pakistan, Malaysia, Thailand, and South Africa.4 Similar to the conventional fund space, there was a sharp decline in the number of Islamic equity fund launches during the 2008 global economic crisis, which spilled over through to 2010.
The industry outlook for Islamic equity funds is positive, now that a transparent and credible investment performance track record of more than five years has been established, from the peak of equity markets in 2007, through the economic crisis years of 2008 and 2009, and lasting into the recovery that began in late 2010. Furthermore, it can be clearly seen that the investment performance is similar to mainstream investment performance, so long as the market recovery is based on business fundamentals. Therefore, Islamic equity funds are a credible alternative in both bull and bear markets.
SUKUK FUNDS
Although comparatively young, the market for Sukuk funds is growing around the world at an encouraging pace. Considering that Sukuk issuance was initially led by Malaysia in 1990, the first Sukuk funds were established in Malaysia and were therefore ringgit-denominated. If the fund invests in Sukuks that are denominated in an international currency like the dollar or the euro, it is categorized as being a global Sukuk fund. These funds are available on offshore funds platforms. Fortunately, with the explosion of Sukuk issuance in the Gulf Cooperation Council (GCC) since 2004 and the value of new Sukuk exceeded USD26 billion in 2011, there is improved liquidity in the Sukuk market to actively manage a Sukuk fund. In March 2012, Al-Hilal Bank of Abu Dhabi (UAE) established the Al-Hilal Global Sukuk Fund. The portfolio is composed primarily of U.S. dollar Sukuk from the GCC, with a smaller portion made up of non–U.S. dollar Sukuk from Malaysia, Indonesia and Singapore. The top five Sukuk make up 38.37 percent of the total portfolio (as of October 29, 2012). These Sukuk are issued by: 1-Hazine Mustesarligi Varl (Turkey) 2-Emarr (U.A.E) 3-DP World Sukuk (U.A.E) 4-Dubai Dof (U.A.E) 5-SQQ (Qatar).5
A comparison of Sukuk performance, represented by the HSBC/DFIX USD Sukuk Index, versus traditional bonds, represented by the Barclays Capital Aggregate Bond Index, shows that the relative performance of Sukuk against conventional bonds is comparable over the past few years.
Traditionally, conservative investors held a significant amount of their overall investment portfolio in bond funds, as they provide a predictable income stream, that can result in a higher rate of return than bank deposits. The major risk factor that can impact returns is the possibility of default of the fund’s bond holdings. Now conservative investors are also able to invest in Sukuk funds. Sukuk securities have the same financial characteristics as conventional bonds but are governed by legal contracts that comply with Shariah principles.
That said, it is still not possible for investors to invest in a global Sukuk fund that is Undertakings for Collective Investment in Transferable Securities (UCITS)-compliant. This is due to the stringent liquidity requirements specified under the UCITS risk framework, which states that investors should receive their investment proceeds easily upon redemption. This issue should be resolved as the Sukuk market grows and matures.
EXCHANGE-TRADED FUNDS (ETFS)
Islamic ETFs are gaining in popularity. Similar to conventional ETFs, Islamic ETFs are generally managed on a passive basis in which the fund manager aims to replicate the returns of an Islamic index, like the Dow Jones Islamic Markets Indices, FTSE Global Islamic Index Series, S&P Shariah Indices, and MSCI Global Islamic Indices.
Since an ETF is listed on a stock exchange, it is able to offer greater flexibility and convenience in trading the units and higher liquidity than most typical unit trust funds. In addition, it generally has a lower overall cost of investing relative to an actively managed fund, making them a desirable investment option.
There are 13 Islamic ETFs with total assets under management of USD382 million as of March 28, 2011.6 The largest contributor is the Malaysian-based My ETF with USD197 million. These 13 ETFs are listed on the U.K., France, Turkey, Singapore, India, Malaysia, and South Africa stock exchanges. They are invested in the equity asset class on a global (developed and emerging markets), regional (Europe), and single country (India, South Africa, Japan, and Malaysia) basis.
While the first Islamic ETF, Dow Jones DJIM Turkey, was listed in December 2007 on the London Stock Exchange, the first Asian Islamic ETF, My ETF, started trading in the first quarter of 2008 and was developed by Bursa Malaysia and Dow Jones. The first U.S. Islamic ETFs were listed in 2008.
The global pool of conventional ETFs totaled USD1.25 trillion as of September 30, 2011, and has grown spectacularly since they were first introduced to the market in 1989. We expect Islamic ETFs to similarly gain significant traction as the demand for Shariah investing increases. Like most ETFs, the demand comes from both retail investors and asset managers who will use ETFs for cash equitization as demand for actively managed Islamic funds grow.
MONEY MARKET FUNDS
Islamic money market funds are domestic-centric and are currently only available in Malaysia and Saudi Arabia. They comprise 22.2 of the assets under management of global Islamic funds.7 There are not many money market funds in other parts of the world due to the limited supply of short-term Shariah investment instruments.
Businesses and corporate investors with short-term liquidity needs, and who are mindful of ethical investment, will seek out Islamic money market funds that can provide higher returns than bank deposits. Thus, Islamic money market funds are able to be utilized for a company’s working capital needs. This type of fund invests in short-term investment instruments with a maturity date of less than one year. An example of a tradable money market instrument is the Government Investment Certificate (GIC) issued by the Malaysian government. Islamic money market funds generally have lower risk than Islamic equity and Sukuk funds.
ALTERNATIVE FUNDS
The attractiveness of alternative funds to an investor is due to their lower correlation to the equity and Sukuk asset class. Over the long term, this should reduce the volatility of the overall investment portfolio returns. Therefore, performance is unlikely to suffer if sufficient diversification is achieved by including alternative funds in an investor’s overall investment portfolio in addition to the typical mainstream Islamic equity and Sukuk funds.
Islamic alternative funds can include anything from private equity and real estate to infrastructure and commodity asset classes. In Saudi Arabia, where the investors still prefer ownership of physical assets, real estate is a popular asset class to invest in. There are two primary challenges when investing in alternative funds: opaque pricing and the relative illiquidity of the assets. Therefore, these funds may not be easily accessible.
This class of funds generally requires a larger investment amount that can be locked in for an extended period of several years. Given the higher barriers to investing, alternative funds are generally more appropriate for high-net-worth individuals or institutions.
REAL ESTATE INVESTMENT TRUST FUNDS (REITS)
The funds invest in real estate securities that sell like stocks and also invest in real estate based on Shariah guidelines. REITs become attractive due to special tax considerations, better yields, and potentially high payouts to the investors. High-net-worth and institutional investors are able to participate in real estate with high liquidity. Individual investors are able to invest in real estate with smaller investment amounts required compared to purchasing real estate directly. Islamic REITs work along similar principles to conventional REITs, but Shariah-compliant REITs do not invest in properties that involve nonpermissible activities. For example, casinos whose main revenue source comes from gambling would not be allowed in the REIT. In the case of hotels, it is important to look closely at the source of revenues. If alcoholic beverage sales in the hotel comprise more than 25 percent of revenues, then the hotel property is not eligible for inclusion in the REIT.
Islamic REITs were first introduced to the Asian market by Malaysia in the year 2005. The country issued Islamic REITs guidelines in 2005 to ensure the proper management and administration of REITs within an Islamic capital markets framework.8 It is still the only country in the world with guidelines for Islamic REITs. Therefore, these guidelines can serve as the standard for the international development of Islamic REITs. Listed in Malaysia in 2006, the Al-’Aqar KPJ REIT is the first listed Islamic Healthcare REIT in the world and the first Islamic REIT in Asia. The world’s first Islamic plantation-based REIT, the Al-Hadharah Boustead REIT, was listed in Malaysia as well in 2007.9
It is expected that more countries are likely to adapt conventional REITs’ guidelines to facilitate the issuance of Islamic REITs. For example, the Sabana Shariah Compliant Industrial Real Estate Investment Trust is Singapore’s first Islamic REIT, listed in 2010. In the 13 months since its inception, it has grown to an impressive USD833 million in total assets as at the end of 2011. The manager of this REIT targeted high-net-worth investors in the Middle East, as did Dubai Islamic Bank, which listed its Emirates REIT at the same time. The Emirates REIT invests in residential and commercial properties in Dubai, and its asset size grew to USD68.3 million by the end of 2011. This proves that the demand exists, provided enough permissible properties exist to create a diversified Islamic REIT. The Al-’Aqar KPJ REIT was oversubscribed by 4.13 times,10 while the Sabana Shariah Compliant Industrial REIT was oversubscribed by 2.5 times.11
PRIVATE EQUITY FUNDS
Private equity involves direct investment in businesses where part or all of the shareholding is purchased, either in the form of venture capital or with the acquisition of the firm. The purpose of private equity is to provide working capital to a target company to nurture expansion or new product development or to restructure the company’s operations, management, or ownership. Shariah private equity investing encourages direct ownership of real and productive businesses. It follows certain guidelines regarding the permissibility of the business activities and means of financing.
In a private equity fund, the goal is to exit after a specified time period (typically five years), having attained a targeted internal rate of return (IRR). Therefore, given the portfolio nature of private equity funds, they are usually long-term and illiquid, require high initial amounts of investment, and are therefore high-risk, high-return investment alternatives. Therefore, these funds are more appropriate for high-net-worth investors and institutions that have the knowledge, money, and time to stay invested over a longer time horizon.
Private equity investment has long been favored by high-net-worth investors in the GCC but it is only since 2003 that such portfolios have been available on a Shariah-compliant basis. Arcapita, a Bahrain-based private equity firm, acquired Caribou Coffee, one of the largest American specialty coffee chains through Islamic private equity. Investment Dar and Adeem Investment Company, the Kuwait-based companies involved in the acquisition of Ford’s Aston Martin, were again based on Shariah-compliant private equity participation. As a result, leading private equity firms like Blackstone and Carlyle invite Gulf investors during major investment opportunities to participate through private equity, and consequently, Shariah-compliant private equity is gaining familiarity in the western world.
The Unicorn Global Private Equity Fund, launched in May 2006, can invest in the GCC, Levant, Turkey, United States, and Southeast Asia. It is a U.S.-dollar-denominated fund with a minimum investment amount of USD100,000 for individuals and USD1 million for institutional investors. The fund targets well-managed midcap companies across the consumer products, health care, business services, and light manufacturing industries with near-term growth potential and annual revenues in excess of USD10 million.
HEDGE FUNDS
Hedge funds have evolved in both the strategies and objectives since their inception. They were created to hedge (manage) risks against potential losses of investments due to uncertainty in the market. With the shift to wealth preservation and capital protection, these funds have received attention in the Islamic arena. These funds have received much attention and deep interest from Shariah scholars considering short selling prohibition. The basic Shariah principles do not allow the sale of goods without legal ownership of those goods. Also, the principles do not allow leveraging positions that are found in the structure of the hedge funds. However, based on certain Islamic contracts, it is possible to structure a Shariah-compliant hedge fund. As such, there have been a number of Shariah hedge funds developed under the guidance of Shariah scholars.
Shariah Capital, a U.S.-based firm, emerged as one of the leading companies that provide technologies and advisory services to Islamic hedge funds. In 2008, Shariah Capital and Barclays Capital launched Al Safi Trust Platform for hedge funds, in which Shariah Capital provides advisory service and Barclays Capital is the prime broker and custodian. Other developments include Newedge, jointly owned by Calyon and Société Générale, which launched an Islamic hedge fund in 2006 replacing short selling with a Salam-based Shariah alternative. Only a handful of hedge funds are currently listed on its platform, including the Al Raed Emerging Markets Fund (North of South Capital), the Old Mutual Al Saqr Fund (Old Mutual) and the Lucerne Shariah Istithmar Fund (Reach Capital Management). The Malaysian Securities Commission’s Shariah Advisory Council approved Ijarah-based structure to mirror short selling. There are still differences of opinions, but the growth in the asset class will ensure development in terms of sophistication of the products and consensus of opinion.
Shariah-compliant hedge funds are progressing to meet investors’ demands for capital protection and wealth preservation. Shariah scholars and attorneys are continually devising strategies using Shariah-compliant contracts to fulfill these demands.
LEASE FUNDS
These funds exclusively invest in lease obligations. The funds have a fixed tenure and regular income like bond funds but have shorter maturities. The Shariah-based leasing or the Ijarah funds have no objection to the fixed component of the regular returns, as that corresponds to the mutually agreed rental payments between the two parties. However, the Shariah-based Ijarah funds have to fulfill certain additional requirements. The asset used for leasing must be permissible under Shariah guidelines. The rental must be fixed and known to both the parties at the time of entering into the contract. Furthermore, the fund must hold all the responsibility following its ownership of the asset.
The Ijarah fund uses the subscription amounts to buy assets like properties, vehicles, and machinery for the purpose of leasing. The fund owns the assets and the lessees pay the rentals. These rentals form the regular income streams for the fund. The first such aircraft leasing contract took place between Emirates Airlines and Al Rajhi Banking and Investment Corporation; it raised USD60 million through Ijarah. The Ijarah financing is used in many other Asian countries, predominantly in Iran, followed by Malaysia and others. The secondary market for these funds is still nascent.
CONCLUSION
Despite more than 700 available Islamic funds available around the world for investment, the reality is that most of these fund offerings are domiciled in different countries and meant for domestic investors. International investors are not comfortable with them primarily because they are being denominated in local currencies and subject to varying regulatory and Shariah frameworks. Therefore, it is not convenient for international investors who are inclined toward investing their money responsibly.
This poses a serious challenge for investment managers to create investment funds that will attract international inflows. Hence, it is encouraged that investment managers progress toward internationalizing their offerings by using established global platforms like Dublin, Luxembourg, the Cayman Islands, and Isle of Man.
To address this, a small number of investment managers have launched some funds that are subject to a single set of regulations across multiple jurisdictions and are available in international currencies like the U.S. dollar and the euro. The UCITS framework is the most globally recognized regulatory framework for investment funds, and it is this framework under which most of these newer international funds have been established. There are 26 Islamic UCITS funds, which are domiciled on the Luxembourg and Dublin international fund platforms (as of May 6 2012).12 Therefore, despite the stagnation of the industry’s AUM growth at USD59 billion between 2010 and mid-2011, we now see a tipping point where there will be significant AUM growth traction. This is because at this point, most of the funds in Dublin and Luxembourg platforms will reach the minimum five-year track record needed to convince institutional investors to invest.
The challenge of harmonizing Shariah interpretations has existed on the supply side. However, as these Islamic investment products progressively meet with more success and acceptance, Shariah scholars have responded positively to harmonize their interpretations into widely acceptable investment solutions in tandem with the growing cross-market recognition of regulatory frameworks.
On the demand side, the existing perception is that Shariah investing does not result in comparable long-term risk-returns to mainstream investing. However, there is sufficient empirical evidence that most of these asset classes have demonstrated that the underlying Shariah principles have proven to grant resilient long-term performance compared to mainstream investing. The demand for these products will be further supported by the emerging trends toward ethical and responsible investing along the lines of Shariah investing. This is evidenced by the initiative taken by European-domiciled financial institutions to structure Shariah solutions alongside conventional solutions. Banking institutions headquartered in France, Germany, Switzerland, and the United Kingdom offer their Islamic products outside the euro zone.
With the existence of the broad choice of Islamic funds ranging from equity, balanced, and Sukuk to money market, ETF and alternative funds, an ethically inclined high-net-worth investor should ideally be able to form a complete investment portfolio comprising all asset classes invested responsibly.
NOTES
1. KFH Research Ltd. and the Global Islamic Finance Forum (GIFF). “Global Islamic Finance Forum (GIFF).” Kuala Lumpur, Malaysia: September 18–20, 2012.
2. Bloomberg, LP, “Total Assets of Al Ahli Global Trading Equity Fund,” November 28, 2012.
3. KFH Research Ltd. and the Global Islamic Finance Forum (GIFF).
4. Ernst & Young, 5th Edition Islamic Funds and Investment Report (IFIR 2011): Achieving Growth in Challenging Times. 2011.
5. Al Hilal Global Sukuk Fund Fact Sheet. October 29, 2012.
6. BlackRock, “ETF Landscape, Global Handbook.” March 28, 2012.
7. KFH Research Ltd. and the Global Islamic Finance Forum (GIFF).
8. Tan Sri Nor Mohamed Yakcop “Speech: Launching of Dow Jones RHB Islamic Malaysia Index Fund.” Malaysia Treasury web site (2006), www.treasury.gov.my/index.php?option=com_content&view=article&id=954
9. Eugene Malingaham. “Potential in Islamic REIT,” The Star Online, Malaysia (2011). http://biz.thestar.com.my/news/story.asp?file=/2011/6/11/business/8870870&sec=business
10. Malaysian Islamic Finance. “August News Briefs.” Malaysian Islamic Finance Issuers and Investors Forum 2006 (2006), www.malaysianislamicfinance.com/monthly/mifsupplement/aug.html
11. www.islamicfinanceasia.com/article.asp?nm_id=18594
12. Islamic Finance News. “The Takaful and re-Takaful Industry.” Islamic Finance News Supplements (May 2012), www.islamicfinancenews.com/2012_supplement/2012takaful/Takaful.pdf
13. The verse and the legal maxim indicate that everything in business is allowed and permissible, provided that wealth is acquired in an ethical way and through responsible manners that have a positive impact on the wellbeing of people. This can represent a broad range of Islamic investment products available for investors, such as equity, sukuk, private equity/venture capital, real estate, ETF, etc.
General Reading
Gough, Leo, with the Citibank Asia Wealth Management Team, The Citibank Guide to Building Personal Wealth. Essential Information for The Asia Pacific Investor. Singapore: John Wiley & Sons (Asia) Pte Ltd, 2005.