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Gamble or risk control? Islamic hedging row rages – Developments in Islamic Finance June 8, 2007

Posted by islamicfinanceaffairs in Uncategorized.

Gamble or risk control? Islamic hedging row rages

Demand for hedge funds and for Islamic finance is booming, which makes a hedge fund that complies with Islamic law the holy grail for fund managers who want to tap huge liquidity in the Gulf.

But most Islamic finance industry players say the two sides are incompatible and that common hedge fund strategies break Islamic law. [….]

On the bankerme.com Web side, Islamic finance consultant
Michael Gassner describes deal structures that hedge funds
combine in a complicated series of steps to win Islamic

But Ahmed Abbas, of Bahrain’s Liquidity Management Centre,
criticized such mechanisms as false to the spirit of sharia. “I
don’t care, if you take 20 Islamic steps in order to short sell,
you cannot sell what you don’t own.

“Islamic banking is not about drawing an Islamic veil over
something un-Islamic.”


1. Yusuf Talal DeLorenzo - June 9, 2007

Though hedge funds have existed since the late 60’s, and have taken many shapes and forms (owing to the strategies employed by managers) the most widely-accepted definition of a hedge fund is that it is a fund that uses leverage, shorting and options to achieve its investment goals, beginning with the protection of investor capital. Aside from the negative press and public image brought about by the spectacular failures of a handful of hedge funds in recent years, most Islamic investors are wary of hedge funds for the more fundamental reasons. Chief among these is the notion that short sales and hedge funds go hand in hand. Indeed, looking at the definition above, it is indeed clear to see the essential relationship between the two. Then, when the text book definition of a short sale includes the borrowing of securities and their subsequent sale into the market, it should come as no surprise if the Islamic investor prefers to stay away from hedge funds. Indeed, in the article cited here, the objection that “you cannot sell what you don’t own,” is fundamental.

Over the past several decades, Islamic Finance has advanced steadily toward the mainstream of the financial industry. In the past year or two, the industry has suddenly picked up the pace toward credibility, stability, and profitability. It is not owing to religious conviction or sentiment alone that the depositor/investor base of Islamic Finance continues to grow. Islamic Finance is developing the ways and the means to be competitive. Islamic financial products and services need no longer to be offered at a premium, or packaged in ways that only the faithful can tolerate. On the contrary, the clients of Islamic financial institutions expect and receive Shariah-compliance in a range of products and services that cost no more than their conventional counterparts. Equally as important, the new Islamic alternatives are competitive with their conventional counterparts where it really counts, at the bottom line. Ultimately, it is the management of risk that protects the bottom line.

Islamic investors, like all investors, have different levels of tolerance for risk. The same is true of the Islamic banks and finance houses themselves. Moreover, for reasons related to regulatory compliance and fiscal responsibility, Islamic financial institutions must be able to manage risk in accordance with established processes and standards. In the past few years, several important developments have occurred within the industry to bring risk management into alignment with worldwide standards. The first was the introduction of the Sukuk instrument as an alternative to the conventional bond, thus providing Islamic treasuries with the sort of rated, liquid, fixed-income instrument that anchors financial institutions worldwide. Another of these breakthroughs has been in regard to further diversification, as investment funds and instruments move into new asset classes and become more efficient. In regard to investments in securities traded on the stock markets of the world, however, the most significant development for the industry since the launch of the Dow Jones Islamic Market Indexes nearly ten years ago is the advent of the Shariah-compliant hedge fund. Presently, a handful of such funds are in existence; and it is likely that many more will follow.

But what of the issues discussed above? Hedge funds are popularly believed to be highly speculative and thus may run contrary to the Shariah prohibition of gharar. At an even more fundamental level, however, hedge funds use short sales to neutralize the influence of market forces; and short sales involve the sale of what one does not really own, which is haram.

Let’s look at the first issue, that of speculation and gharar. In the hedge fund industry, the preservation of capital is rule number one. It is unfortunate that many people have the impression that hedge funds are about speculation and wild rides on Wall Street. Nothing could be further from the truth. The fundamental principle of hedge funds is that every trade, every move is calculated to preserve capital. The name itself, hedge, is indicative of this fundamental principle. (The Arabic word for the same, tahawwut, is equally indicative of this fact.) In most cases, there is more risk in an ordinary mutual fund than in a hedge fund. For most hedge funds, slow and steady wins the race. Typically, however, it is not the slow and steady horses that catch the eye of the public. Finally, the true nature of a hedge fund is to protect against gambling and speculation, even when others in the marketplace are doing so. Or should I say, especially when others in the market are doing so. Thus, to equate hedging with gharar is clearly a mistake. For mature and efficient markets to exist, there need to be both speculators and hedgers.

Let us turn now to the matter of shorting. Obviously, the conventional short sale, the text book borrow and sale of securities, is in no way compliant with Shariah principles. Finding a practical solution to the problem of replicating a short sale began with a study of the fundamentals on all sides of the equation. Nearly everyone involved in the projects to find solutions, including lawyers, fund managers, and Shariah scholars insisted from the outset that the solution, from the perspective of Islamic jurisprudence, should be straightforward, employing contractual norms established by the classical jurists of Islam. In other words, the solutions should not employ legal stratagems or devices (short cuts) that might lead to controversy. The second principle that was agreed upon was that the solution should fit seamlessly into the existing systems established by prime brokers under SEC or FSA regulations.

The obvious problem with the conventional short sale is that it involves the sale of what one does not own (or bai’ ma la yumlak). It is, however, a transaction that involves two different times for initiation and completion. In this respect, it is immediately suggestive of two types of sales sanctioned by classical Islamic law. These are the salam sale, used primarily in an agricultural context, and the `urbun sale. Just as an aside, it is interesting to note that the salam sale is itself a tool for hedging and the management of risk, and was designed to give farmers protection from overly speculative merchants. The `urbun sale (and there is also an `urbun ijarah model) also has its roots in classical Islamic law. In an `urbun, the seller takes earnest money from the buyer with the understanding that the advance will be credited toward the price if the sale is concluded. Equally as important, the OIC Fiqh Academy, in 1993, reviewed the `urbun transaction and found it acceptable for use by modern Islamic banks and investment houses. Both of these models have been considered by research and development teams; and both have been deployed by Shariah compliant hedge funds. Both models allow for replication of the processes and practices, or what might also be termed the “mechanics” of a short sale, while maintaining the “economics” or the financial results of shorting. In other words, in neither model is the fund manager borrowing stocks and then selling them into the market. On the contrary, in the short sale alternatives the `urbun or the salam facilitates the purchase of the stocks, so that the investor actually has ownership. It might be important to note here that only the `urbun model, however, has been deployed for use in compliance with both Shariah and SEC regulations.

By means of short sale alternatives, the Shariah compliant hedge fund manager has the ability to hedge against drops in the market and thus limit downside exposure. Until recently, most Islamic funds simply tracked the stock market; so that when the market fell, the value of the Islamic portfolio fell with it. The actively-managed, long-only, Islamic mutual funds had only their stock picking abilities to manage risk. With the ability to sell short, Islamic fund managers can now record gains with falls in the markets, clearly providing for the more efficient use of capital. In terms of risk management, a Shariah compliant hedge fund manager may take a market neutral strategy that reduces the net exposure of the Islamic investor to the market. In other words, when the market moves significantly in one direction, long positions might lose money but short positions will gain, thereby negating the effects of the move.

In terms of how risk is to be managed, the solutions developed for the Shariah compliant hedge funds are especially comprehensive and efficient; and much of what these funds do will be helpful to the industry in general. Eventually, these funds will be aggregated into Shariah compliant funds of funds, meaning that risk is managed through the diversification of managers, sometimes called a multi-manager approach. By investing in several uncorrelated funds, the fund of funds’ strategy is to capture returns regardless of what is happening in the market. When each of the constituent funds has proven itself historically to outperform the market, the results are all the more likely to be positive. Finally, the plurality of managers will ensure that even if one fund underperforms, this will be offset by positive performances on the part of the other funds.

Finally, it should be pointed out that the solutions for Shariah compliant hedging have been approved by the most demanding and experienced of our Shariah scholars. In fact, five of the six members of the Dow Jones Islamic Market Indexes have signed fatwas certifying such funds.

It is understandable that many Muslim investors are as yet unaware of these funds. After all, there are only a very few in operation at the present time. However, given the importance of these funds for the effective management of risk, and the need for such management by Islamic portfolios worldwide, it will not be long before Shariah compliant hedge funds are commonplace. Moreover, the stability they bring will contribute significantly to the growth of the industry in general, and the benefits it can bring to Muslims everywhere.

2. Yusuf Talal DeLorenzo - June 12, 2007

Opalesque Exclusive: Sharia hedge funds alive and kicking

From Benedicte Gravrand, Geneva: In an article titled ‘Gamble or risk control? Islamic hedging row rages’, Reuters reported last week on the Islamic Finance Conference in Bahrain and described some of the difficulties faced by the industry to produce sharia compliant hedge funds. The article also quoted Antoine Massad, of Man Investments Middle East (part of Man Group), who said that such funds did not exist. To quote: “There are some who claim to have Islamic hedge funds in the market. Yes there are three or four, but no one has invested in them, so to me they don’t exist… Hedge funds use leverage, derivatives etc. – all of that is haram (forbidden by Islamic law). It is not only not halal (acceptable by Islamic Law); it’s haram”. Opalesque checked with industry experts to find out more – are sharia hedge funds dead or alive?
Charles Bathurst is the Director of International Sales at Old Mutual Asset Managers (www.oldmutualfunds.co.uk). Old Mutual is the third of five hedge funds that use the Ratings/FIMAT platform and to date the first three have raised around US$100m from the Gulf since October last year and are only now actively marketing with huge interest and potential.

“These comments were very ill-informed. There is a transactional model that has been approved by some very serious scholars who themselves sit on the boards of many of the financial institutions. Where I think Mr. Massad was ill-informed is that you don’t actually do the same thing but you end up with a similar methodology – but you are not doing it exactly the same way. You cannot use leverage at all. You don’t borrow stock. There are methods that allow you to in effect do a forward transaction, a bit like commodity, but that is fully funded. When you do a short position, you don’t borrow stock. What you do is go to the market and place a forward transaction to purchase shares at a price in the future and that price will be lower than today’s price. You fully finance that forward contract at the time of purchase. You hold that contract for 3 months. During that period, should the price target be reached or if you wish to fulfil your obligations at a different price you can do that. It’s exactly the same as a commodity transaction which is all fully approved. That’s called a salam. That is a methodology that the scholars have approved as being appropriate for equities…”

It will be a very active business – although there may be disputes
“Money is being raised and we expect this to be a very active business. What will happen is, the first five funds – all big names – have gone into the market and are now raising money with big local institutions behind them. The problem with this whole area is that there are certain elements of the Islamic finance world who by definition are more conservative and will always dispute other academics thesis, as it happens in every forms of life.”

Mushtaq Shah is the CEO of Ratings Intelligence (http://www.ratingsintelligence.com), which provides a comprehensive set of services for investors who wish to invest in stocks in accordance with Islamic principles. RI also advises the S&P Islamic Index. RI is the leading Islamic consultant in this space who have contracted four of the leading Islamic scholars from Saudi Arabia, Syria and Kuwait (all of whom have approved a mechanism for replicating a hedge fund transaction without borrowing stock or using leverage and issued a fatwah).

Ultimately, it is an academic matter
“You really have to be a sharia scholar, with the right qualifications, with 20 years of practical experience studying the scriptures, to have an informed view on this type of issues… my view is that we as lay members, we are not scholars, we structure products but we do so with the blessing and approval of our Sharia committee. We rely on them to tell us what they are in the position to do so. Ultimately, it’s an academic discussion as to whether something is compliant or not, and it should be done by academics. It’s like me having a view on how Michael Schumacher should drive his car. You need to have credibility and experience before you start making comments. The way investors will look at it ultimately; they rely on the opinions of scholars whom they trust and believe are experts in the field not on practitioners who are trying to sell their own products. “

“I have no view on whether the comments are right or wrong. My view is I don’t think it’s appropriate of us to make these types of remarks. “

Salam contracts
“We don’t use leverage. We use salam contracts which seems to be acceptable in Saudi. Obviously as it is new, there are some issues with it but a number of prominent Saudi scholars have signed off on it. The contract was designed for hedging commodities. The issue is whether it is applicable to securities or not. But, the technical issue requires a technical discussion. The scholars in the committee think it is. They have some support from the Saudi government who agree with them – which is our target market – which means that they agree with the intellectual (idea). Do you remember at the time of the prophet, when those contracts were first used, there were no joint stock companies, there were no stock exchanges, structured companies didn’t exist at that time. So the issue is, do the lifted listed companies have the same relevant characteristics as commodities do – relevant from a sharia perspective – to make it compliant or not? Our scholars take the view that they do and there are a number of other people who agree with them…”

Make serious reference to the Koran
“There are various other methodologies out there based upon different concepts. If you want to discuss whether or not they’re correct or not, I think it has to be through the technicalities of the mechanisms not through a ‘Oh, I don’t think this works’ reaction, because that is not a sensible, intellectual discussion. A scholar from our committee, a very intellectual man, said to me if we discuss whether something is prohibited or not, we should discuss it in more detail and have a deep intellectual discussion with reference to the Koran, etc. not just disagreeing which is what people who have their own vested interests do – they might be pushing Islamic bonds, not wanting hedge funds because it’s an alternative to what they are doing… the discussion has to be done at a different level… that’s how you do it in the West, right?”

“I don’t see anybody justifying their position with reference to anything”
“Saying that Shariah hedge funds don’t exist is not appropriate. If you looked at the western hedge funds world, there was not very much money in there initially and then there was a big flow of money from pension funds, etc., and that took years. That is the way markets develop. We know that and we are not too concerned about comments like that… I am not sure how one can set the records straight in this context. For any new product you see in the Islamic world, there are a lot of people who will engage them. Some of the people quoted in the article are very critical of some of the products that are produced… I just don’t think that is an appropriate way to proceed because so long as their products are signed off by a Shariah committee that is reputable, that is all one can see… I cannot engage any Shariah scholar on that level because they study these things. They cannot engage me on financial econometrics which is what I did my PhD on. I think critics act on good faith, but if we are to disagree we should engage at the right level. If you think it is not compliant, you should justify yourself with references to the scriptures. I don’t see anybody justifying their position with reference to anything.”

Philippe de Chardin is the MD of Fimat (www.fimat.com). The brokerage company has been issued a fatwa (a considered opinion in Islam made by a mufti, a scholar capable of issuing judgments on Sharia (Islamic law) by Ratings committee to provide a hedge fund transaction model in an approved manner Mr. de Chardin said he did not want to comment on such hearsay, saying that the whole process should be left to scholars, and that sharia hedge funds are meant for serious investors.

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