Investors in the GCC have been investing in the conventional hedge fund market for a number of years. GCC institutions have, in terms of their own portfolio diversification, generally mirrored global investment thinking. Strong regional growth and the steady liberalisation of the GCC markets have attracted a wide range of conventional hedge fund managers to the Gulf.
Sophisticated investors in the GCC are attracted by the differing investment returns on the variety of alternative strategies when compared to conventional and regional stock markets, private equity, property and oil-based returns. Within the Gulf, investors are turning to hedge funds as a source of stability and security during the regional stock market volatility evident in certain Gulf states in recent years.
Investors which perceive that regional equity, property and IPO successes may not be sustainable are also looking to diversify their successful portfolios by investment in structures that may protect down-side risk.
Conversely, hedge fund managers have been also motivated by the success of locally concentrated investment funds. Many financial institutions and law firms have set up offices in Dubai and Bahrain.
In February 2006, Volaw established an office in Dubai and became licensed by the Dubai Financial Services Authority (DFSA) to provide trustee and fund administration services. The move was motivated by the flow of business opportunities, but also by the proactive regulatory environment in the DIFC. The DIFC offers a platform for leading financial institutions and professional service providers doing business in the Gulf regions including hedge fund managers. The aim of the DIFC is to place Dubai at the hub of Middle Eastern institutional finance, creating a new pre-eminent international regime in the Gulf for funds, trusts and financial services generally.
In December 2007 the DFSA issued its Hedge Fund Code of Practice, the first of its kind to be issued by a regulator and a landmark code in the regulation of the international hedge fund industry. The code sets out best practice standards for operators of hedge funds in the DIFC. The code addresses some specific risks that are associated with hedge funds and reflects the DFSA’s commitment to risk-based regulation.
There are nine high-level principles in the code, which cover areas of key operational, management and market-related risks, particularly in the areas such as valuation of assets, back office functions and exposure to market risks. Shari’ah compliant hedge funds
Due to the support of some Shari’ah scholars, the theoretical concept of a Shari’ah compliant hedge fund is now well established. Islamic finance is constantly developing ways of staying competitive with conventional markets within an Islamic framework. Major Gulf financial institutions expect Shari’ah compliance in a wide range of products. They also expect such products not to cost substantially more than their conventional equivalents.
Shari’ah compliant equity fund structures have proved popular since, in theory, they are consistent with Shari’ah principles of participating in and sharing of risks and rewards of a joint venture. This has made Shari’ah compliant equity investment funds particularly attractive to Islamic investors and has led to examination of ways in which similar forms of absolute return funds can be structured.
Accordingly, asset managers in the Gulf region have been seeking to develop Islamically acceptable strategies that will replicate the absolute return mechanisms of global hedge funds, whilst continuing to adhere to the principles of Shari’ah. In the past few decades, there have, of course, been many differing forms of conventional hedge funds, owing to the various strategies employed by fund managers.
However, the most widely agreed perception of a hedge fund is ‘a fund that uses derivatives, leverage, shorting, margin trading and option techniques to achieve its absolute return investment goals’. Usually, short sales include the borrowing of securities and their subsequent sale into the market. Shari’ah scholars are wary of any conventional form of short sale since, under fundamental Shari’ah principles one cannot, of course, sell what one does not own.
Shari’ah of course, generally imposes restrictions on types of investment. It requires that Shari’ah compliant funds avoid transactions in unethical goods and services; the earning of returns from financial instruments (Riba or interest); excessive uncertainty in contracts (Gharar); as well as trade in debt contracts, forward foreign exchange contracts and general forms of financial options and similar derivatives.
As with all Shari’ah compliant products, any hedge fund strategy would have to be certified by a recognised Shari’ah scholar via a Fatwa. There are to date various potential mechanisms in place which aim to reproduce, as near as possible, the equivalent derivative trading techniques of conventional hedge funds. In particular, the aim of producing a Shari’ah compliant methodology which replicates the economic effects of short selling seems to have been established in a number of cases to manage risk in similar means to conventional hedge funds.
The success of a Shari’ah compliant hedge fund will also depend upon the hedge fund being able to combine the techniques and strategies used with the ethical requirements of openness.
Several such funds have been adversely affected by articles in the regional and Islamic finance press that criticise the lack of transparency in their short selling methodology, despite an initial Shari’ah sign-off or Fatwa.
The need for transparency causes a problem over intellectual property for the institution developing the product. However, the rewards for being transparent should far outweigh the risk of being copied by competitors.
Within the long/short hedge fund methodology, there are various issues that need to be addressed before Scholars will issue their fatwa on a fund.
These will include:
Stock selection
All investments must meet certain qualitative criteria such that any company undertaking Haram activities is excluded; a common example is a company producing alcoholic drinks. A second test is to ensure that any company financed in a Haram manner, for instance with too much debt, is also excluded.
Leverage
Many hedge funds are heavily leveraged, but the fund will not be allowed to borrow money in a conventional manner such that interest is paid; leveraging can usually be achieved within the structure using a Murabaha or other Islamic contract.
Short sale
This is the major hurdle for the fund manager to overcome, as it is a fundamental principle of Shari’ah that you can’t sell what you do not own. Several institutions have attempted to use various forms of Islamic contract, some of which are discussed below, as a means of effecting a transaction akin to a short sale of shares. However, the use of Islamic contracts can lead to problems in itself in that prime brokers and other financial institutions will have established systems based upon internationally accepted forms of contract and may not be willing to change their systems for only one fund.
The more common forms of contract that have been proposed in these circumstances are:
Salam
This is a sale contract with a deferred delivery and was the method generally favoured by early funds. However, Shari’ah Standard 21 issued by the Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI), which came into effect in January 2007, stated that it was not appropriate to use Salam contracts for transactions in company shares.
Arbun
This is a sale contract with a non-refundable deposit. Whilst the Hanbali school of Islam generally allows Arbun’s use in transactions over shares, the Hanafi school seems to declare it Haram. The main effect of this would be to harm the marketing of a fund which uses Arbun in areas where the residents generally follow the Hanafi school, such as much of Saudi Arabia.
Wa’d
This is strictly not a ‘contract’ but a unilateral undertaking, or promise, by one party to another. It is widely used in Islamic finance but the methodology has its critics. In 2007, Sheikh Yusuf DeLorenzo, one of the world’s leading Scholars, published an article titled ‘Total Returns Swap and the Shari’ah Conversion Technology’ which considers the implications of using Wa’d contracts in structured finance transactions, including hedge funds. Sheikh Yusuf was particularly critical of certain structures that have been approved where a Wa’d has been used to convert profits earned from Haram activities into Halal income. The debate over Sheikh Yusuf’s article is likely to have a major bearing on the future structuring of Islamic hedge funds.
Shari’ah compliant or Shari’ah-based?
Several leading experts in Islamic finance have questioned the appropriateness of using forms of contract derived from an agricultural economy of several hundred years ago in modern financial transactions. A recurring theme in scholarly ideas is a move from Shari’ah compliant product structuring to Shari’ah based product development. This move suggests a back-to-basics approach in Islamic finance, such that transactions are structured around the principles of Shari’ah and not by ‘Islamising’ conventional products.
As far as characterisation of hedge funds as highly speculative is concerned, this may be a reason why they have been seen as difficult to achieve in a Shari’ah compliant context. However, of course, the theory is that hedging is seeking to minimise rather than take advantage of risk. It is at least arguable that there is no greater speculation or Gharar or excessive uncertainty, element in Shari’ah compliant hedge funds than in Shari’ah compliant private equity funds.
It may, ironically, be that the July 2007 global credit crisis may be the point at which conventional hedge funds are reassessed. However, even in this crisis there may be promise for the development of Shari’ah compliant hedge funds. This is because of the ethical rules which may restrict the leveraged and debt positions taken by such funds and may lead Shari’ah compliant hedge funds to be less susceptible to such losses.
This back-to-basics approach should lead to a much wider acceptance in financial circles of Islamic funds, which are often unfairly criticised as being re-engineered conventional financial products, and should lead to the development of a truly Islamic hedge fund. In any event, the development of the various Shari’ah compliant hedge funds has resoundingly demonstrated that Islamic finance is constantly evolving.
Bill Gibbon is group partner at law firm Voisin and is head of its Shari’ah h funds department. Trevor Norman is a director of Volaw Trust & Corporate Services and is the head of Volaw’s Islamic finance and Middle East group.