Special Focus:Islamic hedge funds viable?

Although there is strong interest, the process of developing syariah-compliant hedge funds has been constrained by Islamic law, which prevents the use of derivatives, where one transfers the risk of payments in a business dealing to another person. Islamic law forbids short selling because it involves selling an asset that one does not own. Forward and futures contracts are equally forbidden because they are construed as “selling promises”, reports The Edge.
“Options, meanwhile, include payment for a future ‘right’ to do something, but such a right, without obligation, makes it dependent upon future events and therefore creates uncertainty, an element also forbidden under Islamic law,” the report quoted Nik Azhar Abdullah, executive director and head of Alliance Investment Management Bhd.
THE REPORT GOES ON:
A Reuters article in mid-April quoted some Islamic finance proponents as saying hedge funds that based their investment strategy on syariah or Islamic legal principles would face significant disadvantages compared with non-syariah hedge funds. They said many strategies would be difficult to achieve because these would be too expensive to perform in a syariah-compliant way or because the tools themselves would be inappropriate under syariah law.
The Securities Commission has looked into a regulated short selling and securities borrowing and lending framework with a view to introducing appropriate flexibilities within the syariah context. This would enable the establishment of alternative strategy funds that are highly dependent on their ability to undertake hedging strategies. These regulatory developments seek to provide a basis for alternative strategy funds to be used as a launch pad for Islamic funds employing absolute return strategies.
Nik Azhar says with new developments in Islamic investment, there is a view that hedge fund managers can adopt some of the accepted Islamic finance practices to work with conventional hedge fund strategies. For example, a fund falls within the permitted domain of Islamic finance by creating “stipulating options” or options where a buyer makes an advance partial payment for goods at a later date. If the buyer later decides not to complete the deal, the seller keeps the advance and this is the closest product in Islamic finance to an option.
“A further development of the hedge fund principle is the Salam Sale, where one sells a commodity to a buyer against full upfront payment for delivery at a future date. An investor can hedge downside risk by selling stocks as a Salam Sale, with the same result as short selling, but without a borrowing element. The performance fee may be structured similarly to the mudharabah contract where the investor and entrepreneur agree on the profit-sharing ratio upfront,” says Nik Azhar.
He believes that a syariah-compliant hedge funds market will grow in the future but it may be restricted to certain types of hedge fund investment as there are more prohibited than permissible areas in hedge funds.
Humayon Dar, CEO of BMB Islamic UK Ltd says there is nothing in syariah law that is against the basic philosophy of hedge funds, which earn market-neutral returns for their investors.
Says Badlisyah Abdul Ghani, CEO of CIMB Islamic Bank: “Islamic financial markets fall under the ambit of muamalat or human societal relationship where everything is allowed unless it is expressly disallowed under syariah. Few things are expressly prohibited in muamalat and these can be broadly categorised as not conducting riba or charging interest and/or trading ribawi goods and to avoid uncertainty in contract, the buyer and seller must be clear on the goods sold, and the timing and price must be outlined in the agreement.”
Other restrictions are not to gamble or trade in an exhaustive list of non-halal goods or trade in goods with no value.
Innovation and development can only arise when research is done, says Badlisyah. “If syariah law is not followed under the principle of muamalat, unless there are clear prohibitions, we will never do the research to know whether hedge funds can be done. To my mind, if we adhere to syariah, there are many areas that can be explored.”

This article appeared in the Islamic Banking & Finance page, the Special Focus pullout of The Edge Malaysia, Issue 755, May 18-24, 2009.