Research

Introduction

As the development of Islamic finance continues, it is increasingly possible to establish with greater certainty industry trends and product characteristics. While transparency remains a goal rather than an achievement, there are several tools and proxies available to do this. Thus we continue our effort of relying on quantifiable data in order to minimise the use of estimates and maximise the accuracy of our analysis.

We therefore extend our previous review of Islamic funds, with the focus now placed on new products, industry drivers, overall performance, regional characteristics and the behaviour of these funds against the overall market. The following analysis relies on our research and coverage of Islamic funds, currently encompassing 351 Shariah-compliant products across various asset classes (real estate, private equity, alternatives and mutual funds).

New Product Demand

The overall number of products available to investors has grown considerably over the last decade as seen in Figure 1, with more than 150 products being launched in the last three years alone. The types of exposures have widened as well, on one hand established markets that make the bulk of the product range have continued to flourish (namely the Middle East and Asia Pacific) and at the same time less traditional exposures (where oddly enough North America and Europe can be categorised) have been introduced into the marketplace.

This change responds to the evolution of market players – the more established ones expanding regionally and the new entrants leveraging their expertise in their own markets. On the other hand, overall investor appetite is for diversification and exploration of new markets so there is a demand for emerging markets (like India, Indonesia, etc) and more conventional markets (such as Canada, Japan, etc). This not only allows for a broader spectrum of products but also introduces greater challenges in terms of demand for proper due diligence and the need for valid track records to lure investors.

Figure 1: Fund Launches by Geographical Mandate

Source: Eurekahedge
Click on the image for an enlarged preview

 Drivers of Growth

The rate of growth of the industry has been a matter of guesswork, to say the least. We provided a proxy for this by focusing on year-on-year growth of the number of funds available (as opposed to asset growth).

This is shown in Figure 2 and while we can ascertain an average growth rate of 15% over the last decade, this is only half the story.

Far more revealing is the fact that industry growth is preceded by years of strong fund performance (good years of growth are preceded by good years of returns), particularly 1998 and 2003. Therefore viability can be argued as a strong driver for growth, since investors seem to demand more of these products after seeing the results – in the form of positive returns. This rate has not been constant though, but then again the last three years have shown a steady increase and stronger years cannot be ruled out.

As part of this industry expansion, there is an expectation that assets will start flowing into these products – either existing assets seeking to reallocate or new assets altogether. Figure 3 outlines the number of funds by asset size, where this reallocation could be taking place. There is an apparent dichotomy in terms of a grouping of funds with less than US$40 million in size against another group above US$100 million in size.

Regardless of the source, asset flows will be encouraged through intermediation products that can close the gap between these two camps. Fund of funds programmes, both existing ones as well as others in the pipeline, are positioning themselves to do this. Diversification would be one reason but due to the increasing number of products, the demand is also there for their expertise in terms of portfolio building and due diligence.

Fund Performance

We take a portfolio approach to consider an equally-weighted Islamic fund index as the equivalent of a naive portfolio of funds and compare it against a broad Islamic equity index (such as the Dow Jones Islamic market world index) as the equivalent of a naive portfolio of equities. This allows us to contrast an active investment style against a passive investment style as shown in Figure 4.  

Our analysis starts on January 2000 – as the arbitrary starting point for all of our indices – and illustrates how these funds have outperformed a global Islamic index over this period, and incidentally the conventional counterpart for this index as well. While this vindicates many pundits, further scrutiny is necessary in terms of analysing regional indices as well as a comparison against conventional funds.

Nevertheless, the products now available offer exposures in very diverse markets and these exhibit distinct differences in terms of performance and correlation. We can observe this by deconstructing the index into its regional components as seen in Figure 5. This doesn’t mean one exposure is better than another, but instead an investor can reasonably expect to build a portfolio that is diversified globally (with an emerging markets flavour) to outperform the global stock market (compared to a global stock index), and do this by the added-value of Shariah compliance (arguably an unquantifiable benefit to the investor).

Figure 4: Islamic Fund Index

Source: Eurekahedge
Click on the image for an enlarged preview

Figure 5: Islamic Fund Sub-Indices

Source: Eurekahedge
Click on the image for an enlarged preview

We survey the regional indices and summarise the results in Table 1. This shows that Middle East funds have clearly outperformed in the last six years (despite the downturn in the last quarter of 2006), both in terms of overall performance (with a total rise in NAV of 86.06%) and risk-adjusted performance (with the highest Sharpe ratio and lowest standard deviation measures).

Nonetheless, the best monthly returns have come out of Asia Pacific and European mandates (14.46% and 10.94% respectively), and they have also shown resilient returns in the last three months (whereas Middle East fund have taken a rest in the same period).

North American and Global mandates have not been stellar either, as both annualised returns and Sharpe ratios have dipped into negative territory. However, this must again be taken in context since overall returns have not reached the levels of 2004 and 2005 (8.52% and 11.18% respectively), with the overall index slowing down to 4.21% for the year 2006.

Table 1: Summary Data and Risk/Return Measures

Source: Eurekahedge

Market Behaviour

Due to restrictions imposed on certain financial instruments for not being compliant (namely options and other derivatives), the argument is often made that Islamic funds are long-only vehicles, and would thus be closely correlated to the overall stock market. Nonetheless, this has been debunked due to the expansion of the fixed income market (ie sukuks), increased trade in structured products (ie ijara/leasing contracts) and the introduction of other exposures (ie real estate and private equity). It could also be argued that Shariah screening provides for an early flight from securities prior to market downturns, although this does not always prove to be the case.

As indicated previously, we follow a short-sighted analysis spanning January 2000 until January 2006. Two well-defined bear and bull markets have occurred in this period to allow an analysis in both of these environments. We incorporate the Dow Jones Islamic market world index as a comparison tool (repeating the passive index vs active index evaluation).

Fund performance in a bear market

We start off with the bear market behaviour as seen in Figure 6, which spans roughly between January 2000 and January 2003. Capital protection can be argued for the overall index (but not in all market exposures). In this case markets such as Middle East and Asia are less correlated during a global downturn by rising between 18% and 20% in NAV (but this protection is not immediate). However the European and North American mandates (which are also more closely linked to the DJIM index) do not provide substantial protection although they do outperform the index during this time period.

Fund performance in a bull market

The analysis continues in a bull market scenario as seen in Figure 7, which spans roughly between January 2003 and January 2006. In a less glamorous fashion, these funds are arguably hugging the global index (although this is more prominent in certain regions). In this case no clear geographical mandate is exempt although European mandates seem to perform better through this period. On the other hand not all indices are as closely correlated and they tend to spread away (as opposed to the strong correlation observed in a bear market). Nonetheless, this also highlights the increased importance of manager selection in upward trending markets.

Having said that, we recognise that in certain instances this global index comparison might be biased towards large-cap US stocks and not fully representative of the entire investable universe.  However, it does challenge fund managers to justify their management fees and highlights the increased importance of manager selection whether it is in upward or downward trending markets. Further evidence of this is the diminishing margins observed between top-quartile returns (the top 25% returns in a given month) and bottom-quartile returns (the returns below 75% of the overall population in a given month).

Conclusion

Without a doubt Islamic finance will continue to develop and the fund universe is poised to expand further. Nonetheless investors face new challenges in terms of due diligence and overall portfolio construction, whereas the onus is on fund managers to bring to the table products that add value in terms of performance as well as uncorrelated returns. What is certain is that a Shariah-compliant portfolio has never been more achievable and can certainly be crafted to provide as many benefits as a conventional one would.