Research

Introduction

Islamic investments have garnered interest over the years and have gained momentum not only from established participants but also from a variety of new entrants. While some outsiders would care to refer it as a subset of the socially responsible industry, the informed observer will note that the industry has taken a life of its own and is poised to develop further.

In response to investor demand, Eurekahedge launched a database of Shariah-compliant investment products this year, adding to its coverage of the alternative investment universe. This platform currently collates information on more than 330 funds, out of a universe which oscillates around the 400 mark. It is by far the most comprehensive attempt to provide transparency to investors and provide factual data to its participants.

As a measure of industry development, the number of funds launched has grown consistently over the years, as shown in Figure 1. A decade ago, one would have relied mostly on the established markets of Saudi Arabia and Malaysia to find around 100 funds, but this number has grown steadily over the years. Following the number of funds alone, the average rate of growth has been 15% per year. A critical mass has arguably been reached that has triggered interest from institutional investors as well as non-Islamic institutions, not only due to size but also from track records that are now falling under closer scrutiny.

Figure 1: Industry Growth over the Years

This review seeks to provide a comprehensive overview of the industry and an analysis of its key components. In order to do so, we examine the overall make-up of available products, their growth and development, their historical performance and establish a benchmarking index to track and compare these funds with one another. As the information available to us has seldom been collated before, we make a concise effort in minimising our use of estimates and focus instead on the factual data. As we rely purely on our database for information, we acknowledge the fact that further transparency is needed to reach the levels offered in other industries.

Industry Make-up

I. Fund Location and Geographic Mandate

Traditionally there have been two main geographical regions that have dominated the industry, namely the Middle East and Southeast Asia). As the graphs below show, this still holds true but the number of funds by head office location are increasingly found outside these two clusters (Figure 2). This is an indication of the importance of the two regions as drivers of the industry, but also of the arrival of product offerings from less traditional sources. The presence of offshore products (Figure 3) is again a sign that these products are increasingly being offered to investors across multiple domiciles and developing more sophisticated structures. Thus a third undefined cluster is emerging, as existing participants explore new markets and new entrants introduce new offerings.

Furthermore, geographical mandates follow a similar theme as shown in Figure 4 below – the GCC and Asia-Pacific markets clearly dominate, and their established institutions further leverage on their experience and extend their product offerings to their client base. Yet investor appetite is increasingly heading towards new markets and/or less traditional exposures. Some of these might be at the periphery of established Islamic financial centres, yet some others are new altogether. For example, in the first half of 2006, new fund launches have seen products with exposure to China, Egypt, India, Pakistan, South Africa and Turkey – to name a few.

Figure 4: Funds by Geographical Mandate

II. Industry Growth

While the number of funds have seen steady growth (as shown in Figure 1), the assets under management have become a matter of debate, mainly due to the lack of information available if not anything else. We focus on a more telling characteristic, the number of funds segregated by fund size (as shown in Figure 5). This is not a bell-shaped curve but one skewed to the right (small-sized funds are the norm but the tail extends to large-sized funds), which is partly due to the local focus of most funds (as they have catered to their domestic constituents) and also to the capacity constraints of some smaller markets (in fact many new mandates emphasise their cross-border exposures as they seek to further differentiate their offering).

Figure 5: Distribution of Funds by Size

The evidence also suggests that a potential rebalancing of portfolios could be in the making (merging of the two poles towards a more “normal distribution” of the industry). However, this might not be immediately possible due to capacity constraints and a lack of intermediation products that might enable this – although a telling observation is the rather recent development of fund of funds structures and their role in this redistribution of assets. The flow of funds seems to be more relevant in this case than the actual asset size of the industry – which might also be prone to miscalculations as we observe that not all assets under management are exclusively managed under the same mandate of compliance with Shariah.

Another often encountered impression is to relate the industry’s growth, performance and overall development with the surplus of petrodollars that has been observed in the last few years. This might as well be a contributing factor, but as seen in Figure 6, in the past decade the growth of the industry has seen 1998 and 2003 as the years with the most notable rate of growth. Certainly the last five years have been witness to more than 180 new products (almost doubling the investible universe). However, we find no distinct correlation to any exogenous events, as the overall rate of growth in the industry has remained solid and stable throughout.

Figure 6: Year-on-Year Growth

Performance

I. By Sectors

In tandem with our approach to other industries, we have created a set of indicators similar to our other fund indices. We have used the same methodology to create an Islamic funds index, namely: an equally-weighted approach, wherever possible we have included data from obsolete funds, and chosen December 1999 as a practical starting point for the analysis. The indices would be further rebalanced as new funds are added to our database, or existing funds disclose their performance details¹ .

We have further created sub-indices according to the investment mandate of the funds (by geographical exposure). We have selected five sub-indices as being the most representative of the industry (in terms of number of constituent funds as well as the market dynamics). Therefore the indices chosen are as follows: Asia Pacific, Middle East/Africa, North America, Europe and Global (which incorporates broad based mandates as well as emerging market funds). These are charted in Figure 7

Figure 7: Islamic Funds Sub-Indices

From the above, we can isolate various distinct trends, the most notable being  that Middle East/Africa and Asia-Pacific indices have exhibited the strongest performance within this timeframe. This is despite the fact that the strongest index closely followed the correction observed in the overall GCC marketplace. It is further evident that all indices are trending upwards since the end of 2002 in line with the recent bull markets observed globally. This supports the notion that because of short-selling and other restrictions, some funds might have limited ability to protect against downside movements in the markets.

Lastly, the three remaining indices (Europe, North America and Global) seem to be closely related to one another in terms of overall performance (although European mandates have exhibited a stronger rebound). This could be due to a reliance on broad-market indices that are inclined to follow global stocks.

Taking the construction of passive Islamic fund sub-indices one step further, we decided to compare fund performance (from Jan-2000 to Aug-2006) by their year of launch (depicted in Figure 8) to further investigate a) the year-on-year growth in number of funds seen in Figure 6, and b) whether newer funds are indeed better performing than older funds.

Figure 8: Performance by Year of Launch

As can be seen from Figure 8, while there is no clear trend of old school funds beating the vanguard or vice versa, the two years that saw the highest growth in number of funds (1998 and 2003) were both preceded by years that saw well-performing (in absolute and/or relative terms) newly-launched funds (1997 and 2001 respectively). Their strong performance certainly spurred the industry into further growth as more players found it viable to enter the fray.

That said, a more detailed analysis of the data is in order, and we will elaborate on this in the following section.

II. Descriptive Statistics

Analysing the data has limited benefits, but overall the return distribution of Islamic funds seems to possess quite useful characteristics as seen in Figure 1. Based on 6,917 monthly return data points, Islamic funds overall exhibit a positive average return (mean of 0.6%), positive skewness (2.18) and a rather significant positive kurtosis (38.62). Taken in context, these reflect a slight bias towards positive returns and a predisposition for outliers (which mostly appear on the right-hand side of the spectrum). Overall, the data is not normally distributed but platykurtic and a significant standard deviation that widens the range of outcomes quite substantially.

Figure 9: Distribution of Islamic Fund Returns

However, there is more to be said about the various market segments and their relationships with one another. Once again we analyse the historical monthly returns but here we further segregate according to geographical mandate. Table 1 provides a summary of statistics for the 2000-2006 timeframe. We can again restate that the Middle East/Africa and Asia-Pacific regions have posted the strongest performance as measured by average return. This is further substantiated by a simple Sharpe ratio analysis, which again sees these two regions ranked above the remaining three categories. Only in Asia Pacific does skewness and kurtosis seem notable (whereas there are no significant values for the other four), but we defer to a correlation analysis to enable a closer look at how these markets move compared to one another.

Table 1: Descriptive Statistics of Historical Monthly Returns

Our preliminary observations are substantiated by a correlation analysis (Table 2) of the sub-indices that we manufactured earlier. The strongest correlation is between the European, North American and Global indices, with an almost perfect correlation between Global and North America. On the other hand, Asia Pacific exhibits the lowest correlations against all other indices, and the Middle East/Africa index has a similar tendency.

Overall, the indication is that diversification benefits for a portfolio  derive mainly from adding a global component,  though this also depends on the existing allocation of the portfolio ( for example, an European portfolio would diversify best with an allocation into the MENA or Asia-Pacific regions). Still, an Asia-Pacific portfolio would benefit the most from allocating into Shariah-compliant mandates outside of its vicinity.

Table 2: Correlation Statistics of Islamic Sub-indices

	Asia Pacific	Europe	Global	Middle East/Africa
Europe	0.4791	1
Global	0.2787	0.9051	1
Middle East/Africa	0.8872	0.5935	0.3055	1
North America	0.1096	0.8725	0.9760	0.1829

III. Indices and Benchmarking

The aim of introducing the indices is to provide an overview analysis of the overall industry as well as to generate a benchmarking tool for both investors and fund managers. We further introduce a broad-based Islamic fund index which encompasses all other sub-indices. It is similar in methodology (equally weighted, starting in the year 2000, etc) and can be simplified as a naively diversified portfolio of Shariah-compliant fund managers.

While market indices focus on financial instruments as their underlying investment (thus representing a passive investment strategy), a fund index goes a step further as its underlying are not stocks but rather fund managers. Therefore, they are a proxy for an active investment approach and represent overall manager skill available in the market. One can therefore compare a passive index  with an active index to determine what returns are being delivered between the two (and extract the potential alpha available).

Figure 10 below outlines this approach by comparing the Eurekahedge Islamic Fund Index against the broad-based MSCI World Equity Index, in order to analyse the overall performance of Islamic managers over and above the general market. The returns observed are consistent and on average provide an additional 40 basis point of return above a passive investment approach (ie a strategy that would follow one of these indices). It can be said that, within the timeframe observed, Islamic funds have benefited from an upward trending global market and have managed to either create or preserve value for their investors. One can certainly extend further the analysis by reviewing the sub-indices and how they fare against unrestricted geographical indices, as well as comparing against Islamic indices that screen their constituents for Shariah-compliance (for instance, we can make a comparison with an available Islamic index). Here we use the MSCI index as the tool of choice as it is a broad indicator of market performance.

Figure 10 also introduces an additional layer of benchmarking by comparing our Islamic fund index’s performance with that of other Eurekahedge alternative fund indices.

Figure 10: Comparative Index Performance

Islamic funds have been outperformed by their hedge fund and absolute return fund managers, yet we recognise that hand-in-hand comparisons are not entirely appropriate as these investments carry additional benefits to the investor that cannot be quantified. Nonetheless, one can sense from the above figure that these fund indices are not clearly correlated to the Islamic fund index. Table 3 below quantifies these inter-correlations:

Table 3: Correlation Statistics of Eurekahedge Fund Indices

	Eurekahedge Islamic Fund Index	Eurekahedge Hedge Fund Index	Eurekahedge Fund of Funds Index	Eurekahedge Absolute Return Fund Index
Eurekahedge Hedge Fund Index	0.654	1
Eurekahedge Fund of Funds Index	0.601	0.945	1
Eurekahedge Absolute Return Fund Index	0.802	0.788	0.744	1
MSCI World Index	0.808	0.607	0.508	0.779

 
From the above we can summarise that Islamic fund returns a) are highly correlated (relatively speaking) with global equities, b) have provided consistent returns above global equity markets in the recent past, and c) are not highly correlated with other alternative investment vehicles. This suggests that Islamic funds are well positioned to attract attention from funds of funds and institutional investors as they further diversify their asset allocations. It is also interesting to note that absolute return funds are closely correlated to Islamic funds, as they are long-only products which are tasked with generating alpha. In certain cases, they might only require a screening mechanism to become Shariah compliant, and this might well be a new breeding ground for new Islamic products.

In Closing

Summarising the observed trends, Islamic investing in particular is quickly emerging as a unique asset class in the investment landscape. This is evident not only from the pace of growth but also from the increasing diversity of manager locations and geographic mandates. Our investigation into the returns generated by these funds and how they compare against their peers further supports the viability and long-term prospects of this industry.

 

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