The Eurekahedge Islamic fund database has grown considerably from its launch last year to now encompass information on more than 458 Shariah-compliant funds (representing a 95% coverage of the market). Our analysis focuses on factual data, allowing it to be comprehensive as well as reliable. The Islamic fund platform encompasses funds from across all asset classes (equity, fixed income, real estate, private equity, etc) and our estimate of the total universe stands at approximately 480 funds, with 500 a feasible industry milestone by year end.
In our third paper dedicated to Shariah-compliant funds, we endeavour to refine our analysis and zoom in on specific features and market dynamics. Having laid the groundwork in previous articles, we seek not to restate data but rather further scrutinise it to unearth more telling trends. We start by reviewing the overall industry make-up and our most recent metrics, then delving into performance statistics, and finally drawing a variety of industry comparisons (in terms of asset class mix, etc).
The data used in the following analysis is based on the size, structure and related details of 435 Islamic funds, and the historical performance details of a sample of 257 funds.
As mentioned earlier, the fund universe is nearing the 500 mark and while these numbers reflect a thriving industry, various developments are further evidence of continued asset flows (for example, through the emergence of fund of funds products). This is supported by innovative products in development (from both established institutions as well as new comers to this sector), making this one very dynamic space. Estimates to the total size of the industry seem to have reached a USD800 billion consensus, however, this is a rather misleading figure since it is also agreed that this is an all-encompassing figure (from bank deposits to direct investments) and that a significant proportion of assets in Islamic banks are placed in short-term contracts.
With regards to actively managed products, we estimate that assets under management in Islamic funds are hovering between USD50 and USD70 billion (ie well below 10% of the total industry assets). This would support calls for increased allocation, provided manager skill can be qualified and portfolio liquidity not greatly compromised.
Without a doubt, the industry continues to be pushed forward by its two key centres (as shown in Figure 2), with almost half of all products having originated from either Malaysia (23%) or Saudi Arabia (25%). Kuwait has had a strong showing as well, being the staging point for 12% of all funds (which includes an India mandate and at least two funds of funds). However, there is also evidence that products are increasingly being marketed to a broad spectrum of clients – since there is a strong predilection for offshore domiciles (over 18% of all mandates ranging from Cayman Islands, British Virgin Islands, to Ireland, Bermuda and Luxembourg) as seen in Figure 3.
A few markets in the periphery are also worthy of note – Pakistan, Egypt, Indonesia – not in percentage terms but because of their fast emergence and market potential. In fact out of these three markets, every single Islamic fund – with only one exception in Jakarta – has been launched by a local institution (not a global investment bank or a mega Islamic bank). They offer an unbiased barometer of things to come since these firms are tapping into their investor network (from retail, to high net worth and institutional), validating the feasibility of such products within these markets.
New launches have emphasised new flavours for investors as seen in Figure 4 (with global mandates growing to 15% and emerging markets making a first-ever appearance) as well as innovative structures (among the buzz words we count funds of funds, exchange-traded funds and pan-Asian funds). However, because of their limited track records they pose a challenge for investors, while new brand names coming to the market are increasing the demand for due diligence services. Thus approximately 60% of assets are still retained in Middle East mandates as seen in Figure 5 below. This diffidence is perhaps due to assets adhering to legacy investments, a continued appetite for GCC economies or simply more effective marketing channels.
Over the last three years, the industry has experienced its most significant expansion to date, with over 150 launches in the period between 2004 and 2006. While the current year has been eventful, this rate is expected to level off for 2007 (we note just over 40 new launches year to date with a few more in the pipeline) with the focus perhaps shifting to building track records and marketing the maturing products. Fund attrition remains stable, as we observe between four and six funds being liquidated per year – either through scheduled exit strategies or otherwise.
As seen in Figure 6, the mandates appearing in the last few years have aimed to offer greater geographical diversification (with global mandates accounting for one quarter of all new funds in 2007). On the other hand, Asian mandates have slowed down, from almost 50% of new launches in 2006 to (a still significant) 25% by mid-2007. There has also been a small (yet noteworthy) number of new entrants – ranging from fund houses in a deregulated Saudi Arabia to other less-established markets such as Egypt (which has gone from one to five Islamic funds in the last 12 months alone).
Equity funds remain the bulk of available products as seen in Figure 7 (over 50% of new funds in each of the past five years have been equity focused), but the overall make-up is more diverse than ever. Real estate funds saw a healthy 2005, and 2006 saw money market and commodity funds bringing back more liquid choices (Section 4 below further probes the asset class mix of Islamic funds).
Once again, a less prominent but noteworthy trend is the emergence of alternative products. These funds attempt to offer a variety of benefits, from intermediation and due diligence (most notably through several multi-manager structures) to specific market exposures (such as a recent Malaysian capital-guaranteed structured product and a global large-cap exchange-traded fund). Efforts have continued towards bringing to market Islamic hedge funds, and while we regretfully inform there is no hedge fund stampede into Shariah compliance, this has nevertheless produced a healthy by-product of new entrants as well as a fresh dose of product innovation.
The continued efforts to deploy Islamic hedge funds have focused on index-linked products, managed accounts or fund-of-managed accounts. While none of these are hedge funds per se they do exemplify product innovation in the space. Continuous work on the feasibility and industry acceptance of outright short-selling will keep this a space to watch. In fact, further industry comments are expected from the recently implemented AAOIFI standards that restrict the use of Salam for equity transactions (forward contracts have been an oft-cited approach to short-selling).
On the other hand, Islamic portfolios are not devoid of an allocation to alternative investments as it pertains to real estate and private equity (Table 4 below shows that 18% of Islamic funds are within these two categories). They require from investors a similar if not longer investment horizon (lock-in periods addressing their illiquidity) as well as a high degree of sophistication (and mainly accessible to larger allocations). The predilection for these “hard-asset” investments seems to stem from the perception that returns would not be compromised from the screening criteria (an oft-cited issue for Islamic equity funds) and that a critical component (Islamic financing) is available in similar terms as in the conventional space.
We have recently refined our Islamic fund sub-indices to both reflect geographical mandates as well as to zoom in on the various asset classes available (eg we can now build an Asia-Pacific Balanced Fund Islamic Index). Further scrutiny is now possible on the performance of the various asset classes on a historical basis and Tables 1 and 2 give the latest snapshots in terms of annualised returns and annualised standard deviation.
The GCC stock markets have managed to rebound by 21% from a rather difficult 2006, yet Asia Pacific has remained the least volatile of regions (with a standard deviation below 12%). Fixed income funds seem to be on par across the board (although market depth is fast increasing with a sleuth of sukuk issuances). Finally, both balanced and money market funds seem to favour global strategies when considering their risk-adjusted returns.
Table 1: Islamic Funds - Annualised Returns
Table 2: Islamic Funds - Annualised Standard Deviation
Active vs Passive Equity Indices
We further focus on equity-only funds by considering our Islamic fund equity indices and analysing their performance against broader Islamic stock indices. More specifically, we compare returns data from third-party stock indices (such as Dow Jones Islamic and Al Madar) against those from the Eurekahedge Islamic Fund Equity Indices1. We break down our analysis into the following mandates: A composite index of all equity funds, Developed Markets (North America and Europe), Middle East/Africa and Asia Pacific.
Table 3 below compares the correlations between our Islamic fund equity indices and their respective underlying equity markets, to give a rough initial estimate of how closely related they are. As can be seen, the composite Islamic fund index, its developed markets component and to a lesser extent, the Middle East/Africa component, are all highly correlated with the corresponding equity market benchmarks. The same, however, cannot be said for the Asia Pacific component (0.527). On the face of it, this suggests that Islamic fund equity allocations in Asia are more actively managed than their counterparts in other geographic mandates, especially given the fact that they have seen superior returns over the period compared (refer to Figures 8 and 9 below). That said, we believe that a closer scrutiny of country-specific equity benchmarks (more specifically, Malaysia and Indonesia), would allow us to further scrutinise this hypothesis.
Table 3: Correlation Statistics of Islamic Sub-indices
DJ Islamic Market World Index
DJIM World Developed Index
Almadar GCC Sharia Index (Middle - East)
DJIM World Asia Pacific Index
EH Islamic Fund Equity Index
EH Islamic Fund Developed Markets Equity Index
EH Islamic Fund Middle East/Africa Equity Index
EH Islamic Fund Asia Pacific Equity Index
Source: Eurekahedge, Dow Jones, Al Madar
The analysis continues by comparing the total returns generated by each of the aforementioned Eurekahedge indices over the last six years (Figure 8). At first glance, allocations to Middle East/Africa have significantly outperformed those into Asia and the developed markets. A comparison of risk-adjusted returns for the same set of indices (Figure 9), however, tells a different story.
Using the same benchmark equity indices as in Table 3 above, the excess (annualised) returns and the information ratio2 of each of the Eurekahedge indices is compared (as seen in Figure 9). Among the regional mandates, both excess and risk-adjusted returns are the strongest in the Asia Pacific Index – a reflection of the region’s strongly positive markets. This also ties back to the brisk fund launch activity observed in the past few years (Figure 6).
Figure 9: Comparative Index Returns on a Risk-adjusted Basis
The above discussion tests whether active management (by investing in an Islamic fund manager) provides any excess returns over passive management (by investing in the components of a broad Islamic equity index). Based on the above analysis, we believe that this is indeed the case and Islamic fund managers are very well able to deliver alpha.
4. Industry Comparisons
The Asset Class Mix
As the number of available products continues to flow in, we investigate whether the mix of Shariah-compliant offerings (in terms of asset classes) matches the one offered at the conventional level. We thus collate the asset class mix of Islamic funds by geographical region and compare this to a global portfolio of conventional mutual funds. We use statistics from the Investment Company Institute (ICI), which surveyed over 61,000 mutual funds across the globe, and together with our data we produce a heat map as shown in Table 4 below.
The prominence of equity funds is felt across all regions (from 49% to 67% penetration), but this is no different to the proportion found in the conventional side (42%). In order to maintain comparability, we choose to analyse the proportions based on total number of funds – as opposed to using proportions based on asset size. On the other hand, money market funds also seem to be well received – particularly in Global and Middle East mandates (at 27% and 14% respectively, well above the conventional 6%). Also noticeable in the Others category is the popularity of European and North American real estate products, as well as Middle East multi-manager portfolios.
In terms of deficiency, fixed income and balanced products seem to be lacking in all but one of the geographies. While Asia Pacific seems to offer the closest match to conventional markets, it is the unresolved acceptance of Malaysian sukuks that might limit the appetite for the fixed income and balanced offerings found in the region.
Table 4: Asset Class Mix
Source: Eurekahedge, Investment Company Institute (ICI)
Green: Within 10% boundary
Blue: Below 10% boundary
Red: Above 10% boundary
Islamic Funds and Socially Responsible Funds
A direct comparison with socially responsible investing (SRI) funds is not entirely appropriate, but key issues can be extracted by putting the two industries side by side. While there are over USD21 trillion invested in conventional mutual funds across the globe, SRI funds represent a mature and well-developed subset. On the other hand, Islamic funds are still young with assets under management between USD50 and USD70 billion, with third-party figures indicate total assets in the Islamic finance industry at USD800 billion.
With regards to SRI, there are USD179 billion allocated into approximately 250 SRI mutual funds in the US alone, and total socially responsible assets in the US market are estimated table as high as USD2.29 trillion. The European market, is not too different in structure although smaller in size at about EUR1.03 trillion in total assets, with a smaller amount (over EUR24 billion) allocated across 400 SRI mutual funds.
Quite revealing is the fact that most SRI assets are placed not in mutual funds but rather in managed accounts or discretionary portfolios, with the figure highest in the US (92%) and still significant in Europe (79%). Thus an analysis of Shariah-compliant investments would require a further survey of private mandates as well, especially if the percentage is anywhere near the figures found in the SRI space.
The predilection for discretionary mandates in SRI is also due to the institutional source of these allocations. Assets from US Public Pensions compose 81% of all SRI managed accounts, whereas in Europe 94% of all assets in SRI mutual funds originate from institutional investors. Islamic funds can draw a parallel to SRI in that they have a market potential at this level (in particular from the pension plan equivalent: takaful).
Nonetheless, what can be considered as an SRI and/or ethical investment has proven difficult to define. In fact over 80% of the SRI screening criteria is focused only on tobacco and alcohol exclusion. This figure is even higher in private mandates, which predominantly purely focus purely on tobacco exclusion. Overall, the SRI industry predominantly follows a dual screening approach (positive and negative screens) coupled with additional social components or activist criteria (but to a lesser degree). This is in contrast to Islamic funds which rely all on negative screening (in terms of non-permissible industries and financial ratio exclusion).
Another favourable trend in SRI is the demand for more complex ethical mandates (not just a tobacco-screening exercise). It is here where Islamic funds differ the most, since they follow a well-defined set of guidelines (in fact they are relatively more standardised than SRI despite having several schools of thought) and the screening criteria remains exclusionary.
Islamic Funds and Conventional Funds
Comparing performance metrics of Islamic funds against SRI funds (or any other group of funds) carries many caveats, and it has been avoided for a variety of reasons (in particular the low overlap of investment geographies and mandates). An alternative approach could compare tracking errors (analysing SRI funds versus an SRI index, Islamic funds versus an Islamic index, etc) and Section 3 took the first steps in that direction. This could allow an assessment of both populations, but is not feasible since SRI data and SRI indices are not immediately available.
A less optimal but nonetheless interesting alternative is to consider whether a naive investor could build two fund portfolios (one Islamic and another conventional) and expect similar returns from both. We thus select funds at random from our Islamic funds database to collate a sample of 30 (a somewhat similar experiment to the one that selected stocks from the pages of the Wall Street Journal). This method also allows us to incorporate analysis of not only equity funds but also the other asset classes (fixed income, money market and balanced funds).
Two groupings are used (15 Middle East funds and 15 Asia-Pacific funds), eliminating all other mandates as previous analysis has proven them to be highly correlated (ie North American, European and Global) and therefore would either bias the results to an expected outcome or require a larger sample size. The random sample yields almost the same asset mix discussed in the previous section: 18 equity (60%), 5 money market (17%), 4 fixed income (13%) and 3 balanced (10%) funds.
For each Islamic fund, an equivalent conventional counterpart is sought in terms of geographical mandate, type of instrument traded and with a full performance track record for 2006. The focus is on 2006 returns since there is greater market depth (the fund universe is larger than five years ago) and efficiency (the test can be extended to analyse volatility, monthly returns or any other available data point).
This creates two sets of data that are “matched” and not independent of each other (the random choice of the Islamic fund influences the choice of the conventional fund). This is a matched paired test that allows comparing two random samples, with the full analysis included in Appendix A.
Three tests are carried using a 95% level of confidence, first analysing 15 funds in each region separately and then all the 30 funds. In all three cases, the data consistently support the hypothesis that the populations do not differ (Ho: µ1 - µ2 = 0). In other words, Islamic funds neither underperform nor outperform their conventional counterparts (as this is a two-tailed test), but rather offer an ambivalent choice to investors.
While the analysis is a compromise on the data, we hope it encourages further tests of comparability (by extending the sample size, zooming in further on specific mandates or geographies, etc). The test could be done for each asset class separately (eg only fixed income or only balanced funds), by specific geography (eg only Kuwaiti or only Indonesian funds) and the sample size can be increased by analysing monthly or daily data where available.
However, we again note that an investor would be interested to analyse a mixed portfolio. Thus at a minimum we can conclude that an investor could have started 2006 by building a naive portfolio of Islamic funds and observed on par performance against a similarly naive conventional portfolio.
Islamic funds are maturing, not only in terms of track records and fund manager expertise, but also in terms of data transparency, industry consolidation, investor familiarity and overall market penetration. Increased levels of information are helping in the understanding and quantification of the total market opportunity. Recent Islamic bank mergers and acquisitions also suggest a repositioning from established players, especially as we observe the recent entry of global investment banks into the fray (further evidence of the confidence in terms of the underlying market potential).
Nonetheless, the new entrants still lag behind in terms of the depth of their client networks whereas some well-established names are only recently exploring their existing clients’ appetite for Islamic products (hence increasing their Islamic share of wallet). On the other hand, local and regional players are looking for more innovative products and structures, away from plain vanilla solutions. Ultimately, a compromise seems to be the partnership between specialised institutions and Islamic banks, where they are able to amalgamate the best of breed products with a readily-accessible investor base.
1Information Ratio may be defined as the excess return generated by a fund/index over and above that of a comparable fund/index, per unit of risk (which is measured here as the Tracking Error between the returns series compared). Tracking Error measures the variance in the excess returns from month to month.
2 Based on the returns data of 140 constituent equity-focused Islamic funds.
Comparing two populations head-on is not feasible since the data must be assumed independent of each other. The alternative is to use the difference between the pairs is analysed (denoted by Di, where Di = Islamic fund return minus conventional fund return). Since the sample size small (n < 30) this prescribes test statistic to be used (student t-distribution) and the degrees of freedom are either 29 (d.f. = n – 1) for the full portfolio or 14 for the regional portfolios.
Di = Xi - Yi for i=1, 2, ... , n
If E(Xi) = µX and E(Yi) = µ Y then
E(Di) = E(Xi) - E(Yi) = µX - µY
var(Di) = var(Xi) + var(Yi) - 2cov(Xi,Yi)
The coefficients for the last formula are not necessary, instead we let var (Di) = s2D
The null hypothesis states that the performance of the two populations does not differ:
Ho: μ1 = μ2 , i.e. μ1 - μ2 = 0
This is tested against the alternative hypothesis:
H1: μ1 ≠ μ2 , i.e. μ1 - μ2 ≠ 0
To test H0 : µ1 = µ2 versus H1 : µ1 µ2 use where ~ N (µ1 - µ2, s2D / n)
If H0 is true then (µ1 - µ2) = 0
This is a two-tailed test with a 95% level of confidence (p = 0.05), using a student t-distribution.
If the observed value statistic is greater than the critical value, then we must reject Ho.
TEST 1: = 1.38, sD = 6.15, n = 15. t-statistic: 0.87 critical values: (-2.1447, 2.1447)
TEST 2: = -4.38, sD = 9.10, n = 15. t-statistic: -1.87 critical values: (-2.1447, 2.1447)
TEST 3: = -1.50, sD = 8.17, n = 30. t-statistic: -1.01 critical values: (-2.0452, 2.0452)
The first test is performed on Middle East funds (n = 15), with the data summarised in Table A-1. A test statistic is computed (0.87) and this is within the two-tailed boundary (critical values of -2.1447 and 2.1447), which concludes there is no statistical difference between the 2006 returns of Islamic and conventional funds in this geographical region.
Table A-1: Matched Pairs Test of Middle East Funds (Islamic vs Conventional)
2006 returns (Islamic)
2006 returns (Conventional)
Regional Fixed Income
Kuwait Money Market
Kuwait Money Market
We extend the same analysis to Asia-Pacific funds (n = 15), with the data summarised below in Table A-2. Here the test statistic is again computed (-1.87) and this is within the same two-tailed boundary (critical values of -2.1447 and 2.1447), which concludes there is no statistical difference between the 2006 returns of Islamic and conventional funds in this geographical region.
Table A-2: Matched Pairs Test of Asia-Pacific Funds (Islamic vs Conventional)
2006 returns (Islamic)
2006 returns (Conventional)
Malaysia Money Market
Malaysia Fixed Income
Malaysia Money Market
Malaysia Fixed Income
Malaysia Fixed Income
Malaysia Money Market
The third test collated all 30 funds together to use a greater sample size (n = 30), with the data summarised below in Table A-3. The test statistic is (-1.01) and this is within the two-tailed boundary (critical values of -2.0452 and 2.0452), which arrives at a similar conclusion as the two previous tests.
Table A-3: Matched Pairs Test of Middle East and AsiaPacific Funds (Islamic vs Conventional)