The demand for Shariah-compliant funds is growing. But does the dominance of equity funds over other types of funds indicate a growing asset allocation gap?
The objective of asset management is risk-constrained return maximisation. Since asset returns are ordinarily less than perfectly correlated, the risk to the returns of a group of assets taken together is less than the sum of the risks of individual assets taken in isolation. This is good news for investors with well-diversified portfolios and a major incentive to invest in funds.
In all honesty, funds come into being from a desire of their sponsors to earn fee income. Given the enormous collective amount of investible wealth held around the world by individuals seeking Islamic investment opportunities, financial institutions, both conventional and Islamic, are clamoring to offer ever more attractive funds to their clients. A large number of these are real estate funds. A seemingly even larger number of these are equity funds, and to be specific, long-only equity funds, which, as the name suggests, entails holding only long positions in each underlying equity.
However, conventional funds can also short-sell equities, which is an investment strategy positioning the investor to gain when prices fall. This makes for a substantially wider set of equity strategies available to conventional funds, including short-only, long/short and market neutral strategies. However, shorting any asset relies on selling something which is not owned. Owning an asset is, at least Islamically, a necessary precondition for sale, and therefore, short-selling contravenes an essential tenet of Islamic finance.
Some fund managers claim to have overcome this rather clear-cut restriction. Their approach invokes an ethereal distinction between separate profit units within a single entity. In this set-up, one profit unit (the fund) sells equity for future delivery (using a bai-salam contract) while the equity sold is vested in another profit unit up until the time of delivery. This mechanism apparently holds water because at the entity level at least, legal title is indeed held prior to sale. However, the continued almost singular use of long-only strategies may indicate that like many other aspects of Islamic finance, scholars remain divided.
But why elaborate on short-selling? Well, what the above illustrates is that the set of feasible strategies available to Shariah-compliant funds grows rapidly as the number of permissible types of allocation increases, where for ease of discussion, “allocation” is taken to mean the combination of asset class and whether held long or short (for example, allocation to a short equity position, allocation to a long sukuk position and so on).
This now begs an interesting question: What is the minimum set of possible allocations that would provide the Islamic market with what it needs to fully meet investor demand? The difference between allocations currently possible and those required by investors is the “allocation gap”. The aim of this article is to raise this question and to highlight the issue.
A useful start is that whatever is permissible Islamically is also permissible conventionally, but not vice versa. This places an upper bound on the number of possible allocations for Islamic funds.
Additionally, although conventional funds can in general use derivatives (to hedge risks or take exposures), many do not (this is mandate driven), and for those that do so to create exposure (as opposed to hedging unwanted risks), the alternative route – which is through funded positions in the underlying securities themselves – may instead be possible. So, we will not muddy the waters by also discussing derivatives.
Funds also target particular return objectives within given risk tolerance. The risk versus expected return profile of funds within the universe of available products populates a range from low risk (for example, credit risky, low-yielding products based on murabahah and/or sukuk) to high risk (higher-yielding equity funds).
So, to put the question concerning allocation gap another way, what matters is whether the number of available allocations spanning the risk spectrum is sufficiently concentrated at various risk/return points at which there is also investor demand (gauged through feedback from relationship managers).
Directing ourselves to product supply, the table below provides a brief list of asset classes/sub-classes seen in conventional funds and their nearest Islamic equivalents:
Commodity sale forms the basis of Murabahah deferred settlement
Fixed rate bond
Deferred payment can be structured to replicate conventional fixed rate bond cash flows
Floating rate bond
Ijarah permits periodic reset of profit rate
Islamic equities must pass Shariah screening criteria
No principal differences
As evident from the table, it is quite possible to also structure balanced funds that are Shariah-compliant. Balanced funds combine allocations to fixed income securities that are lower risk (and generate income) with allocations to equity securities that are higher risk (and provide capital appreciation).
However, most Islamic funds are not of the balanced fund type, and the reason is simple – sukuk allocation requires available sukuk assets, and there are not enough to go around since most are held to maturity following their origination. The same problem does not arise for equity allocations because Islamic fund managers can dip into a large and global market for conventional equity securities, selecting from the many that satisfy their filtering criteria.
It is also noteworthy that Shariah constraints affecting the successful structuring of real estate and private equity funds are rarely binding, the appeal of these funds being access to high-yielding investment returns that are uncorrelated to those of more traditional asset classes such as fixed income/equities.
The market for Islamic funds has come a long way, and where there were significant product gaps in fixed income, these have since been mostly filled by sukuk. However, basic trading approaches such as short positions, taken so much for granted by conventional funds, are still off the menu for Shariah-compliant funds and where progress has been made in product development, it has so far fallen short in terms of market depth. Nevertheless, progress is additive. Sooner or later, the enduring appeal of economic gain will close the allocation gap.
Dr Ken Baldwin is a director and head of risk management at the Venture Capital Bank in Manama, Bahrain.
This article first appeared in Islamic Finance news (Volume 4, Issue 43).