Luxembourg’s strengths in conventional investment funds make Shariah compliant investment funds a natural next step. Over the past 20 years, the Grand Duchy has become the leading centre for global fund distribution and Europe’s number one fund domicile in terms of assets. It now also ranks in the top five domiciles for Islamic funds.
The development of UCITS and implications for Shariah compliant investments
While Luxembourg’s success in the fund industry is a result of its business model, it is above all the success story of a truly European idea: the UCITS framework, which celebrated its 25th anniversary last December. On 16th December 2010, the Luxembourg Parliament ratified UCITS IV, making Luxembourg once again — as in 1985 and 2002 — the first EU country to incorporate the new rules into national law.
UCITS stands for ‘Undertaking for Collective Investment in Transferable Securities’, and derives from a European directive of the 20th December 1985 that introduced a single EU-wide regulatory regime for open-ended funds investing in transferable securities such as shares or bonds.
This directive is aimed at ensuring high levels of investor protection; it regulates the organisation, management and oversight of UCITS funds, and sets rules for diversification, liquidity and risk management.
One key aspect of UCITS is the ‘European passport’, which makes it easy for a fund domiciled in one EU country to be sold to investors in all the others. Over the years, UCITS has become a strong global brand, and these funds are now well accepted in many non-European jurisdictions. Today Luxembourg-domiciled investment structures are distributed in more than 65 countries around the globe, with a particular focus on Europe, Asia, Latin America and the Middle East.
Over time, Luxembourg has also become the leading centre for global distribution of investment funds. By the end of 2010, 75% of all funds sold in at least three countries were domiciled in the Grand Duchy, and its leadership in cross-border fund distribution has made a decisive contribution to its growth, attracting fund promoters from around the world. More recently, these have included promoters of Shariah compliant funds — a natural development, since the UCITS structure is well suited to the principles of Islamic finance.
Because UCITS funds are designed primarily for retail investors, their main concern is safety, and their rigorous investment policies are consistent with Shariah law’s prohibition of gharar (uncertainty). UCITS funds are therefore especially appropriate for Shariah compliant fund promoters targeting retail or institutional investors worldwide.
The UCITS framework has evolved over the years. UCITS III, adopted in December 2001, consisted of two directives: the Management Company Directive and the Product Directive.
The Product Directive allowed funds to invest in a wider range of financial instruments, making it possible for promoters to establish money-market funds, index-tracking funds and derivative funds as UCITS funds. But whereas including derivatives as eligible assets for UCITS funds has encouraged the use of more innovative investment strategies, not all of these new strategies are suitable for Shariah compliant funds.
UCITS IV brought still more innovation, introducing a passport for management companies that allows a UCITS fund to be managed by a company authorised and supervised in a member state other than its home member state.
The new directive aims to achieve economies of scale by facilitating mergers between funds located in different European countries, and through a master-feeder structure which provides for pooling of assets.
In addition, the Simplified Prospectus required under UCITS III is replaced by a Key Investor Information Document (KIID), a two-page sheet containing information that must be fair, clear and not misleading.
Last but not least, UCITS IV introduces a new regulator-to-regulator notification procedure for cross-border marketing of UCITS funds within the EU. None of the new measures will have a specific impact on Islamic funds, but promoters of these funds will benefit from UCITS IV innovations along with the rest of the industry.
The list of fund promoters with Shariah compliant vehicles in Luxembourg shows that prominent international names in conventional investment funds have been quick to climb aboard. In most cases, these promoters already had a conventional range domiciled in Luxembourg and simply added a Shariah compliant fund.
More recently, smaller players from the Middle East have also begun setting up funds in the Grand Duchy. These promoters usually already operate funds for domestic investors in their home countries but have difficulty selling them abroad. For them, Luxembourg’s international reach has definite appeal. While this is still a new trend, it is set to intensify in the coming months, with a number of projects now in the pipeline.
Though UCITS is the preferred structure for Islamic fund promoters targeting retail or institutional investors in different countries, SIFs (specialised investment funds) and other structures may be more appropriate, depending upon the promoter’s investment strategy and targeted investor base.
When SIFs were introduced four years ago, they paved the way for a new generation of alternative investment funds targeting an international, qualified investor base. More than 1,200 SIFs have been launched since this option was created, and they are often used for Shariah compliant real estate and private equity funds.
Developments at the institutional level
Islamic finance has also benefited from initiatives by Luxembourg’s government, which is strongly committed to helping it grow. In early 2008, the government set up a taskforce to identify obstacles to the development of Islamic finance and suggest ways to promote its growth.
ALFI, the representative body of Luxembourg’s fund industry, simultaneously launched a dedicated working group that conducted research into assets eligible for Shariah compliant UCITS funds. It also started to develop best-practice guidelines for financial services in this area, and reviewed the tax treatment of Shariah compliant vehicles.
The group’s report concluded that Luxembourg was able to offer a range of vehicles (such as UCITS and SIFs) that are appropriate for Shariah compliant investment, meeting the specific needs of both investors and promoters without additional legislation.
In a note published in May 2011 the CSSF, the Grand Duchy’s financial regulator, took the same view, concluding that no specific legislation was required for Shariah compliant investment funds, since Luxembourg’s current law contains no obstacles to it. The CSSF also noted that the role of the Shariah Board would have to be described in each fund’s prospectus.
Taxation was the only area in which special action was taken. In January 2010, Luxembourg’s direct tax authority published a circular on Islamic finance, clarifying the tax treatment of murabahah contracts and sukuk transactions, and in June 2010, a circular from the indirect tax authority clarified treatment of murabahah and ijarah contracts.
Administration of Islamic funds raises another essential question. Administrators are naturally required to understand how Shariah compliant funds work, but their systems must also be adapted to accommodate them. Shariah law bans usury and short-selling, and prohibits investment in forbidden goods and services, and complying with these requirements affects administration of an Islamic fund.
For example, in a long-only Shariah fund, the administrator will provide oversight of the fund manager by monitoring and checking for Shariah compliance: if an improper trade is made (e.g., the shares of a company engaged in haram business are traded), the administrator will cancel the trade, with any losses covered by the manager and any gains donated to charity.
Also, because a Shariah compliant fund cannot earn interest on its investments, standard cash management services often cannot be used, since cash held by Shariah funds must be kept separate from cash held by all other funds.
And because most commonly-used fund accounting platforms cannot provide Shariah compliant fund accounting, service providers often have developed their own reporting method to comply with Shariah rules.
In July 2008, ALFI launched a working group to identify potential operational challenges linked to servicing Shariah compliant funds, find solutions, and recommend standard practice for local players. In the course of their work, the group’s members have built a shared understanding of the operational challenges faced by Shariah compliant funds and their service providers. The group has now begun work on guidelines for Shariah compliant fund administration.
Today, there are over 40 Shariah compliant fund units domiciled in Luxembourg. Compared with the total of 13,000 Luxembourg-domiciled fund units, they are still a niche activity — but this is clearly only the beginning of the story. Key figures in government and in the financial sector see Shariah compliant funds as a promising opportunity for growth.
Pierre Oberlé is the business development manager at the Association of the Luxembourg Fund Industry (ALFI).
This article first appeared in Islamic Finance News (3 August 2011, Vol 8, Issue 30, Page 27 – 28). For more information, please visit www.islamicfinancenews.com.