Cerulli: Islamic funds still ignored by Middle East institutions

Cerulli Asia Pacific Edge, July 2011

On first glance, the dynamics supporting the Islamic fund management industry look very strong. In the GCC markets of the Middle East in particular, the region is galvanized by high oil prices so that at both an institutional and an individual level, wealth is growing. As that wealth requires a greater range of products to be invested in, and since these are all Muslim countries, shouldn’t that be the spur to a dramatic increase in Islamic asset management?

Well, yes and no. It’s true that retail investors in the Middle East and in Malaysia have firmly embraced Islamic funds. This is nowhere more true than in Saudi Arabia, where the mutual fund industry is overwhelmingly Islamic: about 80% of funds sold in the country are Shariah-compliant. The degree of penetration varies elsewhere from market to market – entrenched in Kuwait, popular but not dominant in Malaysia (where Islamic unit trusts are 10.6% of the market in volume terms) and Bahrain, limited in the United Arab Emirates – but it is certainly true to say that many individual investors have welcomed the opportunity to invest in a way consistent with their faith.

For institutions, though, it’s a different story. The Middle East is best known, in institutional terms, for its vast sovereign wealth funds: the Abu Dhabi Investment Authority, believed to be easily the biggest of them all; the Kuwait Investment Authority; the Qatar Investment Authority; the parts of the Saudi Arabian Monetary Agency that fulfill sovereign wealth duties; and several other smaller funds. But none of these invests in a Shariah-compliant way. They might well consider Shariah-compliant mandates if there was a demonstrable advantage in doing so in terms of returns or risk diversification. But just for the sake of religion? Not at all.

Even in the strictest Islamic country of them all, Saudi Arabia, one could not say that SAMA is Shariah compliant. It’s true that it tends to invest with elements of Islamic principles in its mandates, such as avoiding investments in alcohol and gaming. But one of the central tenets of Islamic finance – the biggest, really – is that the idea of interest is prohibited. Money cannot turn into more money without performing some purpose along the way, such as trade. Now, for a central bank, that’s clearly implausible: the vast majority of many central banks’ holdings, including Saudi’s, are US Treasuries or similar securities – which, very obviously, pay interest.

There are modest signs of growing institutional interest in Islamic asset management. Several Saudi fund managers say they do have some Shariah-compliant mandates from institutions in the country, although all say that at this stage Islamic finance is to a very large extent just a retail story. And in Malaysia, there have been steps towards greater Islamic investment among institutions, notably Khazanah, the state investment arm which holds stakes in many of Malaysia’s largest corporate enterprises; it conducts all of its fundraising in a Shariah-compliant way through the sukuk markets.

In between retail and institutional, the ground is muddier. High net worth individuals and family offices are a very important part of Gulf wealth, and it is very difficult to generalize about their own investment preferences since they are so individual. But this is perhaps an area within which Islamic asset managers can start to bridge the divide between the low average investment volumes of retail and the high volume but disinterested masses of institutions.

Global fund managers have, by and large, been happy to watch and wait before launching Islamic funds. In the Gulf, for example, a rule of thumb is that many managers will want to be pretty sure of getting $50 million of assets in the door – in some cases $100 million – before it seems a good idea to launch a new fund. Going Islamic requires an infrastructure: most obviously, you need Shariah advisors, who are far from cheap, to endorse your products as Shariah compliant.

And while it might seem straightforward to simply launch an Islamically compliant version of an existing fund, it’s not actually that simple. Let’s say you have a US equities fund, and you want to put a Shariah screen over it. That’s easily done. But given that you’ve now removed all the financial institutions, don’t you want to have a rethink about the rest of the portfolio too? Everything about it has changed – its overall risk profile, the weighting of various sectors – and a diligent portfolio manager is likely to want to start from scratch rather than just accept what the overlay has come up with. It’s clearly easier for passive funds, but as a general comment launching an Islamic range is not as straightforward as it might at first appear.

Also, the available assets to underpin Islamic funds could be more widespread. Equities are easy enough: a simple screening service can help to find which stocks are compliant and which not, and in Malaysia, some 88% of total listed securities are Shariah-compliant (63.83% by market cap). In sukuk, though, the supply is more limited: Malaysia, where there were 181 outstanding sukuk in December 2010 worth RM319 billion and representing 57% of the total bond market, is really the only place with any secondary market liquidity in sukuk, and even there it’s modest. Beyond that, real estate is inherently suited to Islamic finance, but only if the tenants and the property’s financing are compliant.

Probably more international managers would have launched Islamic ranges had the financial crisis not, belatedly, hit the Gulf so hard. Gulf states were about a year behind the rest of the world in entering the financial crisis, and are correspondingly slow to emerge from it again, a process complicated by social unrest in the region. Many stock markets, notably Saudis, remain considerably below their pre-crisis highs, which in turn has meant that the willingness of individual capital to seek new investments has diminished too. If international fund managers didn’t think it made sense to launch Shariah ranges of funds in 2007, it certainly doesn’t make any greater sense now.

That said, there is a counterpoint to that argument. Islamic finance itself escaped the financial crisis very well, even if the economies in which it is prevalent did not. Islamic finance insists on tangible assets performing a real function; that counted out many of the derivative products that brought western institutions unstuck. There is, perhaps, a greater appreciation among mainstream investors, for whom religion is not a consideration, that an Islamic fund constitutes a useful diversifier in risk terms.

One exception to the reticence of foreign houses to go Islamic is Saudi Arabia, where the picture looks slightly different. Many of the biggest houses in Saudi have long-standing foreign involvement – HSBC in Saudi British Bank (now SABB), for example, or more recently Goldman Sachs in NCB Capital, which is the biggest issuer of Islamic mutual funds in the world. All of these institutions have widespread Islamic fund ranges, but they are basically domestic.

And another exception may prove the way forward. When Malaysia launched the Malaysia International Islamic Financial Centre (MIFC), it sought to attract foreign fund managers to set up Islamic ventures in Malaysia, aiming to make them a hub for global Islamic capital. Several, among them Nomura, Aberdeen, BNP Paribas, Principal (through a joint venture with Malaysia’s CIMB), Franklin Templeton, Prudential and India’s Reliance have gone ahead and launched such ventures, attracted in part by seed capital from Malaysia’s key institutional investor, the Employee Provident Fund. It’s not yet clear whether any of these are actually sourcing new money into Malaysia, which was MIFC’s intended goal; but it does demonstrate that in order to get internationals to take the Islamic route, they first need to see some money committed.