Shariah funds: all about equity and trade finance

Cerulli Associates, Global Edge, October 2008

Author’s note: this is one of three articles in a Global Edge special report on Islamic asset management. It was followed by an intensive, 200-page report on Islamic finance published in January 2009, with detailed proprietary data. That report cannot be published on this site but can be purchased from www.cerulli.com

Shariah-compliant funds are dominated by two asset classes: domestic equities and trade finance (similar to money market) funds. Others are growing in popularity, but for the moment these two set the pace.

According to Cerulli research, in Saudi Arabia, the biggest market for Shariah-compliant mutual funds, local trade finance and stock funds account for 90% of Shariah-compliant assets under management. Our research in Malaysia, the most significant southeast Asian market, continues, but preliminary findings show more than half of all Shariah compliant assets going into local equity, and a significant volume (but lower than in the Middle East) going into money market/trade finance products, with a much larger volume than in the Middle East going into sukuk (bond) funds – we’ll discuss the reasons for that below.

It’s natural that domestic equities should be such a dominant class because the bulk of Shariah fund providers are locals rather than multinationals, and few of them have the scale to produce regional or international funds. There are exceptions – fund managers offering regional or global equity funds in Shariah-compliant form include NCB Capital, HSBC, Riyad Bank and Al Rajhi in Saudi Arabia, National Investments Company in Kuwait, and Public and CIMB in Malaysia – but in all Muslim countries the bulk of products look only at the home market.

The growth of more international equity products is likely to mirror that in mainstream asset management in Islamic countries. For example, according to the Saudi Arabian Monetary Authority, only 29% of all assets were international by late 2007 – but that figure had grown from 16% in 2005. Similarly Central Bank of Kuwait data shows a 37.5% increase in foreign portfolio investment over the same period, albeit still seven times lower than domestic assets.

On the fixed income side, there is a pronounced difference with conventional asset management, and it is especially clear in the Middle East. In conventional finance, most fixed income funds invest in bonds. The closest equivalent to bonds in Islamic finance are sukuk, and they represent a large and growing market, but there is a problem: by and large, they don’t trade. That’s because they still have sufficient scarcity value that investors tend to buy them and hold them, reducing any secondary market. That, in turn, makes it difficult to raise or run a mutual fund investing in sukuk, and consequently bond funds in the Islamic sense have been very rare. Outside of Malaysia, it’s only very recently that they have started to appear, from groups such as Jadwa Investments and Falcom in Saudi Arabia and Algebra Capital in Dubai (which, in addition to an existing fund, launched a new US$100 million sukuk fund in September with Bahrain’s Elaf Bank).

In their absence, it is much more common for funds usually known as trade finance products – roughly equivalent to money market funds – to develop, using a structure known as murabaha. By far the biggest Shariah mutual fund in the world, the AlAhli Saudi Riyal Trade Fund from NCB Capital, fits in to this category; it has US$4.113 billion under management in its last disclosed data.

The exception to the rule about sukuk not trading is in Malaysia, which not only has a vibrant local currency primary market in sukuk – by far the most successful local market in the world – but also an active secondary market too. Here, one finds products which much more closely resemble bond funds in conventional asset management: the Public Islamic Bond Fund, the CIMB Islamic Sukuk Fund, PB Islamic Bond Fund and RHB Islamic Bond Fund, for example. With those building blocks in place, more refined products develop too: both the Public and CIMB products come in enhanced versions.

Real estate lends itself well to Shariah financing structures – it’s a physical, tangible asset, and Islamic mortgages are widespread. Consequently Shariah real estate funds are growing in popularity. Cerulli estimates there are at least 70 Shariah-compliant mutual funds in this area. One of the biggest examples is the Emirates Real Estate Fund from Emirates Islamic Bank; another large real estate fund is the Pearl Qatar Real Estate Development Fund, backed and managed by the Commercial Bank of Qatar, though this is a closed-end product. Property funds with Shariah compliance have tended to be a Middle Eastern phenomenon, though the recent arrival of Islamic real estate investment trusts (REITs) in Malaysia demonstrates the potential for the securitisation of real estate on an Islamic basis there in future.

Private equity, too, is very much in the spirit of Islamic finance – participating in a company in its early stages, helping it grow and sharing its risks. Examples of firms who have launched private equity funds on a Shariah-compliant basis include Al-Tawfeek Company for Investment Funds, part of the Jeddah-based Dallah AlBaraka Group, but with its fund incorporated in Bahrain; Unicorn, a Bahrain-based investment banking and asset management group; and Malaysia’s CIMB.

Trends for the future in product development will include more regional and global equity funds, and possibly sector-based or even small-cap equity funds, both in the Middle East and Southeast Asia.

If international fund managers do decide to try to launch Shariah-compliant funds, it’s natural that global equity will be a good place to start. In practice, where foreigners have tried to launch Shariah product, they have wisely gone for areas where local expertise is likely to be limited. The DWS Noor range, for example, covers Asia Pacific equity, China equity, global equity, Japan equity, and precious metals securities. For HSBC Amanah, it includes Americas equity, Asia-Pacific equity, Global equity (and a global equity index version), and pan-European equity, although this manager has also opted for a GCC ex-Saudi and a Saudi equity segregated portfolio.

There are signs of some innovation in Shariah-compliant mutual funds. For example in April, Dubai’s Algebra Capital – in which Franklin Templeton holds a 25% stake – launched a $300 million fund called Beta Mena Fund, focusing on Middle East and North African corporate credit and local currency markets, offered in dirhams and dollars. But by and large, outside of markets like Saudi where Shariah investing is already dominant, this is a time for products to bed in and prove themselves, to develop sturdy track records that can then be used to attract more capital.

This is, in theory, a perfect time for Shariah investing. The principles of Shariah should have kept investors away from investment banks with heavy exposure to sub-prime or CDOs, just as in previous years it has theoretically kept people away from Enron because of its leverage. There have certainly been some high flyers: in 2007 the best performing Shariah fund was a big and respected one, the Amanah GCC Equity Fund sold by Saudi British Bank (now HSBC), returning 81.68%. Year to date, though, it’s down 14.01%, according to Tadawul, the Saudi stock exchange – although that’s still better than most global equity funds. Generally speaking, Shariah compliance has brought little insulation from world market woes: according to Dow Jones, its Islamic Market index is down 18.5% for the year, compared to its world index down 20.5%.

A big question about Shariah funds is whether they cost more. In theory, they should: any manager launching a Shariah fund must pay fees to a Shariah advisory board who will advise on whether or not it is compliant. (This board is enormously important, since it is on the basis of their recommendation that individuals will make a decision on whether or not to trust the fund’s compliance.) In practice, it varies. Malaysian fund managers claim the fee structures on their products are flat with conventional product, and simply wouldn’t sell if they weren’t; in the Middle East, fees tend to be higher than the norm anyway. For example on the Amanah GCC Equity Fund we mentioned before, the annual fee is 1.75%, with a subscription fee of 3.25%.

An interesting aside to the product and manufacturing debate is that where centres of manufacturing excellence exist, they don’t necessarily serve their home market. For example, some in Malaysia have built up considerable expertise in fund design and portfolio construction but have limited confidence in the immediate opportunity there, instead targeting the private funds market in the Middle East.