Can capital protection be Shariah compliant?

Cerulli Associates, Global Edge, February 2009

The idea of capital protection is well entrenched in Islamic asset management, and with good reason:  the wild behaviour of some stock markets in the Muslim world, and particularly in the Gulf, makes a safety net a very desirable companion in an investment strategy.

But although today’s battered markets create the sort of environment in which capital protected product launches usually flourish, new products are proving thin on the ground – partly because of the same concerns about structuring that apply in the developed world, and also because of doubts about how capital protection fits with Shariah compliance.

Capital protected structured products have been available in Islamic finance for many years. HSBC, for example, has sold such products for at least seven years; its HSBC-Link Ethical Capital Protected Fund, sold in Singapore, has been running since 2002.

But one could argue the golden age of Shariah capital protected products came with the huge crashes in Gulf stock markets in 2006, and the period thereafter. The Gulf was already the market with the greatest penetration of Shariah funds – in Saudi Arabia they account for more than 70% of the national mutual fund industry by assets – so it was a natural home for Shariah capital protected products to be developed. Investors certainly felt a need for them: both Saudi and the United Arab Emirates saw their stock markets halve in the space of a few months that year, and while the bottom of such a crash is rarely the best time for investors to seek capital protected products, history shows us that that’s exactly when they tend to sell.

A few examples show how local banks and fund managers quickly grasped the trend. In October 2006 Bahrain’s Khaleej Finance and Investment launched a capital protected fund called Optimum, linked to Islamic equities, crude oil and copper. Deutsche provided the capital protection. In March 2007 Dubai Islamic Bank launched a series of capital protected global real estate investment trust (REIT) notes, investing in the US, Europe and Japan. The following month ABN Amro launched an Islamic capital protected note in the Gulf linked to a basket of commodities, one of a series of Islamic notes from the bank. And in May that year Bahrain’s Shamil Bank launched a 100% capital protected Islamic fund, linked to a basket of global equities and commodities. A three-year product, it is due to pay out next year, and was structured by BNP Paribas.

Outside the Middle East, capital protected options have grown in popularity too. In Malaysia, for example, ING’s Baraka series are capital protected notes linked to global equity markets; CIMB is another Malaysian manager offering protected products from its Islamic range. In Pakistan, Al Meezan Investment Management launched the country’s first Shariah compliant capital protected fund in February 2008, putting up to 80% of the fund into a murabaha structure with Meezan Bank and the balance in Shariah compliant equities.

So there is a track record of these structures all over the Islamic world. But as yet, there has been no wave of new product launches with the fanfare one would expect in such an environment, promising safety of capital. Why not?

One reason is that structuring has become a dirty word in the conventional markets, and some of that reputation has washed over to the Islamic world as well. While many local institutions sell capital protected products, it’s very often an international group like Deutsche, UBS, JP Morgan, BNP Paribas, ABN Amro or SG who’s behind it – and none of those groups are particularly active in structuring at the moment, recognising the dire consequences that have come of some of the structures they have been selling in the conventional world in recent years, and the difficulty in selling them again in the short term.

A broader issue is the role that structuring and capital protection can play in Islamic finance anyway. Shariah law prohibits speculation and unreasonable uncertainty. It also, though, requires a certain level of risk – this is why conventional deposits can’t work in Islam, because money can’t just turn into more money without serving some broader function, such as trade. Guaranteeing a return of capital is not, strictly speaking, Islamic; some practitioners suggest that it’s more appropriate to consider it a promise to do one’s best not to lose the money (though that’s hardly a marketable approach).