Access to Islamic Hedge Funds - Incisive Media

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hedge fund access to al safi Middle Eastern investors keen to access hedge fund absolute returns Hedge fund managers facing narrowing sources of investment for their funds are turning to the significant investor base in the Middle East. While many Middle Eastern investors are willing to put money into conventional hedge funds, a growing number of ethical Islamic investors are keen to see Shariah compliant hedge funds. The Al Safi platform may offer some hedge funds a relatively easy way to become Shariah compliant, giving their fund the reassurance ethical Islamic investors want without disputing the fund’s strategy. There is no doubt there is an attractive pool of investment capital not only in the Gulf Co-operation Council countries but also in the rest of the Islamic world. Tapping into this source of capital has not been easy for hedge funds. Shariah law generally imposes restrictions on types of investment. It requires that Shariah compliant funds avoid transactions in unethical goods and services; earning returns from financial instruments (interest); excessive uncertainty in contracts (gharar); trade in debt contracts; forward foreign exchange contracts; and general forms of financial options and similar derivatives. Funds cannot use leverage or invest in stocks of companies that have excessively high debts or leverage. A hedge fund that uses derivatives, leverage, shorting, margin trading and option techniques to achieve its absolute return investment goals will have some challenges. As with all Shariah compliant products, a hedge fund strategy would have to be certified by a recognised Shariah scholar via a fatwa. Hedge fund managers interested in setting up a Shariah compliant fund on the Al Safi platform have a relatively simple solution to what may seem insurmountable obstacles. The Al Safi platform is being presented as a turnkey solution that provides portfolio screening and related Shariah solutions for hedge funds. This enables managers to operate within Shariah while remaining consistent with their existing investment strategies. A crucial element is the ability of the fund to short stocks in a Shariah compliant manner. This has been solved through the arboon short sale (article, page 12). To see if a fund strategy is compliant with the platform, the Shariah advisor, prime brokerage and trustees first carry out due diligence on the managers’ standards and suitability to be included. This includes a screening of the fund’s portfolio holdings, something Shariah Capital can do in 24 hours. Trust and sub-trust documents are pre-designed, based on industry standards for independent offshore platforms, managed by offshore external counsel. Little negotiation of documentation is expected to be needed, particularly as the documentation is one way to ensure the homogeneity of the platform. Funds that are accepted set up managed accounts. The sub-trust opens an account with Barclays Capital, the dedicated prime broker, including agreements on custody and other related matters. The subtrust commits the investment manager to manage the prime brokerage account through an investment management agreement. The sub-trust and managed account are only set up if there is a seed investment of at least $30 million available. Individual managers of funds using the Al Safi solution are relieved from what Barclays Capital calls the “tedious negotiations of prime brokerage solutions and offshore documentation to ensure Shariah governance”. Managers do not have to set up a Shariah certification framework as that is part of the Al Safi solution. Investors are able to seed Islamic long/short hedge funds. All the hedge fund management companies access the platform through a sub-trust of the Al Safi Trust, domiciled in the Cayman Islands. The Shariah supervisory board, Shariah advisor, trustees and administrator are all part of the package. An initial and annual certification by the Shariah supervisory board is issued to confirm Shariah governance. There is ongoing monitoring of Shariah governance by the Shariah advisor, Shariah Capital. Al Safi is independently controlled and built around independent service providers. n 16 | Access to Islamic Hedge Funds Supplement | November 2008 www.hedgefundsreview.com
investing in hedge funds Funds offer investment strategies for wide range of market conditions While hedge funds were originally attractive only to a high net worth individuals and family offices, institutional investors are also keen to take advantage of the higher returns uncorrelated to markets that hedge funds represent. Alfred Jones is credited with the creation of the first hedge fund in 1949. To neutralise the effect of overall market movement, he balanced his portfolio by buying stocks he expected to rise and selling short the ones he thought would drop in price. The effect was to ‘hedge’ part of the risk due to overall market movements. The industry has grown rapidly with an estimated $3 trillion in assets under management. Hedge funds now account for close to half the trading on the New York and London stock exchanges, according to some sources. Even with the recent market instability and financial turmoil, few believe hedge funds will disappear. On the contrary, this alternative investment sector is one of the fastest growing and most attractive to investors, despite a recent spate of redemptions for some strategies. The attractiveness of hedge funds to investors lies in their generally uncorrelated returns to traditional markets. Returns of many hedge fund investments are not too closely related to the ups and downs of Assets ($MM) 2,000,000 1,750,000 1,500,000 1,250,000 1,000,000 750,000 500,000 250,000 38,910 0 58,370 Estimated assets Net asset flow 8,463 95,720 27,861 167,790 36,918 167,360 (1,141) 185,750 14,698 256,720 57,407 367,560 91,431 374,770 4,406 456,430 55,340 490,580 0 90 91 92 93 94 95 96 Source: Hedge Fund Research estimated growth of assets/net asset flow equity hedge (total) 1990–Q2 2008 23,336 539,060 99,436 46,545 625,554 820,009 972,608 1,105,385 70,635 73,585 1,464,526 1,868,419 46,907 126,474 194,515 1,875,708 1,931,438 16,469 12,515 97 98 99 00 01 02 03 04 05 06 07 Q1 Q2 08 08 traditional markets. The funds can operate in almost any market. They can invest long, like a traditional mutual fund, or short, profiting if the value of the underlying asset falls. Although some question whether hedge fund managers will be able to continue to produce alpha – returns over and above those on the broad market in which they operate, generated due to the fund manager’s skill in exploiting inefficiencies in the market – even those achieving only market returns (beta) are in high demand. The reason is that even a relatively poor hedge fund performance is likely to be better than anything the more traditional long-only and mutual fund sector can offer. Even compared with private equity and real estate funds, the returns are potentially high. Hedge fund investing is not for the faint-hearted. Investors need to understand the risk they take. Historically hedge funds offer a unique source of return drivers that have generated high risk-adjusted returns with relatively low correlations to other assets. In traditional asset classes such as equities or fixed income, active managers have essentially two components to this performance: the market (beta) and excess return versus the benchmark (alpha). In traditional portfolios, alpha can be generated only by overweighting stocks considered undervalued within the benchmark and underweighting securities considered overvalued. Hedge funds, unlike long-only managers whose total returns are dominated by benchmark movements, can achieve returns independent of normal market cycles. Having an alpha focus, hedge fund strategies try to exploit market inefficiencies in a variety of ways. These include buying undervalued securities and selling overvalued ones at the same time, making macro bets or by relying on tactical trading skills. These techniques provide a source of return different from a portfolio of traditional market-driven investments. This absence of correlation with the markets is what many investors want in order to boost their returns on investment. Hedge funds started out as a tool for high net worth individuals to boost the performance of their private offices. Now hedge funds are a tool for institutional investors, particularly pension funds and endowments, used not only to diversify portfolios but also to help increase investment returns. Over time hedge fund strategies tend to exhibit fairly low correlations to equities and low or negative correlation to fixed income. It is no surprise that investors are keen to add hedge funds to a traditional asset mix to reduce overall volatility and generate better returns. Large corporate treasuries are also using alternative investments as a diversifier, often together with protected structured products for large cash holdings. This is one of the key drivers of the significantly increased net inflows to hedge funds. While there are a plethora of hedge fund strategies, the most common is long/short equity. It is certainly considered the largest category in terms of the numbers of hedge funds. But even this relatively simple and common strategy runs into significant problems for any investor applying Shariah principles. While the conventional long/short strategy is outside the precepts of Shariah law, it has taken considerable time and money to find a way to match the Shariah principles with the way in which the hedge fund strategy operates (article, page 17). In the aftermath of the credit crisis and the financial market chaos, hedge funds are expected to continue to play an even stronger role in creating liquidity and making markets more efficient, according to some market observers. Finding ways to enable hedge funds to operate in a Shariah-compliant way will open this alternative investment vehicle to more investors. Hedge fund managers for their part are eager to find ways to modify strategies and the way they create alpha in order to adhere to Shariah principles so that investors in the Islamic community can take advantage of this alternative investment strategy. It is also likely that hedge funds will become more transparent following the financial turmoil of recent months. Regulators will be paying more attention to their activities, as will investors, keen to ensure that operational and counterparty risks, for example, are addressed. Analysis of operational risks involved with hedge funds includes issues such as safe custody of assets, pricing policy and checks and balances within the investment management company. The assessment of credit and market risks is another area investors will want to see managed better in future. n www.hedgefundsreview.com November 2008 | Access to Islamic Hedge Funds Supplement | 17
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Page 4 and 5: introduction to shariah Islamic inv
Page 6 and 7: challenges to setting up al safi Sh
Page 8 and 9: al safi trust platform Innovative o
Page 10 and 11: success of al safi Investors keen t
Page 12 and 13: success of al safi Prime broker agr
Page 14 and 15: dubai multi commodities centre seed
Page 18 and 19: fund profile Strong commodity focus
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Page 28 and 29: fund profile Diverse talents at cor
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Page 32 and 33: strategy profile “We do not hold

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