Access to Islamic Hedge Funds - Incisive Media

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challenges to setting up al safi Shariah poses challenges to hedge fund managers Running a Shariah hedge fund is a daunting task. A number of issues, not least of which is ensuring the underlying stocks traded are all compliant, has scuppered attempts to create a solution acceptable for both hedge funds and ethical Islamic investors. The Al Safi platform thinks it may have the answers. Although the demand for Shariah compliant products is growing, hedge funds have been one of the last alternative investment vehicles to attempt the daunting task of being Shariah compliant. An impressive and combined effort of a number of companies and factors has produced what Barclays Capital hopes will be the blueprint for future Shariah compliant hedge fund platforms. It is not only hedge funds that need to be convinced that the efforts at finding a way to comply with Shariah law are worthwhile. Bankers, investors and many in the media have questioned whether it would ever be possible to find a way to make hedge funds Shariah compliant. Although there are still plenty of sceptics, the Al Safi Trust Platform seems to have raised the bar on standards, introducing a relatively fast and easy way of ensuring compliance while at the same time allowing funds to continue to pursue the strategies that create alpha. Some investors, unaware of the variety of strategies available to managers, expect all hedge funds to be extremely speculative and therefore at odds with the Shariah prohibition of undue speculation. Others think only of short sales and conclude hedge funds must be prohibited by Islamic law. Despite the solution the Al Safi platform presents, it may take some time before investors are comfortable, and trusting, enough for this to translate into demand for Shariah compliant funds. One of the reasons it has been so difficult to come up with a workable solution is simply the development costs. A solution for hedge funds goes beyond the usual development costs (and time) needed for a financial product. It is not enough just to structure a fund. It is also necessary to ensure compliance of the hedging strategy and the securities held in the investment portfolio. The hedge fund solution also needs some fundamental changes to the way trades are processed. In particular the contracts that underlie the exchange of securities need to comply with Shariah rules. These transactions are the preserve of the prime broker. The role of the prime broker, as well as all the regulatory requirements coupled with Shariah rules, has daunted many. To find a solution, a prime broker needs lawyers, internal and external counsel, and more than one set of each, to work with Shariah experts, traders and investment managers to ensure that every step of the process is feasible, compliant and, ultimately, profitable. This costs. Few financial institutions are willing to take the time and spend the money needed to find a workable and sustainable solution. Barclays Capital, as prime broker, has made the financial commitment and seen the potential rewards of stealing a march on competitors also eager to offer Shariah compliant hedge funds and related products to eager investors. In theory at least there should be nothing controversial about the way the Al Safi Trust Platform operates or invests. The Shariah supervisory board insists every aspect of the platform’s (and individual hedge funds’) operations are unambiguously compliant and transparent. The board also uses contractual norms established by the classical jurists of Islam. The result is a bit of a paradox: an innovative new hedge fund platform | Access to Islamic Hedge Funds Supplement | November 2008 www.hedgefundsreview.com
challenges to setting up al safi (Al Safi) based on Islam’s ancient laws using ‘old’ tools to make it work. Short arboon The platform and fund managers do not sell what they do not own. By using a prescribed methodology developed and certified by the Shariah supervisory board, hedge funds implement a Shariah compliant short sale equivalent, known as the short arboon sale. This alternative method, which replicates the economic results of a short sale without using the borrow-and-sell method of shorting, needed two steps to be possible. First was the creation and certification by means of a fatwa of a Shariah compliant short sale methodology. The second was the modification of prime broker documentation to replace conventional short sale methods with the approved, Shariah compliant short sale arboon (article, page 12). The platform also uses an alternative set of prime brokerage documentation for all trades, whether long or short. This ensures every trade is done under Shariah rules: no interest, no prohibited terms and conditions and no prohibited operations (like the purchase or sale of prohibited businesses such as pork or alcohol production, banks and insurance companies). All managers on the platform are contractually obligated to execute short sales through Barclays Capital prime brokerage. Managers can initiate long-only trades with other brokers, but they need to be settled at Barclays. Shariah compliant contracts allow Barclays Capital Prime Brokerage to process trades initiated by hedge fund managers, avoiding all the prohibited elements present in prime brokerage contracts commonly used for conventional hedge funds. Another problem the Shariah supervisory board has to deal with is how a manager can temporarily ‘cash out’ of a position. The money has to be held in a non-interest bearing account or, if the term is longer than say, overnight, the cash needs to be invested in a Shariah compliant, short-term instrument like a murabahah. Purification One potential glitch is what to do when a fund accidentally trades an unacceptable stock. While all companies are screened for unacceptable primary business activities, a manager may not realise a stock being traded is not on the list until after the trade is made. When the Shariah monitoring processes discovers a profit was made from a non-Shariah compliant stock, a few remedial steps can be taken. First, the company will be ‘screened out’ and declared unacceptable for Shariah compliant investments for the future. If ‘impure’ revenues from the transactions are less than 5%, the stock can be held, but investors will be responsible for ‘purifying’ the investment. This is done by giving an equal proportion of the earnings to charities chosen by the fund. Different Shariah supervisory boards have different ways of dealing with purification. The Al Safi Trust Shariah supervisory board takes a practical approach. It offers different solutions for different managers. The board studies the strategy and sector concentration(s) of each fund on the platform. If it finds the fund invests exclusively in a particular sector in which there is almost never any need for purification, such as healthcare, technology or telecommunications, then the Shariah board will recommend there is no need for purification from that fund other than in a special situation, like when a trade in a non- Shariah compliant stock is made. If the fund invests in sectors in which purification often arises – for example, retail outlets or REITs – or if it invests in a variety of sectors, the board will recommend a flat purification rate of, say, 1.5% be applied to the investor’s net earnings. If a fund holds stocks that have especially high revenues from unacceptable activities (still less than 5%), the board has the right to recommend a higher purification rate. If a manager or a trader inadvertently purchases an unacceptable stock, the board will deliberate and could recommend an appropriate amount to be purified from the fund’s profits resulting from the oversight. Investors will be told about all recommendations made by the board on purification through the Al Safi Trust administrator. The Al Safi Trust and hedge fund managers are not responsible for portfolio purification. Investors are. This way investors can donate purification money to the charities of their choice. Although the platform will recommend how much should go to charity, investors make the final allocations themselves. Dealing with cash and purification Clear investment guidelines have been given to all the hedge fund managers on the platform on how to deal with cash. Cash is never to be deposited in interest-earning accounts or instruments. If a manager needed to “cash out” temporarily a position, the money will be held in a non-interest bearing account or, if the term is likely to be longer, invested in a Shariah compliant, short-term instrument like a murabahah. Another area hedge funds may find unusual is the purification process. Although all the company stocks traded are screened for unacceptable primary business activities, there are some companies with acceptable primary businesses, like the manufacture of spare parts for cars for example, that might own or engage in unacceptable businesses, like the sale of alcohol at company canteens or restaurants they own and operate at their factories. When the Shariah monitoring processes show that revenues from an unacceptable source exceed 5% of total revenue, then the company will be screened out and declared unacceptable for Shariah compliant investments. But if the ‘impure’ revenues are less than 5%, the stock may be held. Investors will be responsible for purifying the investment by giving a commensurate portion of fund earnings to charities of their choice. While different Shariah supervisory boards have different ways of dealing with purification, the Al Safi Trust Shariah supervisory board takes a practical approach, offering different solutions for different managers. Stock dividends is another area where there are special rules. While many Shariah compliant funds calculate purification liabilities and then pay the them from dividends, this is not the practice of the Al Safi Trust or its sub-trust managers. There are three main reasons. Not all stocks pay dividends. Hedge fund managers are active traders of stocks and many only occasionally hold stocks long enough to collect dividends. Finally, the Al Safi Trust Platform funds have already been given a purification formula by the Shariah supervisory board. So investors should not be troubled by dividends and complex purification formulas. n estimated growth of assets/net asset flow equity hedge (total) 1990–Q2 2008 Number of funds 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 80 530 127 694 168 937 Hedge funds Fund of funds 237 1,277 291 1,654 377 2,006 426 2,564 389 2,392 477 2,848 515 3,102 538 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Q1 Q2 08 08 Source: Hedge Fund Research 3,335 550 3,904 781 4,598 1,232 5,065 5,782 6,665 7,241 7,634 1,654 1,996 2,462 2,462 2,572 7,601 2,642 7,591 fatwa approvals Short sale equivalent structure Fatwa relating to arboon structure to effect short sales of securities and long sales and purchases of securities’ Dated 12 Rabi’al Awwal 1426 AH (short sale equivalent fatwa) Option equivalent structure Fatwa relating to arboon structure to effect options trading Dated 12 Rabi’al Awwal 1426 AH (options equivalent fatwa) Platform solution Fatwa relating to Shariah governed equity trading software which will be used by Shariah Capital Dated 12 Rabi’al Awwal 1426 AH Fatwa relating to financial screen for Shariah compliance Dated 9 Rajab 1424 AH (Shariah screens fatwa) www.hedgefundsreview.com November 2008 | Access to Islamic Hedge Funds Supplement |
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