Access to Islamic Hedge Funds - Incisive Media

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 |