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ACADEMIC ARTICLE

NEWHORIZON July–September 2008

Islamic hedge funds:

work in progress

Bill Gibbon (above left), group partner at Voisin law firm and head of its Shari’ah funds

department and Trevor Norman (above right), director of Volaw Trust & Corporate Services

Limited and head of its Islamic finance and Middle East group, examine the Shari’ah challenges

in establishing an Islamic hedge fund.

Hedge funds and the GCC investor

Investors in the GCC have been investing in

the conventional hedge fund market for a

number of years. GCC institutions have, in

terms of their own portfolio diversification,

generally mirrored global investment thinking.

Strong regional growth and the steady

liberalisation of the GCC markets have

attracted a wide range of conventional

hedge fund managers to the Gulf.

Sophisticated investors in the GCC are

attracted by the differing investment returns

on the variety of alternative strategies when

compared to conventional and regional

stock markets, private equity, property and

oil based returns. Within the Gulf, investors

are turning to hedge funds as a source of

stability and security during the regional

stock market volatility evident in certain

Gulf states in recent years. Investors that

are perceiving that regional equity, property

and IPO successes may not be sustainable

are also looking to diversify their successful

portfolios by investment in structures that

may protect downside risk.

Conversely, hedge fund managers have been

also motivated by the success of locally

concentrated investment funds. Many

financial institutions and law firms, including

Volaw, have set up offices in Dubai and

Bahrain, motivated by the flow of business

opportunities and proactive regulatory

environment in the Dubai International

Financial Centre (DIFC). The Centre,

established in 2004, aims to place Dubai at

the hub of Middle Eastern institutional

finance, creating a new pre-eminent

international regime in the Gulf for funds,

trusts and financial services generally

(for more details on this initiative, see New

Horizon, October–December 2007 issue).

In December 2007, the Dubai Financial

Services Authority (DFSA), an independent

regulator of the industry within DIFC,

issued its Hedge Fund Code of Practice, the

first of its kind to be issued by a regulator

and a landmark code in the regulation of

the international Hedge Fund industry. The

Code sets out best practice standards for

operators of hedge funds in the DIFC. The

Code addresses some specific risks that are

associated with hedge funds and reflects the

DFSA’s commitment to risk-based

regulation. There are nine high-level

principles in the Code, which cover areas of

key operational, management and marketrelated

risks, particularly in the areas such

as valuation of assets, back office functions

and exposure to market risks.

Shari’ah-compliant hedge funds

Due to the support of some Shari’ah

scholars, the theoretical concept of a

Shari’ah-compliant hedge fund is now well

established. Islamic finance is constantly

developing ways of staying competitive

with conventional markets within an

Islamic framework. Major Gulf financial

institutions expect Shari’ah compliance in a

wide range of products. They also expect

such products not to cost substantially

more than their conventional equivalents.

Shari’ah-compliant equity fund structures

have proved popular since, in theory, they

are consistent with Shari’ah principles of

participating in and sharing of their risks

and rewards of a joint venture. This has

made Shari’ah-compliant equity investment

funds particularly attractive to Islamic

investors and has led to end examination of

ways in which similar forms of absolute

return funds can be structured. Accordingly,

asset managers in the Gulf region have been

seeking to develop strategies that will

replicate the absolute return mechanisms of

global hedge funds, whilst continuing to

adhere to the principles of Shari’ah.

Needless to say, in the past few decades

there have been many differing forms of

conventional hedge funds (owing to the

various strategies employed by fund

managers). However, the most widely agreed

perception of a hedge fund is ‘a fund that

uses derivatives, leverage, shorting, margin

trading and option techniques to achieve its

absolute return investment goals’. Usually,

short sales include the borrowing of

securities and their subsequent sale into the

market. Shari’ah scholars are wary of any

conventional form of short sale since, under

fundamental Shari’ah principles, one cannot

sell what one does not own.

Shari’ah, of course, generally imposes

restrictions on types of investment. It requires

that Shari’ah-compliant funds avoid

transactions in unethical goods and services;

the earning of returns from financial

instruments (riba, interest); and excessive

uncertainty in contracts (gharar); as well as

trade in debt contracts, forward foreign

32 IIBI www.newhorizon-islamicbanking.com

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