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NEWHORIZON Rajab–Ramadan 1429
ACADEMIC ARTICLE
exchange contracts and general forms of
financial options and similar derivatives.
As with all Shari’ah-compliant products, any
hedge fund strategy would have to be
certified by a recognised Shari’ah scholar via
a fatwa (a ruling on a particular issue). There
are, to date, various potential mechanisms in
place which aim to reproduce as near as
possible the equivalent derivative trading
techniques of conventional hedge funds. In
particular, the aim of producing a Shari’ahcompliant
methodology, which replicates the
economic effects of short selling, seems to
have been established in a number of cases to
manage risk in similar means to conventional
hedge funds. The success of a Shari’ahcompliant
hedge fund will also depend upon
the hedge fund being able to combine the
techniques and strategies used with the
ethical requirements of openness.
Several such funds have been adversely
affected by articles in the regional and
Islamic financial press that criticise the lack
of transparency in their short selling
methodology, despite an initial Shari’ah
sign-off or fatwa. The need for transparency
causes a problem over intellectual property
for the institution developing the product.
However, the rewards for being transparent
should far outweigh the risk of being copied
by competitors.
Within the long/short hedge fund
methodology, there are various issues that
need to be addressed before scholars will issue
their fatwa on a fund. These will include:
Stock selection
All investments must meet certain
qualitative criteria such that any company
undertaking haram (prohibited) activities is
excluded (a common example is a company
producing alcoholic drinks). A second test
is to ensure that any company financed in a
haram manner (e.g. with too much debt) is
also excluded.
Leverage
Many hedge funds are heavily leveraged,
but the fund will not be allowed to borrow
money in a conventional manner such that
interest is paid; leveraging can usually be
achieved within the structure using a
murabaha (a financial institution buys and
sells the items required by the customer) or
another Islamic contract.
Short sale
This is the major hurdle for the fund manager
to overcome, as it is a fundamental principle
of Shari’ah that you cannot sell what you do
not own. Several institutions have attempted
to use various forms of Islamic contract,
some of which are discussed below, as a
means of effecting a transaction akin to a
short sale of shares. However, the use of an
Islamic contract can lead to problems in itself;
prime brokers and other financial institutions
will have established systems based upon
internationally accepted forms of contract
and may not be willing to change their
systems for only one fund.
The more common forms of contract that have
been proposed in these circumstances are:
Salam. This is a sale contract with a deferred
delivery and was the method generally
favoured by early funds. However, Shari’ah
Standard 21, issued by the Accounting and
Auditing Organisation of Islamic Financial
Institutions (AAOIFI), which came into
effect in January 2007, stated that it was not
appropriate to use salam contracts for
transactions in company shares.
Arboun. This is a sale contract with a nonrefundable
deposit. Whilst the Hanbali school
of Islamic jurisprudence generally allows
arboun’s use in transactions over shares, the
Hanafi school seems to declare it haram.
The main effect of this would be to harm the
marketing of a fund which uses arboun in
areas where the residents generally follow the
Hanafi school, such as much of Saudi Arabia.
Wa’ad. This is strictly not a ‘contract’ but a
unilateral undertaking (promise) by one
party to another. It is widely used in Islamic
finance but the methodology has its critics.
In 2007, Sheikh Yusuf DeLorenzo, one of
the world’s leading scholars, published an
article titled ‘Total Returns Swap and the
Shari’ah Conversion Technology’, which
considers the implications of using wa’ad
contracts in structured finance transactions,
including hedge funds. DeLorenzo was
particularly critical of certain structures that
have been approved where a wa’ad has been
used to convert profits earned from haram
activities into halal (permissible) income.
The debate over DeLorenzo’s article is likely
to have a major bearing on the future
structuring of Islamic hedge funds.
Shari’ah-compliant or Shari’ah-based?
Several leading experts in Islamic finance
have questioned the appropriateness of
using forms of contract derived from an
agricultural economy of several hundred
years ago in modern financial transactions.
A recurring theme in scholarly ideas is a
move from Shari’ah-compliant product
structuring to Shari’ah-based product
development. This move suggests a back-tobasics
approach in Islamic finance, such
that transactions are structured around the
principles of Shari’ah and not by
‘Islamising’ conventional products.
As far as characterisation of hedge funds as
highly speculative is concerned, this may be
a reason why they have been seen as
difficult to achieve in a Shari’ah-compliant
context. However, of course, the theory is
that hedging is seeking to minimise rather
than take advantage of risk. It is at least
arguable that there is no greater speculation
or gharar element in Shari’ah-compliant
hedge funds than in Shari’ah-compliant
private equity funds. It may, ironically, be
that the current global credit crisis may be
the point at which conventional hedge
funds are reassessed. However, even in this
crisis there may be promise for the
development of Shari’ah-compliant hedge
funds. This is because of the ethical rules
which may restrict the leveraged and debt
positions taken by such funds and may lead
Shari’ah-compliant hedge funds to be less
susceptible to such losses.
This back-to-basics approach should lead to
a much wider acceptance in financial circles
of Islamic funds (which are often unfairly
criticised as being re-engineered
conventional financial products) and should
lead to the development of a truly Islamic
hedge fund. In any event, the development
of the various Shari’ah-compliant hedge
funds has resoundingly demonstrated that
Islamic finance is constantly evolving.
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