Islamic hedge funds Islamic hedge funds: Recipes, merits and critics In a unique report, Islamic finance consultant Michael Saleh Gassner delves into the history of Islamic hedge funds. In the last five years hedge funds have become the fashion of the finance industry since the stock markets have been underperforming. Hedge funds were originally invented in 1949 by Alfred Winslow Jones, a journalist and sociologist, while researching an article on the latest techniques used for analysing and forecasting the stock market for Fortune magazine. He thought he could do a better job than the professionals at this time and so raised an initial amount of $100,000 to start what is now called a hedge fund. His strategy was to buy stocks long where he was positive on them and sell stocks short which he thought would underperform. On top of the funds raised he used credits to 'leverage' the results. In addition his compensation was benchmarked to his success. All the same features are still in place with modern hedge funds. Beside Islamic finance, hedge funds are the growth sector of the financial industry. More than 8,000 funds exist nowadays and providers of such funds show impressive charts that offer returns and risk profiles that should be better than other asset classes like real estate, long-only mutual funds and many other investments. Capital market theory suggest that long/short strategies could eliminate or reduce the so-called market risk and offer absolute returns depending on the selection success, independent of the market trend. Market risk is known by practioners as the way that stocks tends to follow the general market trend despite specific company achievements. But the hedge funds went beyond long/short strategy into other strategies to identify market anomalies, which could be done mainly as they are defined as non-regulated funds for savvy investors (rather than a regulated retail product). Each strategy is practically a different financial product and it is misleading to put them all under the umbrella of the term hedge fund. Many invest in equities, some in fixed income and others in emerging markets. The total number of strategies is over a dozen. Among them low risk and extreme risk strategies could be applied - hedging and stretching. It is best not considered as a single asset class. This leads to the question of whether is there a place for hedge funds in Islamic finance. The question needs to be looked at from different angles; from the Shari'ah, from the prospective investor's needs as well as the quality of supply. The Shari'ah opinions of many strategies are short and simple: Haram (forbidden). Muslim investors following the rules will not go for hedge funds active in conventional fixed income sectors, with conventional leverage and without a screen on the business activities. But is there a way to start, as the hedge fund industry started, with a simple long/short strategy? First of all an investor has to decide whether or not conventional stocks could be compatible with his or her investment strategy. Since 1999 there have been commonly accepted rules about debt levels, interest income and industry activities in which a Muslim may invest. The Dow Jones Islamic Index uses these screening criteria as do most of the Islamic mutual stock market funds. However, not all Shari'ah scholars do agree to compromise, considering time and circumstances in regard to debt levels and interest income. Each single investor needs to decide on his own which position to follow and many still feel uncomfortable discussing whether stock investing is similar to gambling and whether or not Shari'ah scholars accept it. If the answer is positive regarding stocks, the question of the short sale arises. "ERIC MEYER'S ATTEMPT TO LAUNCH AN ISLAMIC HEDGE FUND HAS BEEN DISCUSSED FOR QUITE SOME TIME PUBLICLY AND MIGHT BE THE MOST KNOWN PRODUCT IN THE MARKET." Do not sell what you do not own A conventional short sale is selling a stock which you have borrowed; a transaction which would violate the general Islamic rule of 'do not sell what you do not own'. However, in Islamic contractual law there is another transaction called Salam, which replicates a similar economic outcome. It was used for example to sell wheat on a future date against payment today. As an exception to the general rule, it is subject to certain conditions, which the Shari'ah scholars on the board have accepted will be applied if the contracts and documentation is properly adjusted. Salam fixes the price I get for wheat at 100, which I receive today. I could buy the commodity in three months for 90 if prices are falling, making a profit of 10. If the price goes up, I have a loss. To reach the high water mark, the high return goals set, hedge funds typically use leverage techniques; borrowing money from their broker. Money, however, cannot be accepted to be lent against money. The way Islamic hedge fund operators look at this point is to apply a Murabaha contract for the long position, which replicates economically the standard margin facility. Similar to normal margin finance, the Murabaha deal gets liquiditated with losses if the price goes down below the level at which the bank would no longer be protected. There is no waiting period. The stocks are used as collateral immediately. The leverage for the short position is much more delicate. A Salam contract requires that the full amount be paid immediately and therefore leveraging does not take place and the short position is not replicated as it would be in a conventional hedge fund. The fund of fund concept of Eric Meyer from Shariah Capital therefore uses the Arbun contract. Arbun could be translated as downpayment. The buyer pays 10% of the price for the stocks as a down payment. If the price in the future is below 90% of the price on the transaction date, the buyer will buy the stock cheaper in the market place. His downpayment remains with the seller. If the price goes up instead, the seller has to buy the more expensive stock and take a loss. With Arbun there are two concurrent sayings of the prophet (pbuh), one permitting and one forbidding Arbun and consequently the different schools of thought interpret Arbun differently. The Hanbali School generally accepts it while the Hanafi school seems to declare it Haram. Any Muslim investor seeking to look into such a model should therefore ask for clarification of how the majority of the school he aims to follow interpreted this issue. First market neutral fund in 1997 Islamic hedge funds have been a hot topic for some years now on the Islamic conference circuit. The International Investor (TII) launched in 1997 the Al-Khawarizmi Market Neutral Fund managed by Axa Rosenberg. A market neutral fund uses 50% long and 50% short, so that the market risk is eliminated, while a long/short fund manager may decide to hedge the market risk to a lesser degree if he is positive about the trend. The next hedge fund for Muslims was offered by SEDCO in Saudi Arabia called Al Fanar Hedge Fund, using the long/short strategy with the Salam contract managed by a single manager. Many other asset managers apply long/short strategies to individual managed accounts without going public; among the less known is the GAFM Global Asset - and Fundsmanagenent AG in Switzerland. Such accounts may or may not have a dedicated Shari'ah approval. GAFM might come up at the end of the year with a repeatedly used Islamic hedge fund approved by a Shari'ah board. Deutsche Bank announced their Islamic hedge fund tracker certificate, which is by definition not a hedge fund, but the returns achieved through a not yet disclosed structure are benchmarked to the HFRX Global Hedge Fund Index. We hear that other big names in the market may follow with other offerings. Eric Meyer's attempt to launch an Islamic hedge fund has been discussed for quite some time publicly and might be the most known product in the market. The final launch of two funds is due for September. Having previously employed UBS as placement agent and Noriba as Special Advisor this partnership has now been ended. Eric has invested over $3 million in these products already since 2000 and gained Shari'ah approval from Sheikh Nizam Yaquby, Yusuf Talal DeLorenzo and Dr. Mohammed Daud Bakar. Eric offers a principal protected, liquid market neutral fund as an alternative short-term instrument. Indicated returns should be 200-300 basis points above Murabaha based products. It will be interesting to see whether such anomalies in the markets really do exist. His second product is the Shari'ah Long/Short Master Fund, gathering a number of selected fund managers using the Murabaha/Arbun long/short techniques for a screened stock market universe which goes beyond the limits of the current Dow Jones Islamic Index including a wider number of candidates, screening them with the most current online annual reports and widening the investment universe which is an important approach as capital market theory suggests that a smaller investment universe would result in lower returns. "THE QUESTION NEEDS TO BE LOOKED AT FROM DIFFERENT ANGLES; FROM THE SHARI'AH, FROM THE PROSPECTIVE INVESTOR'S NEEDS AS WELL AS THE QUALITY OF SUPPLY AS WELL." Risky investment or proper hedge Hedge funds commonly claim to have low risk and prove this with charts showing an animal called 'historic volatility' measured in days, months or years. Historic volatility could be explained with the illustration of waves on the sea. For a certain beach, the size of waves are limited, let's say, to one metre in 66% of the cases and in 95% of the cases they will not exceed two metres. However, once in a century there may be a tsunami that the historic wave volatility did not indicate might arrive. Leveraged portfolios like the typical hedge fund suffer most, and the market neutrality feature can be abolished if the wave comes first from the stocks which are long and does not push down those which are short. The entire portfolio will quickly be executed. Leveraging is not a good idea for this reason and the amount of leverage needs to be adjusted to the portfolio of the investor to match their personal risk appetite (which leveraging increases and not hedges). Any investor needs to know the exact exposure of leveraging for his own optimal portfolio, whether margin facilities are applied, other borrowed money, and debt inside the stocks (on- and off-balance sheet). The US Central Banker, Greenspan warned at the beginning of June that hedge fund managers take too much risk to generate the high returns they promised at a time of unsually low market returns. He is convinced that it will not affect the financial system; however, he thinks that the industry will shrink and many wealthy fund managers and investors could become less wealthy. The job of the active fund manager is to achieve outperformance above market risk. If he is achieving returns based on market risk or leverage, this risk/return profile could be obtained much cheaper from an investor's point of view. Is there a long/short hype? The current media perception and the trend to sell hedge fund products to retail clients show a boom which is quite advanced. A hedge fund is an actively managed portfolio which looks for anomalies. An investor should be convinced of the superiority of their trading approach, and be aware that too many managers using long/short techniques are typically coming to an end of the historic out performance of such a strategy. Nowadays the rational way is to decide on the quality of the fund manager since he is dedicated to achieving the indicated results in future. Hedge funds are considered to be an alternative investment class which lowers the entire portfolio risk as it is not correlated with other investments. Following the old strategy of not putting too many eggs in one basket, diversification could be reached by other alternative asset classes as well, which have a different nature from the 'standard' long/short hedge fund. Other alternative investments The Appleton Crescent Currency Fund from Chicago-based Crescent Capital Management domiciled in Cayman Islands was launched in 2003. The fund manager is Appleton Capital Partners in Dublin. The investment strategy follows an approach to buy sets of currencies that look undervalued by mathematical modelling; a long only, no-leverage strategy so far. In 2000 the UBS SEDCO Shari'ah Compliant Timber Fund launched a long term, uncorrelated and absolute returns product, which is a serious investment for pension funds and insurance funds because of predicable returns, lack of leverage and is not related to any current hype in the markets which sets it apart from any bubble. Conclusion Islamic hedge funds might be structured alongside a long/short strategy; it raises some Shari'ah concerns which need to be made transparent to the investor especially if he is following a specific school. The market cycle may not currently favour investing in hedge funds as too many people are following the same strategy and consequently the returns might not be too exciting in the foreseeable future. The hedging of risk is linked to historic volatility. Leverage always leads to higher risk even if limited by a long/short strategy and this is definetely to be taken into account when assessing the personal risk appetite of the individual investor. Alternative investments could be undertaken in other areas and these should be analysed to see if these do not offer potentially better returns and to serve the overall objectives of Shari'ah with regard to society, environment and wellbeing.