Shari'ah issues with islamic hedge funds

Professor Humayon Dar, managing director of Dar Al Istithmar in London examines the Shari'ah aspects of the emerging Islamic hedge funds

Islamic hedge funds have created a stir in the Islamic and wider financial markets, both attracting criticism on Shari'ah grounds and a call for re-thinking on the issue of risk management in complex Islamic financial structures. While some industry experts argue that an average Islamic investor is not sufficiently sophisticated either to understand the functioning of hedge funds or is simply not interested in complex structures, the current lack of demand for Islamic hedge funds is primarily a Shari'ah concern.

Furthermore, some hedge fund managers, like Eric Meyer, created more controversy than providing a genuinely Shari'ah compliant solution. In fact, Eric Meyer's hedge fund proved to be the most talked-about Islamic hedge fund (Shari'ah Equity Opportunity Fund) that never came into existence. Although this brought the issue of Islamic hedge to the fore, it actually created a lot of doubts about structuring Shari'ah-compliant hedge funds. Eric Meyers' Shari'ah Equity Opportunity Fund, however, is not the only failed attempt to set up an Islamic hedge fund. Appleton Crescent Currency Fund (by Crescent Capital Management) also failed to attract investors. Nonetheless, Alfanar US Equity Hedge Fund (by Permal) and Al-Khawarizmi Market Neutral Fund (by The International Investor) provide two success stories, albeit not hugely impressive ones.

Table 1 provides some basic information on some attempts on setting up Islamic hedge funds. Despite my earlier comment, Eric Myer must be credited with generating interest in developing Shari'ah compliant hedge funds. In addition to his own two funds, he has been involved in setting up Gibelli Merger-Arbitrage Fund and GRT Capital Partners' Shari'ah Compliant Principal Protected Fund. Apart from the Shari'ah compliant hedge funds, some funds of funds are also in the pipeline, which would attempt to invest in hedge funds in such a way that their Islamic investors will get Shari'ah compliant returns on their investments. Deutsche Bank is offering hedge funds-linked notes and certificates that expose Islamic investors to risk-return profile of a chosen hedge fund index/basket.

Hedge funds tend to achieve high returns with the help of excessive leverage, apparently another area of Shari'ah concern. A hedge fund manager has access to around 20 different strategies, including long/short, global macro, arbitrage, distressed securities, opportunistic and aggressive growth, to name a few. However, available statistics reveal that long/short funds represent the largest universe of current hedge funds (approximately 30%), and this is what Islamic hedge funds tend to emulate in a Shari'ah compliant manner. The long/short (also known as market-neutral strategies) attempt to offer absolute positive returns to investors by typically combining a short strategy on over-valued assets with a long strategy on some undervalued assets.

While longing poses no serious Shari'ah problems, shorting faces a number of restrictions in an Islamic framework. Islamic hedge funds replicate payoffs of a conventional short by using contracts of Salam and Arbun. The use of Salam for stocks/shares is not endorsed by most Shari'ah scholars involved in the Islamic finance industry. In fact, AAOIFI's Shari'ah standards on financial papers (shares and bonds) explicitly prohibit the use of Salam for selling stocks/shares on a Salam basis (see clause 3/11 and the accompanying bases of the Shari'ah ruling number 14). The use of Arbun is also problematic.

"HOWEVER, FURTHER SCRUTINY OF SUCH STRATEGIES BY SHARI'AH SCHOLARS FOUND THEM INNOCUOUS FROM A SHARI'AH VIEWPOINT, WHICH TAKES HEDGING AS PART OF PRUDENCE AND RISK MANAGEMENT."

Thus, there are three Shari'ah concerns: (1) hedging, (2) leverage, and (3) short-selling. Hedging was initially misunderstood by some Shari'ah scholars to mean complete elimination of risk. Therefore, the early Shari'ah opinion was that hedging was not permissible, as it violated the principle of al-Kharaj bi al-Daman (return should be proportional to the risk assumed). Actually, the idea of an 'absolute return strategy' targeting a return of certain basis points above a chosen benchmark made many scholars sceptical of the notion of an Islamic hedge fund.

However, further scrutiny of such strategies by Shari'ah scholars found them innocuous from a Shari'ah viewpoint, which takes hedging as part of prudence and risk management. Indeed, there has been a switch of focus in the hedge fund industry from performance (and consequent volatility of returns) to gathering and protecting assets. This also helped Shari'ah scholars to form an opinion in favour of Islamic hedge funds. Similarly, Shari'ah does not have problems with leverage as long as it is achieved through Islamic debt. Leverage is not a Shari'ah concern, rather it is an economic issue. Having said that, it may actually be difficult to introduce leverage in an Islamic way, as conventional short-selling is certainly not permissible in Islam.

Although some Shari'ah scholars have endorsed the use of Salam and Arbun for short-selling, such strategies have limited marketability as most Shari'ah scholars do not favour the use of two contracts in this context. The question arises why Arbun poses problems from a Shari'ah viewpoint. The reasons for non-suitability of Arbun for shorting are in fact the same as those for Salam because the way an Arbun-based shorting is executed is in fact more like Salam than Arbun. Figures 1 and 2 give the structures of Salam- and Arbun-based shorting.

Salam-based shorting works as follows:

A hedge fund manager identifies a basket of over-valued stocks, and advises a prime broker to sell it in the market for its market price:

• The prime broker sells the basket of shares in the market;


• The hedge fund, then, sells the same basket of shares to the prime broker on a Salam basis, whereby the prime broker pays the price (from proceeds of the sale of the shares in the market) to receive the basket of shares on an agreed future date;


• The hedge fund uses the money for leveraging;


• On the future date, the hedge fund buys the basket of shares from the market and delivers the same to the prime broker.

The hedge fund enjoys the benefits of leveraging in addition to benefiting from the price differential of the basket (if price expectations are fulfilled). However, the hedge fund assumes risk of loss on the Salam transaction in case of a price movement not in favour of expectation.

The use of Arbun for short-selling is less convincing but it has been put into practice by almost all long-short Islamic hedge funds. Although the exact structure of an Arbun-based shorting may differ from fund to fund, it appears as if a large fraction of the price of the stocks to be sold is paid as Arbun (advance payment) to the seller upfront. If so, the Arbun-based structure is in effect closer to the spirit of a Salam-based sale. This may require the application of the principles of Salam to short-selling rather than of Arbun, hence, rendering the use of Arbun not in compliance with Shari'ah, at least according to AAOIFI). Table 2 compares a conventional short with a Salam and an Arbun based shorting.

Given the controversy over Salam and Arbun, a hedge fund manager will, therefore, have to come up with a shorting method, which not only replicates economic effect of a conventional short but is also acceptable to most Shari'ah scholars. One such technique is based on Mudaraba and another one is based on even a simpler contract - Murabaha.