Overview of 2009 Key Trends in Islamic Funds

Introduction

The growth of Shariah-compliant funds over the last decade is one of the many manifestations of the dynamic development in the Islamic finance sector. The rapid expansion in the number of managers offering Shariah-compliant investment vehicles across the world demonstrates the increasing diversity of the industry in terms of asset classes and geographies. Currently, Islamic funds across the world are estimated to manage assets of about US$70 billion while the number of funds is about 680.

To discuss the various unique aspects of this sector, it is important to develop an understanding of the basic characteristics of Islamic banking and wealth management. The issues which drive the capital allocations to Islamic finance are further applied to developing, managing and investing through Islamic funds. As such, it is prudent to first elaborate on the key characteristics of Islamic funds before analysing the key trends that are shaping the industry.

Overview of the Islamic Fund Industry

The first Islamic fund was launched during the1970s in the Middle East to manage the assets of a new class of Arab investors in a culturally-aware and socially responsible manner. The primary goal of the earlier funds was to engage in “ethical investing” into products and companies that were acceptable to the Islamic faith. While the main criterion for investment has remained more or less the same throughout the years, Islamic funds have expanded at a rapid pace, especially in the last decade, to include the various new Islamic finance products that have been developed over the years. Furthermore, the industry has also widened its clientele base to include a significant number of non-Muslim investors.

Islamic funds have evolved into wealth management vehicles that cater to investors who wanted exposure to capital markets inside a Shariah framework. The main characteristic which distinguishes Islamic funds from other conventional funds (as well as other socially responsible investment funds) is compliance with Shariah, Islam’s legal system that was derived from the Quran, the Sunnah and the interpretation by Islamic scholars. Islamic fund managers, therefore, are required to invest in economic activities that are deemed ethical and in companies that do not flout Islamic teachings; for these purposes, Islamic funds employ the services of Shariah scholars who can certify the funds’ compliance with Islamic tenets.

Consequently, such an investment mandate rules out those companies that are associated with pork, alcohol and tobacco products, gambling or pornography. Furthermore, one of the important aspects of the Islamic finance industry is the prohibition of interest and any profits made from related activities – as such, traditional banking is seen as haram. This has led to innovation within the finance industry to provide bonds and loans in a halal manner, culminating in various products such as sukuk (Islamic bonds) and mudarabah. Such instruments are structured to eliminate interest and excessive mark-up (which is what riba loosely means); for instance, instead of giving a mortgage loan to a customer, the bank would enter into a lease agreement with the buyer. This means that the bank would purchase a house for the customer and charge rent until the entire amount is paid off.

Developments in Islamic Finance

With an increasing number of products being offered in the market, Islamic funds now have a wide range of investment opportunities across the world. An increasing number of western banks and companies, as well as sovereign and government-related entities, have started issuing sukuk, particularly since the credit crunch in 2007 and the subsequent financial crisis. It is estimated that sukuk issuance increased by 40% through the first ten months of 2009.

An additional factor driving the development of new products is the push towards the mainstream by Islamic fund managers to attract non-Muslim capital. As such, firms offering Islamic investments are increasingly becoming popular from a diversification angle, especially after the recent market downturn. Furthermore, the idea of ethical investing is also gaining popularity as it also offers distinct advantages; for instance, Islamic funds were little affected by the scandals afflicting companies such as Enron and WorldCom several years ago as these companies' highly leveraged balance sheets restricted Shariah funds from buying them.

Islamic finance and investment vehicles have gained further attention through some high-profile sukuk offerings by companies such as General Electric while Islamic funds also outperformed mutual funds and other socially responsible funds during the credit crunch and financial crisis, but they did suffer losses of about 25% on average. Even though Islamic funds have a more restricted investment universe, they have done better than mutual funds through the last decade. Interestingly enough, Islamic funds recently received support from an unlikely quarter – the Vatican. In March 2009, the Vatican’s official newspaper Osservatore Romano publishedan article saying that "the principles of Islamic finance may represent a possible cure for ailing markets".

More recently, however, the world of Islamic finance has gone through some turmoil with the delaying of sukuk debt payments by Nakheel, the real estate subsidiary of Dubai World. Although there was emergency support available from neighbouring oil-rich Abu Dhabi to the parent company, the firm put off debt repayments for Nakheel by about six months. The subsequent weeks have resulted in investors and fund managers alike searching for the various options that they can avail, including whether they could seize assets. This is, however, seen as the first major test in the 40-year history of the industry but it is expected that the sector will overcome the hurdle and continue to grow strongly. 

Figure 1: Islamic Funds vs Mutual Funds

 

Industry Make-up and Growth Trends

Over the last decade, the Islamic fund industry has grown rapidly, driven by the increase of wealth in the Gulf Cooperation Council (GCC) countries due to the rise in oil prices. Newer asset class structures and products have emerged as Middle Eastern investors recognised their need to diversify their portfolios from the oil industry. Total assets under management currently stand at around $70 billion and the number of funds tapping into Islamic finance is expected to surpass 700 by early 2010.

Figure 2 shows the growth in the number of Islamic funds since 2000.

Figure 2: Growth in the Number of Islamic Funds

The highest number of new funds launched was in 2007 and the fastest pace of growth was seen from 2006 to 2007. The financial crisis and economic recession in 2008 resulted in a slower growth rate of Islamic fund launches. It is interesting to note, however, that even through the market downturn, the number of funds did not decrease as most Islamic funds invested in asset-backed securities and also, unlike the hedge fund industry, Islamic funds did not employ leverage, thereby limiting performance-based losses. This enforced the positive perception of the investment managers which prevented a widespread flight of capital.

The positive correlation between the price of crude oil and the number of new Islamic fund launches in the past suggests that most capital flowing into the industry still comes from Middle Eastern investors. The future pace of new fund launches is expected to follow a similar pattern although there is a greater interest in the investment vehicles from other non-Middle Eastern investors. 

Figure 3: Number of Islamic Fund Launches by Regional Investment Mandates

In terms of new launches by regional mandates, most newly-launched Islamic funds focused investments in Asia Pacific as it has increasingly attracted investors’ interest as a growth region. This is also because Middle Eastern investors looking to diversify regionally could find suitable Islamic fund managers in the Southeast Asian region – most notably in Malaysia (assets under management in Malaysia has reached US$9 billion) and to a lesser extent, Singapore. The number of Islamic funds that invested in the Middle East/Africa also drew interest on the long-term positive outlook on oil and its likely affirmative impact on the Middle Eastern/African region. It is interesting to note that very few funds which focus solely on North America or Europe were launched as these regions do not offer a significant number of Islamic finance products; such managers looking to allocate to these markets would generally have a global mandate.

Manager Location/Domicile

Figure 4: Islamic Funds by Manager Location

Malaysia and Saudi Arabia are the most popular Islamic fund centres. The former is seen as one of the most attractive fund centres in the world for Islamic finance given the number of incentives planned and the further liberalisation of the Islamic finance sector in the country. The country allowed two foreign banks to compete in the domestic banking industry in 2009 and plans to issue five more licences to foreign banks by 2012. Malaysia was also early in establishing the Shariah framework to create a conducive environment for Islamic banking – the Islamic Banking Act and the Takaful Act were introduced in 1983 and 1984, respectively. 19.6% of the funds were based in Saudi Arabia because of the recent growth of interest in retail funds coming from consumers and from the wealth derived from high oil prices. The emergence of the Islamic bond market in Saudi Arabia in the last two years also saw more asset managers setting up funds in the region. 

Figure 5: Islamic Funds by Domicile

Most Islamic funds are domiciled in Malaysia as the country provides good benefits for Islamic fund managers. For example, Islamic banks, takaful and fund managers domiciled in Malaysia and involved in managing foreign investors’ assets are exempted from paying taxes for ten years. 20% of Islamic funds are domiciled in Saudi Arabia because of its unique tax policies and dominant wealthy Muslim population. The country does not impose corporate taxes on local firms but on foreign firms. However, if the foreign company is a GCC investor and forms a joint venture with a Saudi company, then the foreign company is subjected to zakat taxes only rather than corporate taxes. Asset managers who want to create an Islamic fund would therefore be incentivised to set them up in the country.

Over the years, Islamic funds have also been set up at various traditional fund centrrs across the world, which accounts for the high percentage listed as “Others” in the above chart. These include United States, United Arab Emirates and Singapore as well as European countries with significant Muslim populations such as United Kingdom, France and Germany.

Geographies

Figure 6: Islamic Funds Assets by Investment Geography

Most of the Islamic funds are invested in the Middle East/Africa because the region has the highest concentration of companies that abides by the Islamic law. Secondly, 2000s saw a surge in the number of high net worth (HNW) individuals in the Middle East and asset managers created investment funds to tap into the affluence of these individuals. These HNW individuals had an instinctive preference in investing in their regional neighbours as a result of rising oil prices while the pre-December 2008 rise of real estate market in the United Arab Emirates was also an area of significant interest among the investors. Apart from investing in the Middle East, most other funds invested globally to cater to the need for portfolio diversification for Islamic investors.

Strategies

Figure 7: Islamic Funds Assets by Fund Type

Most of the Islamic funds in the world cater to retail investors as most of them are structured as mutual funds. Mutual funds are regulated vehicles and can only invest according to their stated investment mandates and objectives. The abundance of Islamic mutual funds can be explained by the simplicity of the fund’s mandate and its existence within an established regulatory environment to oversee mutual funds. For example, the Securities Commission Malaysia would ensure that Islamic funds under their jurisdiction invest in only Shariah-abiding companies. Launching a well-received Islamic hedge fund on the other hand is difficult as hedge funds employ long/short strategies through derivatives which are speculative instruments and therefore cannot be seen as Shariah-compliant. Furthermore, Islamic law requires transactions to be asset-backed, which limits the range of strategies that hedge funds can use.

Figure 8: Islamic Funds Assets by Asset Class

Most Islamic mutual funds are invested into equities. Equities have been the best performing asset class for the past 40 years and remain to be the favourites among such investors. Furthermore, being shareholders in a company is a very natural fit to the framework of Islamic finance; hence, it is the easiest and most widely available asset class for the managers to allocate to.

Fixed income constitutes a small portion of the Islamic funds primarily because the sukuk market is still very small compared to other developed bond markets in the West. Islamic investors cannot invest into conventional fixed income because the concept of charging interest on loans does not comply with Islamic law, which limits the fixed income investable universe to the sukuk market only. Additionally, Islamic bonds are typically closed-ended, which would not provide the liquidity that equities do, hence, making them less attractive than equities in an upward trending economic growth environment.

Performance Review

The Eurekahedge Islamic Fund Index outperformed most equity and average mutual fund indices during the financial crisis in 2008 while also delivering strong returns of 22.15% in 2009. In the eight years since 2002, the index has gained 52%.

Figure 9: Eurekahedge Islamic Fund Index vs Dow Jones World Sustainability Index

The Eurekahedge Islamic Finance Index has a positive correlation with the Dow Jones Sustainability World Index for the past decade. However, investing in Shariah-compliant companies and products proved to be more profitable than investing in companies that advocate policies such as climate change and human development. Another reason for the outperformance is that many Islamic funds are invested in the Middle East, wherein the region outperformed more developed markets where the Dow Jones World Sustainability Index constituents allocate to.

Geographical Mandates

Islamic funds invested in Asia were the best regional performers in 2009. Majority of the index constituents were benchmarked against Malaysian securities (Asian Islamic equity funds tracked the Kuala Lumpur Composite Index while fixed income funds took reference from the 12-month Malaysian General Investment Account Rate) while funds in other indexes were benchmarked against the Dow Jones World Islamic Indices. Malaysian companies performed well as they were leveraged on the growth of China, being the country’s largest trading partner. Malaysia has also kept its inventory levels very low from 2007 to 2009 which helped cushion the effects of an economic downturn in 2008. Being an emerging market, Malaysian securities outperformed the Dow Jones Islamic Index securities, which were mainly based in the developed markets.

Figure 10: Islamic Funds Performance by Geographies

Figure 11: Islamic Funds Performance by Instruments Traded

Breaking down the Islamic mutual funds by their asset class performance, equities and balanced funds (funds that invest in a mixture of assets) gave the best returns in 2009 as investors’ risk appetite improved on a V-shape recovery scenario. Islamic balanced funds were largely invested into equities which explained their close equity-like performance numbers last year. Real estate was the worst hit among Islamic mutual funds as residential prices in the Middle East, Europe and North America have fallen sharply from their highs in previous years. The environment for real estate companies remains challenging as banks are not willing to issue more property loans as they perceive that property values are too high and risky for their balance sheets. Money market funds that invested in shorter-dated fixed income securities saw the best returns from a 3-year time frame as investors demanded more of these securities on a flight to safety scenario during the crisis in 2008.