Islamic Finance

Innovative sharia-compliant products are sparking global interest, and in the constrained financial climate they are catering to customers' growing risk aversion. Writer James Gavin
Islamic investors have become used to a wider array of products to place their money over the past year, as fund managers attempt to penetrate an untapped market with some innovative new instruments.
Whether traditionally structured equity and real estate funds - still the most popular - or the more esoteric products that have emerged more recently from financial institutions, such as Islamic hedge funds, the choice is wider than ever.
The surge in interest from overseas institutions in the Islamic space is largely a by-product of the Middle East's huge spurt of wealth creation that followed the dramatic rise of oil prices from 2002 onwards.
Demand is set to grow, experts say. The market for Islamic investment products is growing by 15% to 20% a year and equity fund assets alone are forecast to jump from $15bn to $53bn by 2010, according to the FTSE Group.
Islamic communities across the globe have always preferred to save and invest their capital in an Islam-compliant manner, but this has not always been possible as sharia compliant avenues were not always available in which to channel them.
Once investment houses realised the possibilities offered by Islam-compliant investment funds, and the profitability that could be delivered, they moved with alacrity to fill the gap.
Product engineering
Sometimes providers have little alternative but to engineer their product slate in an Islamic fashion. "Certainly in Saudi Arabia, a lot of clients say it is now almost a necessity to provide products that are sharia compliant," says Mark Stanley, assistant manager of Ernst & Young's advisory services and part of the Islamic Financial Services Group in Bahrain.
The 120 sharia-compliant mutual funds in Saudi Arabia account for a majority of Saudi assets under management in the kingdom.
Then there are attempts to tap the Middle East's investor base. "A number of Western product providers have recently shown an interest in restructuring their existing products to become sharia-compliant, particularly when they are asset-backed types of instruments," says Mr Stanley.
The activity is not just the result of Western institutions in pursuit of quick profit. Islamic banks are also becoming more creative in their product offerings. They carry four main asset classes within their investment portfolios, property, equity, sukuk and managed funds.
The Islamic fund space has gradually expanded, starting in the Gulf region. According to an Ernst & Young study, there were fewer than 500 sharia-compliant funds two years ago, but this could double in number by 2010.
Most Islamic investment strategies are focused on equities, an emphasis that has left the fund universe skewed against fixed-income sectors. Difficulties in structuring economically viable and truly sharia-compliant fixed-income-oriented mutual funds has left the Islamic space vastly different than that of the US, where bond and equity funds follow an asset allocation model of in the ranges of 60/40 to 70/30.
Financial climate
The worsening financial climate of the past six months may cause interest in Islamic fixed-income funds to pick up. "Fixed income is an area that is under-represented in the sharia-compliant space. From an investor's perspective, it makes sense to have a balanced portfolio, with some money in equities, and some in fixed income," says Saqib Masood, Saudi-based head of Islamic product development for HSBC Asset Management.
Diversification is the watchword: "Asset managers at Western banks have long acknowledged that you have to diversify portfolios if you are going to ride out the tougher periods, and this current crisis has forced a reassessment of concentrations, particularly in real estate," adds Mr Stanley.
Structural obstacles need to be surmounted. For example, Islamic funds of funds have found it difficult to place fixed-income funds. The inflationary spike that afflicted the Middle East last year also eroded the appeal of products whose returns were typically about 5% to 6%, well below many Gulf states' consumer price indexes.
Sukuks also carry large minimum investment levels, which put off retail investors. With the sukuk market illiquid, Islamic banks found it difficult to attract buyers at satisfactory prices. This may stymie the take-up of this asset class, although income generator types of products may draw more interest from customers.
Whether fixed-income or equities, neither class is likely to witness significant new product innovation so long as investors are bent on being cautious. Simpler solutions may prove more attractive to the average investor.
Wider interest
High-net worth individuals (HNWIs) have shown some interest in hedge funds and private equity funds, given their greater investment exposure to these strategies in the conventional space, but this demand has yet to seep into the wider retail sector.
Last July, Barclays Capital and the Dubai Multi Commodities Centre Authority (DMCC), an agency of the Dubai government, announced the launch of sharia-compliant hedge funds on the Al Safi Trust, a comprehensive sharia-compliant platform comprised initially of single-strategy alternative investment managers