In the last six years there has been a major shift in global capital controlled by individuals and institutions in the Islamic world away from the US. This was largely prompted by 911, and the fear that US authorities would freeze assets that remained there, particularly those owned by Arabs. Although these fears have proved largely groundless, it has created a strong demand for alternative investments in this market. While money has been flowing into real estate, sterling-denominated assets, Asian markets, and indeed local Arab markets, there has also been a corresponding demand for Shariah-compliant investments in other areas, although this demand has as yet been under-served. That situation is starting to change, however, and even the hedge fund world has been waking up to the opportunity.

The high oil price has also made Middle East investors more active on a global basis, focusing minds on re-investing oil wealth elsewhere, and also creating a need to recycle foreign currency. The recent Dubai Ports World bid for P&O is a manifestation of a larger trend happening beneath the surface. Amongst those products which are likely to see growth going forwards, as a result of these trends, are Islamic hedge funds. "When you drill down, you find two types of investors in this market, those who don't want religiously responsible products, and those who do," says Philippe Teilhard de Chardin, Managing Director at Fimat Global Fund Services Group. "The investor segment is becoming more sophisticated, both in the Gulf countries and further east in Southeast Asia."

Limited options

Currently, there are a limited number of investment products on the market that could properly be considered Shariah-compliant. Most that are available have money market rates of return. Shariah law prohibits profiting from interest and the unethical use of money (eg investing in gambling, arms, alcohol and tobacco companies for example). Consequently, managers of Shariah funds need to be very aware of which companies and assets they are buying, and whether these are also Shariah-compliant. It presents a new host of demands for those firms seeking to venture into this space, although it might be slightly less challenging for portfolio managers already used to ethical investment strategies.

Historically, murabaha transactions were seen as a progressive area for the Islamic investment market. "A lot of Islamic scholars at the time said it was really pushing the envelope," says Teilhard. "Today, Shariah-compliant investments have really taken off. Anyone who is really serious about Shariah-compliancy is buying murabaha investments. The really strict Islamic institutions in the Arab world use this sort of transaction very commonly." It is a low risk, low volatility investment, but some investors are looking for something a little more.

Real estate has also been a popular destination for Islamic money, and has recently provided Islamic investors with considerable upside, although less liquidity. Shariah-compliant equities have also started to pick up, but these represent a high risk option, and there is sensitivity in the Middle East region and beyond to the sort of radical correction that we have seen in Arab world stock-markets last year. What seems to be lacking is an investment offering a bond-type of return with bond-style volatility. The sukuk market has been around for some time, certainly, and there are already a fair number of issuers active in this area, but it remains a nascent market for the time being. Various national-level initiatives to boost the availability of Islamic finance instruments should help to populate the sukuk universe, but at the moment, the market is unable to offer investors much in this area of middle ground between direct equity investment and the low-risk murabaha market.

"In Asia, when everything fell off [in 1997-98], the big issue was that all these countries had been borrowing short-term in US dollars, and they were investing in their own economies for the long term," says Teilhard. "When all those economies crashed, the local currencies collapsed and US dollar borrowings became very expensive. The result of that was all the Asian countries needed some means to finance their own economies long term.

The solution was the development of the Asian bond markets. They introduced measures to issue in local currencies and create pan-Asian bond funds to provide some reliance on local fund capacity, rather than tapping the US bond markets. Some years later, it has developed quite a lot. The sukuk market is a growing market, [but] it will take a fair amount of time for it to become a meaningful market for investment."

The hedge fund solution

The solution, in Teilhard's opinion, is a fund of hedge funds. "Hedge funds are shooting for a 9-14% return, using half the volatility. We thought if you could have Shariah-compliant hedge funds, it would be a pretty good proposal for Islamic investors to diversify their risk. This would fill the gap between the high risk, high return Islamic equities and the cash-type return in the murabaha market."

Easier said than done, however. Fimat realised it needed to introduce the building blocks that would provide for the launch of Shariah-compliant hedge funds. The bank was aware that success in this area is difficult to achieve: consistency was an issue, as was cost. "We spent a lot of time talking to a lot of Islamic investors and Islamic service providers," says Teilhard. "We drew up a long list of actual obstacles. By looking through that we realised what we needed was a very simple product. We didn't want to have a wrapper solution. We wanted something we could build from the ground up, every brick of the house, rather than just the paint."

Fimat went on the hunt for the best Shariah advisors to help it with this project, and retained Ratings Intelligence to assist it. Set up in 2000, Ratings Intelligence provides advice to investors seeking to invest in the equity markets from a Shariah-compliant perspective. It combines a Shariah committee with western investment banking knowledge, and contacts in both the Muslim and non-Muslim financial worlds. Its Shariah committee includes Dr Muhammad Ali El-Gari; Dr Abdul Sattar Abu Ghuddah; Dr Nazi Hammad; and Dr Mohammad Amin Ali Qattan, all respected Islamic scholars with first-class academic credentials (eg Dr Hammad was a professor at the College of Shariah at Um Alqura University in Mecca). The credibility of the committee that advises a product or service that is to be classed as Shariah-compliant is critical to the product's acceptability in what can be a highly discerning marketplace.

Fimat is aiming its platform at those big brand name hedge fund managers with the reputation and scale that would allow them to launch a Shariah-compliant product. In Teilhard's view, it was essential that the hedge fund names associated with the proposed platform would add to its credibility. Fimat wanted to provide hedge fund managers with software that would allow them to screen the equity universe from Shariah-compliant companies for their portfolios. "We were quite adamant that the Shariah-compliancy of a product should remain so on an ongoing basis," says Teilhard. "You cannot have an Islamic investor buying a Shariah-compliant product which is compliant today, but not tomorrow. This was the tendency in the past, we realised." Funds losing money might be tempted into making investments that would violate their compliancy.

It has been over two years in the making, but Fimat has now been able to deploy a Shariah-compliant prime broking platform for the hedge fund industry, segregated from the established Fimat platform. "We spent a lot of time developing the automation of the systems, in order to be able to provide a service where one of the first constants, when you look at the price of Shariah-compliancy, is no huge drag on the performance versus the benchmark of the non-Shariah-compliant version," says Teilhard. "There is always a risk that a portfolio manager, working with a narrower, Shariah-compliant universe, will be forced to give away some of his performance as a consequence. "In the genesis of the product, and indeed throughout its development, the key issue was to be able to provide a service with the smallest possible drag on performance," he says.

The platform has been beta-tested by three major hedge fund firms that already use Fimat as a prime broker, amongst them Stark Investments, North of South (a long/short manager), and an undisclosed long/short Japan specialist with offices in London and Tokyo. Shariah-compliant hedge funds will tend to be long/short equity, as most other strategies – other than a handful of commodity funds – will find it impossible to pass the Shariah test.

The Fimat platform has also been used for the launch of Old Mutual Asset Manager's Al Saqr Shariah-compliant hedge fund. This is an equity market neutral hedge fund that makes use of murabaha and salam contracts, and draws on OMAM's existing expertise as a quantitative manager. It is being run by the same team that looks after OMAM's market neutral and global long/short funds. The new fund trades globally in liquid stocks using a multi-factor proprietary model and will typically hold between 200 and 300 Shariah-compliant stocks, selected from the MSCI World Enhanced Index of approximately 3300 stocks. "We believe that there is a significant and growing demand for funds which meet the specific religious and investment requirements of the Islamic community," says Eoin Murray, CIO at OMAM.

The obvious criticism that has often been levied at Shariah funds to date has been that there is a significant drag on performance once compliancy has been achieved, and this is something that Teilhard's team has been working hard to reduce. But OMAM, in the person of Charles Bathurst, Head of Hedge Fund Distribution, reckons this is no different than any ethically-shaped investment strategy. The client recognises that there is a price to be paid for narrowing the universe of available investments. "Take our standard global sector model," he says. "We have a universe of 3000 stocks. Once that is constrained, it drops to 1800. If you eliminate half the universe, you end up working with a very different universe. The performance characteristics will be very different from that of the fund using the unconstrained universe."

It is more than just having to put up with a smaller universe. The portfolio will occasionally also have to be traded when companies held are dropped from the universe because they are ruled as non-compliant. A typical compliant universe will be audited by the committee every quarter, and portfolios adjusted accordingly. This could result in a turnover within a typical constrained product of approximately 15% per year.

Bathurst recognises the importance of ensuring that a fund is advised by a respected Shariah committee. There are only a small number of Shariah scholars available to sit on Shariah boards, and they can be roughly divided into two camps: the traditional and inflexible school, and the more dynamic and forward thinking school. It is the more flexible thinkers that have been advising on the development of Islamic finance products, and contributing to their sudden growth in popularity. "You need to get the process and the product approved," says Bathurst. "The distributor or investor has to have their own committee, their own scholar to approve the investment. There is consequently an additional layer [of compliancy] here."

It goes deeper than this, even. Internally, the fund's trade file management must be Shariah-compliant, hence internal systems have to be adapted, with non-compliant language removed from the middle office. In a way, OMAM, with its quant-based models, is well-suited to running Shariah-compliant funds, as investment decisions are being made on a very dispassionate basis. Yes, indicators have to be re-built in order to allow for a smaller universe of stocks, but ultimately, the investment strategy itself remains the same. Good news, perhaps, for those firms that have been investing in their quant desks over the past couple of years.

In many ways, Shariah fund management represents the same challenge faced by ethical fund managers when they were first starting out, but now many ethical products are doing well. "It's an opportunity to access an original investment opportunity," explains Bathurst.

Serious about the Islamic market

The fund manager prepared to take on this additional burden of work must be serious about the Islamic market and convinced that it is a large enough source of business to be worthwhile. It is unlikely to appeal to small, boutique-scale operations, or those considering only one or two launches in this direction. Potential future managers of Islamic hedge will include those big blue-chip asset management houses that already manage internal hedge fund money, and either have reliable distribution networks in the Islamic world already, or feel confident they will be able to build them in the future. There may also be scope for hedge fund managers to manage hedge fund products on behalf of Islamic banks, particularly funds of funds.

The OMAM fund has been attracting interest from both institutional and high net worth clients. However, it is also well-positioned to benefit from a new trend that has seen some governments stipulating that a percentage of state assets be invested in Shariah-compliant assets. With so much money suddenly seeking the right investment opportunities, there is an excess of capital and a shortage of opportunities. "People who came into this market first will capture the assets first," says Bathurst.

According to Teilhard, another fund is due to launch on the Fimat platform in June, and there are a further four fund managers talking to Fimat about potential Shariah-launches of their own. "This idea of a Shariah-compliant hedge funds business is part of our aim to bring more innovative solutions to our hedge fund customers," he says. "Fimat has been something of an outsider in the hedge fund business. Now it is a highly competitive business. Our approach has been to try to be quite different from our competitors – we are more the outsiders in this business. We didn't want to be a niche prime broker, or a huge prime broker. We have positioned ourselves as a derivatives-based house."

Fimat's prime broking strategy is to avoid a bias towards a specific investment style, but it is also addressing diversification issues in the markets it serves. Islamic hedge funds were a worthwhile investment: none of the other large prime brokers had been able to establish themselves in what is still a very nascent part of the hedge fund universe, and the opportunity was also there to increase Fimat's presence and customer base in the Middle East, and amongst those institutions with strong links with the region.

"There is a difference between what volatility means for Gulf investors compared with what it means for American or European pension funds," Teilhard says. "There are two types of prospect in this business: those who want a low volatility, low return type of investment, and those who want some type of performance, but don't want to leverage themselves. The former get by having a huge universe to choose from, but right now this model is being questioned by the rise in interest rates and bond yields. Thetruth is, there is a big market right now for concentrated funds of hedge funds."

Teilhard sees plenty of mileage for funds of funds following a bottom-up approach, happy to invest with 10 to 15 managers, and mainly with equity-based strategies. This will require, of course, enough single manager funds to stock the universe these funds of funds will fish from. No-one is assuming that there will soon be thousands of Shariah-compliant funds on the market, but in time there should be a respectable universe of managers to choose from, many with blue chip credentials.

Teilhard sees the launch of this platform as part of the changing face of prime broking services for hedge funds. Yes, hedge funds have been pursuing multi-broker relationships partly for price, but also because some brokers have been able to cater to special requirements. In a highly competitive market, where banks are now falling over themselves to win secondary broker mandates, it is those firms that can win business on the basis of additional, highly specialised services that will win out. Fimat has been able to do this historically because of its strength in the cross-margining business, for example. A Shariah-compliant hedge fund platform is an additional string to its bow, and not one that will require a high degree of financial innovation to provide. Ultimately, a Shariah hedge fund will be following a fairly conservative strategy, and should be relatively straightforward to service once the infrastructure of the Shariah platform has been fully beta-tested.

Teilhard stresses that it is still early days, but with four hedge funds up and running on the platform, he hopes to soon get to 10, after which, the process will have its own traction. Certainly, there seems to be a lot of interest from established names in the industry that are serious about managing Islamic capital.

Says Teilhard: "We're happy to add our own stone to the edifice of Islamic finance."