Chapter 6 Asset & Fund Management

1. Review and Fundamentals of Islamic Investing. Contractual Terms and Certification by Sharī'ah Experts. Structure Islamic Investments Funds. Sharī'ah Governance of Islamic Funds. Risk Management for Islamic Investment Funds Chapter 6Asset & Fund Management

2. Review & Fundamentals of Islamic Investing • The Holy Qur'an emphasises necessity of financial planning and asset management (Qur’an 12, verse 47-49 سورة يوسف ) • Wealth in Islam considered as a means to an end • Wealth must be managed in such a way to cater for interests of current and future generations • Islamic asset management firms & Fund managers must be professional & responsible • Sharī'ah-compliant investing corresponds with the values of socially responsible investing based on ethical dealings • Islam prohibits all forms of interest (riba) in Islamic investing

3. Review & Fundamentals of Islamic Investing Islam prohibitsunethical investments : investments that deal with: • Gambling, Alcohol, Pork, Uncensored media/leisure & Other activities that are explicitly prohibited under the Sharī'ah Islamic investments must • Exclude all riba(interest-bearing) products • Avoid speculative investments • Be socially responsible • Ensure that contractual terms comply with Islamic law

4. Non-Interest-bearing Products • Islam places special emphasis on ethical investing • Islam prohibits all forms of interest, whether fixed or floating, simple or compound • “Nominal” or “excessive” interest amounts are prohibited and they are treated alike under the prohibition rule • Fund managers must ensure that clients’ investments are free from all forms of interest-bearing products and investments are Sharī'ah-compliant • Financial returns must bear two inseparable features of Islamic investing, i.e. profits and loss

5. Avoiding Speculative Investments • Speculative investment may involve both uncertainty (gharar)and gambling (maysir) Islam prohibits: • Investment activities involving excessive risk, speculation or uncertainty • Uncertainty & contingency in contracts such as short selling & derivatives • Conventional insurance & derivatives • Fund managers must respect the wishes of their clients by investing only in Sharī'ah-compliant products

6. Social Responsibility The Sharī'ah requires fund managers as well as their clients to discharge their social responsibility from their investment activities. Mechanisms for fulfilling social obligation include • zakat (compulsory alms) • sadaqah (voluntary alms) • waqf (charitable endowment) • takāful (Islamic cooperative insurance)

7. Contractual Terms & Certification by Sharī'ah Experts • The fund managers must ensure contractual terms conform to the principles of Islam • Necessary certification by Sharī'ah experts (a panel or Board) should be sought for all contracts • The Sharī'ah Board ensure compliance of all investment funds

8. The Islamic Stock Market Index • Stock selection involves a process of screening to establish Sharī'ah-compliance • An index is used to measure fluctuations in the performance of stocks • Securities are traded in a place called the Stock Exchange –buyers and sellers of securities trade here • Islamic indexes were introduced to set benchmarks for Sharī'ah-compliant products

9. Prominent Stock Exchanges • The Honk Kong Stock Exchange • The New York Stock Exchange (S&P 500, Dow Jones) • The London Stock Exchange • The Frankfurt Stock Exchange (DAX) • The Kuala Lumpur Stock Exchange (KLSE) • Tokyo Stock Exchange (Nikkei)

10. Prominent Islamic Indexes • The Dow Jones Market Index • FTSE Global Islamic Index • S&P Global Investable Sharī'ah Index • MSCI Barra The Dow Jones Islamic Market Indexesare the oldest and most visible and widely-used set of Shari´ah-compliant benchmarks Stocks are screened to determine eligibility for the indexes

11. Sharī'ah Supervisory Board • Advise Indexes on methodology for screening securities (for inclusion( • The board consists of 5 eminent Shari´ah scholars from around the worldEstablished to advise Dow Jones The Process of Selection of Islamic Stocks • Ensure Sharī'ah compliance at every step of the investment selection process • The selection process includes the following steps: • Sector screen or industry screen • Financial screen • Selecting Sharī'ah compliant transactions & instrument • Purification of income distributions

12. The Sharī'ah Screening Process for Islamic Funds

13. Sector Screen or Industry Screen • Evaluate and certify business activity of the potential company to ensure its compatibility with Sharī'ah restrictions • Exclude companies producing or selling prohibited goods or services from Islamic funds investments • Scrutinize investments in large corporations that might have more than one line of business • Analyze acquisition mode and target firms’ business focus whenever a business conglomerate acquires a new subsidiary business

14. Financial Screen The firms under investment should be operating according to Islamic financial norms. i, e., free of any prohibited financial practice including: • riba (interest) • maysir (gambling and pure games of chance) • gharar (speculations and excessive risk) • any other prohibited element in commercial transactions

15. AAOIFI Ratios For Financial Screening • Conventional debt / total assets < 30% • (Cash + interest-bearing deposits)/total assets <30% • (Total interest income + income from non-compliant activities) / total revenues < 5% • Accounts receivable / total assets < 45% (AAOIFI Sharī'ah Standard No. 21)

16. Selecting Sharī'ah Compliant Transactions & Instruments • Conventional investment funds rely heavily on interest-based debt to finance their activities • Because of prohibition of riba, maysir, & gharar, Islamic investment funds cannot invest in fixed income instruments such as: • Corporate bonds • Treasury bonds and bills • Certificates of deposit (CDs) • Preferred stocks • Warrants • Some derivatives (such as options)

17. Selecting Sharī'ah Compliant Transactions & Instruments • Islamic investment funds cannot trade on margin or get involved in any interest paying debt to finance their investments • It is not permissible to engage in sale and repurchase agreements (i.e., repos or buy-backs) • Islamic fund managers are not allowed to speculate or undertake any unnecessary risks

18. Purification of Income Distributions • If the fund observes some part of its income is doubtful (income from interest-related dealings), then those earnings should be foregone • No consensus among Muslim jurists on the cleansing of capital gains: • Some observe that cleansing of capital gains earning is necessary • Others argue that no purification is required since selected firms belong to halal industries • Purification technique to dispose the portion of income resulted from interest-related dealings

19. Issues of Non-compliant Stocks • Sharī'ah supervisory board keeps constant monitoring of the business operations of the Islamic fund • Sharī'ah compliance of firms that may engage in mergers, acquisition or divestures should be re-scrutinized periodically

20. Degree of non-compliance : • Temporary non-compliance with Industry or Financial Screens • Short-term non-compliance with Industry or Financial Screens: • Fund manager should report to the supervisory board if stock becomes non-compliant for a longer period of time • Supervisory board should review the status of the non-compliant stocks at regular intervals • Fund manager should donate restricted earning to charity • Permanent non-compliance with Industry or Financial Screens: The Sharī'ah board may ask fund manager to divest from such stocks

21. Structure Islamic Investments Funds Islamic Investment Fundcan be defined as a joint pool to which investors contribute their surplus money for the sole purpose of investment in legitimate business from which they will earn permissible (halal) profits in conformity with the fundamental principles of the Sharī'ah regulating business transactions

22. Islamic Investments Funds • The fund manager issues a certificate (may be called “shares”, “units” or “certificate” or “instrument” to the subscribers (investors) certifying their rate of subscription •  Profits earned by the fund are distributed in accordance with subscribers respective investment portfoliosafter deducting the managerial expenses The validity of the subscribers' certificate is subject to: • No fixed return for the certificates • Funds realized from the pool should be invested in Sharī'ah compliant activities

23. Major Islamic investment funds commonly used by Islamic funds manager • Islamic debt funds • Islamic equity funds • Alternative investments • Special asset classes

24. Islamic Debt Funds An arrangement where the capital of an equity-based fund is invested in fixed-income yielding activity such as an operating lease which naturally involves a debt

25. The Five Steps in the Structure of Islamic Debt Funds

26. Commodity Funds • Commodity funds involve murabahahoperations or baibithamanajil(BBA): the fund manager uses the subscribed pool of funds to purchase different commodities for reselling at a profit (based on a deferred payment arrangement) • The amount of profit from the resale constitutes the main income of the fund • Profit is distributed among the subscribers based on their pro rata subscription to the fund

27. Ijarah Fund • The ijarahfund is • Created through the pool of surplus financial resources • Managed by a fund manager • Used to purchase a leasable asset for establishing a lease agreement with a third party (the ultimate user) • The rentals that are charged from the lessee constitute the income for the fund • The income is distributed pro rata to the subscribers accordingly after deducting the managerial expenses

28. Islamic Equity Funds • The most common and widely practiced portfolio among Islamic fund managers around the world • The structure of Islamic equity fund may either be based on amudarabah contract, or amusharakah contract a mudarabah contract The two main parties are: • The investors (rabb al-mal) assume the role of silent partners in the trust partnership   • The fund manager (mudarib) as the entrepreneur performs the managerial functions

29. A musharakah contract (partnership financing): • The formation of partnership between the investor and the entrepreneur. Both parties share the assets of the business to the extent of the ratio of financing • Musharakah gives both the entrepreneur and the bank the opportunity to share the finances as well as the management of the business • Profit and losses are shared according to pre-determined proportions after deducting the entrepreneur’s management compensations)

30. AlternativeInvestments The three main forms of funds under the alternative investments are: • Private Equity Fund • Islamic Venture Capital Fund • Real Estate Funds or Real Estate Investment Trusts (REITs)

31. Private Equity Fund • Structured as private limited companies with a few numbers of stakeholders • Private equities usually • Engage in non-exchange traded or illiquid investment strategies • Embark on long-term investments in a portfolio of growth companies   • Applying Sharī'ah compliance audit to boost the confidence of the investors in private equities

32. Islamic Venture Capital Fund • The term “venture capital” defined as the money and resources made available to promising startup firms and small businesses - encompasses managerial and technical expertise  • Venture capital fund • not traded on exchanges but engages in long term investments • is structured as an open-end fund • Venture capital investments may take place at any or a combination of different stages

33. Islamic Venture Investments Venture capital investments may take place at any or a combination of the following stages: • Seed-stage financing • Early-stage financing • Formative-stage financing • Later-stage financing • Expansion-stage financing • Balanced-stage financing

34. Liquidating the Investment Venture capitalists liquidate their investment through any of the following procedures: • Initial public offering (IPO) • Company buyback • Trade sale • Write-off • Secondary sale • Reorganization of investee company

35. The Structure of Islamic Venture Capital Fund • Is based on a contractual arrangement between the fund manager and the institutional and individual investors • Individual and institutional investors are the passive investors and would act as the “limited partners” • Private equity experts are considered as the “general partners”; they undertake the management responsibility • Analyzing the feasibility of possible ventures include: • Islamic venture fund performs Sharī'ah-compliance screening • Islamic venture fund conducts project feasibility analysis similar to the conventional VC fund

36. Real Estate Investment Trusts (REITs) • REITs structured as limited companies and are often listed in stock exchanges • REITs that are not listed or that are traded over-the-counter are known as Private REITs • Islamic Equity REITs basically replicates a fund structure that is similar to the Ijara fund • While Ijara Funds may have fixed maturity, the maturity of Islamic Equity REITs Funds may be long or ongoing • REITs are structured in such a way that allows the investors to replicate their target exposure for stock and real estate in a single contract

37. Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Special Asset Classes • Islamic Hedge Funds • Funds of Funds • Mixed Funds

38. Fund of Funds • Instead of creating its own portfolio, fund of funds applies a passive investment strategy where the investing fund invests in another fund with a different investment objective to diversify its exposure • The conception of fund of funds may be a less efficient technique for Islamic funds due to the number of Islamic funds as well as the higher commissions and fees involved

39. Distribution & Marketing of Islamic Funds • Islamic funds as an industry is: • Still in its infancy stage • Going through a transitional phase in terms of functional structure, marketing & distribution systems • The interrelationship between the Islamic investment funds and Islamic banks can partially be explained: • Islamic banks have preceded other IFIs • Islamic banks were the pioneers for the Islamic investors’ demand for Sharī'ah-compliant alternatives to conventional investment funds

40. Common Business strategies of Islamic Investment Funds • Joint Venture • Strategic Alliances • Franchising • Outsourcing

41. Joint Ventures Islamic investment funds may enter into joint venture agreements with other Islamic banks or conventional banks to: • get higher market exposure and increase the investor network at a lower cost • create newer exposure to prospective investors in other geographical locations

42. Franchising • Islamic investment funds may engage in franchising to promote their products in different markets • Franchising is preferred between Islamic funds and other Islamic financial institutions • The Islamic fund should make sure that the buying financial institution complies with the requirements of the Sharī'ah • Like a joint venture, an Islamic fund may seek investors beyond national boundaries

43. Challenges in Marketing & Distribution of Islamic Funds • Lack of liquidity • Inadequacy in the number of Sharī'ah-compliant investment funds and investable securities • Segmented Islamic financial markets • Lack of appropriate management skills and difficulties in outsourcing of such skills • Lack of awareness of Islamic investment process entails assuming additional responsibility to create an educated investor base (to ensure customer loyalty)

44. Sharī'ah Governance of Islamic Funds The Sharī'ah governance framework oversees that every aspect of the investment products, services & contracts is compliant with the fundamentals of the Sharī'ah. The Modern Practice of Islamic Wealth Management – Three Alternatives • To adopt the practice in the wider Islamic finance industrywhere standing Sharī'ah Boards are established • To employ the services of Sharī'ah consulting firms • To employ the services of independent Sharī'ah scholars on an ad-hoc basis to review their investment processes, services, and contracts to ensure a full compliance with the requirements of the Sharī'ah

45. Composition ofthe Sharī'ah Supervisory Board • Islamic funds include members from different demographics • Whether an institution has a minimum of three members for the Sharī'ah supervisory board (as per the requirements of AAOIFI) or a single supervisor is its own choice • The composition of the Sharī'ah board should be included in the charter of the fund • The members of the board should possess: • Strong academic and professional background in Islamic jurisprudence • Understanding of the financial transaction & financial system

46. Functions of the Sharī'ah Supervisory Board The responsibilities of the Sharī'ah board include: • Monitoring the fund’s compliance with the Sharī'ah • Overseeing the fund’s portfolio purification • Reporting on the compliance status of the fund • Assisting the fund management • Advising on zakat (charity) and identifying the procedures for its distribution

47. Independence of Sharī'ah Committee & Islamic Fund Infrastructure • The independence of the Sharī'ah supervisory from the management’s influence is more likely to: • impart better supervision • boost the confidence of the investors • ensure the best functionality of the Sharī'ah governance organ • Any prospective new product should be cross-checked for Sharī'ah compliance in the first place by the Sharī'ah board

48. Compensationand Monitoring Fees • Compensation and monitoring fees for the Sharī'ah board members is based on professional expertise and academic qualifications • Transparency and consistency in the compensation system to avoid conflict of interest • The Sharī'ah board members may be compensated in the same manner as the Board of Directors on the basis of: • monthly remuneration • additional payment for meetings • out-of-pocket expenses • special allowance

49. Disclosure Issues • Better disclosure practices for all the investment funds • The disclosure of Sharī'ah compliance information • In addition to the annual Sharī'ah-compliance reports issued by the boards, Islamic investors might need to prepare additional Sharī'ah-compliance reports on a regular basis

50. Risk Management for Islamic Investment Funds • Islamic fund managers replicate some of the basic risk management strategies found in ‘normal’ investment funds • There are additional risk management issues associated with the uniqueness of Islamic funds and their products • Islamic fund managers consider the limitations of Islamic investments while forming risk management strategies: • - the lack of investable securities • - lack of liquidity • - lack of Sharī'ah compliant derivatives