Chapter 6 Islamic Asset and Fund Management

Introduction to Islamic Banking and Finance: Principles and PracticeM. Kabir Hassan, Rasem N. Kayed Umar A. Oseni Chapter 6Islamic Asset and Fund Management

Learning Objectives Upon the completion of this chapter, the reader should be able to: 1. Understand the unique nature and fundamentals of Islamic asset and fund management; 2. Identify the criteria for the selection of Islamic stocks for investing and review Islamic fund performances; 3. Examine the structure, marketing, and distribution of Islamic funds; 4. Understand the Sharī'ah governance for Islamic funds and the importance of Islamic fund management; and 5. Know the meaning and importance of risk management issues for Islamic funds, including risk-reward profile, with specific analysis of the risk-reward profile of the major Islamic finance products

Learning Objective 6.1 Understand the unique nature and fundamentals of Islamic asset and fund management Review and Fundamentals of Islamic Investing • The Holy Qur'an emphasises necessity of financial planning and asset management (Qur’an 12, verse 47-49) • 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 • Fund managers and Islamic asset management firms must be professional in the discharge of their responsibilities • 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

Learning Objective 6.1 Understand the unique nature and fundamentals of Islamic asset and fund management Review and Fundamentals of Islamic Investing Islam prohibitsunethical investments including investments that deal with: - Gambling - Alcohol - Pork - Uncensored media/leisure - Pornography - Other activities that are explicitly prohibited under the Sharī'ah

Learning Objective 6.1 Understand the unique nature and fundamentals of Islamic asset and fund management Review and Fundamentals of Islamic Investing Islamic investments must • Exclude all riba (interest-bearing) products • Avoid speculative investments • Be socially responsible • Ensure that contractual terms comply with Islamic law

Learning Objective 6.1 Understand the unique nature and fundamentals of Islamic asset and fund management Review and Fundamentals of Islamic Investing 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

Learning Objective 6.1 Understand the unique nature and fundamentals of Islamic asset and fund management Review and Fundamentals of Islamic Investing Avoiding Speculative Investments • Speculative investment may involve both uncertainty (gharar)and gambling (maysir) • Islam prohibits: - Investment activities involving excessive risk, speculation or uncertainty - Uncertainty and contingency in contracts such as short selling and derivatives - Conventional insurance and derivatives • Fund managers must respect the wishes of their clients by investing only in Sharī'ah-compliant products

Learning Objective 6.1 Understand the unique nature and fundamentals of Islamic asset and fund management Review and Fundamentals of Islamic Investing 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)

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and 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

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts 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

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts Prominent Stock Exchanges • The Honk Kong Stock Exchange • The New York Stock Exchange (NYSC) • The London Stock Exchange • The Frankfurt Stock Exchange • The Kuala Lumpur Stock Exchange (KLSE) • Tokyo Stock Exchange (Nike)

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts Prominent Islamic Indexes • The Dow Jones Market Index • FTSC Global Islamic Index • S&P Global Investable Sharī'ah Index • MSCI Barra

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts Figure 6.1: Example of a Stock Market Index

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts The Dow Jones Islamic Market Index - The Dow Jones Islamic Market Indexes are the most visible and widely-used set of Shari´ah-compliant benchmarks - Stocks are screened to determine eligibility for the indexes

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts Sharī'ah Supervisory Board • Established to advise Dow Jones Indexes on methodology for screening securities (for inclusion in the Dow Jones) • The board consists of five eminent Shari´ah scholars from around the world

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts 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 and instrument - Purification of income distributions

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts Figure 6.2: The Sharī'ah Screening Process for Islamic Funds

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts 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

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts 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

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts 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)

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts Selecting Sharī'ah Compliant Transactions and Instruments Conventional investment funds rely heavily on interest-based debt to finance their activities, thus they may invest in: - Interest-bearing debt securities - Preferred stocks - Warrants - Common stocks - Any other suitable instrument

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts Selecting Sharī'ah Compliant Transactions and Instruments • Because of prohibition of riba, maysir, and 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)

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts Figure 6.3: Fund Results: Amana Trust Income Funds

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts Selecting Sharī'ah Compliant Transactions and 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

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts 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 • Zakat may be used as a form of purification technique to dispose the portion of income resulted from interest-related dealings

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts 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

Learning Objective 6.2 Identify the criteria for the selection of Islamic stocks for investing and review the Islamic funds’ performances Contractual Terms and Certification by Sharī'ah Experts Issues of Non-compliant Stocks Degree of non-compliance : 1. Temporary non-compliance with Industry or Financial Screens 2. 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 3. Permanent non-compliance with Industry or Financial Screens: The Sharī'ah board may ask fund manager to divest from such stocks

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Islamic Investment Fund Islamic investment fund can 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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Islamic Investment Fund • 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 • Certificates commonly known as sukuk in Islamic finance • 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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Structure of Islamic Investment Funds Major Islamic investment funds commonly used by Islamic funds manager: • Islamic debt funds • Islamic equity funds • Alternative investments • Special asset classes

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds 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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Insert Figure 6.4:The Five Steps in the Structure of Islamic Debt Funds

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Commodity Funds • Commodity funds involve murabahah operations or bai bithaman ajil (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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds IjarahFund • The ijarah fund 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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds 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: a) The investors (rabb al-mal) assume the role of silent partners in the trust partnership b) The fund manager (mudarib) as the entrepreneur performs the managerial functions

Structure Islamic Investments Funds Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Islamic Equity Funds 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)

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Alternative Investments 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)

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Marketing and Distribution of Structure Islamic Investments Funds 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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds 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 - is 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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds 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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds 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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds 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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds The Structure of Islamic Venture Capital Fund • 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 venture capital fund

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds • 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 venture capital fund

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Raising Funds for Islamic Venture Capital The Islamic venture capital fund draws its funds from a wide range of investors including: • Sharī'ah-compliant institutions such as: - Islamic banks and financial institutions - Takaful companies- Individual investors who prefer the Islamic finance products • Mudarabah contract

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Real Estate Investment Trusts (REITs) • The Real Estate Investment Trusts (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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Three Categories of REITs 1. Lending or financing activities in the real estate sector 2. Managing own real estate 3. Both financing others' and managing own real estate 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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Three Categories of Conventional REITs • Equity REITs: - acquires and develops its properties primarily to operate them as part of its own portfolio - engages in a wide range of real estate activities such as leasing, real property and tenant services 2. Mortgage REITs: Extends credit facilities to real estate owners and operators 3. Hybrid REITs: A combination of the above two categories where the REIT acquires and develops properties and at the same time lends money to real estate owners and operators

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

Learning Objective 6.3 Examine the structure, marketing and distribution of Islamic funds. Structure Islamic Investments Funds Islamic Hedge Funds Hedge funds are often set up as private investment partnerships open to a limited investors and requiring large initial minimum investments • Investments in hedge funds are illiquid • Hedge funds are acceptable in the Islamic investment sector if they are free from all forbidden elements • While some Sharī'ah scholars believe in the possibility of having Islamic hedge funds, others argue otherwise due to the speculative elements embedded in such portfolios

Chapter 6 Islamic Asset and Fund Management