azerbaijan: emerging market islamic banking and finance

INNOVATION SPOTLIGHT
NEWHORIZON October–December 2008
Islamic dynamic strategies
In light of the recent market turmoil, a number of Islamic investors have turned to Islamic hedge
funds in search of alpha (a risk-adjusted measure of the active return on an investment). In this
article, Ahmad Chaudry and Ruggiero Lomonaco of RBS Global Banking & Markets discuss
some of the problems associated with these vehicles and instead propose a movement of the
Islamic wealth management industry towards ‘Islamic dynamic strategies’. In this context, the
article presents the ‘Islamic Navigator’, the first multi-asset strategy that utilises a unique
dynamic allocation and volatility stabilisation mechanism on a number of Islamic underlyings.
Since the spring 2006 correction in GCC
equity markets and the global credit crunch
just over a year later, buy-and-hold
strategies on the two dominant asset classes
in the Islamic wealth management industry,
namely Islamic equities and real estate, have
begun to develop a less desirable riskreward
profile. That is, investors find
themselves facing higher levels of volatility
for lower returns.
Because of this deterioration in the riskreward
trade-off, Islamic investors are
shifting attention to Islamic hedge funds.
These aim to provide stable, positive
returns by means of a Shari’ah-compliant
investment. On the one hand, critics of
these vehicles highlight the intrinsic
contradiction between Islamic finance and
speculation/arbitrage, whilst on the other
Shari’ah-compliant investors have expressed
a need for investments which offer decent
returns without exposing their capital to
excessive risk.
The issue of the level of Shari’ah compliance
observed by Islamic hedge funds is beyond
the scope of this discussion. Instead, we
focus here on whether Islamic hedge fund
vehicles meet the goals and expectations
of investors and whether there are
alternative ways of achieving the same
goals. The first and sometimes most
frustrating limitation for investors when it
comes to hedge funds is the large minimum
investment amounts. This automatically
narrows the target audience to high net
worth individuals and institutional
proprietary books. As a result, a sizeable
retail market is left to choose its investments
from an Islamic wealth management market
that offers a limited choice of innovative,
low risk alpha strategies.
Secondly, hedge funds, be they Islamic or
conventional, very rarely offer capital
protection. If the market turns considerably
against the fund, investors could lose a
significant amount of the invested principal.
In such an event, losses to investors can be
compounded by the fact that hedge funds
routinely limit or even ban redemptions
when it suits them. In practice this means
hedge funds restrict redemptions when they
incur losses and investors would like to
withdraw funds. In effect, liquidity in hedge
funds is even more limited than assumed at
the outset of the investment precisely at
those times when investors may want it.
This leads to the third issue: the level of
risk taken by these vehicles. Whilst it is
generally true that hedge funds operate
with strong risk controls in place, in
practice it is impossible to tell exactly what
the individual fund is doing. One has to
trust on faith that the fund’s managers have
not decided to take on board excessive risk
relative to their advertised mandate. At the
end of the day, this is left at the fund’s
discretion and investors have no way of
ensuring or even demanding compliance.
This in turn leads us to the fourth issue: lack
of regulation. It is because of this that
Islamic hedge funds are able to operate as
black boxes, making it difficult to follow
their trading activities, which are often
executed at high frequency. This also means
that the level of protection that would
otherwise be available legally to investors is
lacking when they take up hedge fund
investments.
The fifth issue is that despite all this, Islamic
hedge funds charge high management fees,
which can be as high as ten per cent upfront
of the invested principal and up to 30 per
cent of the performance.
Finally, additional issues include an illiquid
– or even complete lack of a – secondary
market, as well as short track records.
Islamic hedge funds are relatively new
vehicles.
In an effort to address these concerns and
provide Islamic investors with more
accessible alpha ideas, the Islamic wealth
management industry needs to encourage
the development of ‘Islamic dynamic
strategies’ (see also NewHorizon,
July–September 2008 issue). Through
whatever strategy the investor may believe
is optimum, whether it be based on meanreversion/momentum,
a dynamic weightings
adaptation of the ‘efficient frontier’ or some
other fundamental-based algorithm, it could
be this breed of investing that will drive the
14 IIBI www.newhorizon-islamicbanking.com