Sharia law generally imposes restrictions on types of investment. As with all Sharia-complaint products any hedge fund strategy would have to be certified by a Sharia scholar via a Fatwa.
In February 2006, Jersey’s Financial Services Commission (JFSC) approved the Algo Al-Qayyim Fund as its first Sharia-compliant hedge fund to fall within its ‘expert fund’ regime.
The fund appeared to have overcome all the obstacles, and was expected to launch shortly after the Jersey approval. It represented the culmination of two years work by Jersey-based fund administrator Volaw Trust & Corporate Services Limited, a firm with a long history of working with Islamic financial institutions.
The fund was set up to be administered in Jersey by Volaw Trust. It required input from the scholars provided by the Sharia Supervisory Board of Yasaar Ltd., the skills of Algo Capital Management in devising appropriate screening techniques, and the support of Citibank, acting as prime broker.
The process of developing such a fund is a complex business. While conventional Sharia-compliant funds must satisfy certain qualitative and quantitative criteria, the very nature of some aspects of hedging makes complying with Sharia somewhat problematic.
In order to achieve its objectives of maximising income and price appreciation, and in order to allow the fund to ‘short’ a stock in an acceptable manner, the Algo Fund planned to use the ‘Urbun’ contract of Islamic law. An Urbun contract is a deferred sale with a down-payment where, should the buyer not complete the purchase, the down-payment becomes a forfeit.
It took less than a week for the JFSC to approve the fund, but earlier this year after a number of launch delays and four years after the plan was originally conceived, the Algo Fund was quietly withdrawn.
Trevor Norman, director of Volaw Trust and head of the firm’s Islamic Finance and Middle East Group, now believes that the Sharia challenges in establishing an Islamic Sharia-compliant hedge fund are too great for any to be set up in the future. He also questions whether there is sufficient demand.
In addition, Norman disputes that any current funds which purport to be Sharia-compliant hedge funds are in fact implementing Sharia-compliant strategies.
Trustnet Offshore met Trevor Norman in Volaw’s Jersey office to find out the full story behind why the fund failed, and started by asking him to explain the background to the hedge fund that never was.
"Our involvement in Islamic finance goes back twenty years so this is not a new area for us. We have been doing this as a firm since 1982. My involvement started in 1994. We did the award-winning Islamic securitisation motor vehicle fleet Caravan I Sukuk deal in 2003/2004, which involved eighteen months hard work.
"And then having sorted out that deal my colleague decided that our next challenge should be to go for the holy grail of an Islamic hedge fund. So starting in 2004 we spent eighteen months going backwards and forwards visiting the Islamic scholars with various ideas. At the time there were two or three people who had claimed they had done it.
"The one who is regularly quoted is Eric Meyer, [president and chief executive of US-based Shariah Capital] who announced his Cayman-based Islamic hedge fund that was promoted from Bahrain initially in 2004. He did it himself, sold it to UBS and then it had various lives. But one of the problems with it was that having invested a lot of money in devising the methodology Meyer was very protective, and came in for a lot of criticism from various parts of the Islamic press for not opening up the black box and transparency as to how he had done it.
"Bill Gibbon, [group partner at Voisin law firm and head of its Sharia Funds department], and I have written an article in our recent newsletter which questions whether a) there is a true Islamic hedge fund out there, and b) is there truly a demand for one. I think there is a big question mark on both of those issues.
"We started looking at the issue of setting up an Islamic hedge fund, and started working with Algo, which led to the Algo Al-Qayyim fund. We got as close as having a draft fatwa from the Shariah Board when rather unfortunately in January 2007 AAOIFI, (the Accounting Auditing Organisation of Islamic Finance Institutions) published Shariah Standard No 21, which said that you could not use Salam-type contracts for share transactions. A Salam contract is a way of replicating forward contracts using an Islamic vehicle.
"Algo, with some input from ourselves, then went down the route of using an Arbun contract, which is a slight variation on Salam. Arbun is effectively a sale contract that involves a non-refundable deposit, but the Arbun contract is frowned upon by some of the Islamic schools, such as the Hanibali school of Saudi Arabia.
"The next phase, and not just Algo but several other institutions, tried using is Wad-based contracts. Wad is not a contract as such but a unilateral undertaking (a promise) by one party to another. But, again in 2007 Sheikh Yusuf DeLorenzo, one of the world’s leading Islamic scholars, published an article titled ‘Total Returns Swaps and the Sharia Conversion Technology’, which is a thinly veiled attack on some of the Wad contracts that had been passed by some of the scholars.
"This has led to a big question mark as to whether it is possible to have an Islamic hedge fund, or is shorting possible within the Sharia. The basic principle of Sharia is that you cannot sell what you do not own. The article by DeLorenzo is not necessarily challenging a Wad contract in itself, but it is challenging the way it is being used or some would say abused. DeLorenzo is saying that Wad is being misused to effectively convert profits earned from Aram trading into Halal income. It is an attack on a couple of products that are being approved in the UAE.
"The fallout from the article meant that our product was licensed but never launched. We were running in parallel with getting the licensing from the JFSC, because Citibank who were acting as prime brokers were looking for evidence that the fund was moving ahead as were various other parties. So we went ahead with licensing the product with the JFSC and then at about the same time Shariah Standard 21 came into force.
"The JFSC are not particularly concerned with the methodology of the fund. They are concerned with – who is the prime broker, who is the promoter, who are going to be the investors, and distributors – those sort of factors. So now the fund is now effectively abandoned."Q: Do you think there is still demand for Sharia-compliant hedge funds?
A: "I spoke at a Dubai hedge fund conference in February about Islamic finance. What was interesting to me was that it echoed my own thoughts regarding whether there really is true demand for an Islamic hedge fund at the moment.
"There is perceived demand – no doubt about it. Two years ago everything indicated there was demand. But at the moment there is a lack of traditional good old boring long-only type equity funds. I am not sure what demand there is even for those, because if you look at all the MENA fund administration we see coming to us – and our prime role is in establishing funds and administering funds – at least 65% of it is for real estate funds, 20% - 30% private equity funds and then traded equity. There is just not much demand for traded equity.
"When is the property bubble going to burst in the region generally - that is the $64m question. If I knew that I would not be sitting here today. "
Q: Did you originally think any scholarly objections to the fund would be overcome?
A: "We did. When Standard 21 came out and we could not use Salam it was a real kick in the guts because it was a fundamental part of our methodology."
Q: Could it be reversed in future?
A: "It is very difficult to see it being reversed without a lot of support from the scholars and what I have not been privy to is the underlying reasoning as to why Salam of the shares was not allowed. And I suppose I have not asked the question either."
Q: Did people involved in the fund not ask that question either?
A: "Once the ruling has been made and published to all extent and purposes it is a regulation and you would have to argue against the regulation. So the line of least resistance or the obvious way forward was 'ok, we cannot use Salam, let’s move on and try first Arbun and then Wad'. At the end of the day there are probably only between six and ten funds claiming to be Islamic hedge funds out there. None of which seem to have been a riproaring success.
Q: And none of those are Sharia-compliant, is that what you would say?
A: "Well, they claim they are – they must have a Fatwa. Some of them when you look at them in a bit more detail are effectively long-only funds with some unusual types of trading in them, or arbitrage-type structures because hedge funds cover so many different types of trading. I had really only been thinking of long/short which is around 70% of hedge funds.
"And I think the Islamic investors are asking that very question: are these Islamic hedge funds truly Sharia-compliant and if so, how have they have achieved it and at what cost?
"One of the areas that we ran into certain issue with was the prime broker. All of the prime broker contracts have to be Sharia-compliant as well, so the prime broker really has to stick their neck out to be prepared to do this and say ‘right, we are going to revise our whole back office procedures for this fund."
Q: So presumably they have not done that on the other funds?
A: "Well there was one released quite recently by Barclays which said that they have done this. To what extent has it really been done – I have not looked at them in detail. It is an area that fascinates me but there are other areas to carry on and work in."
Q: Returning to the Algo Fund, when did you give up on it?
A: "The Algo team spent eighteen months-plus (after Standard 21 was published) trying to make it work. From our perspective, you invest three years of your life trying to get something to work you do not give up on it. At the end of the day there is an intellectual challenge of Islamic finance from my perspective. With regard to the fund – we effectively stopped in the first quarter/second quarter of this year, but I cannot speak for Algo. From our perspective it is a dead duck."
"One of the issues that we have discussed with clients over the year is the issue of transparency versus intellectual property and getting that balance right is very important, particularly in the Islamic market.
"If you are creating something new you need to be transparent enough that people understand what you have done, but on the other hand if you have invested 18 months to get something to work you do not want to give away all the crown jewels. So it is about getting the balance between people understanding how it might work and understanding that yes, this is not just a little black box of tricks that is converting Haram trading into Halal. This is something that really does work, but on the other hand you do not want to say 'here is 18 months research and hard work x, y and z company just come along and copy it', and that balance is pretty fine. It is quite a challenge."
Q: Do you think Sharia-based rather than Sharia-compliant funds is a more helpful definition?
A: "It has been a theme that has arisen at many Islamic conferences over many years. The difference is that Sharia-compliant would be looking at a conventional transaction, for example leasing, and say we want to do a sale or lease back, how do we do it? We use an ijara contract, which is effectively akin to leasing. There are differences but it is fairly close.
"Or if you want to do a transaction and you look at the different stages of the transaction and build in Islamic forms of contract all the way through it. For example – as we are talking about hedge funds – what is the closest we have to a forward sale? A Salam contract. What you are effectively doing is taking a conventional mode of transaction and making it Sharia-compliant using Sharia-compliant forms of contract.
"Some of these forms are even pre-Islam and are from an agricultural age where the idea of the contract might have been to buy somebody’s seed, to take a share of the crop in six month’s time when the wheat is harvested. Now, is it appropriate to take those form of contract and use them in the 21st century? Probably not.
"So, Sharia-based would be going back to the fundamental principles of Islamic finance whereby the investor and the manager are participating in the project together and profits are shared based on the efforts people put in. But do we need to do that? Do we need to use contracts that are given names or do we use bases of trading, so effectively build from basics up. Sharia-based would be base-up as against taking a conventional type of contract and making it compliant by slotting contracts in.
"One of the issues in the past has that particularly with hedge funds you may have devised a methodology and some of the scholars have historically said: 'are you using a Salam or Arbun based contract' - and sometimes it is difficult to turn around and say 'no, we are not using Arbun, Salam, or Wad'. The basic principles of the contract transaction are Sharia-based. More and more people seem to be looking at building transactions from a Sharia base up."
Q: Do you see there being Sharia-compliant hedge funds in future?
A: "I am sure there is a place for them, but I am just not sure if the market is ready to accept them at the moment. It would be a hard sell because real estate is king. It is also important to recognise that a huge percentage of the investment in the Middle East is conventional. Sometimes this is something that some promoters miss.
"Some say we have got a hedge fund let’s make it Sharia-compliant. I must get a call every other day from a fund manager saying I have got this fund it is doing really well, what do I have to do to make it Sharia-compliant? The first thing you have to ask them is why? ‘Well, so I can sell it in the Middle East’. If your fund is so good it will sell in the Middle East anyway.
"There will be a large pool of investors who are strict Muslims, who will not invest in it but a large percentage of Middle East investors are not Muslims, and a fair percentage of Muslims will still invest in conventional products as well. A lot of them will prefer that the product is ethical to some extent but it need not be fully Sharia-compliant.
"I had somebody who came to me who wanted to do a Sharia-compliant senior debt fund. Debt is not Sharia-compliant and you certainly cannot have senior debt because you cannot have a preference, but some people have not researched what they want to do enough and why they want to do it.
"I was speaking to an investor the other day and his concern was that some of these products may not be as Islamic as they say and that for some of them the returns are not that impressive either – is he willing to forego the return because he is going to go purely Islamic? Or should he have to forgo a return? Some houses seem to be charging silly fees because they are saying we have an Islamic product and they seem to feel they can charge a higher fee. I am not sure why costs should be higher just because the fund is Sharia-compliant. Yes, the scholars charge – there is an extra overlay there – but it seems to be higher than just the scholar charge from some of the funds."
For more information on Sharia investment concepts click here to read our Sharia Law Guide for investors
This is one of a series of Jersey-related articles:
London hedge funds beat path to Jersey
Inflation due to peak, says Ashburton
Ashburton reveals five-year offshore platform plan
China led by sentiment, says Ashburton