Financial services

Riddle of how to make hedge funds comply with Islamic rules

By James Mackintosh and David Oakley

Published: June 19 2008 03:00 | Last updated: June 19 2008 03:00

Hedge funds are at the heart of a debate raging between Islamic scholars over whether their practices – particularly short-selling – can be squared with prohibitions on paying interest and on gharar , sales where the value is uncertain. Followers of Islam have increasingly managed to square these injunctions with buying bonds structured to avoid paying interest, with bank accounts and with mortgages. Now financiers are trying to convince the devout to put millions of dollars into hedge funds, extending rules originally used by merchants in order to simulate the effect of short-selling, borrowing shares to sell in an effort to profit from a fall in the price. “There’s a changing preference towards sharia compliance,” said Bindesh Shah, co-founder of Amiri Capital, a London manager preparing to launch an Islamic fund of hedge funds. “We definitely think it is going to be in the tens of billions of dollars for alternative investments that are sharia-compliant.”

So far, though, it has been slow going for the handful of hedge funds that claim to meet Islamic law. Investors have proven less willing to part with their cash than hoped, while there is a debate raging about the methods used to get around strictures on selling something one does not own – the heart of short-selling. The first suite of sharia-compliant hedge funds was launched 18 months ago using a platform from broker Fimat, now NewEdge, and has just under $100m, thanks to a seed investment by NCB Capital, part of Saudi Arabia’s National Commercial Bank. Philippe Teilhard de Chardin, head of prime brokerage at NewEdge, says expansion is “much slower than hoped”. “Interest is there, but I can’t say honestly that there’s a massive influx of billions of dollars of sharia-compliant money,” he said. He attributes this in part to the small number of funds available, which makes diversification impossible. But he says six more funds are in the process of joining the NewEdge platform, to add to four active funds already available, which he hopes will attract investors by allowing them to spread their risk.

The arrival of Barclays Capital, which will today announce the launch of a sharia platform with five big-name managers and $250m from an arm of the Dubai government, could help. “There’s no doubt at all that the markets are substantial,” said David Rutledge, chief executive of the Dubai Multi Commodities Centre, which has invested the money through a new fund of funds set up jointly with Aim-listed Shariah Capital. Certainly, Islamic finance has grown dramatically, soaring fourfold to an estimated $800bn since 2000 as Islamic banking, bonds and mutual funds hit the mainstream.

However, bankers and analysts are divided over whether Islamic versions of hedge funds can repeat the success of other products, given that religious laws ban speculation and gambling. Scholars, the arbiters of what constitutes an Islamic-compliant product, have begun to accept investment in hedge funds if they are for hedging purposes, but not if they are seeking to speculate or gamble. Khalid Howladar, senior credit officer at Moody’s, said: “I would propose it is difficult to distance hedge funds from speculation, and while many scholars accept the need for risk management and hedging, the financial tools applied are often the same. For the scholar, the tough element will be assessing the compliance of strategy – is hedge fund investing for profit and hedging or is it pure speculation/gambling?”

Barclays, NewEdge and Amiri – which uses Lehman as prime broker – all believe they can get round the problem, using salam , arbun or wa’ad contracts, and have impressive line-ups of Islamic scholars on their side. But all also question whether the methods used by their rivals meet the strict criteria, even as they dismiss questions on whether their method of mimicking short-selling amounts to the promotion of form over substance. “That’s really a philosophical debate,” says Mr Rutledge. “That’s not to say it is not a valid debate but you can’t deny the reality of the industry. There are millions of people out there, trillions of dollars, that want to be invested according to Islamic principles. It is a question of the customer being right.” The problem for the (overwhelmingly Christian) promotors of sharia-compliant hedge funds is that each major institutional investor has its own board of Islamic scholars. There is no central authority in Islam, and on questions at the cutting edge of financial theology they often disagree. “There’s definitely a fluid debate about the acceptability of certain contracts for short replication techniques,” Mr Shah says. What all agree on is that the funds may not invest in or short companies too reliant on interest payments, or which pay a lot of interest, or in those operating in banned areas such as pork, gambling or alcohol. That means the hedge funds on Barclays’ new platform cannot invest in the bank itself.

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