Will Islamic finance, which bans speculation because of religious objections, ever see Islamic hedge funds?
Opinions are divided.
Hedge funds as they exist now are in essence money making machines and speculation is fundamental to their operation.
The notion of “short selling”, a common strategy of hedge funds that involves betting that a market will fall, is un-Islamic, according to sharia orthodoxy.
However, this has not stopped lawyers and investors from attempting to construct Islamic hedge funds.
They insist that hedging can be used, claiming it is the ultimate goal of a sector that attempts to replicate conventional markets.
Islamic finance has, for example, successfully created products equivalent to those used in conventional finance, such as Islamic bonds, or sukuk.
Middle East investors In particular recognise the attraction of sharia-compliant hedge funds.
Yet, since the financial crisis in 2007, progress on the creation of Islamic hedge funds has been slow.
One of the biggest problems is finding an acceptable equivalent to the key tactic of short selling: investors typically borrow assets and sell them, hoping the price will have fallen by the time they have to buy the assets to return them to their original owner. They can then pocket the difference. The practice aims to take advantage of a falling market.
Other bread-and-butter hedge fund strategies, such as equity long-short and bond arbitrage, also face fundamental problems with sharia-compliance.
A further hindrance is the fact that many Islamic investors are happy to invest in non-Islamic products, which reduces the need for a religiously acceptable alternative.
So far, therefore, the development of an alternative hedge fund industry has been slow.
Many Islamic investors are unwilling to risk their money in these funds when they can use conventional funds or stick with Islamic products that are universally accepted as compliant with the rules.
On the other hand, many scholars have begun to regard investment in hedge funds as acceptable, if the intention is to hedge against risk instead of gambling.
One banker says: “There is demand for Islamic hedge funds, mainly from [wealthy] individuals who at the very least want to hedge risk rather than speculate.”
Using the concept of maslahah (the public good), hedging could be seen as a justifiable way of avoiding risks for investors, but the dynamic nature of most hedge fund portfolios means they would require constant checking by sharia boards.
Such specialist services are expensive. The cost of operating a sharia-compliant hedge fund is, therefore, one of the greatest hindrances to development.
In spite of their reputations, hedge fund management companies are lean businesses that can ill afford high cost bases without market-beating performance to back them up.
Attempts to recreate tactics such as short selling have been most successful where the underlying assets are commodities – tangible products lend themselves more easily to compliance with sharia, which frowns on the accumulation of money in the form of interest payments as well as speculation.
It is no coincidence that the most prominent sharia-compliant funds are commodity specialists, but there are not many of these and they are limited in how they trade, compared with conventional hedge funds.
Many strategists say it is hard to separate speculation from the hedging of risk.
One senior strategist says: “I would propose it is difficult to distance hedge funds from speculation, and while many scholars accept the need for risk management, 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 in order to compensate for risk or is it pure speculation – gambling?”
It is also significant that the appetite for an Islamic hedge fund industry has waned since the financial crisis of 2007.
Many fund managers no longer have the money or the desire to hunt for returns in a new market that provides little advantages, compared with conventional finance.
Indeed, one of the biggest problems for the overwhelmingly western, non-Muslim promoters of sharia-compliant hedge funds is that each large institutional investor has its own board of Islamic scholars.
There is no central authority and these boards of scholars often disagree on questions at the cutting edge of financial theology.
There is a large body of opinion in the market that is sceptical that hedge funds can ever truly develop in Islamic finance. And it is a debate that may never fully be resolved.
Source: Financial times