Islamic funds remain determined to push their ethical credentials, even if links to fossil fuel producers and expediency in relation to compliance serve to dull their ‘green sheen’. Paul Golden delves deeper into the booming world of Islamic finance.
Sharia compliant investment continues to grow, although there remains considerable potential for further expansion. Sharia compliant assets make up only around 1% of the world’s financial assets, yet Muslims account for around 25% of the world’s population.
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A new report from TheCityUK’s UK Islamic Finance Secretariat indicates that Islamic funds reached $74bn in 2012 and at current growth rates, Sharia compliant assets could top $2 trillion by the end of next year.
The latest edition of Ernst & Young’s world Islamic banking competitiveness report suggests that market opportunity will drive more Islamic banks to set up international platforms to offer Islamic fixed income advisory services.
Sukuk (Islamic bond) issuance during 2012 reached a record high of $139 billion and a further $59 billion was issued in the first half of this year, explains Wayne Evans, director of overseas strategy TheCityUK. "From a private client perspective, access to a wide range of sharia compliant asset classes is now available and weighting of a balanced portfolio of Islamic cash, fixed income and quoted equity based instruments can be achieved, as well as exposure to alternative investments such as real estate and private equity," he says.
In the sukuk market, ijara (lease or rent) based contracts remain popular says Mark Watts, CIO and head of fixed income at National Bank of Abu Dhabi Asset Management Group, adding that there is no statistically significant reason why such investments should either out or underperform or have more or less risk than their conventional counterparts.
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By GlobalData"The main point is that the investments are structured or invested in a way that adheres to certain principles. If those principles fit with those of the investor then that tends to be the driving force.
"For this reason, Watts says the terms sharia and ethical are being used interchangeably by some segments of the market and that sharia-compliant investment is attracting interest from institutional as well as retail investors. "Takaful companies, banks and pension funds all have significant pots to invest. Those that have Islamic mandates often choose external managers to execute their strategies," says Watts.
According to Evans, many fund managers list Sharia compliant investment products on their ethical investment platforms. "As the number of high-net-worth individuals increases globally it is inevitable that numbers will grow in proportion within the Gulf and other Islamic states. In the past, many of these individuals were content to invest in US Treasury Bonds, but now many want their investment managed more actively and in currencies other than the US dollar and also in Sharia compliant products.
"Ibrahim Warde, adjunct professor at Tufts University in Massachusetts is a specialist in Islamic finance. During this year’s CFA Institute Middle East investment conference, he suggested that Islamic finance has compromised its early ideals in that it was intended to be mudaraba (or investment management) based equity financing, whereas in practice it is largely murabaha or sale at a disclosed profit-based debt financing.
Critics argue that in modern Islamic finance, conventional financial products can be sold at a higher price if their legal form is changed to comply with Islamic law. In this instance, the economic substance is retained, which circumvents the Islamic prohibitions of riba and gharar and defeats the objectives of the Islamic law.
In this context, it is hardly surprising that Usman Hayat, director of ESG and Islamic finance at CFA Institute, rejects the suggestion that the prohibition of interest is the main obstacle to co-operation between providers of Islamic finance and sustainable and responsible investment (SRI).
"The prohibition of riba is widely interpreted to include a ban on lending money on interest and SRI doesn’t subscribe to such a constraint. But in practice, we know that in Islamic finance the prohibition is complied with in contractual form (as per Islamic commercial jurisprudence) rather than in economic substance," says Hayat.
Warde says the ethical aspect is implicit in the proposition of a sharia compliant investment. "If you ask a Muslim what sharia compliance is about they would probably mention the socially responsible element. One of the ethically attractive elements is the underlying real economy asset – since the global financial crisis this requirement has made such investments appear much more solid. If a product is not well understood and does not have a proven link to the real economy, it will not be approved by a sharia board."
The focus in Islamic finance so far has largely been on avoiding traditional ‘sins’ such as alcohol, gambling and pornography. Therefore, one can argue that Islamic investment products have at least a passive social dimension to them, agrees Hayat.
"The environmental dimension is less clear and issues such as carbon emissions and climate change are far less prominent in Islamic finance than in SRI. Similarly, governance considerations do not necessarily fall within the scope of sharia compliance.
Critics do question if focusing on traditional ‘sin’ activities in a passive manner is sufficient ethics. There is an interesting and ongoing debate on economic and moral value addition in Islamic finance with a push towards doing more than the legal minimum."
Many would agree that ethics is an integral part of the value proposition of Islamic finance, but it is not always easy to point out how the Islamic product is ethically superior to comparable conventional products, says Hayat.
"For instance, how Islamic home financing has the ethical dimension that is missing from a comparable conventional home financing is a tough question to answer, given the many similarities between the two. On the other hand, how an Islamic equity fund has an ethical dimension missing from a conventional equity fund is a relatively easy question to answer, given some clear differences between the two."
When he talks to professionals working in Islamic finance, Hayat says he often gets the message that they are keenly aware that the long term sustainability of their business depends on offering economically competitive and ethically superior financial services – even if they are not always able to do so.
According to Warde, there has already been some interaction between SRI and Islamic investment in the area of product screening (analysis designed to remove investments that are not acceptable on the grounds of a non-conforming business activity/industry and also financial activity).
"Many of the criteria are the same – for example, excluding stocks of companies that operate in certain industries. There is a great deal of overlap and there has been successful co-operation between various religious groups in the US to impose common screening mechanisms. It has also been suggested at various conferences that different religious based screening mechanisms have a lot in common and that it would make sense to work together."
Hayat rejects the notion that lower awareness of SRI issues in the Middle East could at least in part explain why such interaction has been limited and is equally sceptical that SRI providers are avoiding collaboration with Islamic finance providers for fear of cannibalising their potential market.
Evans says there is increasing evidence that institutional investors and sovereign wealth funds are looking to place more of their funds into Sharia compliant products.
Institutions will base their marketing strategies on what is likely to work best in their target segments, adds Hayat. "In general, what I have seen in Islamic finance is more focus on Muslim consumers and greater emphasis on Sharia compliance. But the world is changing – I regularly come across Muslim youth who put substance over form and believe that being Islamic must mean being socially and environmentally responsible."
"I think that as the number and strength of Muslim youth in Islamic finance increases – be it as Islamic finance professionals or consumers – it will probably become more ‘green’, in both the Islamic and the environmental sense," he observes.
When asked whether there are enough products/funds available to meet demand from investors, Warde observes that demand still outstrips supply. "There is a great deal of financial liquidity in the oil producing countries of the GCC and there has been a trend towards Islamic investment from sovereign wealth funds from these countries."
Initially there were more extensive offerings in the cash and quoted equity segments and insufficient availability within the equivalent of the fixed income segment, explains Evans. "However, the emergence of the Islamic capital markets has started to address this and as a result, a range of sukuk and enhanced performance liquidity management funds have been brought to market."
Warde concludes that there is a perception that the strictures imposed by Sharia are conducive to the creation of lower risk products. "This has attracted interest from across the investor spectrum, for instance wealthy individuals who are looking to diversify. This is an additional incentive for promoters of Islamic investments to make sure their products are competitive in terms of returns."
