Hedge funds seen unsuitable for Islamic finance

Hedge funds seen unsuitable for Islamic finance

By Martin de Sa’Pinto

GENEVA (Reuters) – Hedge funds basing their investment strategy on sharia, or Islamic legal principles would face significant disadvantages compared with non-sharia hedge funds, some exponents of Islamic finance say.

Many strategies would be difficult to achieve because they would be too expensive to perform in a Sharia-compliant way, or because the tools themselves would be inappropriate under Sharia law. “You cannot have long-short hedge funds, because the idea of short selling, or selling something that you don’t own, runs contrary to the principles of Islamic finance,” Fares Mourad, Head of Islamic finance at Swiss private bank Sarasin told Reuters. “I have not seen a credible structure that resolves this,” Mourad said.

Toby Birch of Birch Assets Ltd said that as sharia forbids riba, or interest, most fixed-income strategies would be ineligible. Restructuring cash flows to make them sharia-compliant would send costs soaring, he said.

Birch also doubts whether hedge funds could in principle be sharia-compliant, calling Islamic hedge funds “something of an oxymoron.”

“In theory hedge funds can charge higher fees for their ability to increase returns or reduce risk,” he said.

“However if managers are to achieve this they need to use products such as interest-based gearing, which runs against sharia tenets, or derivatives, which often have the net effect of increasing overall systemic risk.”

While the concept of shared risk between counterparties in a transaction is embraced under sharia principles, shifting risk onto unwary third parties might be frowned on, he said.

Islamic products can be costly in any case, because there are things like sharia board expenses and extra monitoring of the product. Adding on the typical hedge fund cost structure would make products uncompetitive, said Marc Rochat, chief executive of Faisal Private Bank.

There are some combinations of Islamic financial products that could be used to ensure absolute returns, but their costs reduce the upside, he said.

Also, the theological ground is shaky.

Birch said some funds considered to be sharia-compliant use swaps, which give investors access to the returns of an asset without holding the asset itself, to invest in products whose source of return is unacceptable under sharia principles.

“This is an area of controversy, while such structuring might obey the letter of sharia, it is not compatible with the spirit,” said Birch.

The same is true of some structured products, said Rochat. “I have seen products judged sharia-compliant even though they were based on funds of hedge funds whose underlying investments were not compliant,” he said.

Such ambiguities would persist until a recognized regulatory body could be established to sanction, or otherwise, products designed to be sharia-compliant.

SOURCE: http://www.reuters.com/article/IslamicBankingandFinance09/idUSTRE53F4X220090416