Experts see advent of Islamic hedge funds

Jamila Qadir
Filed on July 28, 2006

DUBAI With Islamic equity investments growing at an unprecedented level, the days of Islamic hedge funds may not be far off, industry experts say.

Despite the fact that attempts to put together a Shariah-compliant hedge fund have so far failed to be successful, Islamic finance companies are optimistic as they managed to develop many other products that were also once thought irreconcilable to compliance.

According to Nicholas Kochan, director of London-based Cosmos Communications, the development of new structures to appeal both to Islamic and conventional investors is key to the expansion of Islamic finance.

The development of Shariah-compliant hedge funds had been earlier constrained by the strict rules of Islamic law, which prevent the use of those forms of derivatives where one is transferring risk for payment of something to another person.

Islamic law forbids short-selling because it involves the sale of something that one does not own. Forwards and futures contracts are equally forbidden because they are construed as "selling promises."

Options, meanwhile, encompass payment for a future "right" to do something, but such a right, without obligation, makes it dependent upon future events and therefore creates uncertainty, an element also forbidden under Islamic law.

Now there is a feeling that hedge fund managers can still adopt some of the accepted Islamic finance practices to work with conventional hedge fund strategies.

For instance, the fund that falls within the permitted ambit of Islamic finance by creating "stipulating options," namely options where a buyer makes an advanced partial payment for a good at a later date.

If the buyer later decides not to complete the deal, the seller keeps the advance and this is the closest analogy in Islamic finance to an option.

A further development of the hedge fund principle is the 'Salam Sale', where one sells a commodity to a buyer against full up-front payment for delivery at a future date. An investor can hedge downside risk by selling stocks as a Salam Sale, with the same economic result as short-selling, but without the involvement of a borrowing element.

The Salam Sale price includes the time value of money, but early delivery will not cause a fall in price and no refund is allowed.

According to Kochan, the macro-economic picture for Islamic finance is healthy, with an average of 15 per cent yearly growth in deposits. To date, the global Islamic finance industry has an estimated total capital of $13 billion, with $262 billion in assets.

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