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Out of the shadows

By John Butcher November 2011

Shariah-compliant funds have experienced a rapid rise in popularity this year with a spate of launches and conventional products converting to become Islamic. The growing interest is based on overall strong performance driven by a conservative investment approach that has proved compelling in bear market conditions. With around 26 percent of the world's population estimated to be Muslim and growing interest among non-Muslims, the potential for market growth is huge
Islamic finance is on course to become a mainstream asset class in the coming years if recent developments are anything to go by. But the winners in this space will also have to improve the way they do business.

Shariah funds have outperformed non-Shariah over the first half of 2011, demonstrating the advantages of their cautious approach to investing that has proved beneficial in a bear market.

Across the GCC, most funds launched this year have been Shariah compliant. Observers have suggested they are now part of the "mainstream" in Malaysia, where both Muslims and non-Muslims have shown growing interest in them.

Some non-Shariah products are even converting to Shariah-compliance in an effort to tap in the groundswell of interest. The Tata Mutual Fund, part of India's Tata group of companies, recently made its Select Equity Fund, which has around $28.1m in assets under management, Shariah-compliant. The fund was renamed the Tata Ethical Fund in September.

Islamic finance has shown resilience in the face of the challenging economic times, but it has not been unaffected. The economic crisis has proved beneficial, by focusing investors on the benefits of Islamic investment rules, but it has also highlighted areas of business that are often lacking across the MENA investment industry in general.

The sudden growth and popularity of Shariah financial products is a function of two factors: a traditional shortage of investment products and improving relative performance. In the past there has been a shortage of products in the Islamic asset management space, which the industry has now recognised and is working to fill. Alongside this shortage, Shariah funds have begun to outperform their traditional peers. They have benefited largely from minimal exposure to the financial sector, an area of the market that is considered non-compliant for Muslim investors and that has underperformed the wider market in recent months on concerns over the global economic recovery.

Shariah indices have also benefited from the application of accounting-based screens, which require companies to operate with more conservative balance sheets and lower levels of debt.

According to Ian Lancaster, CEO of Reliance Asset Management Malaysia, "Many investors continue to look favourably on this 'quality' aspect of Shariah-compliant equities in the current economic environment."

While there has been a rapid rise in the number of Shariah-compliant products being launched, many of them remain on the small side. What is happening is a type of product testing phase.

"If fund performance is good and investors are well rewarded we should see a continuation of the growth in investor numbers and launches," says Lancaster. "Funds that do not perform will eventually close. This is the same pattern as we would expect with conventional fund launches. Industry success will depend on providing investors access to well thought out products in growth markets."

The main growth in the Shariah compliant space is likely to come across a wide geographic area, including the MENA region and parts of Asia including Malaysia and Indonesia, all of which are working to promote Islamic finance. However, India, Pakistan, Bangladesh and Turkey are also potential growth areas for the industry.

As the market expands and matures it will begin to cater to niche areas that are currently ignored. Reliance Asset Management (Malaysia) for example, has been appointed investment manager for the Reliance China-India Shariah Growth Fund.

"This is only the second fund combining Shariah-compliant investments in these high growth markets," according to Lancaster. "The lack of Shariah-compliant fund offerings in these exciting markets is rather surprising and an indication of the type of innovative strategies that we believe are still lacking in investment products available for Shariah-compliant investors."

While all the indications are that there will be rapid industry growth there remain barriers that must be overcome. According to Ashar Nazim, executive director and MENA head of Islamic Financial Services at Ernst & Young, "Having achieved the critical volume estimated at $1 trillion in Islamic assets, the question reverberating across board rooms, and among users of Islamic financial services, is about differentiation, or the lack thereof, that Islamic financial institutions have on offer. Effectiveness of existing Shariah governance frameworks, as well as synthetic product structures commonly in use, are especially under discussion."

Scarcity of data and under-investment in analytical tools means that Islamic banks' focus remains limited to a handful of asset classes while their operating costs are, in many cases, higher than their conventional peers, in the view Nazim. In order to tap opportunities outside the traditional captive clientele of Islamic financial products, firms will need to upgrade their business models.

"Decision makers at Islamic financial institutions need research and tools to assist in making informed decisions on the future growth trajectory of their businesses," says Nazim. "Implications of Shariah rulings on governance, product structures and markets need to be appropriately incorporated at the planning phase itself."

The regulatory environment, which has tightened across the MENA region and other areas of Islamic finance expansion since the financial crisis, could also hold back the industry. In addition, distribution is proving a challenge as many Shariah-compliant funds have short track records, which makes it difficult for them to be listed on main investment product platforms. This is also an issue when pitching for institutional mandates.

"In addition the financial advisor networks, on which many conventional funds rely for promoting launches, still lacks understanding of the principles of Shariah-compliant investing," according to Lancaster.

"In relation to management, maintaining the Shariah-compliance of a fund requires vigilant monitoring and efficient back-office systems. It can also increase the level of fund turnover, since accounting-based Shariah-compliance screens are linked to a company's market capitalization. However, once the manager's investment process has been enhanced to accommodate such factors, we see no reason for this to impact an investment manager's ability to add value across the universe of Shariah-compliant stocks."

Despite the barriers, Lancaster, and other observers, are confident of growth. The Islamic finance space, which is growing at around 14 percent per annum, manages around $1 trillion, compared to $110 trillion in the conventional asset management and insurance industries. With around 26 percent of the world's population estimated to be Muslim, this leaves enormous room for growth in the Islamic finance sector. Alongside this is the fact that much of this investor base is growing in wealth and will be increasingly looking for ways to invest.

"These numbers alone would indicate that substantial industry growth is ahead," says Lancaster. "In addition, I would add that Shariah-compliant investing offers a more conservative investment approach and a compelling ethical position. If the industry continues to educate all potential investors, not just Muslims, then the potential for this industry is greater than many have forecast."

© MENA Fund Review 2011

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