Shariah Advisory
Shariah Supervision
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The Arboon Sale
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Arboon Transaction Explained
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FAQs
Shariah Capital, Inc. is a Shariah advisor. Shariah Capital, Inc. is not an investment advisor and does not provide investment advisory services. Shariah Capital, Inc. is not registered as an investment advisor under the United States Investment Advisor Act of 1940, under similar laws of any state of the United States or under similar laws of any other jurisdiction. With respect to all matters described herein that relate to investment advisory services (or matters that might be deemed to relate to investment advisory service under applicable law) Shariah Capital, Inc. has discussed with and had language approved by one or more parties that engage in investment advisory services.
There is a general impression that hedge funds are highly speculative. Is this true?
Is hedging the same as gharar?
How are Shariah compliant hedge funds superior to mutual funds?
Can you give an example, outside of the stock market, of how a Shariah-compliant short sale works?
What has happened? Explain how I earned money when the price of wheat fell.
How does this transaction illustrate what happens in a Shariah compliant short sale?
Why is a short sale on the Al Safi Trust platform Shariah Compliant?
OK, the refined screens are more efficient. But can you explain how this is so?
In practical terms, what is the result of this refinement and focus?
Is all of the screening accomplished by means of software?
How do Al Safi Trust managers deal with cash?
How does the Al Safi Trust deal with purification?
How exactly are purification amounts donated to charity?
How does the Al Safi Trust deal with stock dividends?
Is there a need for Shariah compliant hedge funds?
Is there a demand for hedge fund products in the Islamic market?
Why until now have so few - if any – Shariah compliant hedge funds launched?
How did Islamic hedge funds perform in the past year? How were they affected by the big sell-off?
To what extent are Asian-focused investors/ clients demanding these products today?
How are these products different from those offered by investment banks today, for example?
Under what conditions is hedging compliant with Shariah principles?
What is the purchase price of the security that is the subject of an arboon transaction?
Is there a set price for the security at the beginning of an arboon transaction?
What are the consequences if the Islamic investor chooses not to complete the arboon transaction?
Is the down payment really credited towards the purchase?
Is collateral pledged for an arboon transaction?
How do you prove you really own the stock?
How do I know the transaction isn't gharar?
What is Barclays role in creating or facilitating the arboon transaction?
Is there a bona fide counterparty to the arboon transaction?
There is a general impression that hedge funds are highly speculative. Is this true?
It is unfortunate that many people have the impression that all hedge funds are about speculation and wild rides on Wall Street. For the majority of hedge funds, nothing could be further from the truth. In the hedge fund industry, the preservation of capital is rule number one. Typically, however, it is not the disciplined funds that catch the eye of the public.
A fundamental principle of hedging is that every trade, every move is calculated to preserve capital by balancing risk against reward. The name itself, hedge, is indicative of this fundamental principle. In a garden, a hedge is used to protect flowers from the feet of people walking by. The Arabic word for the same, tahawwut, is equally indicative of this fact. In challenging market circumstances, there is more downside risk in an ordinary mutual fund with fewer tools than those available to hedge funds. Hedge funds, with their variety of sophisticated strategies, are designed to better protect capital in challenging markets while offering superior returns when markets are favorable. This is certainly true of the hedge funds on the Al Safi Trust platform whose strategies and track records establish them as truly risk averse and profitable. Back to Top
Is hedging the same as gharar?
To equate hedging with gharar is clearly a mistake. Hedging should be understood to mean "protecting". The true nature of a hedge fund is to protect against gambling and speculation, even when others in the marketplace are carried away by speculation. For example, at times buyers speculate wildly, perhaps on the basis of no more than a rumor, and bid prices up, leading to artificially inflated markets. Then, when investors realize that stocks have become over-valued, and the market adjusts or corrects (usually downward) to compensate, hedge funds that employ strategies to reduce volatility (like long/short or market neutral) will not be affected. This is how hedge funds protect against volatility caused by speculation in the markets; and this is why hedging is not the same as gharar. Back to Top
But, even so, hedge funds do speculate and may therefore run contrary to the Shariah prohibition of gharar. Is this correct?
All business is based on a degree of speculation because no one, other than the Almighty, knows the future. Without some level of speculation and risk, there can be no business or progress. Shariah compliant finance is based on risk and reward; and the key to success in business is managing risk intelligently. The prohibition against gharar is a prohibition against undisciplined and uncontrolled speculation or the sort of speculation that resembles a toss of a coin. Hedge funds employ the most modern and technologically advanced tools, including complex mathematical models, to identify, quantify and deal with risk. Thus, when they accept investment risks, they do so in a disciplined and informed manner. It is this aspect of hedging that makes hedge funds the investment of choice for sophisticated investors. None of this runs contrary to the Shariah prohibition of gharar. Back to Top
How are Shariah compliant hedge funds superior to mutual funds?
Mutual funds and unit trusts are "long-only" funds. These are generally divided into two categories: (1) growth funds and (2) income funds. Income funds make money for investors by buying stocks that pay steady dividends. Growth funds make money by buying stocks that appreciate in value over time and may be sold for more than it cost to buy them. Purchasing a stock in the market and holding it in a portfolio is called taking a long position or "going long." The challenge faced by a long-only fund manager is whether or not to continue to invest while the market moves downwards.
By means of short sale alternatives, the Shariah compliant hedge fund manager has the ability to protect against drops in the market and thus limit declines in the portfolio’s value. By utilizing the arboon short sale mechanism devised by Shariah Capital, the manager can profit from short positions when stocks are falling in value. Until recently, most Islamic funds simply tracked the stock market; so that when the market fell, the value of the portfolio fell with it. Actively-managed, long-only, Islamic mutual funds manage risk by successfully picking stocks that appreciate in value. If more of their choices appreciate in value and fewer lose value, the manager will be successful. This is true of hedge funds as well. However, in addition to taking long positions, Islamic hedge fund managers with the ability to sell short can reduce the net exposure of the investor to the market by recording gains even when the markets fall. This is clearly a more efficient use of capital, and an obvious advantage over long-only funds. This also is why the hedge funds on the Al Safi Trust platform may be considered more risk averse investments. Back to Top
Does the Al Safi Trust employ legal stratagems (hiyal) or short cuts to make it compliant with Shariah?
There is nothing controversial in the way that the Al Safi Trust operates or invests. The Shariah Supervisory Board insists that every aspect of the Trust's and the sub trusts' operations must be unambiguous and transparent. The Shariah Supervisory Board also insists on employing contractual norms established by the classical jurists of Islam. Thus, while it may be said that the Al Safi Trust is innovative, this is meant only in the sense that it brings about new solutions... but it employs old tools to do so. There is nothing controversial about the transactions themselves, as these are based on models approved by the classical jurists of Islam. Back to Top
In a conventional short sale, stocks are borrowed from the prime broker and then sold into the market. Does the Al Safi Trust sell what it does not own?
The Al Safi Trust does not sell what it does not own. Utilizing a prescribed methodology developed and certified by the Shariah Supervisory Board, hedge funds of the Al Safi Trust do not sell what they do not own when they implement the “short sale equivalent.” Instead, they use an alternative method which replicates the economic results of a short sale without using the "borrow and sell" method of shorting. To achieve this, two steps needed to be taken. One was the creation (and certification by means of a fatwa) of Shariah-compliant short sale methodology. The second step was the modification of prime broker documentation to replace conventional short sale methodology with the approved, Shariah-compliant short sale methodology.
One of the obvious problems with the conventional short sale is that it involves the sale of what one does not own (or bai' ma la yumlak) which is clearly prohibited by Shariah rules. It is, however, a transaction that involves two different times for initiation and completion. In this respect, it is immediately suggestive of two types of sales sanctioned by classical Islamic law. These are the salam sale, used primarily in an agricultural context, and the arboon sale. (Just as an aside, it is interesting to note that the salam sale is itself a tool for hedging and the management of risk, and was designed to give farmers protection from overly speculative merchants.) The arboon sale (and there is also an arboon ijarah model) also has its roots in classical Islamic law. In an arboon, the seller takes earnest money from the buyer with the understanding that the advance will be credited toward the price if the sale is concluded.
Equally as important, the Jeddah-based OIC Fiqh Academy, in 1993, reviewed the arboon transaction and found it acceptable for use by modern Islamic banks and investment houses. Both of these arboon models have been considered by research and development teams; and both have been approved by Shariah supervisory boards around the world.
Both models also allow for replication of the processes and practices, or what might also be termed the “mechanics” of a short sale, while maintaining the “economics” or the financial results of shorting. In other words, in neither model is the fund manager borrowing stocks and then selling them into the market.
In the Shariah-compliant short sale alternatives, stocks are purchased using either the arboon or the salam contract, so that the investor actually has ownership of the stocks. Thus, no stocks are borrowed in a Shariah-compliant short sale. It might be important to note here that only the arboon model, however, has been deployed for use in compliance with both AAOIFI (the Accounting and Auditing Organization of Islamic Financial Institutions) and SEC (Securities and Exchange Commission, the US regulator of stock markets and securities trading) regulations. Today, Islamic banks and multinational banks with Islamic windows all over the world routinely use the arboon contract as a base solution for financing everything from cars to securities in structured product baskets. Back to Top
Can you give an example, outside of the stock market, of how a Shariah-compliant short sale works?
Imagine an opportunity to buy a shipload of wheat valued today at 500k for a down payment of 50k, when you know that the market price for a shipload of wheat at present is 500k. In fact, you are certain that you can find a buyer for that price the very next day. The seller, however, stipulates two things: (1) that you must repay in kind, i.e., one shipload of wheat within two months, minus the down payment, and (2) that if you do not sell the wheat then you must return it, and the seller will keep the down payment. Since you have traded wheat for the past twenty years, your specialized knowledge of the market tells you that in two months the price of a shipload of wheat will have fallen to 450k or even lower. Therefore, you agree to the deal. You pay 50k down for the first shipload and sell it to the buyer, a third party, for 500k the next day. At this point in the transaction, you have paid out 50k, but then you have taken in 500k, netting you 450k, and leaving you with an obligation to deliver a shipload of wheat (minus the down payment) to the original seller in two month's time. When two months pass, you discover that your knowledge of the market was correct and that you will be able to buy, for only 450k, a shipload of wheat to fulfill your obligation to the original seller. You buy the replacement shipload for 450k and you fulfill your obligation. In the process, you earn 45k on the trade. Back to Top
What has happened? Explain how I earned money when the price of wheat fell.
To understand, let's divide the shipload of wheat into 50 units. When you agree to buy the shipload at 500k, you value each unit at 10k. When you actually buy the shipload, you make a down payment of 50k, which may be applied to the purchase of five units. In addition, when you buy the shipload, you agree to replace the remaining 45 units in two months, or to return the 50 units and forfeit your down payment. At this point in the transaction, you have spent 50k and you have earned 500k on the sale, netting you 450k and leaving you with an obligation to replace 45 units. When the price of wheat falls to 450k for a shipload in two months, you buy 45 units at 9k per unit, spending 405k to do so. In this way, you have earned 45k on the entire transaction, the difference between 450k and 405k. If the price had fallen more, you will have earned more. For example, if the price had fallen to 8k per unit, you earn 90k on the transaction, the difference between 450k (the price you paid the original seller) and 360k (the cost of replacing the wheat that you return to the original seller). Back to Top
How does this transaction illustrate what happens in a Shariah compliant short sale?
The terms of the sale of the shipload of wheat above are exactly the terms of a transaction known in classical Islamic jurisprudence (fiqh) as an arboon. In an arboon sale, the buyer agrees to purchase goods by paying earnest money against an agreed sale price. Under the arboon sale, if the buyer does not complete the purchase within the time period specified, he must return the goods and forfeit the down payment of earnest money. The great Imam, Ahmad ibn Hanbal cites as an example that Nafi ibn Abdul Harith purchased a building on such terms from Safwan ibn Umayyah at the request of the Caliph Umar. Since this incident shows that the Caliph Umar approved of the arboon, the Imam Ahmad ibn Hanbal accepted it as proof of the validity of the Arboon sale. Other jurists of the Hanbali school went on to approve an arboon lease as well. Recognizing the value of this transactional model for applications in modern finance, the OIC Fiqh Academy approved the arboon for use by modern Islamic banks and finance houses in the purchase of goods or shares of stock. This was documented in the Journal of the Islamic Fiqh Academy, 1993, vol. 1, number 8, p. 641. Since that time, the arboon has been employed in a variety of financial products offered by Islamic financial institutions all over the world. It has not, however, been incorporated in a short sale equivalent until now. Back to Top
Why is a short sale on the Al Safi Trust platform Shariah Compliant?
The Al Safi Trust platform utilizes an alternative set of prime brokerage documentation by means of which all trades, whether long or short, may be conducted in accordance with Shariah rules, with no interest, no prohibited terms and conditions, and no prohibited sales (like the sale of what one does not rightly own or like the purchase or sale of prohibited businesses like pork or alcohol production, banks and insurance companies, and so on). All managers on the Al Safi Trust platform are contractually obligated to execute short sales through one prime broker, Barclays Capital Prime Brokerage. (Otherwise, managers can initiate long only trades with other brokers, provided those trades are settled at Barclays.) Shariah compliant contracts allow Barclays Capital Prime Brokerage to process trades initiated by the platform's hedge fund managers, while avoiding all the prohibited elements (interest, prohibited terms, prohibited transactions) that are present in prime brokerage contracts commonly used for conventional hedge funds. Back to Top
How are Stocks Selected?
By means of a refined Shariah screening process utilizing proprietary screening metrics and software, managers on the Al Safi Trust platform are able to choose from an expansive universe of stocks. Though it may seem paradoxical, the enhanced screening criteria is at one and the same time stricter from a Shariah standpoint than the present screening criteria used by the well-known Islamic indexes; even so, it allows for investment in a significantly greater number of stocks.
Perhaps the best way to understand this is to imagine the well-known screens as a net designed to screen out “unacceptable” companies. Because it is an inefficient net, however, having been designed to accommodate screening criteria developed by Shariah boards before electronic reporting and, in particular, before the EDGAR database established by the US Securities and Exchange Commission in the late 90s, this "net" screens out many good companies along with the bad. The members of the Al Safi Trust Shariah Supervisory Board are also members of Shariah boards that have approved and now supervise the Dow Jones Islamic Market Indexes, the FTSE Islamic indexes, the MSCI Barra Islamic Indexes, the Standard & Poors Islamic indexes, and others. It is the belief of the members of the Al Safi Trust Shariah Supervisory Board that the screening criteria developed for the Al Safi Trust are superior to all others, and that it is only a matter of time before these are adopted as the industry standard. Back to Top
OK, the refined screens are more efficient. But can you explain how this is so?
The refined screens developed for funds on the Al Safi Trust platform focus directly on what is prohibited, whereas the other screens focus indirectly on these elements. All of the well-known screens begin by considering a company's primary business, and then by scrutinizing its financials. Typically, the first of the financial items to be considered will be corporate debt. This is because in the same way that smoke indicates fire, corporate debt indicates interest expense; and logic dictates that more debt equals more interest expense.
Islamic indexes measure corporate debt in two different ways. One method is to divide total assets by total debt, and the other is to divide market capitalization by total debt. According to the Shariah Supervisory Boards of these indexes, if the ratio of debt/assets or the ratio of market capitalization/assets is less than 33%, then the stock will pass through the screens. If it is greater, the stock will be "screened out" and declared unacceptable for Shariah compliant investments.
The refined screens employed for the Al Safi Trust, however, do not focus on debt. Instead, the refined screens focus directly on what is prohibited. They focus on interest. Debt, in and of itself, is not prohibited by Shariah rules. What is prohibited by Shariah rules, however, is the by-product of modern, conventional debt which is interest. So, when the truly offensive element in corporate debt is interest, the focus of Shariah screens also should be interest. Instead of measuring the smoke and estimating the size of the fire, it is more efficient and accurate to measure the fire itself. Back to Top
In practical terms, what is the result of this refinement and focus?
As stated above, the results from the use of the refined screens are paradoxical because, while the screens are clearly more exacting, the numbers of companies that pass them are nonetheless greater than the numbers that pass the well-known screens. Using advanced software and data feeds, managers on the Al Safi Trust platform have access to nearly forty thousand stocks traded on exchanges around the world of which more than two thirds are Shariah compliant. Using the screens employed by the various Islamic indexes, however, less than one half of the stocks screened will be Shariah compliant. So, the refined screens generate a significantly greater universe of acceptable companies than the universe that results from other popular Islamic indexes. Back to Top
Is all of the screening accomplished by means of software?
No, it is not accomplished by software alone. The process also involves the hands-on attention of a full time Shariah scholar.
In addition to the screening software, the Al Safi Trust platform employs a process involving its Shariah board in the vetting of stocks for possible inclusion in the portfolios of the platform's hedge fund managers. The Shariah advisor may be queried at any time by fund managers in regard to stocks that they have targeted. While hedge fund managers have access to the results of screening software, they also have the ability to seek the opinion of the Shariah Advisor whenever they encounter a stock about which there may be questions as to whether it is acceptable or unacceptable. For example, the manager may have direct access to information about a company’s plans to restructure debt within a certain period of time, or to liquidate a business that presently disqualifies it from inclusion, or to merge with a larger company and thus become compliant. This information could affect whether or not a company meets Shariah standards. Back to Top
It is well known that Shariah scholars have many demands on their time. How does the Al Safi Trust answer questions without delay?
All of the situations mentioned in the answer above demand the attention and consideration of Shariah scholars. By defining a process to deal with these questions, and by providing access to Shariah scholars, the Al Safi Trust brings to investors a platform that is as efficient as it is responsive to the needs of its Shariah compliant managers and investors. Moreover, the Al Safi Trust is unique in that the Shariah Supervisory Board includes an Executive Representative, a Shariah scholar who is dedicated to working full time for the Al Safi Trust. The Executive Representative works with fund managers, the prime broker, and with the trustees of the Al Safi Trust to ensure that every aspect of the Trust's and sub-trusts' operations comply with the guidelines laid down by the Shariah Supervisory Board. Back to Top
How do Al Safi Trust managers deal with cash?
The Shariah Supervisory Board has issued clear investment guidelines to all managers of funds on the Al Safi Trust platform. These guidelines specify that cash is never to be deposited in interest-earning accounts or instruments. Should the need arise for a manager to temporarily "cash out" of a position, the cash will either be held in a non-interest bearing account or, if the term is likely to be longer, then the cash may be invested in a Shariah compliant, short-term instrument like a murabahah. Back to Top
How does the Al Safi Trust deal with purification?
While all companies are screened for unacceptable primary business activities, there are some companies with acceptable primary businesses, like the manufacture of spare parts for automobiles for example, which also own or engage in unacceptable businesses, like the sale of alcohol at company canteens or restaurants they own and operate at their factories. When the Shariah monitoring processes reveal that revenues from such unacceptable sources exceed five percent of total revenues, then the company will be "screened out" and declared unacceptable for Shariah compliant investments. If such "impure" revenues are less than 5%, however, the stock may be held, but investors will themselves be responsible for "purifying" the investment by giving a commensurate portion of fund earnings to charities of their own choice.
While different Shariah Supervisory Boards have different ways of dealing with purification, the Al Safi Trust Shariah Supervisory Board takes a practical approach, offering different solutions for different managers. To begin with, and annually thereafter, the Shariah Supervisory Board studies the strategy and sector concentration(s) of each fund on the platform.
- If it is determined that the fund invests exclusively in a particular sector in which there is almost never any need for purification, such as healthcare, technology, or telecommunications, then the Shariah Board will recommend that there is no need for purification from that fund, other than in exceptional cases (when, for example, a stock is mistakenly purchased, as explained at number 4 below).
- If it is determined, however, that the fund invests in sectors in which the need for purification often arises, such as retail outlets or REITs, or if it invests in a variety of sectors, then the Shariah Supervisory Board will recommend that a flat purification rate of, say, 1.5% be applied to the investor's net earnings.
- If the Shariah Supervisory Board discovers that a fund is holding stocks of a company or companies that have especially high revenues from unacceptable activities (albeit less than 5%), then the Shariah Supervisory Board has the right to recommend a higher rate of purification.
- Finally, in the event that a manager or one of its traders inadvertently purchases an unacceptable stock, the Shariah Supervisory Board will consider the mistake and recommend to investors an appropriate amount to be purified from the fund's gains resulting from that oversight. Back to Top
How exactly are purification amounts donated to charity?
The Shariah Supervisory Board will consider each of the Funds on the Al Safi Trust platform and make recommendations regarding how these are to be treated for purification (in accordance with categories 1-4 above). All recommendations made by the Shariah Supervisory Board in regard to purification will be communicated to investors by the Al Safi Trust administrator.
Neither the Al Safi Trust nor any of the Al Safi sub trust managers will be responsible for portfolio purification. Instead, investors will themselves be responsible for deducting appropriate amounts and donating the same to charity. In this manner, investors are free to donate purification money to the charities of their choice. Likewise, while the Al Safi Trust will recommend certain amounts that should go to charity, investors are free to make the final allocations for this purpose themselves. Back to Top
How does the Al Safi Trust deal with stock dividends?
While it is the practice of many Shariah compliant funds to calculate purification liabilities and then pay the same from dividends, this is not the practice of the Al Safi Trust or its sub trust managers. There is more than one reason for this. Firstly, not all stocks pay dividends. Secondly, hedge fund managers are active traders of stocks and may only occasionally hold stocks long enough to actually collect dividends. And finally, as explained above, the funds on the Al Safi Trust platform have already been given a purification formula by the Shariah Supervisory Board. Thus, investors need not be troubled by dividends and complex purification formulas. Back to Top
Is there a need for Shariah compliant hedge funds?
Hedge funds provide Islamic banks and financial institutions with a number of advantages they currently lack. In today's financial climate especially, the ability to hedge is a clear advantage for investors, and by adding hedge funds to their portfolios/product lines, Islamic banks can further diversify their investments and investment products. In much the same way that Sukuk provided Islamic banks and institutions with a fixed income instrument that looks and acts like a conventional bond, thus filling an important gap on the balance sheet, Shariah compliant hedge funds provide Islamic banks and institutions with an effective tool for the management of risk. Moreover, when packaged in the form of funds of funds, or structured products (perhaps wrapped with some form of principal protection), hedge funds may well become indispensable to the fiscal health and stability of Islamic banks and institutional investors. Back to Top
Is there a demand for hedge fund products in the Islamic market?
Potentially, yes. The demand is huge. Hedge funds, however, have only now been introduced to the Shariah compliant market and so bankers and investors alike are not yet familiar with them, their strategies, performance, and risk characteristics. It may, therefore, take some time for Islamic investors to become comfortable with hedge funds. After all, there are a lot of popular misconceptions, however undeserved, about hedge funds.
Many people, unaware of the variety of strategies available to managers, suppose hedge funds to be extremely speculative and therefore at odds with the Shariah prohibition of undue speculation. Others think immediately of short sales and conclude that hedge funds must be prohibited by Islamic law because it prohibits the sale of borrowed stocks. So, while there is a clear need, it may take some time before investors become acquainted with the true nature of hedge funds. At that point, need will translate into demand. Back to Top
Why until now have so few - if any – Shariah compliant hedge funds launched?
Two words: development expense. The hedge fund solution goes beyond the usual development of a financial product because it is not enough just to structure a fund. It is then necessary to ensure compliance of the hedging strategy and the securities held in the investment portfolio by means of screening, investment guidelines, and oversight by a qualified Shariah supervisory board. The hedge fund solution requires, in addition, fundamental changes to the way that trades are processed. In particular, the contracts that underlie the exchange of securities must be made to comply with Shariah rules.
Such changes are not made at the fund level, but at the level of the prime broker. Then, all such changes must be considered in view of government regulatory requirements, Shariah rules, and business terms. In other words, lawyers, internal and external counsel, and more than one set of each, will have to work with Shariah experts, traders, and investment managers to ensure that every step of the process is feasible, compliant and, ultimately, profitable. All of this adds up to considerable time and money which many financial institutions have apparently found prohibitive to the development of such products. Back to Top
Is there still wide disagreement over Islamic hedge funds’ compliance status? Or is the industry moving towards consensus over this issue?
The consensus of the industry is, and always has been, that if a fund is structured and does business in accordance with established Shariah standards, then the fund will be accepted as compliant as long as it has a reputable Shariah board, follows the Board’s investment guidelines, and is completely transparent in its dealings. This is as true for a hedge fund as it is for a leasing or a real estate fund. Back to Top
Could you explain simply how your hedge replicates short-selling and leverage without violating the Shariah?
The simple answer is that, on the advice of our Shariah board, we employed a transactional model from the classical jurisprudence of Islam-called an arboon sale- to replicate the economic effects of a conventional short sale. In doing so we needed the cooperation of a major prime brokerage and, even more importantly, we needed legal counsel to assist in altering the documentation underlying the transactional process. All of this is explained in a White Paper which is available in both English and Arabic. Back to Top
How did Islamic hedge funds perform in the past year? How were they affected by the big sell-off?
At a time when many hedge funds saw negative results and consequently went out of business, owing to their excessive use of leverage and other factors, the DSAM Kauthar funds outperformed every one of the various market benchmarks, including the Islamic market indexes. Having weathered the worst market conditions in a hundred years, our funds today find themselves trading in a market in which many valuable companies are selling at historically low prices. What this means is that the market now presents investors with the kind of opportunity that comes along perhaps only once or twice in a lifetime. Back to Top
With hedge funds in general falling out of investor favour, what does this mean for the fledgling Islamic hedge fund industry?
Actually, our Islamic hedge funds stand as examples of how hedge funds can have success. One of the fundamental differences between Shariah compliant hedge funds and hedge funds in general is the matter of transparency. In order to comply with Shariah, Islamic hedge funds have to open their trading books to oversight by their Shariah boards. In addition, they offer investors separately managed accounts, something that conventional hedge funds almost never do. Schemers, like Bernie Madoff, would never have had success with the transparency of separately-managed accounts and the independent administration and auditing required for Shariah compliance. Back to Top
Do you foresee greater difficulty and greater costs involved in setting up and marketing Islamic hedge funds?
Setting up a hedge fund requires the cooperation of a leading prime broker, particularly in the matter of accepting third party risk, but also in capital outlay to cover the costs associated with rewriting prime broker documentation. Given the present credit-averse stance of most banks and the legal costs of developing a completely new way of shorting stocks in order to comply with Shariah, we think it would be very challenging for another prime broker to develop a Shariah solution for hedge funds in the near future. As for the Al Safi platform, where all of these issues have already been addressed, we expect to welcome several new hedge funds in the coming year. Moreover, as these new funds will be ones that have survived the worst market conditions in recent history, we expect that they will thrive in the new market. Back to Top
In February 2008, the AAOIFI decreed that most Sukuk were not Shariah-compliant. Is the hedge fund industry concerned that a similar decree regarding Islamic hedge funds could be issued in future?
Each of the members of the Shariah supervisory board for the Islamic hedge funds on the Al Safi platform is also a member of the AAOIFI Shariah board. As such, each scholar is intimately acquainted with the standards promulgated by AAOIFI and each is satisfied that the Al Safi Trust platform itself, and all of the funds associated with it, comply in every way with Shariah standards. Back to Top
Do you have any statistics on the performance, size and growth in the Islamic hedge fund market that we could refer to?
We at Shariah Capital are very keen on transparency in this regard. It is for this reason that we recently launched the Dubai Shariah Hedge Fund Index which is calculated and reported by Thomson Reuters (RIC code .DUBSHF). In addition, we are in the process of listing information about the DSAM Kauthar funds with several of the better known Islamic finance data providers like the IFIS, Eureka Hedge and Failaka.com. Back to Top
To what extent are Asian-focused investors/ clients demanding these products today?
The products will be offered to investors in the coming month, so it is hard to give empirical evidence regarding demand at present. However, those who follow the markets know that the historically low level of prices at present represent a once-in-a-century kind of opportunity for investors. Back to Top
How are these products different from those offered by investment banks today, for example?
These are Shariah compliant hedge funds employing long/short strategies for investment. No other bank or asset manager in the world is offering such products. Back to Top
When structuring these products, what are the key guiding principles that form the backbone of these structures that are absent in conventional derivatives?
Islamic Finance is based on sharing risk and rewards in the creation of real goods and services. Thus, our products do not trade in debt, or buy notional assets, or sell what is not already owned. Our investment guidelines ensure that investment managers deploy money in profitable and real business activities that comply with Shariah principles. Back to Top
How should we understand the issue of speculation and profiting by way of hedging, which, if I understand correctly, is not compliant with Shariah principle?
Shariah principles prohibit excessive speculation. They do not prohibit the protection and preservation of capital by means of hedging, if the hedging methodology complies with Shariah. We at Shariah Capital have devised just such a methodology and, with the cooperation of Barclays Prime Services, have found a way to put that methodology into practice. Back to Top
Under what conditions is hedging compliant with Shariah principles?
All business is based on a degree of speculation because no one, other than the Almighty, knows the future. Without some level of speculation and risk, there can be no business or progress. Shariah compliant finance is based on risk and reward; and the key to success in business is managing risk intelligently. The prohibition against gharar is a prohibition against undisciplined and uncontrolled speculation or the sort of speculation that resembles a toss of a coin. Hedge funds employ the most modern and technologically advanced tools, including fundamental and technical analysis, often using complex mathematical models, to identify, quantify and mitigate risk. Thus, when they accept investment risks, they do so in a disciplined and informed manner. It is this aspect of hedging that makes hedge funds the investment of choice for sophisticated investors. None of this runs contrary to the Shariah prohibition of gharar. Finally, it should also be noted that speculation is often fueled by excessive leverage. Shariah principles discourage the use of leverage, and the Shariah Supervisory Boards of Shariah compliant hedge funds monitor managers very closely to ensure that this sort of speculation does not occur. Back to Top
How does your team deal with uncertainty and bai' ma'dum (buying and selling something which does not exist) when devising Shariah hedging strategies for clients?
This actually equates to the sale of what one does not own, and the Arboon short sale is the solution. Please see the attached White Paper. Back to Top
Some investment banks today are offering products such as cross-currency swaps, credit default swaps that are presented as Shariah compliant. Do you see much demand for these products today in the US?
Among Islamic investors I don’t see any demand anywhere for products that swap prohibited returns for permitted returns. Back to Top
How big a potential for these products in Asia? Are these also something that your team would expand into?
Shariah Capital has been in talks with several different Asian entities, both investors and product providers, and we are confident that, as leaders in Islamic finance and savvy investors, Asian bankers understand the value of this innovative new product line. Back to Top
Since Your firm also partners with others on a white labeling basis, what is such business potential for the Asian market?
We feel that the potential is real. For years Islamic Finance has been in need of the diversification and risk management characteristics afforded by Alternative Asset classes. Now that a solution has come to market, we expect that what once was a need will soon become a demand. Back to Top
What is an arboon?
It is a transaction whereby a party acquires an ownership interest in an asset by making a non-refundable down payment conferring the right to either confirm or cancel the sale. The "arboon" is also the non-refundable down payment. If one fails to complete the arboon transaction, one forfeits the down payment (or arboon). Back to Top
What is the purchase price of the security that is the subject of an arboon transaction?
The market (or fair) value of the security in question, determined at the date the arboon transaction is completed (i.e. when the remaining purchase price is paid, if at all). Back to Top
Is there a set price for the security at the beginning of an arboon transaction?
Yes, there is a set value at the beginning. It is a calculation that includes both value (price) and time (a finite period of time, for example, 90 days) to complete. Back to Top
What is the earnest money?
It is the down payment given to the Prime Broker. This payment is also referred to as the arboon. For Al Safi and its Prime Broker, the down payment is usually 2% of the value of the subject of the arboon transaction (i.e. securities) at the initiation of the transaction. Back to Top
What happens to the down payment if the Islamic shareholder chooses not to complete the arboon transaction?
The Prime Broker keeps it. Back to Top
What are the consequences if the Islamic investor chooses not to complete the arboon transaction?
The investor forfeits the down payment and will have to make good (deliver) on any obligations (i.e., he'll have to give back the securities that are the subject of the arboon transaction). Back to Top
Is the down payment really credited towards the purchase?
Yes, if the investor completes the transaction, upon completion of the arboon the down payment is credited as part of the total purchase price. Back to Top
Is collateral pledged for an arboon transaction?
No. But the Prime Broker, to assure the creditworthiness of an investor (as a counterparty), is permitted under applicable law to require the maintenance of certain amounts of value in a trading account. Back to Top
How do you prove you really own the stock?
Barclays Capital, the custodian for the securities, credits the Islamic investor's account with the securities when the arboon down payment is paid. Title transfers at that time and the security is reflected in the Islamic investor's account. After title has transferred, the investor (as owner) may either hold or sell the stock. Back to Top
How do I know the transaction isn't gharar?
Gharar, or "unreasonable uncertainty" happens when there is ambiguity in the terms of a contract. In the arboon short sale, the terms of the price for purchase and sale are clear. In addition, the buyer/investment manager has the option to either terminate the transaction and return the securities (thereby forfeiting the arboon or down payment) or to complete the transaction by paying the full purchase price. In other words, the buyer not only has knowledge of the price, but also has the ability to cancel the transaction within a specified period of time. So, the choice of how to settle the transaction rests with the buyer alone. There is no uncertainty in the transaction of the sort that rises to the level of gharar; and nothing to suggest that buyer would be caught unawares and without recourse. Back to Top
What is Barclays role in creating or facilitating the arboon transaction?
Barclays is the Prime Broker and custodian. More importantly, Barclays has agreed to serve as a counterparty to the arboon transaction whereby it sells (transfers title) to the Islamic investor in a customized transaction. Back to Top
Is there a bona fide counterparty to the arboon transaction?
Yes, Barclays Capital acts as the bona fide counterparty. This is a unique role for Barclays and of critical importance to the transaction's success: Barclays has agreed to serve as a counterparty and take risk as a counterpart to sell a security under an arboon contract. Back to Top
Can the Islamic investor really bring in a like kind of security if he terminates the arboon transaction?
All securities underlying the arboon transaction are traded on recognized national exchanges. As such, the delivery of one share of value is no different than bringing in another share of the same security. (In other words, one share of IBM is no different than another share of IBM - they are fungible.) Back to Top
I am trying to understand the Arboon Short Sale White Paper posted on the Shariah Capital website. Does the prime broker already own the shares when the arboon contract is initially entered into with the investment manager. Then why is it stated in point 5 (on p. 5) that to close out the position the investment manager must inform the prime broker to purchase the stock?
Point 5 seeks to show how the prime brokerage arrangement follows the classical arboon model by comparing what happens after the arboon/earnest money downpayment has been made; in one case, to the prime broker (who has acted on behalf of the investment manager to purchase securities from the market) and, in the case of the classical arboon, to the seller.
Perhaps the confusion arises from the next step in which, now that the purchaser has ownership, the purchaser is free to dispose of (either hold or sell) the purchased security/asset.
Point 5 reads: "In the classical arboon, once the purchaser has paid the arboon earnest money to the seller, he is free to dispose of whatever he purchased." This much should be clear.
In the short sale arboon transaction, the prime broker acts on behalf of the investment manager/investor to both buy and sell securities. After all, this is what prime brokers do. So, once the investment manager has ownership of the securities (having made a downpayment to the prime broker for their purchase), he, as the new owner of the securities, may instruct the prime broker to sell those securities back into the market; or he may hold the securities for as long as he likes. Back to Top