Plenty of room for growth and product innovation

Education in the segment is sorely needed

The expanding shariah-compliant investment fund universe has been attracting more and more fans from outside the Islamic world, as their overall volume of capital under management grows and attention shifts to alternative products and asset types not implicated in the post-2008 crisis. According to the Ernst & Young Islamic Funds and Investments Report 2011, “the Islamic funds industry grew to US$58 billion in 2010, achieving a 7.6% growth. The Islamic fund universe comprises of some 100 fund managers”. With change and development sweeping through the Islamic world, shariah-compliant investing seems only destined to grow further.

The shariah panacea?

Shariah-compliant investing actually developed something of a reputation as a haven as the global financial crisis hit, with more conventional investment areas increasingly facing both performance and perception problems. “From an investor’s perspective, Islamic funds present an alternative to the crowded conventional space, and serve as another avenue for diversification,” asserts Akmal Hassan, CEO and executive director of Asian Islamic Investment Management Sdn. Bhd. (AIIMAN). “The growing awareness of this asset class is fast dispelling the common belief that shariah-compliant investments tend to be plain-vanilla type and returns are generally ‘moderate’ due to restrictions in the permitted investment universe.” And, as Sandeep Singh, country head of Franklin Templeton Asset Management (Malaysia), adds: “This particular segment is still in a very early stage, and the market is still evolving, with more players coming in and more product innovation.”

Indeed, although the amount of capital managed in shariah-compliant vehicles may be quite limited to date compared to other asset classes the potential investable universe is quite large. The top ten constituent stocks alone of the FTSE Shariah Global Equity Index, for instance, have an aggregate net market cap of slightly under $2 trillion, and include such blue-chip names as Chevron, Microsoft and Oracle, all verified by Yasaar Research Inc scholars, who, FTSE claims, “represent all of the major shariah schools of thought.”

However, this honeymoon period post-2008 may fast be drawing to a close, according to some views. “I believe the cheerleading days, where Islamic finance and Islamic funds management were seen as saviours to the global economic crisis, are coming to an end,” says Rejina Rahim, managing director of Nomura Asset Management Malaysia. “Islamic fund managers and investors alike are coming to a realisation that they are not operating in a separate realm and are in fact very much part and parcel of the global economic system.”

“It is a myth to say Islamic funds have no downside risk,” confirms Abdul Jalil Rasheed, CEO of Aberdeen Islamic Asset Management. “Any investments related to stock markets are impacted during a crisis.” And, Mr. Singh admits, “It’s difficult to compare it with the conventional space since it’s still very small.”

Shariah and performance

In particular, some of the shine appears to be coming off certain facets of the shariah-compliant story as other sectors recover, which compels reconsideration of the intrinsic merits and performance of the shariah-compliant platforms themselves. “Post-crisis, such products present an attractive proposition and tremendous growth opportunity both locally and globally,” Mr. Hassan remarks. However, “we should look at performance on a fund-by-fund basis rather than generically as an asset class,” adds Mr. Rasheed.

“In terms of performance, while the banking sector in most markets was underperforming the markets, Islamic funds were faring well, but of late, with more positive news emerging, it is the conventional banking sector that has been performing, causing some of the funds to lag their conventional peers,” notes Ms. Rahim. “It is difficult to fully discount an exposure to banking, as in most markets, the banking sector would make up about an approximate one third of the market, while shariah-compliant stocks would generally only be 60-70% of the total market value.”

Innovation and new products

With shariah-compliant investing still relatively immature, despite its fast growth and evident popularity, new product lines are an important consideration. The 2011 Ernst & Young Report notes that, “favoured asset classes continue to be equities, commodities, sukuk and alternatives”. All the same, the same report points out that Islamic funds make up only 5.6% of an Islamic financial services sector amounting to some $1 trillion worldwide, with most investors still sticking primarily to banks. So there is obviously tremendous room – and need – for growth and product innovation.

“Shariah-compliant funds are still nascent, having really come onboard about five years ago,” points out Mr. Rasheed. “It’ll take time for the industry to develop & mature. Till then, I expect that it’ll be the plain vanilla shariah-compliant equities/sukuk funds that’ll continue doing well in terms of interest.”

Sure enough, the E&Y Report notes that “equity dominates the overall AUM, which remains concentrated in traditional asset classes”, citing a total of 39% of assets in equities, with a further 15% in commodities, 12% in fixed income and 10% in real estate. “There is tremendous potential,” affirms Mr. Singh. But, he adds: “There’s still a lot of education required in this segment.”

Structural limitations in the various international markets also crimp potential product diversification. “One of the main challenges faced by fund managers is the unavailability of Islamic instruments in most countries,” points out Mr. Hassan. “Malaysia is indeed blessed to have the wide array of enabling infrastructures [put] in place by the relevant government agencies and regulators, coupled with the existence of a highly liquid market with growing product offerings. However, the same scenario does not exist in most of other countries. This poses setbacks in Islamic investing in some countries and will invariably, limit the multitude of products.”

“We have learnt that from the institutional space, the average mandate size is comparatively smaller. Thus we are planning for more pooled fund structures to cater to a wider group of clients,” says Ms. Rahim. And she adds: “What we have noticed is that investors in the Middle East are moving their interest away from the developed markets and actively looking at Asian markets.”

Mr. Rasheed at present sees relatively limited room for product innovation. “An Islamic hedge fund is a difficult concept to grasp whilst shariah-compliant properties too lack a globally acceptable shariah guideline to be successful.” As a result, he notes, his firm focuses almost entirely on “plain vanilla shariah-compliant equities and sukuk mandates”.

Ms. Rahim warns, though, that the asset class needs both innovation and performance to continue to grow. “There will be a minimal number of investors looking for shariah-compliant products if the range of product offerings is limited and not performing,” she cautions. “Losing money is a big no-no from all investors, Islamic or otherwise.”

Distribution and the investor base

Once shariah-compliant products are developed, of course, they still have to be distributed to a potential investor audience. And there too arises the question of the nature of the current investor base, in a sector where even an Islamic audience may be facing a new proposition that needs some explanation and investor education. Fortunately, fund professionals are seeing positive developments in their investor audience. But an increasingly sophisticated and insightful investor base also brings challenges as well as opportunities.

“The level of sophistication among investors locally and abroad has increased tremendously,” admits Mr. Hassan. “The challenge for investment managers like ourselves is not only to build and maintain an impressive track record, but to up the awareness of our value proposition.”

Shariah-compliant product purveyors are also well advised not to limit their outreach too narrowly, many feel. “A common misconception is that a Muslim majority country is where shariah fund interest lies,” affirms Mr. Rasheed. “In Malaysia, the bulk of shariah products are subscribed by non-Muslim customers.”
In Southeast Asia, Mr. Hassan concurs: “Both Muslims and non-Muslims are looking to diversify their investment through shariah-compliant products that are lower in risk, and offer greater transparency coupled with decent returns. However, there is also an increasing demand and room for product innovation for shariah-compliant investment products in the Middle East countries.”

“It’s still a very nascent market,” says Mr. Singh. “We’re excited because of the long-term potential. We are not looking at an AUM six months or a year down the line; that would be very irrelevant compared to the long-term potential. You have about 20% of the world population Muslim; and one should not go with the mindset that these products should be targeted only at the Muslim market.”

“In setting up of the Islamic funds business, we have been leveraging on the group’s presence in Bahrain, Dubai, Riyadh and others,” recounts Ms. Rahim. “This year, we will be aggressively marketing our Islamic capabilities [in areas] outside of Malaysia, such as the Middle East and the Southeast Asian region.”

There are clear signs, though, that the investor base still needs to be grown further. According to the 2011 Ernst & Young Report, with the exception of Malaysia: “Over-dependence on a few institutional investors… is a key structural weakness in Islamic markets”.

Expectations and outcomes

With these and other challenges to growth still clearly in place despite the ebullient demand and output in the shariah-compliant fund universe, practitioners do inevitably have some concerns about the sector’s development. These don’t appear likely to upset shariah investing’s evolution, but could dictate it.

“In any business, profitability is a major concern. The funds management business margins are small compared to some other industries thus we need volume. Growing the business to a viable volume is challenging in any situation, but magnified even more when most competitors are all focusing on the same number of investors. By virtue of its religious connections, many expect the major institutional funds operating in Muslim countries to automatically have an asset allocation to shariah-compliant products. The truth is far from it,” says Ms. Rahim.

Education is a key challenge, Mr. Rasheed feels, but not simply in the product sales sense. “We need to educate clients on what shariah compliant funds are, how different they are from conventional funds, and that it’s not a rebadged conventional product. There are important elements like shariah-compliant cash management, custody, trusteeship, all of which have to be shariah-compliant but are often not seen/highlighted because they are back-end in nature. This needs to be articulated properly to clients.”

Mr. Hassan cites the sukuk market as another area of concern, even though, the E&Y Report notes: “2010 proved to be a record year for global sukuk issues with over $50 billion raised”, and issuance already at almost $30 billion in 1Q2011 alone. However, he believes: “There is currently too much variation in terms of what is considered compliant where sukuk structures are concerned. As such, some investors avoid structures which they are not comfortable with. This calls for the need to develop a ‘universal’ set of shariah standards that can be applied across different geographies and schools of thought by the investors.”

Ms. Rahim also insists that shariah-compliant providers must avoid a certain complacency that can come with their approach. “Investors are investors, no matter where they operate from,” she affirms. “Islamic investors are no different from conventional investors; they look for performance within their risk range. Shariah compliance in itself is not a major selling point. Islamic finance practitioners and promoters must realise this.”

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