Hedge funds are a touchy subject in Islamic finance, with scholars widely disagreeing about the Shariah compliance of various strategies. Irfan A Naheem talks us through the key concepts and controversies.
Hedge funds lack a definition, but the word ‘hedge’ usually describes a strategy used to evade the risk. The Securities and Exchange Commission (SEC ) in 2003 considered 14 different definitions. A few characteristics that reflect from these definitions are:
- Funds using different investment strategies to hedge the risk and gain absolute returns independent of the market’s performance;
- Limited partnership investments for accredited investors with high minimum investment usually non redeemable for initial few years;
- Regulations are not as stringent as for mutual funds; and
- The compensation for the hedge fund managers is high and linked to the performance of the fund.
According to Barker & Hui (2003) these funds are actively managed and the managers of these funds use techniques like short selling, leverage and derivatives to generate high profits for their investors. The characteristic of the hedge to generate high profit in both bull and bear markets has made these funds very attractive. However, these funds are highly risky at the same time. The first hedge fund was introduced in late 1940s by Alfred Winslow Jones and the sector has grown significantly since then. According to the Hedge Funds Review hedge fund assets under management were estimated at US$2 trillion by end of 2010 with more than US$1 trillion managed from North America.
The growth of the Islamic finance sector gained the attention of hedge fund managers, and this led to the development of Islamic hedge funds. The conventional long/short strategy, which is not permitted by Shariah, prevented Islamic investors from investing in the hedge funds. However, fund managers have developed alternative Shariah compliant strategies to create Islamic hedge funds. Salam and Arbun are the Islamic alternatives for the conventional short selling. Though these strategies are being practiced there is still a split of opinion among Islamic scholars on the use of these alternatives for short selling and also a mixed opinion on hedging risk through different derivative instruments.
Hedge fund strategies
There are several strategies used by the hedge funds. However, they are broadly classified into directional and non-directional strategies. This section will briefly discuss these strategies and will access which of these strategies can be possibly adapted by Islamic hedge funds.
Relative value strategy
- Convertible arbitrage — Generate profit from mispricing of the convertible bonds and other hybrid debt/equity securities.
- Fixed-income arbitrage — Aims to profit from price anomalies between interest rate securities like mortgage-based securities, government bonds.
- Equity market-neutral strategy — In this strategy the managers tend to exploit the market inefficiency in pricing the securities. Managers long and short the securities at 50:50 ratio.
- Merger (risk) arbitrage — Managers capitalise on the difference of pricing between the current market value of the security and the value post a merger or acquisition.
- Distressed/high-yield securities — take long and short position in debts and equities of organisation is financial distress.
- Equity hedge (long/short) – Managers aim profit by owning better performing securities and short selling losing securities from the same sector. The winning and losing securities are not usually balanced in equal proportion.
- Global macro – Using the predictions and analysis, managers tend to exploit the fluctuation of global interest rates, currency rates and other macro-economic instruments.
- Managed futures – Aim to profit from the buying and selling of exchange traded and over-the-counter (OTC) futures, options and forwards of currencies, commodities and index based on the market trend.
- Emerging markets – Manager use long/short strategy to generate profit from debt, equity and derivative instruments in emerging markets. Usually long strategy is adapted by managers as most of the emerging economies restrict short selling.
The hedge fund sector is not limited only to the above-mentioned strategies. However, these are the dominant ones and the managers usually combine multiple strategies to device their own strategy to manage the funds. It is observed that the managers commonly use leverage, short selling and derivatives such as future and options as tools along with a single or combination of multiple strategies to hedge the risk and generate absolute returns.
Islamic hedge funds — challenges
There are challenges or limitation faced by the Islamic hedge funds with the adaptation of the above-mentioned strategies. The commonly used tools like short selling (one cannot sell what he/she does not own), leverage (Riba) and derivatives (uncertainty — Gharar; or gambling — Maysir) are not permissible by the Shariah. However, the bigger debate is whether hedging is permissible by the Shariah?
Mohamad & Tabatabaei (2008) have discussed that scholars generally agree that hedging is permissible in order to reduce risk in a real assets transaction. For instance, exporters and importers can hedge to protect their profits against the fluctuation of currency rate. However, the scholars do not approve of speculators who expose themselves to risk without the trading of real assets to gain profits. The speculative instruments of the derivative market are not permissible by Shariah as they involve Gharar, Maysir and often there is no real trade that occurs. The speculation in the derivative market is done with the intention of generating profit therefore, the underlying assets in the transaction is not delivered often. The problem with the derivative instruments is that due to speculation they are not tied to the real economic activity and this can imbalance the demand and supply condition of the real economy.
Short selling — Shariah issues
Though short selling is often criticised, many exchanges have legalised short selling because it provides liquidity and improves market efficiency by driving down overpriced securities. The conventional short sell has two parts to it. First, a stockbroker borrows stocks from the owner. The stock owner usually gets certain percentage of interest on the loan (stock). Second, the stockbroker sells the borrowed stocks in the market and buys them back at a lower price at a future date and returns it to the stock owner. It is because of these two reasons of Riba and selling the stock despite not owning the stock, short selling is prohibited by Shariah.
However, the first part of the short selling doesn’t face major issues among jurists as it is permissible to lend provided there is no excess return expected. The disagreement among the jurists is with regards to the second part of the short selling. Kamali (2000) discusses the full version of Hadith from the work of Abu Dawud (English translation) (1984): “Ja ‘far ibn Abi Wah shiyah reported from Yusuf ibn Mahil, from Hakim ibn Hizam [who said]: “I asked the prophet (PBUH) O Messenger of Allah! A man comes to me and asks me to sell him what is not with me, so I sell him [what he wants] and then buy the goods for him in the market [and deliver].”
And the prophet said: “Sell not what is not with you”. It is based on this Hadith that short selling is prohibited by scholars. There are several interpretations of this Hadith. The majorly accepted interpretation is that the seller should own the product at the time of the sale otherwise the sale is invalid even if the seller acquires the ownership later. However, some scholars argue that this Hadith applies to the sale of a particular unique object but not to commonly available. Dasuki, A.W & Abozaid (2008) have cited the work of Ibn al-Qayyim, according to which Ibn Taymiyah and Ibn al-Qayyim interpret the above Hadith as: “Do not sell things you are not able to deliver” and not “do not sell things you don’t own”.
According to them the prophet (PBUH) forbids Hakim from initiating a transaction which he may not be able to conclude because when he is asked to sell a particular object not commonly available then he may not be able to deliver due to non availability of the object in the market or the owner may not be willing to sell the object. Therefore, the essence of this Hadith is to avoid Gharar. They assert that Salam sale is permissible on this interpretation that the seller may not own the commodity during the sale. However, as long as the delivery can be assured due to easy availability in the market it eliminates excessive risk and Gharar. The professionals from the industry have tried to develop Shariah compliant means to short sales securities.
Shariah compliant options — Short selling
Bai Al Arbun — Through this method the fund manager, after analysing the market, picks a stock whose market price will fall at a future date. The fund company makes a part payment and takes the delivery of the stock however, with a promise to complete the purchase by paying the remaining amount within the stipulated time or the fund company has to return the stock and forfeit the down payment of token money.
Ibnul Qayyim (1955) cited by Ayub, Md (2007), discusses a report from Naf’ I Ibnal Harith an officer at Makkah deputed by Caliph Umar (Gbpwh), that he bought a prison house from Safwan Ibn Umayyah for Caliph Umar (Gbpwh) for AED4,000 (US$1,088) on a condition that the sale would be final if the caliph approved of it, otherwise Safwan would be given AED400 (US$108). It is based on this report that Hanbali School considers Arbun as permissible. However, the other Maddhabs disapprove of the sale. Another debatable area in this sale is benefi ting from the stock when the sale is not completed Kamali (2008) cites the work of Ibn Juzay according to which in an option sale the buyer may use the object for investigation and testing. However, he is not entitled to use the object for his benefit during the option period.
Bai Al Salam — Though AAOIFI has explicitly restricted the Salam sale to commodities, the Malaysian Shariah Council has extended Salam’s applicability to financial securities.
Sale and Promise — The Malaysian Shariah Council developed a method where the central exchange buys a security from seller along with a promise to purchase it back whenever the exchange sells at a future date. Similarly sells the stock to a buyer with a promise from buyer to resell the stock to the exchange whenever the exchange demands it. However, the seller’s rights to recall and buyer’s right to resell are embedded in the regulations and they have the right to execute it at their convenience.
Exchange of conditional promises (Wa’dan) — This method of short selling two conditional promises is an exchange between the broker and the Islamic fund. However, at a future date only one promise will be in effect due the condition.
Hedge funds are considered to be one of the fastest growing financial sectors, though they faced strong criticism stating that the industry operates out of speculations and takes excessive risk. It is observed that hedge funds use the best of qualitative and quantitative strategies to device their strategies. The industry despite the challenges managed to successfully create Islamic hedge funds which are Shariah compliant. However, the hedge funds have limited strategies which they can implement to create Shariah compliant hedge funds. The biggest challenge faced by not only Islamic hedge funds but by the Islamic finance industry is lack of harmony.The different interpretation of Fiqh is the biggest challenge faced by the industry. Islamic hedge fund managers would be able to devise new strategies if harmony existed among the scholars. However, the professionals should develop the new strategies keeping in mind the Maqasid Al Shariah and avoid deviating from a foundation in the real economy, which is what the hedge fund industry is primarily accused of.
This article first appeared in Islamic Finance News (7 May 2014, Volume 11, Issue 18, Page 32-34). ). For more information, please visit www.islamicfinancenews.com