INSIGHTS

The Art of Constructing
an Islamic Hedge Fund

The investment styles of hedge funds have changed significantly over time. Today, a lot of hedge funds do not hedge in the strict sense of the term. Hence, in the current context, the term “hedge” is a bit of a misnomer. As a matter of fact, there is no universally accepted definition of hedge funds. Hence, they are best described as “private investment vehicles where the manager has a significant personal stake in the fund and enjoys high level of flexibility to employ a broad spectrum of strategies involving use of derivatives, short selling and leverage in order to enhance returns and better manage risk”[1]. Note that short positions are intrinsic to hedging and are critical in the original definition of hedge funds.

Hedge funds are almost always organised as limited partnerships or limited liability companies to provide pass-through tax treatment. The fund itself does not pay taxes on investment returns, but returns are passed through so that individual investors pay the taxes on their personal tax bills.

[1] Agrawal, V. & Naik, N. (n,d.), Introduction to Hedge Funds, FT Article

This is another complex strategy in which managers aim to make money from the volatility and mispricing of convertible bonds. They typically buy a convertible bond — a bond allowing the holder to exchange it for common stock — and then strip out equity exposure by shorting the underlying equity.

After discussing the strategies, the paper analyses hedge funds from a Shariah perspective.  Hedge funds are privately-owned companies that pool investors’ monies and reinvest them into complicated financial instruments. Their goal is to outperform the market. They are expected to be smart enough to create high returns regardless of how the market does. The objective of a hedge fund is not against Shariah principles.

According to AAOIFI (The Accounting and Auditing Organisation of Islamic Financial Institutions) standards, short-selling is not Shariah compliant. Shariah Standard No.21 on Financial papers states:

3/6 It is not permissible to sell shares that the seller does not own (short sale), and the promise of a broker to lend these at the time of delivery is of no consequence.

Another issue with the conventional long/short equity strategy is the high possibility of purchasing non-Shariah compliant equity and stocks. Stock purchases must pass a qualitative and quantitative Shariah screening with ongoing scholarly oversight before they can be deemed compliant investments.

Global macro funds and market neutral strategies use a variety of non-compliant conventional derivatives in the investments. Merger arbitrage as a concept has the potential to be Shariah compliant provided that the contracts used in purchasing and selling the equity are compliant and the equity themselves are compliant. The convertible arbitrage strategy is not compliant with Shariah as they involve convertible bonds and credit default swaps which are non-Shariah compliant financial instruments.

In discussing the potential alternatives, the paper presents Shariah instruments that can be used to gain some of the outcomes sought through hedge funds. One such instrument is 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.

Another method is 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.

Another method is 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.

Another hedging mechanism recognised in Islamic finance is Tahawwut. The Tahawwut (Hedging) Master Agreement is a relatively new concept in Islamic Finance which was introduced in March 2010 by the Bahrain-based International Islamic Financial Market (IIFM) in cooperation with the International Swaps and Derivatives Association, Inc. (ISDA) and gives the global Islamic financial industry the ability to trade Shariah-compliant hedging transactions such as profit-rate and currency swaps, which are estimated to represent most of today’s Islamic hedging transactions

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