LONDON: Currency swaps, exchange traded funds (ETFs), collateralized debt obligations (CDOs), hedge funds and credit protection transactions until a year or so would have been unthinkable in the global Islamic finance market. No longer.

Hot on the heels of the recent launch by Daiwa Asset Management Company, the second largest asset manager in Japan after Nomura Asset Management, with funds under management of $96.34 billion, of the Daiwa FTSE Shariah Japan 100 ETF, comes the launch at end June of the Islamic Fund of Hedge Funds by Barclays Capital and Shariah Capital Inc. of the US off the Al-Safi Trust alternative investment platform.

Such is the latent appetite for value-added alternative Islamic financial products, that the Dubai Multi Commodities Center Authority (DMCC), an agency of the Dubai government, saw fit to seed the Islamic Fund of Hedge Funds investing a total of $250 million – $50 million in five hedge funds through the Al-Safi Trust alternative investment platform, established jointly also by Barclays Capital and Shariah Capital Inc. in Cayman Islands.

The first five funds on the Al-Safi platform are long-short equity funds focusing on energy, resources and soft commodities and managed by US-based hedge fund managers – Tocqueville Asset Management (gold); Lucas Capital Management LP (energy); Zwelg-Dimenna International Managers Inc. (resources); Ospraie Management LLC (agriculture); BlackRock Inc. (resources & mining) respectively. But the promoters are confident that the platform would attract a whole range of alternative investment products hitherto absent from the Islamic capital and fixed-income product market, in addition to additional long/short equity hedge funds; 130/130 funds as well as specialized investment funds.

Indeed there is a brave new world in Islamic alternative product structuring opening up. Take, for instance, Merrill Lynch International, whose involvement in Islamic product structuring goes back to the 1980s. The main product features of Merrill Lynch’s current Islamic platform includes derivative solutions for options (both vanilla and exotics) and swaps; securitization and CDOs; sukuk; and tradable asset-backed Islamic investment certificates. And the good news according to Emmanuel Crenne, managing director, emerging markets structuring at Merrill Lynch International, who has had a long experience structuring Shariah-compliant products, the days of simply repackaging (or Islamizing) conventional products are effectively over. The new products coming on stream are truly Shariah-based.

Merrill Lynch, for instance, last year launched its own investment platform – Falak Islamic Products Limited – a Cayman Islands vehicle which issues investment certificates against a range of Islamic asset-backed instruments such as energy projects, commodities, equities etc. The size of the platform is a staggering $25 billion aimed primarily at HNWIs.

One of the pioneering investments under this program is the Islamic right way credit protection transaction closed in August 2007 to buy credit protection on counterparty risk generated by a physical power swap it had entered to with a UK power producer. This stresses Crenne, is the first ever non-synthetic Islamic credit default protection transaction, and the $50 million deal was very complex and innovative and was executed with one of the most conservative Islamic financial institutions in the Gulf Cooperation Council (GCC) with a very strict Shariah board.

Strict Shariah compliance is also a strong feature of the latest Islamic Fund of Hedge Funds, according to Eric Meyer, CEO of Shariah Capital Inc., who has been working on this product for the last six years. Shariah Capital Inc., which is now listed on the London Stock Exchange’s Alternative Investment Market (AIM), is the Shariah adviser to the fund and also a joint venture partner with Dubai Commodity Asset Management (DCAM) in Dubai Shariah Asset Management, which is the marketing and distribution manager of the fund. DCAM is a wholly-owned entity of DMCC. Similarly, Barclays Capital is also the prime broker for the fund.

The Al-Safi platform approach seems to offer a neat turnkey solution to Shariah-compliant hedge fund strategies through which hedge fund managers can meet the Shariah criteria. Shariah Capital Inc. is effectively doing the stock screening on a monthly basis to ensure Shariah compliance, thus allowing the hedge fund managers access to a Shariah-compliant universe. There have been other attempts at launching Islamic hedge funds in the past. In 2006, Fimat, the prime brokerage arm of French bank, Societe Generale, launched what it claimed to be the first such fund based on commodities; and Al-Fanar, owned by Worms & Co. and Saudi Economic Development Company (SEDCO), launched the Al-Fanar US Hedge Fund managed by Permal Asset Management.

The major issue in a hedge fund is short selling, which is proscribed in Islamic investment. Barclays Capital and Shariah Capital Inc. have come up with a Shariah-compliant equivalent which replicates shorting using the contract of Arbun. Under this arrangement, the trader who wishes to short a stock in the Al-Safi platform can put a sell order through Barclays Capital’s prime brokerage, which would record the transaction as a purchase and not a loan. This process establishes ownership of the asset before sale to the market. In Islamic finance you cannot sell an asset which you do not own. As such, an investor cannot borrow shares from a brokerage house or a bank and sell them in the market for an eventual gain. Al-Safi also tracks each trade and each position of ach hedge fund manager through separately-managed accounts to ensure strict Shariah compliance.          

The Fimat and Al-Fanar funds however used the Salam contract, effectively using a forward sale concept for equities. But while the mechanics of both structures are different to conventional shorting, the economic effect is similar to the conventional short sell.

Whether the Islamic finance market, inherently still conservative, is ready for such pioneering innovations such as hedge funds or derivatives only time will tell. But then, it is financial engineering and innovation that drives both regulation and market sophistication. And the Islamic finance sector in this respect is no exception.