Over the hedge

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The move by Dubai Islamic Bank (DIB) last week to launch a Sharia-compliant investment fund linked to the performance of non-Sharia-compliant hedge funds has sparked controversy within the Islamic finance industry.

Created in partnership with two of the world's biggest financial institutions, Deutsche Bank and Goldman Sachs, the DIB fund aims to tap into the huge investment potential of conventional hedge funds, but still abide by Islamic law.

No money is actually invested directly in conventional hedge funds. Through what DIB describes as a "Sharia-compliant mechanism", the bank's fund is benchmarked against an index that measures the performance of a group of hedge funds. DIB's attempt to open up conventional hedge funds to Islamic investors, however, has met with criticism from a leading scholar in the industry.

Sharia advisor and Islamic scholar Yusuf Talal DeLorenzo has lambasted the fund, claiming that just because money is not being directly invested, it does not make the fund Sharia-compliant.

"It is a sad day for Islamic finance when an industry leader falls victim to the mistaken notion that just because a Muslim customer's money will never go into a potentially non-Sharia-compliant investment, the returns to the customer will actually be halal," DeLorenzo, chief Sharia officer at Shariah Capital, tells Arabian Business.

"Equally saddening is the notion that because the Muslim's investment returns will ‘reflect the performance' of funds that operate in a non-Sharia-compliant manner, and which invest in non-Sharia-compliant stocks, those returns can somehow be made lawful; as if the reflection of unlawful performance somehow differs from actual performance," he adds.

"It is one thing if an investment ‘reflects' a prohibited transaction in terms of its characteristics. It is another matter entirely, however, if an investment ‘reflects' a prohibited transaction by actually having its returns determined by that transaction," DeLorenzo argues.

The global hedge fund industry is estimated to be worth around $2 trillion, but Muslim investors have largely been excluded from operating in this market because of the difficulty in making hedge funds comply with Sharia law.

Conventional hedge funds use complex investment strategies, being long or short assets, and entering into futures, swaps and other derivative contracts - almost all of which is non-Sharia compliant.

The DIB fund, however, last week announced attempts to give Muslim investors access to a potentially lucrative investment vehicle.

Structured by Deutsche Bank and managed by Goldman Sachs Asset Management, the DIB fund uses five-year capital protected notes that are linked to a hedge index.

At the end of the five-year period, investors receive their initial investment, plus an additional amount calculated from the index's performance during that period. As it is 100% capital protected, even if the index ends lower than where it began, investors do not lose out.

Despite the fact that the DIB fund is indirectly profiting from the performance of non-Sharia hedge funds, because it does not directly invest in the funds, DIB and its partners maintain it is still Sharia-compliant.

The way DIB's fund achieves Sharia compliance, according to Deutsche Bank, is through a technique designed by the bank based on a credit swap. This means an Islamic investor is distanced from alternative assets but can still benefit from their revenue.

"It is an Islamic compliant total return swap," says Geert Bossuyt, managing director and regional head of ME structuring at Deutsche Bank's global markets division. "To give you an example, an Islamic investor who wants to have exposure - not invest into, but get exposure - to hedge funds, gives us US$100. That US$100 we put into Sharia compliant assets.

"Then on top of that we do a total return swap. We give away the return on those Sharia-compliant assets to a counterpart. That counterpart in return gives us exposure to hedge fund returns," he adds. This way, the cash is kept in Sharia compliant assets and the swap is conducted in a Sharia-compliant way, he said. "We cannot allow Islamic investors to invest in non-Sharia-compliant assets, but we have created an exposure to non-Sharia-compliant assets in a Sharia-compliant way," says Bossuyt.

"That may sound strange to you, but if you look at the sukuk [Islamic bond] market, 80% of Islamic bonds are linked to LIBOR [London Inter Bank Offered Rate]. LIBOR itself is a non-Sharia-compliant index."

DeLorenzo, however, claims that even this distanced approach to giving Muslim investors access to the conventional hedge fund industry falls foul of strict Islamic principles.

"Muslim investors would never consider investing in a prohibited business. This product, however, encourages Muslims to put money into a product that at the very least does not discriminate between right and wrong, halal and haram, good and harmful," he argues.

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