Islamic hedge funds: innovation or infiltration?

As Islamic finance emerges as a true alternative to the falsehood of fractional banking, it is essential that its foundations are firm. Arabian Banking and Finance meets UK-based Islamic finance guru and author Toby Birch who shares his views on the future of the sector.

Throughout history it has been natural to copy the culture of the leading powers of the day in the belief that they are role models of sophistication. In modernity, we see mimicry of the West in architecture, consumerism and liberal lifestyles. What appears on the surface to be glamorous and progressive is already proving to be shallow and obsolete.

The beauty of the credit crisis is its revelation of these ugly truths. Only now can we comprehend the prohibition of ‘riba' where the time value of money has created false growth, transforming it from servant to master in the process.

For some reason there is still a belief that Western financial products are pioneering or that complexity is clever. If anything bankers should be embarrassed by the layers of leverage they have packaged and must return to simplicity and transparency. Investment funds have become far removed from the true purpose of money; to aid transactions in the real world.

The word ‘innovation' in Islamic finance is developing into a misnomer or battleground between liberal and conservative interpretations. It is reminiscent of the dot.com bubble where anyone who did not buy into the concept was deemed to be a dinosaur destined for destruction. We must guard against euphemistic language that tricks us into circumventing the rules, particularly when the financial rewards are tempting.

Malignant model

Western finance faces extinction where once it was the essence of evolution. In the Victorian era, stock markets matched investors with entrepreneurs, creating dividend streams rather than capital growth as the reward. There were of course panics but the stability of the gold standard helped companies generate genuine cash flow which was recycled back into the economy.

Venture capital was the source of true innovation which greatly benefited Western nations in the past. It is just a pity that exactly such partnerships form only a minority of Islamic financial transactions. Debt, like the devil, comes in many disguises accompanied by its terrible twin of interest.

Conventional banks failed because they gave way to the temptation of credit creation to reap a harvest of apparently easy money. Just as fiat currencies have become devalued so the activities of banks have likewise strayed from their proper purpose.

Western finance is now a one-sided affair where an imbalance of risk and reward favours the institution. While it is not in a bank's interest to hold bad debts, they ultimately take guaranteed returns while a business lives but get first pick of the carcass if it dies.

Historically, hedge funds have provided reasonable upside and minimal downside, typically run by that rare combination of skilled investment managers who were also entrepreneurs. They deserved high rewards because they took measured risk in conjunction with their clients. Once again, they have mutated far from their original form and have skewed risk and reward in favour of the manager at the expense of the investor.

Not only has performance has been appalling but their investors have been trapped by the one-way gate system; easy to enter, harder to exit. The concept of hedging has led to laziness, allowing too much risk accumulation based on too many assumptions. Compounding the flimsy model, the very securities that hedge funds hold are themselves beset with corporate trickery.

The turn of the financial tide has exposed outright fraud along with corporate accounting abuse. This has no doubt been driven by the conflict of share options; the ultimate form of shareholder dilution.

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