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A Spirited Affair

Islamic finance as an investment theme is garnering more attention from investors worldwide. The entire industry has grown remarkably since the inception of Islamic banking over three decades ago. According to industrial estimates, the annual growth for the Islamic investment industry ranges from 10 to 15 percent. What was once the sole preserve of financial institutions in the Middle East has now spread to Southeast Asia, with Malaysia looking to benefit from being one of the largest hubs for Islamic banking and financial products. Owing to its rising popularity and profitability, institutions in the U.S. and Europe are getting in on the act too.

In the simplest sense, Islamic finance refers to the financial system of banking and investments that is compliant with Islamic law - known as Shari’ah. The most obvious difference between the conventional financial system and Islamic finance is that the latter prohibits the payment and collection of interest on their financial activities. This religious prohibition is known as riba. Investing in businesses, which carry out activities contrary to Islamic values such as companies that sell alcohol and that are involved in the gambling industry, is also prohibited.

However, this does not mean that Islamic finance is not profitable for both institutions and investors. The growth of this industry proves otherwise. It isn’t a coincidence that this sector has boomed along with rising oil prices. Wealth amassed in the Middle East from the ‘black gold’ or oil has been the catalyst for Islamic equity funds, set up to address the needs of Muslim investors who wish to invest in funds that adhere to Shari’ah principles.

The Islamic finance industry is a constant process of evolution. Islamic equity funds were originally targeted for institutions and high-net-worth individuals. Retail investors were unable to participate. However, the opening up of these funds has seen leaps forward with benchmarks established by the FTSE group and the Dow Jones Islamic market indices. In a 2006 Monetary Authority of Singapore reported that the entire Islamic finance industry has a market capitalization of close to $300 billion. That being said, the average size of Islamic equity funds still lags behind traditional global equity funds, which typically house hundreds of millions of investment dollars.

The increasing affluence of the Middle Eastern region is a positive growth driver for Islamic equity funds. Capgemini’s World Wealth Report, shows the Middle East region leading the growth in HNWI (High Net Worth Individuals) holding at least $1 million in financial assets.

These growth figures show that the Middle Eastern region and its people are flushed with cash. The number of potential investors that can shift their cash into assets compliant with the Shari’ah law is huge. But as with any investment, there are risks involved.

Potential Risks

Islamic investments must first be approved by Islamic scholars. Interpretations of the Shari’ah law may vary among different scholars. As such, different opinions have to be sought prior to approval. The problem is compounded, as the ability to assess if an investment is compliant with the Shari’ah law is not a skill that can be attained overnight. The lack of Islamic scholars with the expertise in this area may result in increased transaction costs, and that may not be transparent to a conventional investor.

In addition, Islamic equity funds can be subject to a certain level of volatility as the universe of stocks they are permitted to buy into is smaller, resulting in lower diversification. With the banks and financial institutions (staple components of many equity funds) being excluded from the types of stocks that Islamic funds can invest in, fund managers face some challenges. The risk of missing out on the potential gains from the financial sector — which includes banking and insurance — may lead to underperformance in an investor portfolio, as the financial sector usually delivers consistently good returns in both the developing and developed markets.

Thematic Thoughts

Islamic equity funds are limited by a set of restrictions. However, there is little to stop non-Muslim investors from investing in these funds if they are keen to include such themes in their portfolios. The performance of such funds should be aligned with their respective Islamic equity benchmarks. For investors who are Muslim, the opening up and growth of the Islamic financial market in the world as well as in the region, should spur them to start looking at this theme for investment opportunities.

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