By Rushdi Siddiqui, head of Islamic Finance at Thomson Reuters

It took Islamic finance forty years to reach the magical US$1 trillion benchmark (in terms of size or assets under management), and this niche market is on the march towards the next milestone of $2 trillion within the next five years — with Moody’s predicting $5 trillion.

Considering the fact that it took almost twenty years for the conventional industry to reach the US$ 1 trillion mark, but only ten to reach US$ 6 trillion (see figure 1), it is highly likely that Islamic finance will reach that level within the next five to six years, subject to the clearance of certain bottlenecks.

 

 

 

 

 

 

 

 

 

 

 

 

 

To reach the $2tn benchmark for a start, the usual suspects of suggestions include standardization (need it), scholars (need more), skilled personal (need more), regulations (level playing-field), governance (need to enhance), risk management (need to improve), derivatives (manage risk), consolidation (size matters), etc.

However, very little has been said about connecting Sovereign Wealth Funds (SWFs), commonly found in the six GCC countries, with Islamic finance, also commonly used in the GCC countries.

SWFs may have exposure to Shariah-compliant investments, but not by design, as the universe of compliant opportunities is alleged to be smaller, with an inability to utilize derivatives to mitigate risks or borrow/short to enhance returns.

SWF equity investing exposure may in fact include Shariah-complaint companies — like Microsoft, IBM, Pfizer, ExxonMobil, P&G, etc. — as more than $14 trn out of $30 trn world market capitalization is Shariah-compliant, according to Standard & Poor’s data. Their intention is not to screen for Shariah-complaint companies as it is not their mandate, but such companies are consistent with their fiduciary duties to maximize long-term returns on a risk-adjusted basis.

Approximately 16 of the 57 Muslim countries (members of the Organization of the Islamic Conference, OIC) have sovereign wealth funds (SWFs), the largest, ADIA of Abu Dhabi, estimated as having in excess of $600 billion (see figure 2).

They imply recognition by the sovereign formally to save for future generations from oil & gas revenues, and it is interesting to note that ten of the sixteen 16 OIC SWFs have been operating for about ten years or less.

However, the $1trn Islamic finance industry does not yet have a champion in a dedicated Islamic SWF, and it is the strategic need of the hour for not only figuratively supporting and raising the profile of Islamic finance, but also incubating and building Islamic asset classes and modalities of investment vehicles.

In the last few years there have been serious discussions about establishing an Islamic ‘mega-bank’ by one of the early pioneers of Islamic banking, either via consolidation or a new license, and an Islamic ‘Goldman Sachs’.

In the post-subprime-induced credit crisis, an Islamic SWF might have more of a global reach, cross-sell potential and impact than a local or, at best, regional Islamic mega-bank with bias towards the real estate industry and its chain of borrowers. An Islamic mega-bank would still not directly address the needs of the ‘non-bankable’ Muslims, which is probably 90-95 per cent of the 1.6 billion Muslims in the world.

In addition, if one examines the Muslim ‘naysayers’ or critics of Islamic finance, the skepticism is generally directed more towards the complicated structured financing attempting in many instances to replicate the weapons of mass financial destruction such as speculative derivatives, and less towards the more transparent Islamic investing.

It’s much easier to verify — via the accepted screening methodology from the Islamic index providers like S&P or MSCI/Barra — permissible investing in, say, Shariah-complaint publicly-listed companies like IBM and Microsoft, or Shariah-based like Dubai Islamic Bank or Al Rajhi Bank, than to explain and accept the structure of a total-returns swap-technology-based instrument or a structured note providing conventional hedge fund returns.

Furthermore, as transparency and governance are the determinative and defining paradigms in the post-crisis period, the proposed Islamic SWF would abide by the recently established Santiago Principles signed by many SWFs, and, I would even suggest, the Equator Principles.

In fact, the proposed Islamic SWF should go one step further, and model itself for Islamic finance on transparency, as demonstrated by Norway’s $450 billion Government Pension Fund which is a role-model for SWF transparency and reporting. It’s a well-established principle that financial transparency and accountability inspire confidence, which attracts capital.

Finally, there have been high-level discussions out of South-East Asia about a Global Zakat Fund, as Zakat contributions amount to tens of billions of dollars per annum. However, there are pending Shariah issues on investing charity tax for the poor and impoverished in activities that could be seen as profit generating investments. In contrast, the concept of a global (Islamic) fund modelled and labelled as an Islamic SWF (actually a ‘fund of funds’) has arrived for serious consideration.

Establishing such a fund would create (for the Islamic countries) a unique and definitive comparative advantage or differentiating feature, that of a (Islamic) financial system based on principles of conservative asset based financing, trust, transparency and risk sharing. This in and of itself could potentially be a “pull” factor for institutions looking to get access to reliable and long term financing and also build a unique reputation for Muslim countries for global thought leadership in the applied finance, much like the United States has gained a reputation for innovation and research, South East Asia for high quality technology manufacturing, the former CIS countries for agriculture and South Asia for cost efficient skilled and unskilled workers.

Beyond borders

While an SWF has been traditionally been utilized for the benefit of the home country’s future generations, an Islamic SWF would not be confined to borders, since the mandate is for all 1.6 billion Muslims and others interested in Shariah-compliant/based investing. It would be the equivalent of a global Islamic pension fund.

Just as pension (CALPERS) or endowment (Harvard, Yale, etc.) funds have allocations to traditional and non-traditional asset classes via external managers, the proposed Islamic SWF has a template for study and consideration. Obviously, the major difference would be that investments must be Shariah-compliant/based.

The physical location of the Islamic SWF could be in one of the transparency- and governance-oriented Islamic finance hubs, such as London, Bahrain, DIFC or Malaysia’s MIFC, as a reward for accountability.

The board of directors/trustees should be a combination of globally-experienced regulators, bankers, fund managers, index and data providers, academics, scholars, central bank governors championing Islamic finance (like Governor Zeti of Malaysia), and chaired by political leaders, like Shiekh Mohammad Rashid Bin Maktoum, who have provided important political support to the cause of Islamic finance.

The initial contributions for such a fund could be from the founding members, like the 300-plus Islamic financial institutions, the OIC countries involved/interested in Islamic finance, Islamic finance hubs, Islamic Development Bank, Asian/African Development Bank, the International Finance Corporation (IFC), and other interested parties.

The international lending agencies are involved in Islamic finance in a variety of capacities for developmental aid and financing. Hence, a formalized Islamic SWF would be the next logical step. A global launch with US$10-20 billion should be within rationale, reach and reason.

Within one or two years of operational experience, the Islamic SWF should be promoted and made legally available for investing in by any and every interested Muslim/non-Muslim ‘man on the street.’ As an added incentive, for every dollar/ringit/rupiah/riyal invested, the fund would match it by a one-time 25 per cent contribution after lock-up of two years has expired, to encourage longer-term investing.

Islamic finance has gained traction among enlightened Western governments and global-centric conventional companies, be it UK’s FSA approving five (GCC-backed) Islamic banks, Luxembourg’s intentions to become a hub for Sukuk listing and Islamic funds, or the IFC and General Electric issuing $100m and $500m Sukuk respectively during the credit turmoil in late 2009.

It’s time to ‘dangle serious money’ to build an Islamic asset management industry in (ideally) an OIC Islamic hub, like DIFC, instead of wiring the money to UK or US for fund management. It’s high time to establish knowledge-based Islamic finance, and build the infrastructure for research, analysts, fund managers, and trading, combined with Shariah principles on law, governance, risk management, accounting, prudential regulations, etc.

An Islamic SWF with a respectable amount of assets under management would be an attractive magnet for a variety of external managers, as they would vie for the opportunity to manage different Shariah-compliant fund mandates. Thus, an Islamic SWF would not only facilitate an opportunity for future generations to invest according to their beliefs, but also encourage the building of an Islamic asset management industry.

Western wealth/asset management firms, hedge funds, private equity, and other fund-raising entities know the GCC landscape of tapping capital, whether it is family offices, institutional money, or SWFs. Many manage money in a Shariah-compliant manner by winning ‘request-for-proposal’ (RFP) mandates, and provide market or market-beating performance.

 

Thus, managing money according to Shariah precepts for equities, money market, real estate, etc., already exists today.

However, the above-mentioned Islamic funds are targeted to bankable Muslim professionals, minimal, if any, alternative asset classes, and with a bias towards actively-managed funds (94 per cent). Latest data by Thomson Reuters Lipper show that of £36.3bn total net assets, only $661m were not actively-managed, i.e. exchange-traded funds (ETFs) and index trackers.

Expanding mandate

Islamic banks have been criticized for not directly catering to most of the world’s 1.6 bn Muslims. An Islamic SWF must be about enfranchisement and inclusion of the ‘lost, least and the last.’

Beyond the ‘traditional’ mandate of Islamic equity, money market, real estate, and Sukuk funds, the Islamic SWF should include, amongst other areas, lender-of-last-resort status for Islamic banks along with the home-country central bank, plus a percentage of funds (say 25 per cent) allocated for venture capital, micro-finance, education, SME, halal industry, green technologies, trade finance, distressed investing, and other areas that have not been traditionally funded or financed by Islamic banks.

The culture of ‘buy-and-hold’ patience, consistent with many SWFs, does not exist in Islamic investing. Thus it is an ideal opportunity for the Islamic SWF to build upon the focus on passive investment vehicles from the mere 6 per cent today. Concurrently, it should grow the takaful industry by providing more investment options for takaful premiums. Finally, a collateral benefit of larger-size Islamic funds is shareholder resolutions for Shariah-based companies, as part of corporate governance.

More than anything else, an Islamic SWF should be considered a strategic imperative for the OIC countries, led by a GCC country or Malaysia.

There are few examples of indigenous innovation or industry that the OIC countries can lay claim to. However, Islamic finance remains a distinct ‘standout’, and it is likely to be one of the most significant contributions to the contemporary global financial architecture in the 21st century.

This development would in and of itself boost the image and attractiveness of the Islamic world, and thereby allow for the exporting of the OIC countries’ ‘comparative advantage’, and increase the intellectual and economic trade flows in the opposite direction of today’s marketplace.

Gulf-based SWF are known for their strategic investment decisions, such as Mumtalakat (Bahrain’s SWF) investing in the Bahrain International Circuit, etc. The indirect returns achieved from such strategic investment will continue to flow for decades beyond the initial investment period.

Islamic finance is no longer – having reached the $1trn mark — an uncertain experiment. The next milestone, be it $2trn or $5trn, should include a borderless benchmark-sized Islamic SWF, promoting multiple assets, passive investing, a growing takaful industry, and introducing governance.

Most importantly, is there the political will to enfranchise the 1.5bn Muslims that Islamic finance has missed, not by an Islamic mega-bank or Islamic version of Goldman Sachs, but by way of an Islamic SWF?

The opinions expressed in this article are the author’s own.

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