Aa Article - Islamica-me Mar 2009 - Risk And Reward (complete)

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Risk and Reward

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Islamic Asset Allocation

By Ahsan Ali, CFA, FRM, MSI

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The credit crisis has exacted its toll on the global markets, investor confidence, political will and the financial sector. In the aftermath, Shariah-compliant investments have emerged as an important alternative to purely conventional investing. The question remains: Is Islamic investment methodology superior to conventional means? And more importantly, is superior risk diversification possible using Shariah-compliant investments?

Ahsan Ali is head of Wealth Management and SME Banking for Noor Islamic Bank, UAE. An avid supporter of CSR and development initiatives, he is involved in mentoring, training and program management with various public-private partnerships. He holds an MBA from the Institute of Business Administration, Karachi University, as well an MS in Financial Economics from the School of Oriental and African Studies, London. Ahsan is a CFA Charter Holder, an FRM certified risk manager and a member of the Securities and Investment Institute (SII), UK.

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Modern Portfolio Theory (MPT) Under MPT, unsystematic risk can be diversified away, as investors strive to reach an “efficient frontier,” which is the best possible combination of risk and reward.

tion-based businesses and are also restricted by the nature of business activites (no gambling, pork, arms and ammunition, etc). This excludes virtually all of the banking and insurance sector, as well as restricting companies with a substantial component of their income generated from interest-based earnings. There are two important impacts to consider: • Crowding effect: The existence of limited stocks in the universe might result in a large amount of money chasing limited securities, with the result being an overvalued scrip. This is somewhat similar to excess money supply in a financial system causing inflation. • Commonsense investing: The exclusions effectively focus investments on the “real sector,” free from financial engineering gimmicks and excessive risk taking, as well as following a socially responsible theme. The net effect seems to be a conservative mix of equities with enough investment flows to keep the values stable to slightly inflated.

Expected return/risk

Leverage The concept of leverage (gearing) has been the underlying principle of generating excess returns in areas from manufacturing to financial engineering. The concept of using somebody else’s money at a fraction of the cost of capital sounds very enticing. In an economic downturn, however, this can prove to be disastrous, as it has! Islamic investment guidelines by default do not trust leverage. Above a certain level of gearing, stocks are excluded or penalised by “cleansing” the dividend (via payment to charity). This ensures that fund managers keep their investments as “real” as possible in stocks that have a high loss-absorption capacity in an economic downturn. The impact of the systemic risk is far less for the Islamic portfolio versus a conventional one. A brief glance at the levels of leverage over the last century clearly demonstrate that inordinately high levels of debt have always resulted in less-than-desirable impacts on economies. Yet, as always, the human memory tends to be quite short.

With MPT, any rational investor will have a certain risk tolerance and will try to maximize the return for that level of risk. The concept is equally applicable in Islamic allocation; in other words, MPT is agnostic! However, what is often overlooked is the behavioural investment angle of MPT. Simply stated, the “faith-based” Shariah investor is definitely not agnostic. Theoretically, in a choice between a higher-return non Shariah-compliant stock versus a lower-return Shariah-compliant stock (with the same risk), the choice will not be “rational.” This will cause behavioural aberrations for the efficiency frontier. An interesting comparison could be between ethical investing impacts on MPT versus Islamic investments. Though we lack empirical evidence, I would wager that the “religious” impact would likely be more.

The key question remains: In the pursuit of wealth, is there room for morals and ethics?

Universe of Stocks One of the key differences between Shariahcompliant and conventional stock selection is the number of stocks available. Shariah-compliant stocks cannot be from interest- or specula-

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Total Credit Market Debt / U.S. GDP (1)

(1) Source: Ned Davis Research, 2008 Sukuk as Bond Equivalents Bonds (particularly sovereign instruments) are a cornerstone of portfolio diversification for conventional investors. They produce a flow of stable income with relatively safe principal and are perceived to be less risky. Sukuk over the last five years were said to have filled this space for the Islamic Investor. However, the Sukuk market is still quite limited in terms of issues available as well as liquidity (secondary markets). Fundamentally, Sukuk differ in terms of having a tangible underlying asset versus what is essentially a promise to pay in the case of a conventional bond. Realistically, part ownership of an asset (such as an airport) is not saleable and effectively, recourse on the principal and coupon payment lies with the issuer. Certain fundamental flaws pointed out by Shariah scholars (especially with Waad-based structures) related to Sukuk mean that the future of this instrument has been thrown into disarray. This translates to the conventional asset methodology being superior for bond selection due to the established market, a fair degree of liquidity and indepth data for rating transitions/credit performance.

On the conventional side, “Cash is king,” with a variety of options freely available. Contentment? A pure intangible is the relative degree of satisfaction derived from the fact that your money is at worst “inflicting no harm” and at best is in line with religious obligations. The proponents of capitalism will argue that there is “satisfaction” to be derived from making money. Both approaches seem to have relative merit. However, the Islamic side seems to win on moral grounds. The key question remains: In the pursuit of wealth, is there room for morals and ethics? In this day and age, public opinion will shape the response to this over the next few years. The Best Mix It is evident that the nascent Islamic asset allocations offer some interesting options. At the same time, a pure Islamic portfolio lacks the instruments, market depth and liquidity to rival the conventional setup at this point in time. With the evolution of behavioural influences (ethical, religious, etc.), soft factors such as contentment and the perception of being socially responsible will gain ground against the traditional norms of performance against benchmarks. Within the equities world, Islamic stocks provide a conservative and commonsensical approach which will definitely be a safer haven during recessions and credit downturns. However, the best mix seems to be Islamic equities, with a sprinkling of social responsibility, a dash of bonds and a sauce of liquidity instruments (conventional). It’s not surprising in this day and age that the superior allocation mix happens to be one of “religious tolerance” and harmony.

Cash equivalents Islamic banking suffers from a severe drought of liquidity-based products. This stems from the inherent aversion to interest, which is effectively the construct for most liquidity products. In the last three years, there have been some creative solutions, primarily through the reverse murahaba and wakala structures which replicate deposits. There have also been short-term liquidity solutions introduced; however, the usage of and access to these remains quite restrictive (especially for overnight and short-term liquidity).

The views expressed in this article are the personal views of the author.

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