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When analysing the reasons for the recession that followed the sub-prime mortgage crisis in 2007, one thing becomes clear. Had the world's financial practices been Sharia compliant, it likely would not have happened. We can trace the causes of the collapse to the trading of mortgage debt and speculation. Leveraged homes morphed into interest-bearing instruments that were bought and sold over and again. There was no tangible value attached to these products, which ended up debilitating the portfolios of millions of investors. Islamic practices prohibit the trading of debt — a principle linked to the philosophy that you cannot make something out of nothing. In Islamic law, Riba, the word for interest, means surplus value without counterpart, thus defined to highlight that returns should be equivalent to the real value of the asset. Hence the advantages of a Sharia-compliant investment portfolio are apparent with regard to risk management. Plus, as the Islamic finance industry grows and diversifies through innovation, the financial rewards are catching up with those seen in conventional investments.

So how does one go about building an Islamic portfolio? To start, and to help dispel the myth that Islamic products are an alteration of conventional products is Abubakr Al Falahi, Head of Product Development, Dar Al Sharia, a Dubai-based Islamic consultancy. "We must remember that banking itself was considered a haram (prohibited) activity," he says. "We cannot strictly apply the question of new products because Islamic banking is relatively new. Sharia just asks you to remove certain elements from your financial matters. Dealings should not be based on uncertainty (garaz), prohibited products and services such as alcohol or gambling (haram) and injustice (zulm)." Building on these guidelines is Ameer Hamza Azim, an offshore wealth manager for Citigroup. "Islamic products are usually asset-backed — whether it is a tangible asset or a balance sheet allocation. Derivatives, for example, are options and forwards on an asset, so you don't actually own the asset, you're just betting on the direction of it."

With interest-bearing products off the menu, Islamic finance was able to adapt to a world of conventional products because the financial goals of people are fairly homogenous. Mufti Aziz Ur Rehman, a Sharia manager at UAE-based Mawarid Finance, talks about Islamic solutions that achieve the same end. "Sharia was very rich in offering alternative contracts, which Islamic banks could use to structure otherwise similar financial products in a competitive fashion. While a wide variety of such contracts are used by Islamic banks, they can be grouped into three categories: contracts based on sale relationships, partnerships, and rewards/compensations for specific jobs."

Good wholesome equities

Investing in company shares is generally considered to be Sharia compliant since they are backed by the firm's capital. There are however limitations and protocols associated with such an investment. Falahi of Dar Al Sharia provides some insight. "We must look at whether the company is dealing in products such as alcohol, tobacco, arms — anything that is not good for society. From a Sharia perspective, it is the use of money that determines the company's eligibility, not the source. Therefore the ownership and affiliations are not looked at.

"The financial position of the company also comes into scrutiny. The Sharia standard says that the company can only have standard interest-bearing deposits of up to 30 per cent of their assets. Similarly, they should not have interest-based borrowings of more than 30 per cent of total assets or market capital. Interest income should not be more than 5 per cent of total booked revenue."

Sukuk are often misleadingly referred to as ‘Islamic bonds'. The Accounting and Auditing Organisation for Islamic Financial Institutions, an international, non-profit corporation that sets Sharia standards and benchmarks for the industry, defines sukuk as: "Investment sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or the assets of particular projects or special investment activity. However, this is true after receipt of the value of the sukuk, the closing of subscription and the employment of funds received for the purpose for which the sukuk were issued."

If sukuk represent ownership of assets, they are by definition nothing like bonds. Rehman of Mawarid elaborates. "Conventional bonds merely represent debt obligations, while sukuk are asset-based and not just the right to a debt or revenue. Investors own a pool of assets supporting the sukuk issue." Azim of Citibank points out that sukuk usually compensate for the restrictions on leveraging (a common practice for bond purchasers). "Sukuk offer higher returns than normal bonds because they cannot be leveraged. You cannot even take an Islamic loan to leverage sukuk because end uses of moneys are defined and restricted in Sharia finance."

Risk and return

Islamic structured investment products have recently tapped into an essential area for any portfolio — hedging. Rehman of Mawarid reveals that tools to mitigate market risk and augment investment yields are now able to operate under the Sharia code. March 2010 saw the launch of the International Swaps and Derivatives Association and the International Islamic Financial Market. This in tandem with the Tahawwut (hedging) Master Agreement saw the introduction of a standardised framework for ‘privately negotiated Islamic hedging products'.

"They can help to smooth out fluctuations in rates to allow better planning and scheduling of expenses related to rates, as well as to bolt in future exchange rates for foreign currency purchase requirements, both are built using murabaha financing and investment structures," says Rehman. It is plain to see that Islamic products are a natural hedge against investment risks. What will be interesting to observe with the evolution of the Sharia financial design is the emergence of typically competitive returns.