Islamic investments performed well during the recent financial crisis, drawing attention to the benefits they offer. CAMILLE KLASS looks at how they can maintain a competitive edge over conventional investments.

Despite avoiding investing in financial institutions due to riba, Shariah compliant investments have outperformed their conventional peers since the start of the recent financial meltdown even as the world’s stock markets staged a remarkable rally driven by oversold banking and finance stocks.

Their outperformance is expected to fuel greater interest in Shariah compliant investments that will, in turn, give an added boost to the Islamic finance industry.

“In the short term, the outperformance of Islamic products during the financial crisis has definitely confirmed their added value for investors worldwide, and has greatly contributed to the momentum of the industry,” said Cheng Tan Feng, global head of Shariah compliant business development at BNP Paribas Investment Partners. “In our view, these factors have also put Shariah compliant solutions on the radar of non-Muslims.”

In the 12 months to January this year, the total net asset inflow for Malaysia-domiciled funds in the Islamic global bond category doubled to RM781.4 million (US$235.4 million), according to funds research, ratings and analysis provider Morningstar. Over the same period, in the Shariah equity funds category, net asset inflows jumped 78% to RM4.168 billion US$1.255 billion), while they rose 48.2% to RM477.5 million (US$143.8 million) in the Islamic balanced funds category.

Although the impressive percentage increases highlight a growing appreciation for the principles of Islamic finance amid the recent backdrop of dysfunctional financial markets and banking instability, industry participants noted that the performance has to be looked at in context. Islamic investments still constitute a fraction of the conventional finance industry’s universe of investment products and net fund inflows.

Its comparatively small size, while understandable given its youth, is among one of the biggest challenges that Islamic investment firms face in competing with their conventional financial investment peers, industry participants said.
In 2009, Shariah compliant assets managed by the top 500 Islamic financial institutions were estimated at US$800 billion, up 25% from the previous year, according to a survey.

Innovation needed
Despite the robust growth, the industry lacks a wide range of innovative and competitive Islamic products to meet the growing needs of Islamic investment firms and their investors. That could be helped, they said, by attracting international expertise in developing and structuring products that are more international in flavor.

In terms of performance, while adhering to Shariah principles does help provide safeguards against weak governance and a high level of leverage, it also does limit the scope of investments available to Islamic investors, which makes expertise in managing assets a key priority for firms.

“The smaller universe in the Islamic market can be a hindrance when constructing a portfolio,” said Abdul Jalil Rasheed, director, head of equities, at Aberdeen Islamic Asset Management. “In many countries, banks are seen as proxies to the growing economy, but Islamic investments don’t allow banks. “It’s not a problem because there are many other investable stocks, but it illustrates the added skill set needed to construct an Islamic portfolio.” For BNP Paribas Investment Partners, Shariah compliance doesn’t mean a narrowing of the investment universe, “but rather taking a sector approach towards the best-in-class companies and sustainable projects,” said Cheng. The interest in Islamic products generated by the stellar performance of Shariah compliant assets may see fund inflows swell, but industry participants caution that the recent outperformance is no indication of sustained gains in the future.

As with any market or product, Islamic investments will continue to experience periods of underperformance and outperformance in relation to conventional investments, depending on the relative performance of inherent sector biases. “Like any investment, there are periods of cyclicality,” said Aberdeen Islamic’s Rasheed. “During the recent downturn, Islamic investments performed better because they didn’t hold financial stocks. But when the market turns bullish, Islamic investment performance might trail behind (their) conventional peers.”

While investment performance, or returns, can’t be examined without considering the risks involved, the question to ask in relation to risk and performance is whether the philosophy underlying Islamic investments provides a sounder basis for longer-term sustainability of returns at a transparent level of risk, as compared to conventional investments, industry participants said.

BNP Paribas Investment Partners’ Cheng believes so: “Returns that are generated with a dangerous level of risk, especially if unrecognized as the root of the recent credit crisis, are ‘phantom’ returns as they are not based on sound and sustainable fundamentals,” he said. “The basis of Shariah compliant investments (is) sustainable, ethical principles (which) therefore provide returns at a healthy level of risk.”

Diversifying portfolio
In attracting investors to Islamic funds, enlarging the range of products and ensuring that they fit investors’ risk and reward profile would help. However, greater awareness of products, in terms of their potential risks and rewards, is also crucial.

“There needs to be lots of educational efforts, both to institutional investors and retail,” said Aberdeen Islamic’s Rasheed. “There seem to be many Islamic products in the market but the man on the street does not understand them. There can only be greater appreciation for Islamic investments when it is understood and makes sense.”

With the effects of the financial crisis still fresh in investors’ minds, investment appetite appears to be more for “less risky and more liquid types of investments, for example government-backed Sukuk listed on organized markets, while the appetite for stock market, real estate and alternative investments — private equity, for instance — seems to be limited,” said Mohamed Damak, credit analyst at Standard & Poor’s. Rasheed said his firm “has always favored Shariah compliant equities and Sukuk,” but qualified this by saying the choice of investment product needs to be determined by the investor’s risk appetite.

Citing the launch of TA BRIC and Emerging Market fund in February by TA Investment Management, for which BNP Paribas Investment Partners is an advisor, Cheng said the firm has seen renewed interest in equity open-ended funds this year, especially in the Malaysian market. BRIC refers to Brazil, Russia, India and China.

Hit by news of defaults last year and concerns over the legal enforceability of documentations and Sukuk holders’ rights, industry participants said the concerns relating to Sukuk may be overdone. Indeed, Sukuk are gaining in popularity, as evidenced by the oversubscription of all new benchmark issuances in 2009 and demand for new issues. In particular, global Sukuk, which are listed securities with the majority rated by credit rating agencies, are attracting investor attention, thanks to strong demand for Islamic capital market products.

“It is our strong conviction that the global Sukuk market is ready to embark on a virtuous cycle; but there are caveats,” said Cheng. “The resolution of (recent) credit events will undoubtedly lead us to greater regulatory and Shariah clarity and to further market maturation.”

As it develops towards becoming a viable alternative financial industry, the Islamic investment sector will continue to face challenges in maintaining a competitive edge over the conventional investment sector, industry participants said. Areas such as education, harmonization of Shariah standards and expertise in developing international investment products will need to be addressed, they added.

“The challenge will always be to convince the skeptics about Islamic investments,” said Aberdeen Islamic’s Rasheed. “The industry needs to grow further, harmonize its Shariah standards, educate the public and investors, and establish itself as a viable alternative financial system.”