The lies of Shariah Finance-We must read between the lines

Designing Islamic Hedge Fund Is a Lesson in Bridge-Building
By Naureen S. Malik
The Wall Street Journal Online

At a restaurant in Alexandria, Va., in the spring of 2002, venture capitalist Eric Meyer sat across from Nizam Yaquby, one of Islamic finance’s foremost scholars – and the man who could help Mr. Meyer realize his quest to design an Islamic hedge fund.

Mr. Meyer knew creating a fund that would adhere to the strictures of Islam, with its prohibitions on debt and on investments in industries such as alcohol and tobacco, wouldn’t be easy. But doing so could unlock billions of dollars in wealth held by investors eager to earn the higher returns hedge funds can deliver without compromising their religious values.

At the moment, however, Mr. Meyer was looking at a much smaller piece of the puzzle: explaining options. He drew a circle on the paper tablecloth and labeled it “IBM.” Then he sliced the circle into shares. Still drawing, he explained that options are the right to buy or sell existing shares at a given price; Sheikh Yaquby had thought they were a kind of derivative of existing shares concocted by financiers and lacking real value – something forbidden by Islamic law.

“Sheikh Nizam’s eyes lit up,” Mr. Meyer said. “Then I knew I was onto something.”

The misunderstanding was a small thing, but typical of the gulf Mr. Meyer had to bridge between the worlds of western finance, ruled by government regulations, and Islamic finance, which is subject to Shariah, or Islamic law and guided by scholars like Sheikh Yaquby.

Basic financial instruments and strategies are the same in both the U.S. and the Middle East. A hedge fund is an unregulated investment pool that might use virtually any investment tactic, primarily catering to wealthy investors and institutions with millions to invest. Whether in Istanbul or Manhattan, short sellers are selling borrowed securities, hoping to return them at a lower price and pocket the difference, while options traders are buying and selling contracts giving them the right to buy or sell a given security at a set price for a set period.

But when it comes to using these instruments or strategies, the differences between cultures are put into stark relief. In the U.S., investors pursue whatever strategy they think will make them money, While investing is by no means foreign to Muslims – Saudi Prince Alwaleed bin Talal is the largest single foreign investor in the U.S. – many Islamic investors have long considered tactics such as shorting and options as immoral.

Mr. Meyer’s goal was to design a hedge fund using new tools that had the same effect as their western counterparts, but were allowable by Shariah. The dinner with Sheikh Yaquby marked the moment he began to think he might succeed; this fall, Shariah Funds, a subsidiary of New Canaan, Conn.-based Meyer Capital Partners, will begin marketing its fund in Persian Gulf countries.

“Kids, don’t try this at home,” Mr. Meyer says. “This is not for the faint at heart.”

FINANCIERS AND SCHOLARS
To bring Shariah Funds(www.shariahfunds.com) to life, Mr. Meyer assembled a team of businessmen, lawyers and Islamic scholars. Sheikh Yaquby signed on, as did Yusuf Talal DeLorenzo and Mohamed Ali Elgari. Mr. Meyer also recruited two western financiers, Deutsche Bank veteran Dauvin J. Peterson and Joseph E. Gau, who had headed Citibank’s private-banking division for the Middle East and Africa. Rounding out the team was Mike McMillen, an attorney for King & Spalding in New York who designed the first Shariah-compliant mortgage in Saudi Arabia. (The three Islamic scholars serve as advisors to the Dow Jones Islamic Index Fund, a listing of hundreds of firms that comply with Islamic law that is assembled by the publisher of the print and online Journals, and the related Azzad/Dow Jones Ethical Market Fund.)

The team dissected the web of back office transactions that power hedge funds, designing Islamic equivalents that would “replicate the economic transaction without replicating the mechanics of the transaction,” as Sheikh DeLorenzo puts it.

Common hedging tools are forbidden by Shariah, which bans both interest, or riba, and speculation, or gharar. Short-selling, for instance, runs afoul of both those rules, as well as the Quran’s prohibition of selling what you do not own. And every listed company has debt, which by the strictest interpretation of Islamic law would prohibit Muslims from investing in their stock; generally accepted guidelines limit Muslims to investing in companies owing interest-bearing debt of 33% or less of their market capitalization – a limit derived from a ruling of Muhammad’s in a dispute over a bequest.

Speculation, while acknowledged as an inherent part of trading by Islamic law, is forbidden when it treats money as a real economic object – interest, for example – rather than as a symbol of economic activity – such as profits from trading goods.

The Shariah-compliant investing tools were built on precedents in Islamic law and practice with the team sometimes reaching into the past in search of them.

For instance, under the majella, a compilation of law from the Ottoman Empire, a merchant could legally promise to sell products that he would only acquire from later trading. Mr. Meyer realized that meant there had to be a precedent in Shariah for allowing investors to sell shares they would only own later.

That led to the creation of an equivalent to short-selling – though with a few differences. Mr. McMillen explains that when investors want to sell stocks short, regulations require they put a certain percentage of the money down upfront. To comply with Shariah, investors say they aren’t putting the money down to borrow shares, but as an advance on buying them.

FOUR FATWAS
In May, the Shariah Fund scholars issued four fatwas, publicly issued religious rulings crucial to legitimizing an action among Muslims.

Three fatwas approved tools that served as equivalents to Western hedge fund strategies, including short sales, options and balance-sheet leverages. All had key changes: For example, every transaction and fee generated in the process of a short sale is detailed in writing.

“The subject of the transaction must be known, understood and defined,” says Sheikh DeLorenzo. “The time, the place, the delivery – all of these details have to be crystal-clear at the time of the transaction.”

The fourth fatwa was issued for a screening program that filters data from Edgar, allowing fund managers and scholars to examine that data and calculate whether portfolios are in accordance with Shariah.

If Shariah Funds is to succeed, Mr. Meyer will have to convince western players that it would be worthwhile to do things slightly differently than they’re used to – such as by using the screening program. The software lets fund managers check if a portfolio is Shariah-compliant, tagging each stock with a “yes,” “no” or “maybe.”

Managers can ask fund analysts to review stocks that get a “maybe” or a “no,” with complicated issues reviewed by the scholars. As an added layer of security, the scholars can troubleshoot transactions as they arise, reviewing them during the three business days they take to settle.

BUILDING BRIDGES
Shariah Funds says within the quarter it plans to invest its money in a fund of funds spread over 10 fund managers specializing in different sectors; Mr. Meyer says the fund will need $250 million in investments to consider the venture a success.

To reach that goal, Shariah Funds is targeting institutions, pension funds and investors in the Middle East that can make a minimum investment of $10 million. There’s no shortage of candidates: Last November, Standard & Poor’s estimated that Islamic financial institutions had between $200 billion and $300 billion under management.

While Mr. Meyer declines to offer specifics, he says he is negotiating with primary banks and institutions in the Middle East about possible investments, with the banks discussing issues with the scholars.

If he succeeds, his hedge fund could open up new opportunities for Muslim investors and help foster increased understanding between worlds that often seem at odds, but have much in common.

“The way I look at it, Shariah is another body of law, like Anglo-American law,” Mr. McMillen says. “There are some competing points and you structure around them. That’s difficult – but it’s no more difficult on an Islamic transaction than any off-shore transaction.”

Write to Naureen S. Malik at [email protected]