Monday, July 6, 2009

Islamic Hedge Funds?

"Hedge fund" is a term that was originally used to describe a type of investment pool that uses sophisticated hedging and arbitrage tools to trade in the equity markets and explicitly pursues absolute returns on their underlying investments. The most widely-accepted definition of a hedge fund is that it is a fund that uses leverage, shorting and options to achieve its investment goals, beginning with the protection of investor capital.

The first hedge fund was set up by Alfred W. Jones in 1949, the first to use short sales and leverage techniques in combination. In 1966, a "hedge fund" run A. W. Jones shocked the investment community because it outperformed all the mutual funds of its time, despite their huge 20% fee.

According to some experts, hedge funds are believed to be highly speculative and thus may run contrary to the Shariah prohibition of gharar. At an even more fundamental level, however, hedge funds use short sales to neutralise the influence of market forces; and short sales involve the sale of what one does not really own, which is haram.

Toby Birch of Birch Assets Ltd doubts whether hedge funds could in principle be Shariah-compliant, calling Islamic hedge funds "something of an oxymoron," being an area of controversy, where such structuring might obey the letter of Shariah, it is not compatible with the spirit.

Often, in structuring Shariah compliant instruments, a number of contracts are combined to achieve the desired result, a solution that meets the financial or investment needs. On the surface, combines two or more Shariah concepts may sound perfectly acceptable but indiscriminately doing so may lead to what Tarek Diwany describes as “contractum trinius”. Ahmed Abbas, of Bahrain’s Liquidity Management Centre, criticised such mechanisms as false to the spirit of Shariah. “I don’t care, if you take 20 Islamic steps in order to short sell, you cannot sell what you don’t own. “Islamic banking is not about drawing an Islamic veil over something un-Islamic.”

There have been many opinions and views as well as fatwas on whether hedge funds are Shariah compliant or not. We should be looking at the purpose of a hedge fund rather than the mechanics of the fund. This way hopefully we can up with a solution to the problem rather than modifying an existing (probably incompatible) instrument to solve the problem.

To "hedge" means to manage risk. The key word here is risk management. Our objective is to manage risk in a Shariah compliant manner. We shouldn’t be talking about Islamising hedge funds to manage risk, we should be finding means to manage risk which do not contravene Islamic laws. We should not be finding ways to Islamise hedge funds just for the sake of creating or adding to market liquidity and to enhance rice discovery.

Managing risk is permissible in Shariah based finance provided the means of managing that risk complies with the rules of Shariah. Managing risk can come in the form of full transparency, honouring contractual obligations, being accountable and acting in a professional way. Shariah based financial transactions are after all partnership and risk/reward sharing arrangements. Actions undertaken to manage and/or minimise risk should be directly related to the business venture by ensuring that it is undertaken in the proper manner.

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