Introduction to Islamic Banking and Finance:

Principles and Practice

M. Kabir Hassan, Rasem N. Kayed Umar A. Oseni

Chapter 6

Islamic Asset and Fund

Management
Learning Objectives

Upon the completion of this chapter, the reader should be able

to:

1. Understand the unique nature and fundamentals of

Islamic asset and fund management;
2. Identify the criteria for the selection of Islamic stocks
for investing and review Islamic fund performances;
3. Examine the structure, marketing, and distribution
of Islamic funds;
4. Understand the Sharī'ah governance for Islamic
funds and the importance of Islamic fund management; and
5. Know the meaning and importance of
risk management issues for Islamic funds, including risk-
reward profile, with specific analysis of the risk-reward
profile of the major Islamic finance products
 Learning Objective 6.1
Understand the unique
Review and Fundamentals of Islamic nature and fundamentals
of Islamic asset and fund
Investing management

• The Holy Qur'an emphasises necessity of financial planning and

asset management (Qur’an 12, verse 47-49)
• Wealth in Islam considered as a means to an end
• Wealth must be managed in such a way to cater for interests
of current and future generations

• Fund managers and Islamic asset management firms must be

professional in the discharge of their responsibilities
• Sharī'ah-compliant investing corresponds with the values of
socially responsible investing based on ethical dealings
• Islam prohibits all forms of interest (riba) in Islamic investing
 Learning Objective 6.1
Understand the unique
Review and Fundamentals of Islamic nature and fundamentals
of Islamic asset and fund
Investing management

Islam prohibits unethical investments including investments

that deal with:

- Gambling
- Alcohol
- Pork
- Uncensored media/leisure
- Pornography
- Other activities that are explicitly prohibited under the
Sharī'ah
 Learning Objective 6.1
Understand the unique
Review and Fundamentals of nature and fundamentals
of Islamic asset and fund
Islamic Investing management

Islamic investments must

– Exclude all riba (interest-bearing) products

– Avoid speculative investments

– Be socially responsible

– Ensure that contractual terms comply with Islamic law

 Learning Objective 6.1
Understand the unique
Review and Fundamentals of Islamic nature and fundamentals
of Islamic asset and fund
Investing management

Non-Interest-bearing Products
• Islam places special emphasis on ethical investing
• Islam prohibits all forms of interest, whether fixed or
floating, simple or compound
• “Nominal” or “excessive” interest amounts are prohibited
and they are treated alike under the prohibition rule
• Fund managers must ensure that clients’ investments are
free from all forms of interest-bearing products and
investments are Sharī'ah-compliant
• Financial returns must bear two inseparable features of
Islamic investing, i.e. profits and loss
 Learning Objective 6.1
Understand the unique
Review and Fundamentals of Islamic nature and fundamentals
of Islamic asset and fund
management

Investing
Avoiding Speculative Investments
• Speculative investment may involve both uncertainty
(gharar) and gambling (maysir)
• Islam prohibits:
- Investment activities involving excessive risk,
speculation or uncertainty
- Uncertainty and contingency in contracts such as short
selling and derivatives
- Conventional insurance and derivatives
• Fund managers must respect the wishes of their clients by
investing only in Sharī'ah-compliant products
 Learning Objective 6.1
Understand the unique
Review and Fundamentals of Islamic nature and fundamentals
of Islamic asset and fund
management

Investing
Social Responsibility
The Sharī'ah
requires fund managers as well as their clients to discharge
.their social responsibility from their investment activities

Mechanisms for fulfilling social obligation include

- zakat (compulsory alms)
- sadaqah (voluntary alms)
- waqf (charitable endowment)
- takāful (Islamic cooperative insurance)
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

• The fund managers must ensure contractual terms conform

to the principles of Islam
 
• Necessary certification by Sharī'ah experts (a panel or
Board) should be sought for all contracts
 
• The Sharī'ah Board ensure compliance of all investment
funds
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

 The Islamic Stock Market Index

• Stock selection involves a process of screening to establish
Sharī'ah-compliance

• An index is used to measure fluctuations in the performance

of stocks
• Securities are traded in a place called the Stock Exchange –
buyers and sellers of securities trade here

• Islamic indexes were introduced to set benchmarks for

Sharī'ah-compliant products
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Prominent Stock Exchanges

• The Honk Kong Stock Exchange

• The New York Stock Exchange (NYSC)

• The London Stock Exchange

• The Frankfurt Stock Exchange

• The Kuala Lumpur Stock Exchange (KLSE)

• Tokyo Stock Exchange (Nike)

 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Prominent Islamic Indexes

• The Dow Jones Market Index

• FTSC Global Islamic Index

• S&P Global Investable Sharī'ah Index

• MSCI Barra
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Figure 6.1:
Example of a
Stock Market
Index
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

The Dow Jones Islamic Market Index

The Dow Jones Islamic Market Indexes are the most visible -
and widely-used set of Shari´ah-compliant benchmarks

- Stocks are screened to determine eligibility for the indexes

 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Sharī'ah Supervisory Board

• Established to advise Dow Jones Indexes on methodology

for screening securities (for inclusion in the Dow Jones)

• The board consists of five eminent Shari´ah scholars from

around the world
 
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

The Process of Selection of Islamic Stocks

• Ensure Sharī'ah compliance at every step of the investment

selection process

• The selection process includes the following steps:

- Sector screen or industry screen
- Financial screen
- Selecting Sharī'ah compliant transactions and
instrument
- Purification of income distributions
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Figure 6.2: The

Sharī'ah
Screening
Process for
Islamic Funds
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Sector Screen or Industry Screen

• Evaluate and certify business activity of the potential

company to ensure its compatibility with Sharī'ah
restrictions

• Exclude companies producing or selling prohibited goods or

services from Islamic funds investments

• Scrutinize investments in large corporations that might have

more than one line of business

• Analyze acquisition mode and target firms’ business focus

whenever a business conglomerate acquires a new
subsidiary business
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Financial Screen
The firms under investment should be operating according to
Islamic financial norms. i, e., free of any prohibited financial
practice including:

- riba (interest)
- maysir (gambling and pure games of chance)
- gharar (speculations and excessive risk)
- any other prohibited element in commercial
transactions
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

AAOIFI Ratios For Financial Screening

• Conventional debt / total assets < 30%

• (Cash + interest-bearing deposits) / total assets < 30%

• (Total interest income + income from non-compliant

activities) / total revenues < 5%

• Accounts receivable / total assets < 45%

(AAOIFI Sharī'ah Standard No. 21)

 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Selecting Sharī'ah Compliant Transactions

and Instruments

Conventional investment funds rely heavily on interest-

based debt to finance their activities, thus they may invest
in:
- Interest-bearing debt securities
Preferred stocks -
Warrants -
Common stocks -
Any other suitable instrument -
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

and Selecting Sharī'ah Compliant Transactions

Instruments

• Because of prohibition of riba, maysir, and gharar, Islamic

investment funds cannot invest in fixed income instruments such
as:

- Corporate bonds
- Treasury
bonds and bills
- Certificates of deposit (CDs)
-
Preferred stocks
- Warrants
- Some derivatives (such as options)
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Figure 6.3: Fund Results:

Amana Trust Income
Funds
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Selecting Sharī'ah Compliant Transactions

 and Instruments

Islamic investment funds cannot trade on margin or get

involved in any interest paying debt to finance their
investments

It is not permissible to engage in sale and repurchase

agreements (i.e., repos or buy-backs)

Islamic fund managers are not allowed to speculate or

undertake any unnecessary risks
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

Purification of Income Distributions

• If the fund observes some part of its income is doubtful
(income from interest-related dealings), then those earnings
should be foregone
• No consensus among Muslim jurists on the cleansing of
capital gains:
- Some observe that cleansing of capital gains earning is
necessary
- Others argue that no purification is required since selected
firms belong to halal industries
• Zakat may be used as a form of purification technique to
dispose the portion of income resulted from interest-related
dealings
 Learning Objective 6.2
Identify the criteria for the
Contractual Terms and Certification selection of Islamic stocks
for investing and review
by Sharī'ah Experts the Islamic funds’
performances

 Issues of Non-compliant Stocks

• Sharī'ah supervisory board keeps constant monitoring of the

business operations of the Islamic fund

• Sharī'ah compliance of firms that may engage in mergers,

acquisition or divestures should be re-scrutinized periodically
 Learning Objective 6.2

Contractual Terms and Certification Identify the criteria for the

selection of Islamic stocks

by Sharī'ah Experts for investing and review

the Islamic funds’
performances
 Issues of Non-compliant Stocks
Degree of non-compliance :
1. Temporary non-compliance with Industry or Financial Screens
2. Short-term non-compliance with Industry or Financial Screens:
- Fund manager should report to the supervisory board if stock
becomes non-compliant for a longer period of time
- Supervisory board should review the status of the non-
compliant stocks at regular intervals
- Fund manager should donate restricted earning to charity
3. Permanent non-compliance with Industry or Financial Screens: The
Sharī'ah board may ask fund manager to divest from such stocks
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Islamic Investment Fund

Islamic investment fund can be defined as a joint pool to

which investors contribute their surplus money for the sole
purpose of investment in legitimate business from which
they will earn permissible (halal) profits in conformity with
the fundamental principles of the Sharī'ah regulating
business transactions
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Islamic Investment Fund

• The fund manager issues a certificate (may be called
“shares”, “units” or “certificate” or “instrument” to the
subscribers (investors) certifying their rate of subscription
•  Profits earned by the fund are distributed in accordance
with subscribers respective investment portfolios after
deducting the managerial expenses
• Certificates commonly known as sukuk in Islamic finance
• The validity of the subscribers' certificate is subject to:
- No fixed return for the certificates
- Funds realized from the pool should be invested in
Sharī'ah compliant activities
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Structure of Islamic Investment Funds

Major Islamic investment funds commonly used by Islamic
funds manager:

• Islamic debt funds

• Islamic equity funds
• Alternative investments
• Special asset classes
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Islamic Debt Funds

An arrangement where the capital of an equity-based fund

is invested in fixed-income yielding activity such as an
operating lease which naturally involves a debt
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Insert Figure
6.4: The Five
Steps in the
Structure of
Islamic Debt
Funds
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Commodity Funds
• Commodity funds involve murabahah operations or bai
bithaman ajil (BBA): the fund manager uses the subscribed
pool of funds to purchase different commodities for reselling
at a profit (based on a deferred payment arrangement)
• The amount of profit from the resale constitutes the main
income of the fund
• Profit is distributed among the subscribers based on their
pro rata subscription to the fund
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Ijarah Fund
• The ijarah fund is
- Created through the pool of surplus financial resources
- Managed by a fund manager
- Used to purchase a leasable asset for establishing
a lease agreement with a third party (the ultimate user)

• The rentals that are charged from the lessee constitute the
income for the fund

• The income is distributed pro rata to the subscribers

accordingly after deducting the managerial expenses
 Learning Objective 6.3

Structure Islamic Investments Examine the structure,

marketing and distribution

Funds of Islamic funds.

Islamic Equity Funds

• The most common and widely practiced portfolio among
Islamic fund managers around the world
• The structure of Islamic equity fund may either be based on
a mudarabah contract, or a musharakah contract

a mudarabah contract
The two main parties are:
a) The investors (rabb al-mal) assume the role of silent
partners in the trust partnership  
b) The fund manager (mudarib) as the entrepreneur
performs the managerial functions
Structure Islamic Investments
Learning Objective 6.3
Examine the structure,
Funds marketing and distribution
of Islamic funds.

Islamic Equity Funds

A musharakah contract (partnership financing):
• The formation of partnership between the investor and the
entrepreneur. Both parties share the assets of the business to
the extent of the ratio of financing

• Musharakah gives both

the entrepreneur and the
bank the opportunity to share the
finances as well as the
management of the business

• Profit and losses are

shared according to pre-
determined proportions
after deducting the entrepreneur’s
management compensations)
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Alternative Investments

The three main forms of funds under the alternative

investments are:
- Private Equity Fund
- Islamic Venture Capital Fund
- Real Estate Funds or Real Estate Investment Trusts
(REITs)
 Learning Objective 6.3
Examine the structure,
Marketing and Distribution of marketing and distribution
of Islamic funds.
Structure Islamic Investments
Funds

Private Equity Fund

• Structured as private limited companies with a few numbers
of stakeholders

• Private equities usually

- engage in non-exchange traded or illiquid investment
strategies
- embark on long-term investments in a portfolio of
growth companies  
• Applying Sharī'ah compliance audit to boost the confidence
of the investors in private equities
 Learning Objective 6.3

Structure Islamic Investments Examine the structure,

marketing and distribution

Funds of Islamic funds.

 Islamic Venture Capital Fund

• The term “venture capital”
- defined as the money and resources made available to
promising startup firms and small businesses
- encompasses managerial and technical expertise 
• Venture capital fund
- is not traded on exchanges but engages in long term
investments
- is structured as an open-end fund
• Venture capital investments may take place at any or a
combination of different stages
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

 Islamic Venture Investments

• Venture capital investments may take place at any or a
combination of the following stages:

- Seed-stage financing
- Early-stage financing
- Formative-stage financing
- Later-stage financing
- Expansion-stage financing
- Balanced-stage financing
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Liquidating the Investment

Venture capitalists liquidate their investment through any of
the following procedures:

• Initial public offering (IPO)

• Company buyback
• Trade sale
• Write-off
• Secondary sale
• Reorganization of investee company
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

The Structure of Islamic Venture Capital Fund

• Is based on a contractual arrangement between the fund

manager and the institutional and individual investors

• Individual and institutional investors are the passive

investors and would act as the “limited partners”

• Private equity experts are considered as the “general

partners”; they undertake the management responsibility
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

The Structure of Islamic Venture Capital Fund

• Analyzing the feasibility of possible ventures include:

- Islamic venture fund performs Sharī'ah-compliance

screening

- Islamic venture fund conducts project feasibility

analysis similar to the conventional venture capital fund
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

• Analyzing the feasibility of possible ventures include:

- Islamic venture fund performs Sharī'ah-compliance
screening
- Islamic venture fund conducts project feasibility
analysis similar to the conventional venture capital fund
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Raising Funds for Islamic Venture Capital

The Islamic venture capital fund draws its funds from a wide
range of investors including:
• Sharī'ah-compliant institutions such as:
- Islamic banks and financial institutions
- Takaful companies
- Individual investors who prefer the Islamic finance
products

• Mudarabah contract
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Real Estate Investment Trusts (REITs)

• The Real Estate Investment Trusts (REITs) structured as
limited companies and are often listed in stock exchanges

• REITs that are not listed or that are traded over-the-counter

are known as Private REITs
• Islamic Equity REITs basically replicates a fund structure that
is similar to the Ijara fund

• While Ijara Funds may have fixed maturity, the maturity of

Islamic Equity REITs Funds may be long or ongoing
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Three Categories of REITs

1. Lending or financing activities in the real estate sector

2. Managing own real estate

3. Both financing others' and managing own real estate

REITs are structured in such a way that allows the investors to

replicate their target exposure for stock and real estate in a
single contract
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Three Categories of Conventional REITs

1. Equity REITs:
- acquires and develops its properties primarily to
operate them as part of its own portfolio
- engages in a wide range of real estate activities such as
leasing, real property and tenant services

2. Mortgage REITs:
Extends credit facilities to real estate owners and operators

3. Hybrid REITs:
A combination of the above two categories where the REIT
acquires and develops properties and at the same time
lends money to real estate owners and operators
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Special Asset Classes

• Islamic Hedge Funds

• Funds of Funds
• Mixed Funds
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Islamic Hedge Funds

Hedge funds are often set up as private investment
partnerships open to a limited investors and requiring
large initial minimum investments

• Investments in hedge funds are illiquid

• Hedge funds are acceptable in the Islamic investment sector

if they are free from all forbidden elements

• While some Sharī'ah scholars believe in the possibility of

having Islamic hedge funds, others argue otherwise due to
the speculative elements embedded in such portfolios
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Fund of Funds
• Instead of creating its own portfolio, fund of funds applies a
passive investment strategy where the investing fund
invests in another fund with a different investment objective
to diversify its exposure

• The conception of fund of funds may be a less efficient

technique for Islamic funds due to the number of Islamic
funds as well as the higher commissions and fees involved
 Learning Objective 6.3
Examine the structure,
Marketing and Distribution of marketing and distribution
of Islamic funds.
Structure Islamic Investments
Funds
Mixed Funds

• Invest in a pool of different assets

• For Islamic funds, mixed funds require investment in both

equity and debt instruments like equities, leases,
commodities etc.

• Islamic funds have preferred mixed funds investment style

(during the declining global markets of 2001/2002) to
protect their capital
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Distribution and Marketing of Islamic Funds

• Islamic funds as an industry is:
- still in its infancy stage
- going through a transitional phase in terms of
functional structure, marketing and distribution systems

• The interrelationship between the Islamic investment funds

and Islamic banks can partially be explained:
- Islamic banks have preceded other Islamic financial
institutions
- Islamic banks were the pioneers for the Islamic investors’
demand for Sharī'ah-compliant alternatives to conventional
investment funds
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Common Business strategies of Islamic Investment

Funds

• Joint Venture
• Strategic Alliances
• Franchising
• Outsourcing

 
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds
Joint Ventures
Islamic investment funds may enter into joint venture
agreements with other Islamic banks or conventional banks
to:
- get higher market exposure and increase the investor
network at a lower cost

- create newer exposure

to prospective investors
in other geographical
locations
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Franchising

• Islamic investment funds may engage in franchising to

promote their products in different markets

• Franchising is preferred between Islamic funds and other

Islamic financial institutions

• The Islamic fund should make sure that the buying financial
institution complies with the requirements of the Sharī'ah

• Like a joint venture, an Islamic fund may seek investors

beyond national boundaries
 Learning Objective 6.3
Examine the structure,
Structure Islamic Investments marketing and distribution
of Islamic funds.
Funds

Challenges in Marketing and Distribution of Islamic Funds

• Lack of liquidity

• Inadequacy in the number of Sharī'ah-compliant investment

funds and investable securities

• Segmented Islamic financial markets

• Lack of appropriate management skills and difficulties in

outsourcing of such skills

• Lack of awareness of Islamic investment process entails

assuming additional responsibility to create an educated
investor base (to ensure customer loyalty)
 Learning Objective 6.4
Comprehend Sharī'ah
Sharī'ah Governance of Islamic governance for Islamic
funds and the importance
Funds of Islamic fund
management

The Sharī'ah governance framework oversees that

every aspect of the investment products, services and
contracts is compliant with the fundamentals of the
Sharī'ah.
 Learning Objective 6.4
Comprehend Sharī'ah
Sharī'ah Governance of Islamic governance for Islamic
funds and the importance
Funds of Islamic fund
management

The Modern Practice of Islamic Wealth Management –

Three Alternatives

To adopt the practice in the wider Islamic finance industry .1

where standing Sharī'ah Boards are established

To employ the services of Sharī'ah consulting firms .2

To employ the services of independent Sharī'ah scholars on .3

an ad hoc basis to review their investment processes,
services, and contracts to ensure a full compliance with the
requirements of the Sharī'ah
 
 Learning Objective 6.4
Comprehend Sharī'ah
Governance of Shar framework governance for Islamic
funds and the importance
of Islamic fund
management

Composition of the Sharī'ah Supervisory Board

•Islamic funds include members from different demographics
•Whether an institution has a minimum of three members for
the Sharī'ah supervisory board (as per the requirements of
AAOIFI) or a single supervisor is its own choice
•The composition of the Sharī'ah board should be included in
the charter of the fund
•The members of the board should possess:
- Strong academic and professional background in
Islamic jurisprudence
- Understanding of the financial transaction and
financial system
 Learning Objective 6.4
Comprehend Sharī'ah
Sharī'ah Governance of Islamic governance for Islamic
funds and the importance
Funds of Islamic fund
management

Functions of the Sharī'ah Supervisory Board

:The responsibilities of the Sharī'ah board include

• monitoring the fund’s compliance with the Sharī'ah

• overseeing the fund’s portfolio purification
• reporting on the compliance status of the fund
• assisting the fund management
• advising on zakat (charity) and identifying the
procedures for its distribution
 Learning Objective 6.4
Comprehend Sharī'ah
Sharī'ah Governance of Islamic governance for Islamic
funds and the importance
Funds of Islamic fund
management

Independence of Sharī'ah Committee & Islamic Fund

Infrastructure

•Theindependence of the Sharī'ah supervisory from the

management’s influence is more likely to:
- impart better supervision
- boost the confidence of the investors
- ensure the best functionality of the Sharī'ah
governance organ

•Any prospective new product should be cross-checked for

Sharī'ah compliance in the first place by the Sharī'ah board
 Learning Objective 6.4
Comprehend Sharī'ah
Sharī'ah Governance of Islamic governance for Islamic
funds and the importance
Funds of Islamic fund
management

Compensation and Monitoring Fees

•Compensation and monitoring fees for the Sharī'ah board
members is based on professional expertise and academic
qualifications
•Transparency and consistency in the compensation system to
avoid conflict of interest
•TheSharī'ah board members may be compensated in the
same manner as the Board of Directors on the basis of:
- monthly remuneration
- additional payment for meetings
- out-of-pocket expenses
- special allowance
 Learning Objective 6.4
Comprehend Sharī'ah
Sharī'ah Governance of Islamic governance for Islamic
funds and the importance
Funds of Islamic fund
management

Compensation and Monitoring Fees

•Compensation and monitoring fees for the Sharī'ah board
members is based on professional expertise and academic
qualifications
•Transparency and consistency in the compensation system to
avoid conflict of interest
•TheSharī'ah board members may be compensated in the
same manner as the Board of Directors on the basis of:
- monthly remuneration
- additional payment for meetings
- out-of-pocket expenses
- special allowance
 Learning Objective 6.4
Comprehend Sharī'ah
Sharī'ah Governance of Islamic governance for Islamic
funds and the importance
Funds of Islamic fund
management

Disclosure Issues

•Better disclosure practices for all the investment funds

•The disclosure of Sharī'ah compliance information

•In addition to the annual Sharī'ah-compliance reports issued

by the boards, Islamic investors might need to prepare
additional Sharī'ah-compliance reports on a regular basis
 Learning Objective 6.5
Learn the meaning and importance
Risk Management for Islamic of risk management issues in
Islamic funds, including risk-reward
Investment Funds profile, with specific analysis of the
risk-reward profile of the major
Islamic finance products

• Islamic fund managers replicate some of the basic risk

management strategies found in ‘normal’ investment funds

• There are additional risk management issues associated

with the uniqueness of Islamic funds and their products

• Islamic fund managers consider the limitations of Islamic

investments while forming risk management strategies:
- the lack of investable securities
- lack of liquidity
- lack of Sharī'ah compliant derivatives
 Learning Objective 6.5
Learn the meaning and importance
Risk Management for Islamic of risk management issues in
Islamic funds, including risk-reward
Investment Funds profile, with specific analysis of the
risk-reward profile of the major
Islamic finance products

Risk-Reward Profiles of Islamic Investment Products

•Risk-reward theory is a cornerstone of investment philosophy
•Risk reward profile - a chart of the maximum profit or loss a
particular investment can have in the portfolios of investors
•Ratioused by investors to compare expected return on
investment to the amount of risk undertaken to realize return
•The funds managers are in the best position to adequately
extend professional advice to clients on risk-reward profiles of
available investment products
 Learning Objective 6.5
Learn the meaning and importance
Risk Management for Islamic of risk management issues in
Islamic funds, including risk-reward
Investment Funds profile, with specific analysis of the
risk-reward profile of the major
Islamic finance products

How to Calculate Risk-Reward Profile

•Potential investors identify suitable finance products based on
the chart
•Ratiocalculated by dividing the amount of profit the investor
expects to make (i.e. reward) after the close of position by the
amount such investor stands to lose if loss is recorded in such
investment (i.e. the risk)
Reward $
------------- Risk-reward Profile Ratio
Risk $

Prospective investors must always aim at a ratio 1:2 risk-

reward profiles
 Learning Objective 6.5
Learn the meaning and importance
Risk Management for Islamic of risk management issues in
Islamic funds, including risk-reward
Investment Funds profile, with specific analysis of the
risk-reward profile of the major
Islamic finance products

The risk-reward profile of stock ownership is represented in

the graph below

 The graph indicates that:

 a profit that is being expected to be gained does not have a maximum limit;
it can continue to rise to infinity
loss is limited to 0 (one's entire investment)
 Learning Objective 6.5
Learn the meaning and importance
Risk Management for Islamic of risk management issues in
Islamic funds, including risk-reward
Investment Funds profile, with specific analysis of the
risk-reward profile of the major
Islamic finance products

Risk-Reward Profiles of Islamic Investment Products

•Themost common financial instruments used in Sharī'ah-
compliant investment funds are musharakah, mudarabah,
murabahah, and ijarah

•Knowledge of the risk-reward profile of each of these

instruments will guide potential investors in identifying a
better product for investing

•The fund managers must guide potential investors on the best

product according to the prevailing market indices
 Learning Objective 6.5
Learn the meaning and importance
Risk Management for Islamic of risk management issues in
Islamic funds, including risk-reward
Investment Funds profile, with specific analysis of the
risk-reward profile of the major
Islamic finance products

Risk Management Strategies for Islamic Funds

Market Risk Management )1
• Market risk for investment funds arises from price volatility of
the securities under investment
• Islamic fund managers adopt two main strategies to manage
market risks:
a) Portfolio diversification, and b) Portfolio protection
a) Portfolio Diversification
Islamic fund managers engage in portfolio diversification
as a
strategy to minimize their risk exposure
 Learning Objective 6.5
Learn the meaning and importance
Risk Management for Islamic of risk management issues in
Islamic funds, including risk-reward
Investment Funds profile, with specific analysis of the
risk-reward profile of the major
Islamic finance products

Challenges for Islamic fund managers

•They need to diversify their portfolios within a limited range of Sharī'ah
compliant asset classes
•The Islamic market may be more volatile compared to conventional markets
b) Portfolio protection
Fund managers engage in the following strategies in order to minimize their
risk exposures
- SWAPs
- Options (Call and Put Options)
- Futures Forwards

- Other investment
strategies
 Learning Objective 6.5
Learn the meaning and importance
Risk Management for Islamic of risk management issues in
Islamic funds, including risk-reward
Investment Funds profile, with specific analysis of the
risk-reward profile of the major
Islamic finance products

Risk Management Strategies for Islamic Funds

 Liquidity Risk Management )2

•Most of the investors prefer investment in more liquid assets
•Despite surplus of liquidity in the Islamic fund market, there
is low return rate on liquid assets managed by Islamic financial
institutions
•One important liquidity issue that Islamic fund managers face
is the investment exit strategy
 Learning Objective 6.5
Learn the meaning and importance
Risk Management for Islamic of risk management issues in
Islamic funds, including risk-reward
Investment Funds profile, with specific analysis of the
risk-reward profile of the major
Islamic finance products

• As there is no secondary market in a conventional sense,

fund managers may have to depend on:
- sponsor principal
- nominated liquidity agent
- asset management company
• Islamic fund managers are wary of balance sheet
mismatches and exposures to assets that cannot be sold
easily
• Fund managers should be prepared for higher cash out-flow
possibilities during the downward markets when individual
investors may wish to liquidate their position
 Learning Objective 6.5
Learn the meaning and importance
Risk Management for Islamic of risk management issues in
Islamic funds, including risk-reward
Investment Funds profile, with specific analysis of the
risk-reward profile of the major
Islamic finance products

Managing Liquidity Crunches

•Fund managers may cautiously enter into agreements with
other financial institutions or other liquidity provider

•As an immediate measure, fund managers may leave some of

the short-term cash balances in interest-free current accounts
Key Terms and Concepts

• Arbun • Hedge funds

• Economies of scale • Ijarah fund
• Ethical investing • Interest-bearing (riba)
• Exchange-traded • Investable securities
derivatives
• Islamic debt funds
• Fiduciary relationship
• Legitimate investment
• Firm-specific risk
• Leverage
• Fund managers
• Liquidity
• Gharar
• Maysir
• Halal industry
• Nisab
Key Terms and Concepts

• OTC derivatives • Screen

• Portfolio diversification • Stock exchange
• Portfolio protection • Stock market index
• Portfolios • Takaful
• Private equities • Venture capital
• Pro-rata profits • Waqf
• Real estate investment • Zakat
trust (REIT)
• Risk-reward profile
• Sadaqah