The risks and rewards from the explosive growth in Sharia finance

BOOMING Middle Eastern economies and increasing affluence across the Islamic world are fuelling rapid growth in the $1 trillion (£502bn, E677bn) market in Sharia finance.

However, hedge funds can replicate short-selling without falling foul of the ban on paying interest. For example, an investor who owns, say, 10,000 shares of a company when its price is 100p per share can enter a contract with a counterparty to deliver those shares in six months’ time at 99p per share – a payment of £9,900. If, when the six months have elapsed, the share price has fallen to 97p a share, the investor earns a £200 profit. Sharia investors can only make such contracts in assets that are not linked to credit payments.

Other than that, however, the Sharia-compliant investor has achieved broadly the same result as a conventional short-seller; critics would argue there is no real difference between traditional shorting and its Sharia equivalent.

Among the long-only Sharia investment funds is the HSBC Amanah Global Equity Index. This fund tracks the Dow Jones Islamic Market Titans 100 Index of equities. Registered in Luxembourg, the fund is open to investors making a minimum investment of $5,000.

There are now also exchange-traded funds (ETFs), which track Sharia-compliant stock indices, such as the London-listed iShares MSCI World Islamic ETF, which was launched on 11 December last year and tracks the Morgan Stanley Capital International World Islamic Index. (Holders of ETFs do not have to own the underlying components of an index because they merely buy the funds’ shares.)

In its brief life, the ETF has made returns of -9.462%, which is at least not as bad as the -12.4% returns of the MSCI World Index of developed countries’ equities.

But this performance gap is largely down to luck. Sharia-compliant investors avoided the sharp losses suffered by credit crunch casualties like Citi, the American bank, and were not in mortgage-backed securities, so have not felt the sub-prime woes others have. As a result of their ban on holding banks, Islamic funds are also biased towards materials, infrastructure and energy sectors, which have done well on the back of the current commodity bull market.

Looking back over a longer period before the credit crisis erupted, conventional investing beats its Islamic alternative: the Dow Jones Islamic Market World Large-Cap Index has made returns of 80.2% since May 2003; the DJ World Stock Index has achieved returns of 117.7%.

Although growth has been rapid, Islamic finance in relation to modern capital markets is still relatively new and untested by a major financial crisis. It is also unclear how different some elements of it are from mainstream finance – in many cases, it seems that clever bankers have been able to redefine what in practice is hardly any different from interest.

Issuers of sharia products typically appoint scholars to vet and then issue rulings confirming that a product is compliant; there is no single body that does this and currently no single regulatory standard.

A major risk for the Sharia finance industry is that top religious figures could soon decide that much of it in fact contradicts Islamic teachings. Any products or providers that were to fall foul of such a ruling would suffer a guaranteed exodus of investors.