September 2011

ISLAMIC FINANCE: Would she ever buy an Islamic fund?

Lady-TeaAssets under management in Islamic funds are stalling. Pierre Weimerskirch and Farabi Zakaria, of Ernst & Young, give a Luxembourg perspective on challenges to growth, which include product ‘lookalikes’ and the ‘myth’ that Islamic finance is for Muslims only.
After years of strong growth, Islamic finance has lost its momentum. The number of funds, as well as assets under management, has remained flat over the last three years. Projects for new funds are being discussed but just a few are launched. The same situation can be observed for the listing of Sukuk. Indeed, no new Sukuk has been listed during the last 18 months on the Luxembourg Stock Exchange. Taking a look at the global picture, a similar trend can be observed. Globally, assets under management in Islamic funds remain flat:  US$52bn (e35.8bn) at 2008 figures. At the same time, the issuance of new Sukuk declined by 50% to 2006 figures. It is only recently that a sharp resurgence in new Sukuk issuances has been observed. Of course, with the financial crisis, difficulties have been experienced across wider financial markets, but since the end of the financial crisis in late 2009, Islamic finance has only slowly grown rather than bounced back to the strong pre-crisis growth rates of 15-20% per annum. Islamic finance is a budding industry. As for every young company or industry, it has to overcome some major challenges in order to progress from one growth stage to the next. Understanding and meeting these challenges is important in order to reach the next growth stage. There are a number of challenges Islamic finance faces. Under the threshold
For a start there is no global Islamic finance market. The Islamic finance market is mostly local, at best regional, with Islamic fund management also remaining a very local market. Not only is the Islamic fund industry very scattered but 70% of the Islamic fund managers are below the threshold of $80m of assets under management, which is believed to be the required break-even point. In addition, the diverse Islamic finance frameworks and practices in various countries hamper the development of a global Islamic finance market. Next, there are varying interpretations of Sharia law. Sharia law is open to interpretation and Sharia boards can have different views on certain matters. In some instances it may happen that opinions may deviate from previous decisions made by other Sharia scholars – something which happened recently for Sukuk issuances. A major catalyst for global acceptance and the growth of Islamic finance is the standardisation of Sharia law in order to avoid different interpretations and inconsistencies in rulings. In January 2011 Malaysia introduced a new Sharia governance framework for Islamic financial institutions at national level, aiming at implementing a homogeneous Islamic-based operating environment. A similar framework at international level, and publicly available documentation of Fatwa rulings, would further help in aligning and standardising the regulatory and operating framework of the industry. Lookalikes
Another issue is around product authenticity. Most Islamic products seem to be a copy of conventional products adapted to the Sharia framework. This adaptation comes with some costs, which puts Islamic products at a cost and often at a performance disadvantage compared to their conventional lookalikes. The Islamic finance industry has to have genuine products that inherently meet the standards and requirements of Sharia. There is also a lack of adoption of Islamic products by certain types of customers. Ernst & Young estimates in its Islamic Funds and Investment Report (IFIR) 2010 that the propensity to invest in Sharia-compliant products or assets ranges between 20% and 25% for high-net-worth individuals and only 5% and 10% for sovereign wealth funds (SWF) from the Middle East. However, these investors hold a substantial amount of wealth which is held mostly in conventional products today. The lack of specific Islamic products or investment opportunities, or overly high Sharia structuring costs, could be reasons for this lack of adoption. As there is a strong link between Islamic finance and social, responsible (ethical) investments (SRI), putting Islamic finance into this area could potentially increase the adoption of Islamic products by other types of investors. A further issue is that Islamic banks have outgrown Islamic asset management companies. In Malaysia and the Middle East, the development for Islamic finance is mainly centred on the development of Sharia-compliant banks. As a result, this leads to a lack of product diversifications for investors who are keen to diversify their investment portfolio. The 2010 Ernst & Young IFIR estimates that only 5.5% of the Sharia-sensitive assets invest in Sharia-compliant funds as investors mainly deposit their money with banks. There is also a lack of awareness among investors that the Islamic finance industry has to cope with. The number one myth among non-Muslim investors is that Islamic finance is only for Muslim investors. Islamic finance is not a Muslim-only affair. Due to the way Islamic finance promotes its products and services, with the primary emphasis on Sharia compliance, it gives the impression to non-Muslims that Islamic finance is mainly for Muslim investors. Only Khazanah Nasional Berhad, the investment arm for Malaysia and, effectively, the country’s major SWF, solely focuses on Sharia-compliant investments, highlighting the impression that Islamic finance is only for Muslim investors. Other SWFs view Sharia-compliant investments as alternative investments.  Conflict with local laws
Regulatory hurdles also exist. It is interesting to note that Sharia is often in conflict with local laws in various jurisdictions in the Middle East when it comes to the design of Islamic products. Rules and regulations have initially been laid out for conventional products. The launch of Islamic products thus renders necessary a review of local laws and regulations as well as a new way of thinking for central bankers and regulators. Luxembourg can be of assistance to Islamic finance in a number of ways, laying the foundations to reach the next growth stage. Luxembourg can, for example, help to create a critical mass for Islamic products in Europe and beyond by acting as a global hub, and permitting Islamic financial institutions to leverage on the expertise of the financial centre with regard to cross-border distribution and clearing, and settlement of financial products. Furthermore, Luxembourg could reconsider issuing a sovereign Euro Sukuk to provide a missing benchmark to the Islamic debt market. At the same time this would strengthen Luxembourg’s position as a centre for Islamic finance. The potential for Islamic finance is huge; the Sharia-sensitive wealth pool is estimated at $360-$480bn. In the end, however, the fundamental driver for Islamic finance must come from Muslim countries. • Pierre Weimerskirch is a partner and Farabi Zakaria is a senior manager at Ernst & Young, Luxembourg ©2011 funds europe

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