The State of Islamic Asset Management and a Prescription for Change

By: John A. Sandwick and Thom Polson

Nearly all activities labeled today as “Islamic asset management” or “Islamic wealth management” are not at all related to their conventional cousins. They consist of simply creating products with fatwa, throwing them into the market, and seeing what sticks. It is random, undisciplined, and has nothing to do with the professional practice we call asset management.

The theory assumes investors are not seeking to improve their chances of achieving long-term savings objectives through disciplined investing. The theory assumes Muslim investors are not interested in planning and executing an investment savings program based on modern, global investment practices, instead assembling a hodge-podge of investments in a haphazard fashion.

The same bankers who practice “throw it and see what sticks” asset management don’t cross-connect the facts that these same investors may have advanced university degrees, communicate in many languages, or run complex businesses. It assumes Muslims care deeply about Islam in all aspects of their lives, except when it comes to their investments. This theory also conveniently explains the current state of affairs in nearly all banks and investment companies that serve Muslim wealth holders.

The “throw it and see what sticks” school of asset management seems to be alive and well in some private banking and asset management departments of both western and Arab regional banks. Many bankers have told these authors:

• Our Muslim clients don’t want Islamic investing
• Our bank tried one Islamic equity fund and because it didn’t sell we know Muslims don’t want Islamic investing
• Our bank won’t go into an area of investing we don’t understand
• In our experience it won’t work
• Our capital-guaranteed [derivative-based] structured products sell so well we don’t want to change the product mix for Muslims
• We’re afraid to sell Islamic asset management to existing Muslim clients

These excuses are surprising as the basic genetic coding of Muslims is presumably identical to the rest of the world’s population. Universal human values, including the need to organize and execute savings plans, should be the same for Muslims as they are for anyone else. These same banks offer everyone else (Brazilian ranchers, Italian industrialists, Australian artists, California pension funds, etc.) wealth and asset management services derived from a disciplined, professional and well-established process. In those markets most banks approach potential clients with a very specific service offering: “We will manage your assets according to the principles of Modern Portfolio Theory, matching your investment profile with an investment strategy and a pool of carefully diversified investment products that will have a high chance of achieving your investment objectives.” Seemingly this is the global standard, but not for Muslim investors who seek Shari’ah-compliant investing.

Foundations of Asset Management
The Modern Portfolio Theory forms the bedrock of asset management everywhere, and should by any measure form the bedrock of Islamic asset management. This was first conceptualized in 2009, showing how first an asset manager examines a particular client’s profile deriving from that a roadmap for investing. The client profile quantitatively and qualitatively describes the client’s investment objectives by indicating risk and reward preferences, defining end-term investment objectives, and shows current and future assets and liabilities.

From the client profile one can choose an investment strategy that has a certain probability of achieving the client’s investment goals. There are only three kinds of strategies: Income, Balanced and Growth, indicating low-, medium- and higher-risk investing styles. All other strategies are derived from these.

An investment strategy is then matched with an asset allocation model, where there are only four categories of assets: Cash (money market), Fixed Income, Equities and Alternative Investments. These categories are themselves reflective of risk, where Cash and Fixed Income are relatively less risky, and Equities and Alternative Investments inherently more risky.

Asset allocation models are critically important as numerous attribution analysis studies have shown repeatedly that investment success or failure normally evolves from the macro decisions made by the asset manager, not micro decisions. Macro in this sense means not whether to buy Nokia or Motorola, and not whether to buy on a Monday and sell on a Friday. Security selection and investment timing have been shown to be almost insignificant to investment performance.

Instead, the larger decisions on whether to move portions of a portfolio toward Cash and Fixed Income, and away from more risky investments like Equities, can have the single greatest impact on investment performance. Likewise choosing whether to invest in telecommunications equities versus natural resource equities can have a much greater impact on investment performance than time and effort spent on which equities to invest in the respective categories.

Typically the three investment strategies invested in the four asset categories come up with allocations as shown in the following table:

We illustrate the risk-reward ratio and its meaning for portfolio investment strategy selection as follows:

As an indication of what this means in the real world, take a look at contemporary Balanced allocations made by well-respected names in the asset management industry:

Foundations of Islamic Asset Management

Modern Portfolio Theory is known to underpin all professional asset management everywhere except for Muslim clients seeking Shari’ah-compliant investing. In the above-referenced work the principal author showed that there is essentially no difference between conventional asset management and Islamic asset management—whether the client is an individual or an institution—except in security selection. The common, universal steps of the professional practice we call asset management are: 1) client profiling, 2) investment strategy selection, 3) asset allocation, 4) security selection, and 5) investment monitoring and rebalancing. Only at Step 4, security selection, does Islam enter the equation. All other steps are identical for all clients, regardless of faith. Even security selection is nearly identical, the only difference being the selection of high-quality, qualifying assets that have an acceptable degree of Shari’ah compliance.

Fortunately, the Islamic banking community has delivered what we believe is a minimum number of mutual-fund securities that are in fact fully Shari’ah-compliant and represented in all four asset categories. Each asset category has a Shari’ah equivalent: Murabaha or trade finance funds for Cash, sukuk or trade finance funds for Fixed Income, Shari’ah-compliant shares for Equities, and numerous “other” securities such as real estate funds or commodity funds for Alternative Investments.

The Shari’ah-Compliant Funds Universe
These authors believe that Muslim investors are identical to people of all faiths in their need for planned, disciplined savings.

We decided to examine security selection, the only element of the common rules of professional asset management that requires adaptation to Shari’ah. To do this we focused on the universe of Shari’ah-compliant assets to determine just how many investment funds met global standards. The question was: Can an asset manager assemble a professional portfolio of Shari’ah-compliant assets that will meet international asset management standards yet at the same time satisfy the spiritual component of a client’s investment objectives?

No asset management of any kind can be done without data tools. These data tools are found in abundance in the conventional world of asset management. They include Bloomberg, Reuters, Morningstar, IdealRatings, Eurekahedge and many others. In fact, each of these mentioned services have Islamic components, databases that presumably fill the needs of professional investors for information on securities available in the Islamic asset universe.

Unfortunately, on more careful examination it was found that none of these services meet professional standards for asset managers seeking to fulfill the majority of Islamic investment mandates. All of them have incomplete listings of the available universe of Shari’ah-compliant securities mostly suited for the average investor, and even most wealthy investors.

Importantly this is so because the large majority of investing is done on a funds-of-funds basis. That means most allocations are made from an assembly of funds, where each asset category in every investment strategy is populated with funds, not individual securities like stocks or bonds. When witnessing actual allocations in the Swiss private banking industry, for example, there are almost no cases of “smaller” (tens of $millions) accounts being invested directly into individual securities such as stocks or bonds.

While the threshold of “small” will vary from bank to bank, or manager to manager, the concept is the same: 1) managers cannot dedicate cost-effective individualized investing to every client account, and even less so for smaller accounts, 2) most investment failure or success is not based on individual security selections but on broader investment decisions that can be achieved with funds-of-funds allocations, and 3) resources at all asset management units—whether in banks or investment companies—are limited, so that no manager can be said to be professionally competent in all asset markets all the time, therefore stimulating the need for managers of specialized funds.

Funds-of-funds allocations predominate in the asset management universe. Even very large multi-billion dollar pension funds and endowments utilize funds for much of their allocations. Very few very large investors, in fact, will buy straight securities for all of their allocations. With over 3 million investible securities worldwide it is no wonder that mutual funds dominate the asset management allocation process.

As of the end of 2009 there were somewhere around 65,000 mutual funds worldwide according to the Investment Company Institute Factbook. These funds manage collectively around $23 trillion in assets, one of the largest pools of managed money anywhere. A very large number of these funds are identified by the major data sources (e.g., Bloomberg, Reuters), with substantial data on each fund’s history, volume, domiciliation, liquidity terms, and much more.

But what of the Islamic mutual fund space? The Shari’ah-compliant universe consists of a trifling 830 mutual funds and ETFs and about $82 billion in assets under management. The Islamic funds universe is indeed very small; with Shari’ah-compliant funds numbering only 1.3% of their conventional cousins, and only 0.36% in assets under management compared to the global funds universe.

And, a majority of Islamic funds is not available to professional investors simply because they don’t meet professional standards. Typical screening and filtering—based on track record, domiciliation, liquidity and assets under management—reduces that number to substantially less. Adding a Shari’ah filter, where funds without acceptable Shari’ah compliance are eliminated, brings the total number of professionally acceptable Islamic funds to 99, comprising around $30 billion in total assets.

One should then ask: Can we achieve professional investment management for clients seeking Shari’ah-compliant investing? The short answer is yes, of course we can. In fact, one could conclude we have a professional responsibility to meet our client demands for professionalism, global standards and Shari’ah compliance.

Initial Results, the First-ever Islamic Portfolios
The principal author began his own work in assembling a database of Shari’ah-compliant funds in late 2008. The universe was smaller then, but growing fast. The net new number of mutual funds in 2007, for example, was over 160. In January 2009 this author prepared what are believed to be the first-ever asset allocation models comprising entirely of Shari’ah-compliant assets. The authors described this process in great detail in late 2010, thus perhaps pioneering the field of what is called Islamic wealth and asset management.

The initial allocation was made using a standard balanced investment strategy, and benchmarking was quite crude. But these early results were stunning. Despite handicaps in both allocation and benchmarking, the initial results gave confidence that further refinement would show sustained outperformance of Islamic allocations.

These initial results showed an Islamic allocation had nearly 24 percentage point positive variance above a conventional benchmark. By any measure and for any asset manager these results are significant to an extraordinary degree. The fact that further enhancing the allocation and benchmarks resulted in continued positive variance (see below) confirms the validity of the initial assumptions.

Further, this performance was achieved during remarkable economic times. The time scale from January 2006 through December 2008 included one of the largest run ups in asset pricing in modern history. Then, markets crashed worldwide and asset valuations tumbled in some cases as much as 90% or more. Asset deflation was not over by the end of 2008, either, despite the upturn in global markets by December of that year.

The initial allocation, therefore, straddled the manic bubble and the equally manic collapse, yet still maintained sizeable outperformance, reflecting a superior style of investing in both strong and weak market conditions.

These initial results were derived from the following allocation:

The above allocation was reasonably diversified, including investing in all four asset categories. It was also generally aligned with the Balanced investment strategy portfolios produced at the time by major global asset managers. Unfortunately, it was determined the initial allocations were weak in some of the key criteria used to filter and sort qualifying investment funds, as well as diversification weakness (concentration risk). One weakness was the use of a proxy for Fixed Income during the majority of the time period results were measured. Another was the overweighting of global and Arab emerging market equities.

Further, there was no real effort to properly benchmark the results. The above benchmark is composed of 1) a 50% weighting from the Dow Jones U.S. corporate 5-year investment grade bond index, 2) a 35% weighting from the S&P 500, and 3) a 15% weighting from the NASDAQ 100.

The primary author thought at the time (January 2009) that these weightings were sufficient for a comparative benchmark simply because the price volatility of the components were guessed to be roughly equal to the volatility experienced by what would have been a more accurate benchmark, if one had been constructed.

Moreover, it was thought at that time the results were so clearly superior that the underlying premise—Islamic asset management could be proven equal or even superior to conventional investing—would survive even more sophisticated portfolio modeling and benchmarking.

And, they did.

Subsequent Testing & Retesting of the Islamic Allocation Model
These authors began working on a new set of portfolio allocation models beginning in the autumn of 2009, first creating an updated global database of Shari’ah-compliant assets and then sorting and filtering them using the same conventional techniques (plus, of course, adding the Shari’ah compliance filter).

Many anomalies appeared during the process of identifying the 830 mutual funds and exchange-traded funds that were discovered.

Our search involved naming any investible security that had both the nomenclature “fund” and “Islamic” on it. One would think this would be straightforward, but it is not always so. For one, hundreds of investment products were created since around 2002 by the dozens of newly created “Islamic” banks in the Arabian Gulf region. A good deal were just very high risk real estate development funds (e.g., nearly all products from Gulf Finance House), which we categorized as pure private equity. Others were not so obvious.

One well-known bank in the Gulf region, for example, refused to disclose any information at all on their funds—both Shari’ah compliant and conventional—saying such information was given to customers only. This is at direct odds with the industry practice of listing all funds on the Internet and providing regular, transparent disclosure of those funds for interested investors of any kind. For this bank we were forced to simply delete all their Shari’ah-compliant funds from our database.

We found many funds that were mislabeled, knowingly or not, which caused us considerable confusion and presumably caused the same confusion among investors. We were delighted to find one particular Sukuk fund because of the relative paucity of fixed-income funds in the Islamic space. But, further investigation disclosed the real nature of the fund, again very high-risk real estate speculation that had nothing to do with the commonly referred to concept of Sukuk.

But, we considered the risks associated with these funds and determined that indeed the 99 funds and $30 billion in assets met our minimum requirements for assembling Shari’ah-compliant portfolios. We also recognize that risk is sometimes immeasurable, or at least difficult to measure. What, for example, is the additional risk of a fund with only $90 million of assets under management if your investment criteria prohibit funds with less than $100 million? And, what is the additional risk if one buys a fund with only a 3-year track record versus the often-cited minimum 5-year track record? These authors still have not met an asset management risk officer who can answer these questions.

Results of More Highly Refined Portfolio Modeling
We begin here showing the results of our latest modeling, including much more sophisticated asset selection, allocation measurements and security selection displayed as follows:

In the above performance chart we show the results of our more highly refined Islamic allocation for a typical Balanced investment strategy. Then we add the results from commonly available conventional mutual funds from major global investment firms, all with highly similar investment strategies, i.e., Balanced. This performance analysis differs from our previous measurements in two major ways. First, of course, we have changed the composition of the allocation using different funds. Second, it uses real-world comparisons as benchmarks. The new Islamic portfolio is allocated as follows:

We would like to point out that this new, more sophisticated Islamic allocation is purely unmanaged, unlike the referenced benchmarks from BlackRock, Credit Suisse and Julius Baer. But it is still highly illustrative that a credible portfolio comprising world-class Shari’ah-compliant funds still outperforms the nearest competition available from the conventional asset management universe.

While we are not maintaining a 24 percentage point outperformance, we can see that our Shari’ah-compliant portfolio was in negative territory for only 12 of the 36 months under observation, while the conventional portfolios were underwater for almost all of the 36 months. Not until the market rally of December 2010 did two of the three conventional funds turn positive. During two thirds of the measured time period Islamic investing had a double-digit percentage outperformance over conventional investing.

The outperformance margin between Islamic and conventional investing varied over time, but it varied mostly in the 8 to 12 percentage point range, at one time as high as 18 percentage points and in the last half of 2010 averaging close to 10 percentage points.

In the real world of investing, this kind of outperformance is considered an amazing achievement. It’s what delivers tens of billions of new investment dollars to star hedge fund managers.
We have constructed like-for-like portfolio allocations in USD-referenced Balanced investment strategies using investment products that meet global standards for liquidity, size, transparency and corporate governance, as well as Shari’ah compliance. In the above table we’ve used the global USD-referenced Balanced mutual funds as comparisons. It’s obvious there is an extremely high degree of correlation among all three of the funds. This correlation illustrates perfectly that there is indeed a global standard for Balanced investing, and that asset managers everywhere consider the common mixture of money market, fixed income, equity and alternative investments to be the gold standard for globally diversified portfolios. But, what about their benchmarks?

Each of the funds we’ve tested—the Balanced products from BlackRock, Credit Suisse and Julius Baer—all display their own benchmarks as references. Their benchmarks are established to give some guidance as to the success or failure of the respective managers in achieving their stated investment objectives.

We’ve taken those benchmarks and compared them to our Islamic allocation during the same period. As one could guess the results are nearly the same:

What we find fascinating about this chart is again the very high correlation among the BlackRock, Credit Suisse and Julius Baer benchmarks, those benchmarks they construct to compare their own allocation performance. And, of course, in our claimed like-for-like investing methodology our Islamic allocations again beat conventional allocations over time.

We have added our first, crude benchmark to this chart to illustrate that our initial assumption—that our modeling Shari’ah-compliant portfolios could withstand higher levels of sophistication in asset allocation and benchmarking—was indeed correct.

Critique and Conclusion

We can observe Islamic portfolios appearing to consistently outperform conventional portfolios during highly stressed downward market conditions. Equally, the same Islamic portfolios seem to enjoy performance equal to similar conventional portfolios during upward-moving markets.

But further testing and analysis is required to show why. Attribution analysis may help us understand more of the reasons for the outperformance of Islamic investing. It is of course largely due to the fact Islamic investing avoids inherently risky assets such as highly leveraged financing institutions and companies.

About the authors
John Sandwick is the founder of Islamic Wealth & Asset Management, the world’s only dedicated professional service for Shari’ah-compliant investors. He has been a private banker in Geneva, Switzerland, since 1993, and an independent investment and banking professional since 1989. A pioneer in Islamic wealth management, John’s other areas of expertise are Islamic asset management, Islamic asset securitization and Islamic real estate financing. Sandwick has been called a pioneer of Islamic banking by Schweizer Bank magazine, and appeared in numerous venues worldwide.

Thom Polson is a British- and Swiss- educated American with degrees in Islamic banking, Islamic finance and international management. His work has been featured in the New York Times, Business Islamica, and Almasrafiya. Polson is currently in charge of research and portfolio development with Mr. Sandwick’s Geneva based Islamic Wealth & Asset Management consulting practice. This article was excerpted by permission from the original article written for Global Islamic Finance Report 2011