Islamic Asset Allocation - Risk and Reward
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The document discusses Islamic asset allocation and whether Islamic investment methodology provides superior risk diversification compared to conventional investing. It notes that Islamic investing excludes interest-based businesses and companies with substantial non-compliant income. This limits the investment universe but may result in more stable portfolio values with less systemic risk due to prohibitions on excessive leverage. Overall, the document examines how modern portfolio theory can still be applied to Islamic investing while acknowledging faith-based investors may not always make choices solely based on rational risk-return considerations.
Islamic Asset Allocation - Risk and Reward
- 1. 50-53 Risk and Reward_March09:Layout 1 3/7/09 2:51 PM Page 50 www.islamica-me.com • March 09 islamicinvestment Risk and Reward Islamic Asset Allocation By Ahsan Ali, CFA, FRM, MSI 50
- 2. 50-53 Risk and Reward_March09:Layout 1 3/7/09 2:51 PM Page 51 www.islamica-me.com • March 09 islamicinvestment The credit crisis has exacted its toll on the global markets, investor confidence, political will and the financial sector. In the aftermath, Shariah-compliant investments have emerged as an important alternative to purely conventional investing. The question remains: Is Islamic investment methodology superior to conventional means? And more importantly, is superior risk diversification possible using Shariah-compliant investments? Ahsan Ali is head of Wealth Management and SME Banking for Noor Islamic Bank, UAE. An avid supporter of CSR and development initiatives, he is involved in mentoring, training and program management with various public-private partnerships. He holds an MBA from the Institute of Business Administration, Karachi University, as well an MS in Financial Economics from the School of Oriental and African Studies, London. Ahsan is a CFA Charter Holder, an FRM certified risk manager and a mem- ber of the Securities and Investment Institute (SII), UK. 51
- 3. 50-53 Risk and Reward_March09:Layout 1 3/7/09 2:51 PM Page 52 www.islamica-me.com • March 09 islamicinvestment Modern Portfolio Theory (MPT) tion-based businesses and are also restricted by Under MPT, unsystematic risk can be diversi- the nature of business activites (no gambling, fied away, as investors strive to reach an “effi- pork, arms and ammunition, etc). This excludes cient frontier,” which is the best possible combi- virtually all of the banking and insurance sector, nation of risk and reward. as well as restricting companies with a substan- tial component of their income generated from interest-based earnings. Expected return/risk There are two important impacts to consider: • Crowding effect: The existence of limited stocks in the universe might result in a large amount of money chasing limited securities, with the result being an overvalued scrip. This is somewhat similar to excess money supply in a financial system causing inflation. • Commonsense investing: The exclusions effec- tively focus investments on the “real sector,” free from financial engineering gimmicks and exces- sive risk taking, as well as following a socially responsible theme. The net effect seems to be a conservative mix of equities with enough investment flows to keep the values stable to slightly inflated. Leverage The concept of leverage (gearing) has been the underlying principle of generating excess returns in areas from manufacturing to financial engineering. The concept of using somebody else’s money at a fraction of the cost of capital sounds very enticing. In an economic downturn, however, this can prove to be disastrous, as it has! Islamic investment guidelines by default do not With MPT, any rational investor will have a cer- trust leverage. Above a certain level of gearing, tain risk tolerance and will try to maximize the stocks are excluded or penalised by “cleansing” return for that level of risk. the dividend (via payment to charity). This The concept is equally applicable in Islamic ensures that fund managers keep their invest- allocation; in other words, MPT is agnostic! ments as “real” as possible in stocks that have a However, what is often overlooked is the behav- high loss-absorption capacity in an economic ioural investment angle of MPT. Simply stated, downturn. The impact of the systemic risk is far the “faith-based” Shariah investor is definitely less for the Islamic portfolio versus a conven- not agnostic. Theoretically, in a choice between tional one. a higher-return non Shariah-compliant stock A brief glance at the levels of leverage over the versus a lower-return Shariah-compliant stock last century clearly demonstrate that inordinate- (with the same risk), the choice will not be ly high levels of debt have always resulted in “rational.” This will cause behavioural aberra- less-than-desirable impacts on economies. Yet, tions for the efficiency frontier. An interesting as always, the human memory tends to be quite comparison could be between ethical investing short. impacts on MPT versus Islamic investments. Though we lack empirical evidence, I would wager that the “religious” impact would likely be more. The key question remains: In Universe of Stocks the pursuit of wealth, is there One of the key differences between Shariah- room for morals and ethics? compliant and conventional stock selection is the number of stocks available. Shariah-compli- ant stocks cannot be from interest- or specula- 52
- 4. 50-53 Risk and Reward_March09:Layout 1 3/7/09 2:51 PM Page 53 www.islamica-me.com • March 09 islamicinvestment Total Credit Market Debt / U.S. GDP (1) (1) Source: Ned Davis Research, 2008 Sukuk as Bond Equivalents On the conventional side, “Cash is king,” with a Bonds (particularly sovereign instruments) are a variety of options freely available. cornerstone of portfolio diversification for conven- tional investors. They produce a flow of stable Contentment? income with relatively safe principal and are per- A pure intangible is the relative degree of satisfac- ceived to be less risky. Sukuk over the last five years tion derived from the fact that your money is at were said to have filled this space for the Islamic worst “inflicting no harm” and at best is in line Investor. However, the Sukuk market is still quite with religious obligations. limited in terms of issues available as well as liquid- The proponents of capitalism will argue that there ity (secondary markets). is “satisfaction” to be derived from making money. Fundamentally, Sukuk differ in terms of having a Both approaches seem to have relative merit. tangible underlying asset versus what is essentially However, the Islamic side seems to win on moral a promise to pay in the case of a conventional grounds. The key question remains: In the pursuit bond. Realistically, part ownership of an asset of wealth, is there room for morals and ethics? In (such as an airport) is not saleable and effectively, this day and age, public opinion will shape the recourse on the principal and coupon payment lies response to this over the next few years. with the issuer. Certain fundamental flaws pointed out by Shariah The Best Mix scholars (especially with Waad-based structures) It is evident that the nascent Islamic asset alloca- related to Sukuk mean that the future of this tions offer some interesting options. At the same instrument has been thrown into disarray. This time, a pure Islamic portfolio lacks the instru- translates to the conventional asset methodology ments, market depth and liquidity to rival the con- being superior for bond selection due to the estab- ventional setup at this point in time. With the evo- lished market, a fair degree of liquidity and in- lution of behavioural influences (ethical, religious, depth data for rating transitions/credit perform- etc.), soft factors such as contentment and the per- ance. ception of being socially responsible will gain ground against the traditional norms of perform- Cash equivalents ance against benchmarks. Islamic banking suffers from a severe drought of Within the equities world, Islamic stocks provide a liquidity-based products. This stems from the conservative and commonsensical approach which inherent aversion to interest, which is effectively will definitely be a safer haven during recessions the construct for most liquidity products. In the last and credit downturns. three years, there have been some creative solu- However, the best mix seems to be Islamic equities, tions, primarily through the reverse murahaba and with a sprinkling of social responsibility, a dash of wakala structures which replicate deposits. There bonds and a sauce of liquidity instruments (con- have also been short-term liquidity solutions intro- ventional). It’s not surprising in this day and age duced; however, the usage of and access to these that the superior allocation mix happens to be one remains quite restrictive (especially for overnight of “religious tolerance” and harmony. and short-term liquidity). The views expressed in this article are the personal views of the author. 53