islamic finance report
Islamic hedge funds
Submitted to: Mr.Imran Usmani
Prepared by:
Adeel
ahmed, Zakiuddin
khalid, Mohammad ali channa, Sameera siddiqui
Dated :
TABLE OF CONTENTS
WHAT ARE HEDGE FUNDS
WHAT ARE ALTERNATIVE INVESTMENTS
KEY HEDGE FUNDS CHARACTERISTICS
WHAT ARE MUTUAL FUNDS
DIFFERENCE BETWEEN MUTUALE FUNDS AND HEDGE FUNDS
HOW THE ABSOLUTE RETURN CAN BE DEFINED
WHAT IS SHORT SELLING
CRITICAL ANALYSIS
HEDGE FUNDS COMPLYING WITH SHARIAH LAWS
What are Hedge Funds
Surprisingly, no standard legal definition exists. We can find many competing and partially contradicting definitions of hedge funds.
Some of good definitions include:
(The key elements
of these definitions are summarized in figure 2)
'A mutual fund
that employs leverage and uses various techniques of hedging'.
(George Soros, manager of the largest, and
very speculative, group of hedge funds)(5).
'A limited
partnership in which the general partner is typically paid on a performance
basis. (...) Typically, the manager of a hedge fund has a great
deal more flexibility than a traditional money manager, and that is really the
key element'.
(Michael Steinhardt, manager of the third largest hedge fund)(6).
'Speculative funds managing
investments for private investors'.
(Bank for International Settlements)(7).
'Funds that go short, use
derivatives, and employ other forms of leverage, often taking strong views on
the markets' (definition of "market participants"(8)).
'Equity-oriented limited
partnerships that can be both long and short, can use leverage, and pay the
general partner 20% of profits. The general partner traditionally has his own
money in the partnership' (definition derived from A.W. Jones)(9).
'...private investment partnerships, many with fewer than 100 partners (...) and some with an off-shore domicile (...). They (...) do all sort of things that mutual funds, and even registered investment managers, cannot ordinarily do: go long and short, hedge in derivative markets, borrow lots of money, invest any proportion of their capital in any sort of asset' (The Economist on American hedge funds)(10).
'A flexible
investment fund for rich people and institutions. The minimum
investment is typically US$ 1 million and the manager usually receives 20% of
the profits. Hedge funds can virtually use any investment technique including
short selling (...) and heavy borrowing, or leverage (...)' (From a
"primer on hedge funds")(11).
'A private investment partnership
(for US investors) or an off-shore investment corporation (for non-US or
tax-exempt investors) in which the general partner has made a substantial
personal investment and whose offering memorandum allows for the fund to take
both long and short positions, use leverage, use derivatives and invest in many
markets. It also entitles the general partner to an additional management fee
based upon positive returns' (The working definition of Republic
'All are in the business of
delivering absolute returns' (TASS, a hedge fund rating agency)(13).
“Hedge fund: A flexible investment fund for rich people and
institutions. The minimum investment is typically $1 million and the manager
usually receives 20 percent of the profits. Hedge funds can use virtually any
technique including short-selling ... and heavy borrowing, or leverage, neither
of which is allowed for mutual funds.”
The key elements of these definitions are summarized in figure 2 on following page
Figure 2
SUMMARIZED
DEFINITON
‘Hedge fund
is a private, limited investment partnership open only to accredited investors,
meaning people with substantial assets. Beyond that restriction and certain
disclosure and reporting requirements, hedge funds are largely unregulated by
the regulated authorities, so they’re free to use virtually any kind of
strategy a manager chooses.”
That’s because
hedge funds come in so many different flavors. They may be specialized, niche
or sector players or make a handful of concentrated bets across many
industries. They may be highly leveraged or use no leverage at all. In fact,
you can find almost as many hedge fund strategies as hedge fund managers.
That’s why you really can’t generalize about hedge funds — either their returns
or their risks. A hedge fund may be quite risky or very conservative or
anywhere in between. It all depends on the strategy and how it’s executed.
Traditional
managers have a relative return orientation. They measure success by how
well they perform relative to a benchmark such as the S&P 500 or KSE 100
Index. It’s all about beating the market.
For Example:
When the market
has gone down by 20%.
The traditional manager can go to his client and legitimately boast,“I’ve
done a great job for you...your portfolio is down only 18%. Not only have I
outperformed my benchmark, but I’m in the top quartile of my peer group!”
However, Hedge
fund managers look at things quite differently. Their goal is to avoid losing
money — to achieve positive annual returns regardless of market direction.
Hedge funds measure success the same way: by the level of absolute returns
earned for investors.
Hedge funds are considered ‘alternative’ investments since they employ an investment strategy that differs from conventional, long only, money management. ... It encompasses a greater variety of investment instruments (options and futures) and a greater variety of investment techniques (short selling, hedging, arbitrage, etc.) than conventional money management.
What are Alternative
Investments
All alternative assets can be defined by a simple measure, that their
primary drivers of return are substantially independent of broad market
returns.
Alternative investments are
investments, which deliver highly
attractive rates of return. It covers a long and diverse list of investment
categories — private equity, leveraged buyouts, venture capital — the whole
mixed portfolio of asset classes, which deliver highly attractive rates of
return. Equally important, the returns tend to have a low correlation to
traditional stocks and bonds.
Key Hedge Funds Characteristics
The following key characteristics
are common to most or all hedge funds.
1. Free choice of
asset classes: Hedge funds are not by definition restricted to one specific
asset class. Whereas some hedge funds managers may restrict there investment
policy to one asset class (e.g. equity, interest rates, currencies,
commodities), but it is not legally bounded to any such restriction.
2. Free choice of
markets:
Many hedge funds do not focus on one specific market but invest according to
available opportunities in all kinds of geographic locations (
3. Free choice of
instruments:
The majority of hedge funds invest in both cash and derivative products.
Instruments may be exchange or over-the-counter (OTC) traded, and securitized
or non-securitized.
4. High minimum
investment
levels are often required. Sometimes minimum of $1Mn or more is required.
5. Infrequent
subscription and redemption possibilities with long notification periods
have become standard for the industry.
6. A common feature is
the performance oriented incentive fee. Also, due to the nature of the
business, high total fee and cost loads are charged.
7. Unlike traditional
managers, who charge annual management fees based on the amount of assets
they’re handling, virtually all hedge fund managers charge performance-based
fees — usually 20% of investment profits on top of a 1% or 2% asset based fee.
Most funds have what’s called a high-water mark, meaning that if they
lose money in one year, they have to make up those losses before they can start
earning the next year’s performance fees.
- Managers of a hedge
fund are expected to invest their own money alongside the limited partners, thus ensuring that
everyone’s interests are aligned.
9. Hedge funds are
marketed as being oriented towards absolute performance (performance above
zero) instead of performance relative to a certain benchmark or reference
index.
10. Most hedge funds
show low correlation to traditional markets.
What are Mutual Funds
A Mutual fund arenancial intermediary that allows a group of investors to
pool their money together with a predetermined investment objective. The mutual fund will have a fund
manager who is responsible for investing the pooled money into specific
securities (usually stocks or bonds). When investor invests in a mutual
fund, he is buying shares (or portions) of the mutual fund and become a
shareholder of the fund.
By pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. But the biggest advantage to mutual funds is diversification.
Diversification
Diversification is the idea of spreading out your money across many different types of investments. When one investment is down another might be up. Choosing to diversify your investment holdings reduces your risk tremendously.
The most basic level of diversification is to
buy multiple stocks rather than just one stock. Mutual funds are set up
to buy many stocks (even hundreds or thousands). Beyond that, you can
diversify even more by purchasing different kinds of stocks, then adding bonds,
then international, and so on.
Difference Between Mutual
Funds and Hedge Funds
Mutual funds and hedge funds differ in many ways. Common Difference are mention below:
|
|
Mutual Fund |
Hedge Fund |
|
Definition |
A public pool of investment capital organized to invest in a portfolio composed of often-predetermined type of securities. |
A private pool of investment capital organized into a limited partnership to invest in a portfolio made up of a variety of securities |
|
Regulation |
Regulation Athority registered investment vehicles. It is highly regulated. Virtually every aspect of a mutual fund’s structure and operation is subject to strict regulation |
Hedge funds are unregistered, private investment pools bound by the investment agreement (contract) investors sign with the sponsors of the hedge fund. |
|
Minimum Investment |
Usually small minimum investments. |
Large minimum investments required (average $1 million). It is exclusively design for high net worth individuals. |
|
Investors |
Not limited to the number of investors and investors can purchase many funds. |
Are limited to 499 investors ("limited partners") who can invest in any one fund. |
|
Availability |
Available to the general public. |
Must be an accredited investor (net worth must exceed $1 million or individual income must have been in excess of $200,000, or joint income must have been in excess of $300,000 in the past two years, plus investor must expect the same level of income in the current year) |
|
Liquidity |
Daily liquidity and redemption. The investor can take out his money at any time he desires to. |
Liquidity varies from monthly to annually bases. |
|
Short Selling |
Maximum 30% of profits from short sales (although other bear fund options exist) |
Manager may short sell often with no limit to its percentage of profits. |
|
Leverage |
Regulation athority has restricts a mutual fund’s ability to leverage or borrow against the value of securities in its portfolio. Therefore Less leverage. |
Leveraging and other higher-risk investment strategies are often used for hedge fund management with no restriction for regulation athorities. Therefore it uses more leverage . |
|
Down Markets |
Mutual funds are directly affected by down markets. Managers try to decrease the lose. |
Most hedge fund strategies try to hedge against downturns in the markets, but effectiveness depends on the fund. It can perform better in down markets. |
|
Fees |
Limits Imposed by the SEC |
No Limits. Hedge funds typically charge high fees, usually a combination of 1-2% of your assets plus a percentage of the profits (usually 20%) |
METHODS USED IN HEDGE FUNDS:
Various Techniques are employed in case of Hedge Funds to gain profit without any risk
Many Hedge
Funds guarantee an absolute return, which is explained as follows:
How the Absolute Return can be
defineD
Absolute returns are the actual percentage monetary returns that are received. They are distinct from relative returns, which are the returns relative to a well-known index, such as the S&P 500, KSE 100 or any other indices.
Absolute Return can be explained best with simple math. Suppose you’ve invested a million dollars with the goal of earning 15% annually. In the first year, you meet your goal and your portfolio is up 15%. But, in year two, the market drops and you lose 15%. How much do you think you need to earn in year three to keep pace with your goal?
whopping 55.6%.
Hedge Funds
also use short selling to gain risk-less profit, which is explained as follows:
What is Short Selling
To short a stock,
you sell shares, which you don’t own, but borrow, from a brokerage firm. To
close out the short position, you later buy shares on the open market and use
them to replace the borrowed ones you’ve sold. If the stock has declined as you
expected, then u have gain the difference. But if the position goes against you
and the stock you shorted goes up in price, then you lose money when you close
out the trade.
Bottom line is
“When you
sell short, you’re looking for stocks you hope will go down.”
This is risky if you do only short selling.
Successful manager uses short selling to hedge a long portfolio against a
general market decline. Managers combine two speculative investment
techniques — short selling and leveraging — to create a conservative investment
approach designed to systematically produce positive returns in both up and
down markets.
critical
analysis
Critical Analysis of Short Selling
Short selling is not allowed because we are selling what we do not own in this case, which is not allowed in Islam. Consequently this technique would have to be modified in the light of Islam.
Critical Analysis of Swap Position
In a swap, if money of any currency is lend or borrowed on interest, then this would not be allowed according to Islam.
Critical Analysis of executing a forward deal
In a forward deal, the party going to sell or buy a share/currency in forward should undertake a deal to do so. An amount should be deposited so that in case any party defaults, the other party could deduct the loss from the amount deposited.
Hedge
Fund complying with Shariah Laws
How to Execute SPOT Trading:
The fund will lend currency A for a period at ZERO interest from a bank and will borrow currency B and not pay any interest to the same bank. This swap will then provide the fund in currency B thus giving an option to sell currency B in the market. Any amount in the fund could be exercised in Murabaha.
But an important thing to note is that all contracts should be independent of each other and one contract should not depend on the other.
How to Execute Forward Contract:
The Customer will pay a deposit amount to the other party, which would act as a guarantee (Promise-to-purchase) to exercise the forward contract. The purchase contract would be exercised on the delivery date according to the rules and conditions agreed upon which should not go against the Islamic rules.
If in any case the customer does not purchase or sell in future, then the deposited amount could be sued to recover the loss.
Conclusion
In summary, different Islamic Hedge Funds could be developed but the key criteria are to see that the methods used to hedge do not go against the Shariah rules and regulations.
Currently this area is under development by Meezan Bank and
Mr. Imran Usmani, the Shariah advisor of the bank has worked a bit in this
area. The method of developing the Islamic Hedge Fund given above was also
developed by guidance from Mr.Imran Usmani. In the international arena not much
work is being done and this area awaits considerable development.