What is an Islamic structured fund? EVREN YAZMAN provides his definition of this investment structure and how it is used by fund managers globally.
It was about two years ago, on an otherwise pleasant day in December. The UAE was hit by debt worries. The investor sitting in the garden of his house in Dubai in disbelief had just finished going through his financial statements and still couldn’t figure out how his investment portfolio had suddenly shrunk.
His daughter would be getting married soon and he was planning on buying a house back in his home country next year. This was not the situation he was planning to be in at this point in time. The equity market was going down. Real estate values were dropping as well and it was hardly liquid. Even the Sukuk portfolio was deeply under the water: they had all turned out to be from a concentrated local issuer base.
However, he had always thought he was a prudent investor. He had tried to create a diversified portfolio made up of Sukuk, some real estate investments and some equities. He had invested through funds, to benefit from the expertise of professionals.
However he had not realised how limited and connected his investment alternatives actually were. More importantly, he had not done a full risk assessment of his investments and whether they fit his risk profile.
The investor in this story is not a real person, but stories like this are not uncommon. Wealth managers constantly try to provide better solutions to their clients and offer investment alternatives that may better fit their clients’ ability and willingness to take risk.
One alternative available to asset managers in this regard is the use of structured funds. Structured funds aim to allow the asset manager to tailor the risk and return of the products, and fill in the gaps in the product offering. In the Islamic finance market, where product alternatives are still limited, such products can be especially valuable.
Defining a structured fund
What sets a structured fund apart from other funds is the type of assets it can have and also the possibility of providing non-linear pay-outs.
The manager of a Shariah compliant structured fund achieves this by combining different Shariah compliant assets and arrangements in a single fund package. There are plenty of possibilities to use such structures, and finding the best solution will depend on the creativity of the structurer and fund manager.
Creating a structured fund requires expertise in two core areas:
1. Asset expertise. This is the expertise on selection and management of the underlying assets or exposures of the fund.
2. Structuring expertise. This is the ability to combine different Shariah compliant arrangements and create the effect desired by the client, in the risk and return profile of the investment.
These two areas of expertise are like the ingredients of a meal. They have to be selected and mixed in correct proportions to provide the clients with the taste they desire. Finance professionals who specialize in this area are the chefs who effectively mix the components and prepare the funds.
Islamic structured fund platforms are usually created to be able to hold a large variety of Islamic assets and enter into Islamic finance transactions approved by the relevant Shariah board. The funds may be able to purchase Shariah compliant assets such as equities, Sukuk, real estate or commodities. Fund managers may utilize additional agreements, such as Arbun, while purchasing assets. They may also be entering into Murabahah or Ijarah arrangements to generate return from the assets. Islamic hedging arrangements may also be used from time to time.
Uses of Structured Funds
Both individuals and institutions use structured funds to serve their needs.Some assets are naturally more risky. Individuals who have a low risk-taking ability or appetite, most commonly prefer to use capital-protected structures to access such risky assets. On the contrary, if an investor can take more risk than that offered by an asset, and they are targeting higher returns, a yield enhanced structure may be created.
Let’s assume we have a hypothetical investor whose children are starting university in three years time. Her primary goal is to pay for her children’s university education costs. Let us also assume that she has just enough savings to cover those costs right now. The investor may have a secondary goal of buying a luxury car.
This hypothetical investor may be facing the following two simplified choices. First, the investor can use Islamic money market instruments to preserve her investments and meet her primary objective. However the returns are not likely to be enough to meet the secondary objective. Second, the investor can follow a growth strategy and invest in risky assets, to try to generate enough returns to buy a car. However if this results in a capital loss within three years, it may jeopardize the primary objective.
An investment advisor may think a structured fund which provides capital protection, with potential for growth, may be a reasonable alternative, to try to meet both objectives. With a capital-protected growth product the investor may be giving up some of the upside potential, however she instead gets the possibility of meeting both investment objectives.
It is clearly very important to understand any counterparty or added risk in the structure and make sure the investor is comparing like with like, when considering different alternatives.
For institutional investors, structured funds are usually created to deliver bespoke solutions in a single, easy to administer fund package. The funds can be designed to meet the liabilities of the institution. They can also be constructed with quantitative models, to match any volatility or tracking error targets the professional investors may have.
Structured funds can also be used to gain operational efficiencies. The ability to use different instruments may allow an asset manager to select the most efficient way to get to the desired outcome. For example, creating a traditional global equity fund and related set-up may be costly and time consuming for an asset manager.
The asset manager may instead decide that using Wakalah and Arbun arrangements to get exposure to the equities may be more efficient. The asset manager can use the trading and risk management capabilities of a product provider who can provide these services. The core task of an asset manager is making investment decisions and meeting clients’ objectives. Islamic structured funds are one of products available to them, to make this achievable.
These funds are not a solution to all problems. They just aim to provide the fund manager with the flexibility to create bespoke solutions, when there is no easily accessible alternative. Creating and using these funds requires specialist knowledge and extra care. However, when correctly used they can go a long way enriching the Islamic fund product offering.
Evren Yazman is the executive director of global emerging markets at J.P. Morgan. He can be contacted at
[email protected]
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Disclaimer: Nothing in this article shall be construed to provide investment advice.