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mutual funds in Islamic banking in Saudi Arabia Introduction Islam is a religion that unites both spiritual and temporal aspects of life. It regulates not only an individual’s relationship with God, but also human relationships in social and financial settings. Thus the shari’a, or the Islamic Law, is part of every Muslim’s cultural, social and behavioural identity. The application of shari’a to investment choices and management is not a new phenomenon. Earlier Muslims were able to establish an interest-free financial system for mobilizing resources to finance productive activities and consumer needs, which had worked effectively for centuries. As Muslim societies became more sophisticated, and their financing needs more complex, coupled with stagnating The wider acceptance of equity investments by shari’a scholars in the early 1990s paved the way to launch mutual funds that operate in compliance with the ethical guidelines of the Islamic Law (hereafter in this chapter to be called ‘Islamic mutual funds’). In the early 1990s, many shari’a-compliant mutual funds started to appear. There are now about 126funds with approximately US$4 billion in assets under management. Other than being a halal (approved) investment alternative available for Muslim investors, the funds also respond to the specific need for more liquid investment tools. Further, the launch of reliable equity benchmarks by the Dow Jones Islamic Market Index (DJMI) and FTSE Global Islamic Index Series, followed by the the Malaysian Kuala Lumpur Syariah Index, has been a turning point for the industry, giving both Islamic and conventional investors something with which to compare. The Despite the escalating interest in Islamic mutual funds, there has not yet been, to the authors’ knowledge, any research concerning the performance of these funds and how they fare in comparison with conventional funds. This study aims at assessing the performance of the Islamic mutual funds, examining whether there exists any significant reward or penalty for investing in them. A primer on Islamic mutual funds Muslims represent around one-fifth of the world population with more than $800 billion to invest. This amount is growing by 15 per cent annually. Only a small portion of the available funds are invested in Islamic products, which is indicative that this market is, for the most part, unexploited (Hassan, 2002). The Islamic mutual funds market is one of the fastest rising segments within the Islamic financial system, yet, when compared to the mutual fund industry at large, Islamic mutual funds are still in their infancy stage of growth and development, most being around for less than a decade. Islamic funds are fairly diverse for a young industry. Equity fund Usmani explained the differences in opinion among Muslim scholars pertaining to the permissibility of investment in companies which are involved in a halal business but nevertheless have a portion of their transactions involving incidental haram (shari’anoncompliant) activities such as interest. He concluded that a large number of presentday scholars argue that such incidental business activities do not render the whole business unlawful. Nevertheless a list of conditions has to be met before investment in such funds can be ruled as shari’a-compliant. Accordingly Muslims can invest their funds in such businesses that meet some specific conditions, as follows 1. The investment has to be made in businesses that do not violate shari’a. In that respect no investment can be made in companies that engage in unlawful activities such as liquor, gambling and pornography. 2. In the case where the main line of business is lawful but the company is involved in interest-related activities, shareholders have to express their disapproval for such dealings wherever possible. 3. The income generated from dividends has consequently to be purified from such activities by allocating a percentage of that dividend to designated charities in proportion to the income generated from interest-related activities. 4. The shares of the company can only be negotiable if the business owns some illiquid assets. Shares for companies whose assets are all in liquid form can only be traded at par value. The above conditions require a strict filtering process to determine which companies might be included in the fund and which companies should be excluded. The filtering process will first exclude all companies involving forbidden items. The second filtering mechanism involves a set of financial ratios which have to be met by any company before it can be included. These ratios are used in order to safeguard against earning profits resulting from interest. El-Gamal (2000) indicated that most Islamic funds have reached similar compromises pertaining to the ratios acceptable in companies that could belong to the fund. For example, the Dow Jones Islamic Market Turkey Index (DJI, 2005) indicates that the stocks excluded represent companies involved in any of the following activities: alcohol, tobacco, pork-related products, financial services, defence/weapons, entertainment. In addition the financial ratio screens exclude all companies for which any of the following ratios are 33 per cent or more: 1. ‘Total debt divided by trailing 12-month average market capitalization 2. The sum of a company’s cash and interest-bearing securities divided by trailing 12month average market capitalization 3. Accounts receivables divided by trailing 12-month average market capitalization.’ (DJI, 2005) Ijara fund Ijara means leasing whereby funds are used to purchase assets and lease them out to thirdparty users. Ijara is increasing in popularity and is the most popular method of Islamic house finance in the United Kingdom (Matthews et al., 2002). Leasing is an increasingly acceptable instrument from the perspective of many Muslims scholars (Warde, 2000). Rentals are collected from the users and the investors in the fund own a proportionate share of the leased assets. Ownership is authenticated in certificates or sukuk which are negotiable in the secondary markets. Ijara is permissible according to shari’a but also subject to certain conditions (Usmani, 2002). The assets themselves have to be halal; that is assets used in gambling casinos or manufacturing alcoholic products do not qualify. The rental charges should be set at the outset and known to the parties involved in the transaction and should cover the whole period of the lease. The lessor assumes all the responsibilities subsequent to ownership so that the lessor has the duty to manage the assets including repairing the assets in case of malfunction (Warde, 2000; Usmani, 200 Commodity fund Islamic jurisprudence also allows commodity funds which entail the purchase and subsequent sale, by the fund, of commodities for a profit. These profits are distributed among the investors in the fund in proportion to their investment. Some conditions also apply in this case. The commodities themselves have to be halal. In addition, the price of the commodities has to be known to the parties at the time of the transaction. If the price is unknown or attached to another eventuality, this is not allowed. Moreover the seller has to have physical or constructive control over the commodity to be sold. Constructive possession refers to any activity which indicates that the risk of the commodity is transferred to the purchaser (Usmani, 2002). Accordingly forward sales are not allowed in most cases as they involve dealing in commodities which a person does not own or possess at the time of the transaction. Two exceptions are istisnaa and salam (Usmani, 2002). Istisnaa means commissioning a manufacturer to manufacture commodities for later delivery to the purchaser. Marketing and distribution of Islamic mutual funds in saudi Arabia Islamic-based mutual funds offer Muslim investors the double advantage of mutual fund investment and compliance with Islamic guidelines. The tolerability of common stock screening guidelines by an overwhelming majority of shari’a scholars has not been deciphered into more demand for such investing mechanisms. One reason behind this phenomenon could be the fact that Islamic funds have not fared well in marketing and differentiating themselves from their conventional counterparts. Moreover, some Muslim investors fear that there remain some haram elements in them. They prefer to place their money in Islamic banks and institutions that ‘truly’ invest in acceptable products offered by Islamic companies in Muslim countries. Such products include ijara, istisnaa, murabaha and mudaraba. Summary and conclusions This study has examined Islamic mutual funds and the fundamentals of investing in such venues. In doing so, it has explored the dynamics of Islamic mutual funds, their governance and control, and marketing and distribution. We have presented the results of a study verifying whether the application of the Islamic investment guidelines in asset allocation and portfolio selection has had a downside effect on investors’ wealth in terms of risk-adjusted returns relative to the market benchmark. Considering the overall sample of 46 Islamic mutual funds, the total number of overperforming funds ranges between 29 (63 per cent of the sample) and 11 (24 per cent), depending on the performance measure and market benchmark used. In terms of fund category, four of the eight fund categories outperform their benchmarks regardless of what performance measure was used. Moreover the ANOVA statistical test showed that no statistically significant disparity existed for the performance of the funds compared to all indices used. Therefore a conclusion of this study is that the behaviour of Islamic mutual funds does not differ from that of other conventional funds, with some shari’a-compliant mutual funds overperformingtheir benchmarks and others underperforming them. Another interesting finding is observed when studying the performance of the funds over two successive periods within the overall study period. The first witnessed a boomingequity market, while the second was a declining market. The results of the Transformed Sharpe measure showed that the performance of the Islamic mutual funds compared to both benchmarks during the second period dominated by recession is better than that during the first (booming) sub-period. This might imply that the performance of these funds is improving with time, as fund managers are gaining more experience and sense of the market. Another implication from this result is that Islamic mutual funds might be a good hedging investment for any equity investor, if used to hedge against market downturnsand recessions. . Therefore conventional investors can consider Islamic mutual funds in their portfolio collection, especially during slow market periods. However, the onus remains on the investor always to screen out various candidate mutual funds according to performance, regardless of whether the fund is a conventional one, Islamic or other type of ethical or socially responsible fund. In order for an Islamic mutual fund to succeed, it must be successfully promoted.Retail bank employees are insufficiently knowledgeable of investments to sell mutual funds. Their jobs are focused on selling banking products. A qualified investment advisor may be capable of selling mutual funds, but they must also be versed in Islamic practices to promote Islamic funds. Investment firms must avoid customer confusion at all costs. The input of the shari’a board is useful in this situation, providing recommendations on how to promote the Islamic mutual fund. Another key to growth in the Islamic mutual fund industry is patience. The concept of equity investing is new to Muslims, who are typically accustomed to real estate or leasing investments. Therefore time must also be spent in educating the investor. Distribution is also important. The fund must be easily accessed through multiple distribution channels. These channels include automated telephone systems, communication with a broker, or the Internet. A key ingredient in today’s financial market is the ability to access investment accounts via the Internet. A fund itself can be marketed through a distributor such as Al-Rajhi, a national organization operating in the field of finance, or afinancial investment firm (such as Fidelity) may create its own fund. Either way the company should have a solid reputation for successful investments and customer service. At this point, the reputation of the Shari’a Advisory Board must also be considered. In order for a fund to obtain widespread Muslim approval, the shari’a members must be well-respected members of the community. In many ways the success of the fund rests on the Board’s reputation. Arab National Bank (anb) – One of the ten largest banks in the Middle East. It was established in 1979 and has about 190 local branches, 42 ladies sections and one branch in London. Al Rajhi Bank has the largest branch network (over 550 branches), and the largest ATM network (over 3,100) in Saudi Arabia. The bank also has more than 20 branches in Malaysia. Bank Al-Jazira (BAJ) – One of the leading Shari'ah compliant fast growing financial institutions in Saudi Arabia. BAJ provides customers with innovative Shari'ah compliant financial services. Banque Saudi Fransi (BSF) – A full service commercial bank serving the local and international banking needs of its clients. It is a leading provider of comprehensive financial services and products in the kingdom of Saudi Arabia and other markets. Islamic Development Bank (IDB) – IDB was established in pursuance of the Declaration of Intent issued at the Conference of Finance Ministers of Muslim Countries in December 1973. The purpose of the Bank is to foster the economic development and social progress of member countries and Muslim communities in accordance with the principles of Shari'ah. National Commercial Bank (NCB) (Al-Ahli Bank) – The first Saudi Arabian bank. NCB is the largest bank in terms of capital in the Arab world and one of the pioneers in Islamic banking. Riyad Bank – One of the largest financial institutions in the Middle East. The Bank's network includes over 200 local branches and over 1,500 ATMs, as well as international offices in London, Houston, and Singapore. Samba Financial Group (formerly known as Saudi American Bank) is a large banking group in Saudi Arabia, established in 1980 with the takeover of Citibank branches in Jeddah and Riyadh. SAMBA was always the acronym for the Saudi American Bank but the name was changed to Samba Financial Group in 2003. Saudi British Bank (SABB) – Established on January 21, 1978, SABB formally commenced activities on July 1, 1978 when it took over the operations of the British Bank of the Middle East (BBME) in Saudi Arabia. Saudi Hollandi Bank (SHB) – The first bank in the Kingdom of Saudi Arabia, founded in 1926. SHB employs over 1,600 people with a Saudization ratio of over 87% and operates 43 branches, 8 Ladies Sections and over 260 ATMs throughout the Kingdom. Saudi Investment Bank (SAIB) – A Saudi Arabian joint stock company established on June 23, 1976. SAIB offers a wide range retail and commercial banking products and services in addition to investment banking. United Saudi Bank (USB) – In 1999 SAMBA merged with United Saudi Bank by an exchange of shares, to form one of the largest banks in Saudi Arabia and Middle East. The Largest Banks in Saudi Arabia Rank 1 Company National Commercial Bank Total Assets (SAR m, Total Assets (US$bn, 30/06/2012) 30/06/2012) 320,417.91 85.438 2 Al Rajhi Bank 238,211.90 63.518 3 Samba Financial Group 199,508.90 53.198 4 Riyad Bank 180,637.40 48.166 151,904.90 40.505 6 Saudi British Bank (SABB) 5 Banque Saudi Fransi 147,088.70 39.221 7 Arab National Bank 120,392.00 32.102 8 Saudi Hollandi Bank 61,961.10 16.522 10,351.157 * 14.795 53,464.00 14.256 9 10 Islamic Development Bank Saudi Investment Bank (SAIB) 11 Bank Al Jazira 47,267.12 12.604 References Al-Qaradawi, Y. (1999), Fiqh az-Zakat, A Comparative Study, London: Dar al-Taqwa Ltd. Banker Middle East (2005), http://www.bankerme.com/bme/2004/jan/local_news_inbrief.asp, accesssed 11 November. Bauer, C. John and Richard P.Keigher (2001), ‘Islamic equity funds: challenges and opportunities for fund managers’, paper presented at the 4th Annual Harvard Forum on Islamic Finance, 30 September to 1 October, Boston, MA. Islamic mutual funds 271 Bauer, R., K. Koedijk and R. Otten (2002), ‘International evidence on ethical mutual fund performance and investment style’, working paper, Maastricht University. Carhart, M. (1997), ‘On persistence in mutual fund performance’, Journal of Finance, 52, 57–82. Cooper, C and B. Schlegelmilch (1993), ‘Key issues in ethical investment’, Business Ethics: A European Review, 2 (4), 213–27. Curtis Davis Garrard (2000), ‘Islamic banking and finance’ (http://www.cdg.co.uk/), accessed 11 November 2005. DeLorenzo, Y.T. (2000), ‘Shari’a supervision of Islamic mutual funds’, (http://www.failaka.com), accessed November 2005. DJI(2005),http://djindexes.com/mdsidx/downloads/meth_info/DJIM_Turkey_Method.pdf ,accessed11November. Elfakhani, Said, Yusuf Sidani and M. Fahel (2004), ‘An assessment of performance of Islamic mutual funds’, European Journal of Management and Public Policy, 3 (1), 41–64. Elfakhani, Said, M. Kabir Hassan and Yusuf Sidani (2005), ‘Comparative performance of Islamic versus secular mutual funds’, paper presented at the 12th Economic Research Forum Conference in Cairo, Egypt, 19–21 December. El-Gamal, M.A. (2000), ‘A basic guide to contemporary Islamic banking and finance’ (http://www.ruf.rice.edu/~ elgamal/files/primer.pdf), accessed November 2005.