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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
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