LONDON, 18 October 2004 — The launch of the Shariah Equity Opportunity Fund Ltd. (SEOF) in Bahrain last week, once again brings the hedge fund into the  

LONDON, 18 October 2004 — The launch of the Shariah Equity Opportunity Fund Ltd. (SEOF) in Bahrain last week, once again brings the hedge fund into the spotlight, albeit this time from both a risk and Shariah-compliance points of view. The fund is managed by Connecticut-based Meyer Capital LLC, which has been developing this product for over three years. Special adviser to the fund is Noriba Bank, the Islamic investment bank in Bahrain owned by Switzerland's UBS Group.

According to Noriba Bank, SEOF will be composed of leading hedge fund managers but unlike conventional hedge funds, SEOF, being an Islamic fund, will also have to satisfy the requirements of Islamic investment principles which proscribe riba (interest) and gharar (uncertainty).

SEOF has four of the most experienced Shariah scholars on its books — Dr. Mohamaed Elgari of Saudi Arabia, Sheikh Nizam Yaquby of Bahrain, Sheikh Yusuf Talal De Lorenzo of the US, and Dr. Daud Bakar of Malaysia. The fund took a long time to materialize and reports suggest that at least one scholar only recently signed off on the transaction.

"Developing a fund such as this required a real commitment to overcoming the barriers which had dissuaded previous corporate and institutional efforts', says Mohamad Toufic Kafanai, Noriba's chief executive officer.

But there are those who ask if an Islamic hedge fund is desirable or even possible? Or should the market be talking about an equivalent Islamic hedging technique for long/short selling equity strategies. On the other hand, is short selling possible in an Islamic hedging technique for equities? Is hedging a legitimate and desirable risk management technique?

While it is rightly the business of bankers to push the boundaries of financial engineering, there are those who also caution that "highly engineered finance is not necessarily sound finance". In Dubai earlier this year, Dr. Mohammed Khalfan ibn Kharbash, the UAE minister of state for finance & industry, who is also the chairman of Dubai Islamic Bank, for instance warned that "Islamic bankers must be aware of the dangers of creative accounting, creative structuring, and over-engineering contracts for the sake of raising margins rather than efficiency gains.

"Innovation must be a genuine response to investor needs which reaches Shariah compliance and not simply unnecessary layering of products. If the Islamic finance industry is to embrace the new mind-set that has hit the global investment community, it must embrace the underlying investor needs which created it."

Hedge funds per se have once again come under serious criticism in recent months. In a recent issue, The Economist in London, asked "What is the difference between a global investment bank and a giant hedge fund? Very little nowadays, it seems." The publication was warning that some big banks such as Deutsche Bank are in danger of turning into little more than hedge funds and abandoning some of their traditional businesses in retail, merger and acquisitions, corporate finance and so on, where the spread of the businesses offered some stability and security.

Yes, regulators do require banks to stick to value-at-risk (VAR) formulas which take into account market volatility at a given time, but banks have a knack in creating loopholes such as refusing to say how much bank capital is tied up in investments in hedge funds. The fact that governments effectively act as "a Bailer-out of Last Resort" for banks almost exclusively making their living by trading in the capital markets; the access to cheap deposits, of which a portion is insured by the governments; and the obscenely huge bonuses paid to "successful" traders effectively betting on their own banks, are all powerful incentives which suggest that this activity will continue to expand until the next big collapse.

Because of the highly risky speculative nature of conventional hedge funds, which are in any case proscribed in an Islamic capital markets, the cynics argue that Islamic finance should not be involved in this sort of activity because it goes against the spirit of Fiqh Al-Muamalat (Islamic law relating to financial transactions). Islamizing conventional hedge funds, they stress, through a web of complex contractual arrangements is precisely a form of Hiyal, and detracts from genuine efforts at innovating Islamic financial products steeped in Fiqh Al-Muamalat.

Such sentiments may be too extreme. However, the promoters of Shariah Equity Opportunity Fund Ltd., have done themselves no favor by refusing to divulge even the basic structure of the hedge fund strategies and how it will overcome the Shariah proscription on conventional short-selling.

Contrast to this the Alfanar US Equity Hedge Fund, the only other Islamic hedge fund in the market, promoted by the US-based Worms & Co. And the Jeddah-based SEDCO, which uses a centuries-old Islamic contract called Salam to hedge part of the exposure to cover downside risk by selling stock as Salam (in effect a forward sale).