Bank Negara Malaysia Hedge Funds and Islamic Finance

Bank Negara Malaysia Hedge Funds and Islamic Finance
- Discussion Material 4 November 2004 Strictly Private & Confidential

An Overview Strictly Private & Confidential

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Background Asset Allocation Strategies
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Background A Short History
The first hedge fund was set up by Alfred Jones in 1949. Eliminated a part of market risk by short-selling. First to use short sales, leverage and incentive fees. A ‘Fortune’ magazine article in ’66 about a fund shocked every one: The Jones’ fund had outperformed all the mutual funds even net of a hefty 20% incentive fee. The first rush into hedge funds followed and the number of hedge funds increased to over a hundred. Losses & bankruptcies of many managers in the late 60s. Michael Steinhardt and George Soros survived the contraction of and ‘The Institutional Investor’ reported the incredible performance of Julian Robertson’s funds in ‘86. High performance in helped boost the new hedge funds. The fall of the British Pound in ’92 was believed to have been caused by George Soros. The same allegations were stated during the Asian crisis. The bond market crash in ‘94 (following the US rate hikes) led to huge losses. But the industry recovered in The widely publicized failure of LTCM and the poor performance of star managers, Julian Robertson and G. Soros caused a slowdown in ‘98. Strictly Private & Confidential

Background Number of Global Hedge Funds
There are over 8,000 hedge funds available from nearly 3,000 managers.1 Over 56% of all hedge fund managers are located in the United States, with 38% in Europe and 3% in Asia. 2 Long/short equity managers represent an estimated 1/3 of global hedge fund strategies. 3 For Asia Pacific Hedge Fund Managers, it is estimated that 67% pursue the long/short equities strategy. 4 Notes Van Hedge Fund Advisors International 2 Dow Jones News Wires 10 May 2004 Van Hedge Fund Advisors International Eureka Hedge Advisors Strictly Private & Confidential

Background Hedge Funds Assets
The global hedge fund industry broke above the USD1 trillion level for the first time in May There is at least USD1.16 trillion under management in hedge funds today, up from USD745 billion in mid Hedge fund assets were 46% invested in the US, 40% in Europe and 9% in Asia.3 Notes: 1 Dow Jones News Wires 10 May 2004 2 Dow Jones News Wires 10 May 2004 3 Dow Jones News Wires 10 May 2004 Strictly Private & Confidential

What is a “Hedge Fund” A Definition
It is difficult to provide a general definition of hedge fund. Originally... hedge fund was to offer plays against the markets, using short selling, futures and other derivative products. Today... Funds using “hedge fund” appellation follow all kinds of strategies and structure. Clearly... hedge fund cannot be considered as a homogeneous asset class. Some are highly leverage; others are not. Some engage in hedging activities; others do not. Some focus on macroeconomics bets on commodities, currencies, interest rates and so on. Some funds are mostly “technical” taking advantage of mispricing of some securities in their markets. Strictly Private & Confidential

What is a “Hedge Fund” Common Characteristics
Hedge fund managers can go LONG or SHORT. Hedge fund managers use gearing or LEVERAGE. Hedge fund managers are paid through a PERFORMANCE or INCENTIVE FEE. Hedge funds are often registered OFFSHORE or within LIMITED PARTNERSHIP structure. Hedge fund managers often invest their OWN MONEY in their funds. Hedge fund managers aim for ABSOLUTE RETURNS rather than benchmarking performance. Strictly Private & Confidential

What is a “Hedge Fund” Legal Structure
Key issues in the process of fund structuring is flexibility, taxation and investors preference. Typically set up as a limited partnership, limited liability corporation or as an offshore corporation. These legal structures allow the fund manager to take short and long positions in any asset, use all kinds of derivatives and to leverage the fund without restrictions. Hedge fund is also typically open-ended allowing investors to subscribe and redeem their investments usually at net asset value at a regular interval. However, there may be variations in terms of redemption fees, redemption notice period or other redemption limitations etc. Close ended fund structures - where investment is limited to an initial and then subsequent placing of interests in the fund - allow for a more efficient and cohesive strategy from the viewpoint of the fund and its investment manager but are not popular with investors and have a number of practical disadvantages. No routine redemption mechanism. Procedure for issuing new tranches is more cumbersome. A hedge fund may also consider using “feeder”, vehicles that have an ownership interest in the hedge fund that enable the hedge fund to solicit funds from investors in different jurisdiction. These feeders do not keep the money; they are used as conduits that channel the money to a master fund. Strictly Private & Confidential

What is a “Hedge Fund” Legal Structure (cont.)

What is a “Hedge Fund” Legal Structure (cont)
Another main consideration is choosing the domicile for the fund. There is considerable competition between the different jurisdiction. Current practice suggest that the Cayman Island is the domicile of choice, followed by British Virgin Island and Bermuda. For those seeking investors just in the US, Delaware is a key option. Meanwhile, Ireland and Luxembourg have a niche for hedge fund managers looking to establish funds in ‘regulated jurisdiction e.g. If the primary focus is European institution. Key factors taken into consideration in choosing the domicile for the fund includes familiarity of the jurisdiction with hedge funds, reputation, degree of local regulation; local tax and double tax treaties, and availability of service providers such as accountancy firms, legal firms, local banks and administrators. Strictly Private & Confidential

What is a “Hedge Fund” Fee Structure
Fee Structure - Typically comprise of base fee + incentive fee. Base Fee - Is based on value of asset under management. Typically 1% of asset base. Paid regardless of the performance of the fund. Incentive / Performance Fee - Proportional to the realized profits. Typically between %. Normally applied to profits measured above a risk-free rate before incentive fee is activated. High Water Mark - A fund valuation below which performance fee will not be paid. Hurdle Rate - A return that the fund must generate before performance fee is paid. Strictly Private & Confidential

What is a “Hedge Fund” The Main Players
Performance reports Offshore Administrator Fund Manager Offshore Administrator Investors Affirm trades Accounting reports Trade notification Accounting reports Offshore Administrator Prime Broker Global custody International trade clearing Securities lending Reporting Financing Accounting reports Buy/Sell Affirm trades Offshore Administrator Executing Broker Offshore Administrator Pre-launch administrative work Launch phase admin. Accounting function - production of NAV Corporate secretarial and Compliance Other admin. services Other Main Players (1) Accountant (2) Legal Adviser (3) Tax Adviser (4) Technology provider Strictly Private & Confidential

Hedging, Risk and Strategies What is hedging
Hedging is a strategy to offset investment risk. Perfect Hedge vs Partial Hedge A perfect hedge in theory is a strategy that offset gains and losses fully, therefore resulting in being completely neutral. All else will be partial hedge. Direct vs. Cross Hedge A direct hedge is hedging with another asset of similar price movement. For example - hedging common stock with its call option. A cross hedge is hedging an instrument with an unalike instrument. For example - buying preferred stock and hedging with interest rates driven treasury futures. Dynamic vs Static Hedge A dynamic hedge involves changing strategies over time according to market conditions. A static hedge hedge a portfolio without consideration to the market condition over time. Strictly Private & Confidential

Hedging, Risk and Strategies Risk from Leveraging
A common characteristics for hedge funds. Why leverage? Return from strategy employed (e.g.: arbitraging) is too small, leverage is needed to amplify the profits. However, leverage is a double-edge sword - it also magnifies the losses on the downside. How to leverage? Borrowing external funds to invest more or sell short more than the equity capital they put in; Borrowing through a brokerage margin account; and Using financial instruments and derivatives that require posting margins in lieu of trading in the cash securities that require full payment. Strictly Private & Confidential

Hedging, Risk and Strategies Common risk for hedge funds
Market risk Security-specific risk Non- market common factor risk Liquidity risk Borrow/ counter-party risk “Herd” risk Financing risk “Greek” risk Redemption risk Strictly Private & Confidential

Hedging, Risk and Strategies The Various Strategies
There are various hedge fund strategies, each offering varying degrees of risk and return. The categorization of these strategies into directional, relative value and event driven is arbitrary, may also overlap and may vary occasionally depending on which industry source one uses. A hedge fund may also have multiple strategies. Strictly Private & Confidential

Hedging, Risk and Strategies The Various Strategies II
Source: 2004 Van Hedge Fund Advisors International Strictly Private & Confidential

Hedging, Risk and Strategies Fund of Funds or Multi-Manager
One that invests in other hedge funds or allocates among multiple managers. Rather than investing in individual securities, a fund of funds is an investment vehicle that invest in other hedge funds. Fund of funds currently represent 17% of all hedge fund strategies and, according to industry sources, between 20-25% of all hedge fund assets. 1 Eureka Hedge lists 1134 fund of funds today. Of these, 114 are specifically global long/short equity fund of funds. 2 The amount of assets invested in fund of funds is expected to grow steadily. Multi-manager assets (fund of funds) are expected to maintain a 14% compound annual growth rate through Note: Van Hedge Fund advisors International 2 eurekahedge.com 3 Cerulli & Associates (IPE.com) - 27 August 2004 Strictly Private & Confidential

The Case for Hedge Funds Mutual Fund vs. Hedge Fund I
The following table highlights the differences between hedge funds and mutual funds. Strictly Private & Confidential

The Case for Hedge Funds Mutual Fund vs. Hedge Fund II

The Case for Hedge Funds Comparative Performance
Traditional mutual funds and long equity portfolios, including those based on the Dow Jones Islamic Index, have under-performed compared to hedge funds, both in recent markets and over the long term. Hedge Funds Outperform . . . in difficult market and over the longer term Average Annual Performance Compounded Annual Returns Note: Hedge Funds data from CSFB/Tremont Hedge Index. NASDAQ 100, DJII and S&P 500 data from Reuters Note: Hedge Funds data from van Hedge Fund Index. Mutual fund data from Morningstar. S&P 500 data from Bloomberg. Strictly Private & Confidential

The case for investing in hedge funds is based on their historical record and managerial talent. Hedge funds use their track record to support the claim of superior returns, with low risk and low correlation with conventional investments. It is difficult to talk about the performance of hedge funds as an asset class because of their heterogeneity. However, based on indexes of hedge fund performance available from consultants or fund managers, there is a strong case for investing in hedge funds (as illustrated in the graph in the next slide): 1. Hedge funds tend to have a net return (after fees) that is higher than equity and bond markets. 2. Hedge funds tend to have lower risk (measured by the volatility of return or standard deviation) than equity investments. Their investment strategies appear to provide more stable return than traditional equity investments. 3. The Sharpe ratio was higher than that of equity investments and bonds (except HFR fund of funds). 4. Correlation of hedge funds with conventional investments is generally low though still positive. Strictly Private & Confidential

The Case for Hedge Funds Caveat
Investors should exercise caution when using the historical track record of hedge funds as it does not adhere to rigorous performance presentation standards. Also biases in historical performance data can make it difficult to interpret hedge fund performance. Among the biases which may affect performance and risk measures are listed below: 1. Self selection bias 2. Instant history bias 3. Survivorship bias 4. Smoothed pricing 5. Option-like investment strategies 6. Fee structure and gaming Because of various biases, judging the average performance of the hedge fund industry by using the indexes discussed can be difficult. To appraise the funds, investors need to look at their persistence of performance. Strictly Private & Confidential

Issues Facing Islamic Investors Description of the Issues
Islamic investors could not invest in hedge funds because Shariah-compliant equivalents for options, short selling or balance sheet leverage are not available - critical elements of hedge fund strategies that mitigate performance volatility. Most, if not all, strategies used by hedges funds have Sharia'h issues. Short Selling Selling something you do not own. Leverage / element of interest or Riba. Derivatives generally are off limits (more in next slide) Conventional derivatives are presumptively invalid. Shariah rules -particularly bans on Gharar and on “ba’i dayn bi-dayn” – pose challenges for finding Shariah-compliant alternatives. An option is generally considered not acceptable due to being not an obligation, and payment is for some ‘right’ not a property. If it was a promise to buy or sell, there is not a problem. The essence or the locus of the transaction is buying/selling of ‘right’ not the property. A right, without an obligation, makes it dependent upon future events and creates Gharar (uncertainty) , Maysir (a game of chance). A Forward may be acceptable but its non-payment in full creates the problem of selling promises (ba’i dayn bi-dayn). Strictly Private & Confidential

Issues Facing Islamic Investors Description of the Issues II
Macro and Global Strategies and Distressed Securities are not permissible due to the Riba. Equity hedge funds: Usual equity constraints Tool problems: short selling and leverage Global asset allocations. Tool problem: futures Relative value hedge funds Usual asset constraints on long positions Tool problems: Short-selling & leverage Designing a Sharia’h compliant hedge fund is a major challenge but solutions may be possible. Strictly Private & Confidential

Issues Facing Islamic Investors Opinions on Futures Contracts
SAC of the SC, Malaysia Futures trading of commodities is approved as long as underlying asset is halal. CPO futures contract are approved for trading. Stock Index Futures contract - concept is approved. However, since KLCI has non-halal stock, it is not approved. Ustaz Ahmad Allam (Islamic Fiqh Academy - Jeddah) Stock Index futures contract trading is haram since some of the underlying stock are non-halal. Mufti Taqi Usmani (Islamic Fiqh Academy - Jeddah) According to Shariah, sale and purchase cannot be affected for a future date. In most futures transaction, delivery or possession is not intended. Strictly Private & Confidential

Issues Facing Islamic Investors Opinions on Option Contracts
SAC of the SC, Malaysia No formal opinion on options. However, SAC has approved trading of Warrants/TSR as long as the underlying stock is designated as halal stock. Mufti Taqi Usmani (Islamic Fiqh Academy - Jeddah) Promises as part of a contract is acceptable in Shariah but the trading and charging of a premium for the promise is not acceptable. Hashim Kamali (IIUM) Invokes Hanbali tradition, cites Hadith of Barira r.a. And Habban Ibn Munqidh r.a. He finds options acceptable. Draws parallels with al-arbun in arguing that premiums are acceptable. Cites contemporary scholars such as Yusuf al-Qardawi and Mustafa al-Zarqa have authenticated al-arbun. Strictly Private & Confidential

Possible Alternatives About Short Selling
A short sale is generally a sale of a security by an investor who does not actually own the stock. To deliver the security to the purchaser, the short seller will borrow the security. The short seller later closes out the position by returning the security to the lender, typically by purchasing securities on the open market. When you sell short, your brokerage firm loans you the stock. The stock you borrow comes from either the firm’s own inventory, the margin account of another of the firm’s clients, or another brokerage firm. As with buying stock on margin, your brokerage firm will charge you interest on the loan, and you are subject to the margin rules. If the stock you borrow pays a dividend, you must pay the dividend to the person or firm making the loan. In general, short selling is utilized to profit from an expected downward price movement, to provide liquidity in response to buyer demand, or to hedge the risk of a long position in the same or a related security. Strictly Private & Confidential

Possible Alternatives Short Selling Restrictions
Short selling is subject to many restrictions on size, price and types of stocks you are able to short. For example, you may only short sell stocks that a certain minimum average market capitalization, you may not short sell penny stocks and short sales need to be done in round lots. In addition, the "tick test" provides that an exchange-listed security may only be sold short: (i) At a price above the immediately preceding reported price ("plus tick"), or (ii) At the last sale price if it is higher than the last different reported price ("zero-plus tick"). These rules exist so that investors cannot sell short in a declining market, as continuous short selling will make a falling stock keep falling. Broker/dealers effecting sell orders for exchange-listed securities are also required to mark such orders "long" or "short." There are other restrictions on short selling, including margin requirements, net capital requirements for broker-dealers, capital and risk management standards, and costs imposed by the equity lending market. Strictly Private & Confidential

Possible Alternatives Risk in Short Selling
1. In general, stocks have an upward drift and over the long run most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation should somewhat drive its stock price up. What this means is that shorting is betting against the overall direction of the market. 2. When you short sell, your losses are infinite. A short sale loses when the stock price rises, and a stock is (theoretically at least) not limited on how high it can go. On the other hand, a stock can't go below 0, so your upside is limited. In other words, this means that you can lose more than you initially invest, but the best you can earn is a 100% gain if a company goes out of business. 3. Shorting stocks involves using borrowed money otherwise known as margin trading. Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum maintenance requirement. If your account slips below this you'll be subject to a margin call and will either have to put in more cash or liquidate your position. 4. If a stock starts to rise and a large number of short sellers try to cover their positions at the same time, it can quickly drive up the price even further. This phenomenon is known as a "short squeeze." Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is the reason it's advisable to not short a stock with high short interest. A short squeeze is one way to lose a lot of money extremely fast. 5. The final, and most important problem, is being right too soon. Even though a company is overvalued, it may take a long time for it to come back down. In the meantime you are vulnerable to interest, margin calls, and being called away. Strictly Private & Confidential

Possible Alternatives Short Selling in the Region
Note Securities lending refers to the ability of an investors to borrow securities from another party. Short selling refers to the ability to sell a borrowed security to a third party. Data is obtained from the Global Network Management Division at Morgan Stanley, the International Securities Lending at Goldman Sach, market regulators ISSA handbook and practitioners. Strictly Private & Confidential

Possible Alternatives Short Selling in Selected Countries
Note Securities lending refers to the ability of an investors to borrow securities from another party. Short selling refers to the ability to sell a borrowed security to a third party. Data is obtained from the Global Network Management Division at Morgan Stanley, the International Securities Lending at Goldman Sach, market regulators ISSA handbook and practitioners. Strictly Private & Confidential

Possible Alternatives Conditional Sales
Khiyar al-Shart or Stipulated Option “stipulated option” legitimized in several hadiths. An unconstrained right to rescind an otherwise binding contract (for a fixed duration). Ba’i Al-Arbun or Down Payment Buyer concludes a purchase and makes an advance of a sum less than the purchase price. If he decides not to take the good, the seller keeps the advance. Of all Islamic contracts, this offers the closest analogy to the option. Ba’i Al-Salam or Full Payment for Deferred Delivery Sale of goods for delivery at a later date but payment in full is made immediately. The goods were usually agricultural goods but the principle can be applied to other assets. Strictly Private & Confidential

Possible Alternatives An Alternative to Short Selling - Salam Sale
Salam Sale: a seller sells a commodity to a buyer against immediate full payment for delivery of commodity at a future date. Existence of the goods at the contract time is not required. An exception to the rule. Consensus among the scholars. An investor in stocks can hedge part of his exposure to cover downside risk by selling stock as Salam. E.g. We own 1000 shares of Tenaga, current price $10/share Contract to sell at $9.90/share for delivery in six months. We receive $9,900 today. (Placed in a Murabaha a/c) After six months: Share price $9.50/share - Profit $400 Share price $10.30/share - Loss $400 Strictly Private & Confidential

Possible Alternatives Salam Sale vs. Short Sale I
Salam sale shares the same economic result with short sale but differ in the nature of contractual relationship. Short selling actually consists of two distinct transactions: “borrowing” of stock at interest and selling the stock. In Salam, there is a sale but no borrowing of the stock. In a salam sale, the sale price may incorporate the time value of money (financing cost) but early delivery of good will not reduce the price as the full price is paid upfront. For short selling, dividend even during the borrowing period, belongs to the lender. In Salam, it needs to be estimated and factored into the price. Strictly Private & Confidential

Possible Alternatives Salam Sale vs. Short Sale II

Possible Alternatives Salam Sale vs. Short Sale III

Possible Alternatives Issues of Salam Sale of Stocks
A line of credit and collateral (of Murabaha and more) Higher costs & administrative handling. Early delivery does not yield cost reduction. Stacking of back to back contracts (due to the above) increases the cost and potential operational complexity. Dividend estimation. Strictly Private & Confidential

Islamic Hedge Fund SEDCO - Permal Hedge fund
Launched in second half of Size of fund - USD 250 million. Managed by the Permal Group according to Islamic investment guidelines established by a Shariah Advisory Panel with advice provided by the Saudi Economic & Development Company Ltd (SEDCO). Permal Investment Management Services is a US-based group with a total asset under management of about USD18 billion. SEDCO is a private investment firm based in Jeddah, Saudi Arabia. The fund is a single manager hedge fund using a Long/Short strategy focussing on mid-to-large growth US stock. The fund utilizes the ‘salam’ concept in providing flexibility in portfolio construction. Strictly Private & Confidential

Islamic Hedge Fund Shariah Equity Opportunity Fund
The first fund comprised of conventional long / short equity hedge fund managers that complies with Shariah. The fund allocates its assets to a few hedge fund managers. Each of the Fund’s underlying hedge fund managers will invest in his historical investment strategy i.e. based upon their strategic focus and sector concentration. To achieve Shariah compliance, the fund has developed a proprietary software to monitor its fund managers activities and worked with its Shariah scholars to ensure that its methods are in line with Shariah requirements. Strictly Private & Confidential

Conclusion Both industries/niches growing rapidly.
Both are evolving and innovative. Both have to understand each other and look for the crossover bridges. A marriage of the two will be “the best of both worlds”. However, there can be no compromise on Sharia’h. We believe that innovation within Shariah perimeter is the key to growth of Islamic finance. Strictly Private & Confidential

Thank you Strictly Private & Confidential

Contacts Suryono Darnor Assistant Director, CIMB Islamic
Commerce International Merchant Bankers Berhad 10th Floor, Bangunan CIMB Jalan Semantan, Damansara Heights 50490 Kuala Lumpur Tel: Fax: Azri Zaharuddin Assistant Manager, CIMB Islamic Commerce International Merchant Bankers Berhad 10th Floor, Bangunan CIMB Jalan Semantan, Damansara Heights 50490 Kuala Lumpur Tel: Fax: Strictly Private & Confidential

Expressions of opinion herein are subject to change without notice.
Important Notice We have based this document on information obtained from sources we believe to be reliable, and we do not make any representation or warranty nor accept any responsibility or liability as to its accuracy, completeness or correctness. Expressions of opinion herein are subject to change without notice. This document should not be construed as an offer or a solicitation of an offer to purchase or subscribe or sell CIMB investment products. Strictly Private & Confidential

Appendix 1 Factors to be considered in determining the domicile of the fund
Familiarity of the jurisdiction with hedge funds; Reputation; Degree of local regulation; Local tax and double tax treaties; Anti-money laundering measures; Service providers - accountancy firms, legal firms, local banks, custodian and administrators; Convenience for holding board meeting; Duration of local incorporation, licensing and approval process; Cost; Listing; Is the jurisdiction within the OECD; Political stability; and Common language. Strictly Private & Confidential

Appendix 2 Common risk for hedge funds

Appendix 3 Description of various hedge fund strategies

Appendix 4 Biases that affect performance measurements

Bank Negara Malaysia Hedge Funds and Islamic Finance

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