1	Hedge funds: Regulatory (including Sharī<a) issues Mahmoud A. El-Gamal Rice University
2	“Islamic Hedge Funds”: Symptom and Disease “The first ever Islamic-XYZ” Syndrome: Free publicity, star value vs. first mover advantage Put pressure on regulators Get more lenient reception by Muslim investors All are particularly problematic in “hedge fund” space (see later slides) Sharī<a-arbitrage and Islamic jurisprudence: Sharī<a viewed by financiers as an obstacle to be circumvented, secular regulators viewed by jurists as obstacles Shariī<a arbitrage: re-engineer conventional products using classical contract forms, or at least the names thereof Adherence to classical contract forms vs. substance (e.g. hiding debt/leverage by taking it off-balance sheet) Also very problematic in “hedge fund space” (see later slides)
3	What’s a hedge-fund, anyway? U.S.: Unregistered under Investment Company act – less than 100 investors, all of whom must be “sophisticated/accredited investors” (high net worth individuals or legal entities) Recent SEC vote: register managers as “investment advisors” under act of 1940– This is not very restrictive, meant only to exclude felons, etc. Have more freedom in selecting investment strategies: no limits on [direct] leverage, short-selling, derivatives trading, etc. Principal-agent problem: Reduced somewhat by inducing managers to invest a significant portion of their own net worth in the same portfolio with their investors Peculiar return structure: Seeking absolute returns – invites investors to demand them, recent evidence of non-sophisticated investors flocking to hedge funds Difficult to quantify leverage through shorting, derivatives, etc. – invites Sharī<a arbitrage mentality for hidden leverage Selective reporting (survival bias) misguides investors about the amount of risk (gharar/tadlees), sets unreasonable expectations on returns
4	It’s all about leverage In Sharī<a arbitrage forms of Islamic finance: jurists in-fact encourage corporations to take debts off their balance sheets e.g. sale, lease-back, buy-back à easier to pass leverage screens (debt/assets or debt/market cap) Hedge fund strategies add other hidden leverage: Short selling: borrowed/leased stock, not cash! Of course, salam is a form of leverage, but it is very highly regulated, whereas short selling is not Futures, options: roughly 50-to-1 leverage based on common margin requirements All forms of leverage, including quests for absolute returns: reduce probability of small losses, increase probability of very large losses Substance of classical Islamic jurisprudence: regulation to curtail leverage through borrowing, salam, options, and other tools
5	Jurisprudence on limiting leverage All Texts against riba All Texts against <īnah “Do not sell that which is not with you” “Trading one deferred liability for another” Prohibition of al-bay<-ul-mudaf, al-bay<-ul-mu<allaq, etc. Of course, “financial engineering” can circumvent all of those, while adhering to classical forms: Instead of open riba, use <īnah, tawarruq, etc. possibly under the guise of bay<-ul-<uhdah, bay<-ul-amanah, etc. Instead of short sale or forward, use salam + credit facility through <īnah, tawarruq, etc. Instead of options, use <urbūn, etc.
6	Leverage risks SEC staff: The use of leverage may have a significant impact on investment results because, while it may enhance investment gains, it may also magnify investment losses. Leverage also may increase the risk caused by holding assets that are illiquid or whose full value cannot be realized in a quick sale. Recent “Islamic hedge fund”: Principal claimed at a recent Islamic finance conference that hedge funds achieved “lower risk and higher return” based on historical data (ignoring aforementioned selectivity bias + using inappropriate measure of risk) Note: Bloomberg, July 19, 2004 – A three-year-old study by Bing Liang, a professor at Case Western Reserve University in Cleveland, showed that survivorship bias could falsely add as much as 2 percent annually to performance figures reported in hedge-fund indexes Jurist on same hedge fund’s Sharī<a board wrote a lengthy article justifying the use of different screens as stricter and yet allowing a larger universe + hailed hedge fund strategies as risk mitigation mechanisms!
7	Systemic risks Hedge fund language invites investors who demand “absolute returns” In times of low volatility (such as the current time), the only way to meet investors’ return expectations is through [excessive] leverage If volatility remains low, highly leveraged managers perform better, attract more investors Because of “few pickings”, all managers are invested in highly correlated portfolios, and highly leveraged It is not a “hedge” unless you’re the only one making it When volatility returns, many managers fail simultaneously, their “lenders” suffer in turn, etc.
8	Disclosure and solicitation NASD: Promotion of Hedge Funds. Broker-dealers must balance sales material and oral presentations that promote hedge fund investing with disclosure of the risks Free press for “first ever Islamic hedge fund” – is it not an indirect form of solicitation With limited or no regulation, disclosed information is not verifiable by independent third parties Exotic portfolios may be difficult to “mark to market” à high degree of discretion to managers in valuation, reporting, and at liquidation Suggests imposing higher auditing standards for hedge funds Also suggests utilizing restricted mudaraba contracts
9	Conflicts of interest + fraud Conflicts of interest for managers and jurists Multiple clients (long a stock for some fund, short it for another!) Altering screening rules to suit one provider, possibly harming others Relationship with prime broker (longer term, side fees for services that do not directly benefit investors) Bloomberg – July 19, 2004: Edward Siedle, a former SEC lawyer and president of the Center for Investment Management Investigations at Benchmark in Ocean Ridge, Florida, has had three clients who unknowingly invested in hedge-fund scams. One group of investors was taken for $300 million. “There are plenty of hedge-fund scams out there,” Siedle says. “The fact is, high-net-worth individuals and institutions are not so prescient that they can detect scams. They get ripped off all the time.”
10	Concluding Remarks There is room for hedge fund strategies in finance: Islamic jurisprudence regulates but does not eliminate leverage Multiple dangers: Sharī<a arbitrage strategies squander the regulatory content of classical Islamic jurisprudence Deceptive reporting (tadlīs) is very common in hedge fund space, additional selectivity bias in “Islamic” space Unlike conventional leverage, leverage (riba) in hedge fund portfolios is extremely difficult to quantify à higher investor as well as systemic risk/uncertainty (gharar) Recommendation: develop disclosure and leverage computation methods, regulate according to the same rules as mutual funds