islamic hedge fund cimb

Strictly Private & Confidential

1

Bank Negara Malaysia

Hedge Funds and Islamic Finance - Discussion Material

4 November 2004


2

An Overview

Section 1 Background

Section 2 What is a Hedge Fund ?

Section 3 Hedging, Risk and Strategies

Section 4 The Case for Hedge Funds

Section 5 Issues facing Islamic Investors

Section 6 Possible Alternatives

Section 7 Islamic Hedge Funds

Section 8 Conclusion

IMPORTANT NOTICE


3


Asset Allocation Strategies

A Short History

Number of Global Hedge Funds

Hedge Funds Assets








IMPORTANT NOTICE


4

Background

Asset Allocation Strategies

30

50

28

10

30

10

10

10

2

010

523

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Conventional Investor Islamic Investor

Pe

rce

nt

Allo

ca

tio

n (

%)

Cash Bonds Equities Real Estate Private Equity Hedge Funds Others


5

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 69-70 and 73-74.

• ‘The Institutional Investor’ reported the incredible performance of Julian Robertson’s funds in ‘86. – High performance in 1987-1993 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 1995-96.

• The widely publicized failure of LTCM and the poor performance of star managers, Julian Robertson and G. Soros caused a slowdown in ‘98.


6

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

1 2004 Van Hedge Fund Advisors International

2 Dow Jones News Wires 10 May 2004

3 2002 Van Hedge Fund Advisors International

4 2002 Eureka Hedge Advisors


7

Background

Hedge Funds Assets

• The global hedge fund industry broke above the USD1 trillion level for the first time in May 2004.1

• There is at least USD1.16 trillion under management in hedge funds today, up from USD745 billion in mid-2003. 2

• Hedge fund assets were 46% invested in the US, 40% in Europe and 9% in Asia.3

Notes:





8



A Definition

Common Characteristics

Legal Structure

Fee Structure

The Main Players







IMPORTANT NOTICE


9

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.


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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.


Common Characteristics


11

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.


Legal Structure


12

A company structure I.e. limited liability company issuing shares.

Familiar to investors and relatively low risk to fund manager and easy to operate.

Trusts Investors put his money into a trust.

The trust owns the money and run by the trustee, advised by the beneficiary.

Collective investmentschemes

Known as unit trust, mutual fund or UCITs.

Pooling of money to invest in the markets

Hedge fund unlikely to use this as a vehicle.

Partnerships Hedge funds based in US often take the form of a LIMITED PARTNERSHIP underthe section 3(c)(1) Investment Company Act which allows for exemption from most ofUS SEC regulations. However, the fund is limited to no more than 100 partners, whomust be an “accredited investors” and the fund is prohibited from advertising.

Some are organized under section 3(c)(7) which are also exempt from most US SECregulations. In that case, the fund is limited to no more than 500 investors, who mustbe a “qualified purchasers” and is also prohibited from advertising.

Managed funds Account managed by a money manager on a discretionary basis.

A flexible structure but lack the security of a fund.


Legal Structure (cont.)


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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.


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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 15 - 30 %.

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.


Fee Structure


15


The Main Players

Offshore Administrator

Offshore AdministratorPrime Broker

Offshore AdministratorExecuting Broker

Offshore AdministratorFund Manager Offshore AdministratorInvestors

Accounting reports

Accounting reportsAccounting reportsTrade notification

Buy/Sell

Affirm trades

Affirm trades

Global custodyInternational trade clearingSecurities lendingReportingFinancing

Performance reports

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


16




What is Hedging

Risk from Leveraging

Common Risk for hedge funds

The Various Strategies

Fund of Funds or Multi-Manager Strategy






IMPORTANT NOTICE


17

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.


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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.


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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


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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.

Directional strategies

Long / Short Equity

Global Macro

Managed futures

Emerging markets

Futures funds

Short sellers

Relative value strategies

Market Neutral

Fixed Income Arbitrage

Convertible Bond Arbitrage

Warrant arbitrage

Mortgage arbitrage

Statistical arbitrage

Event Driven

Risk Arbitrage

Distressed securities

Special situation


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The Various Strategies II

Fund of Funds17%

Value17%

Market Neutral Arbitrage12%

Aggressive Growth11%

Opportunistic10%

Market Neutral Securities Hedging

6%

Emerging Markets6%

Special Situations5%

Distressed Securities3%

Income3%

Multiple Strategies3%

Macro3%

Short selling1%

Market Timing3%

Short selling

Fund of Funds

Value

Market Neutral Arbitrage

Aggressive Growth

Opportunistic

Market Neutral Securities Hedging

Emerging Markets

Special Situations

Distressed Securities

Income

Multiple Strategies

Market Timing

Macro

Source: 2004 Van Hedge Fund Advisors International


22


Fund of Funds or Multi-Manager

Advantages

For same amount, investor can get exposure to alarge number of hedge fund

FOF better equipped to perform due diligence

Risk control through diversification

Asset allocation expertise of manager of FOF

Access to managers not accessible individually (e.gfund closed)

Disadvantages

High fees – The fee charged by FOF manager is inaddition to that charged by each hedge fund.

Lack of transparency

Lower overall return due to diversification

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 2008. 3

Note:

1 2004 Van Hedge Fund advisors International

2 eurekahedge.com

3 Cerulli & Associates (IPE.com) - 27 August 2004


23





Mutual Funds vs. Hedge Funds

Comparative Performance

Caveat





IMPORTANT NOTICE


24

The Case for Hedge Funds

Mutual Fund vs. Hedge Fund I

Mutual Fund Hedge Fund

1. Directional Strategy Directional, arbitrage and spread strategies

2. Two asset classes: stocks, bonds Four asset classes: stocks, bonds, currencies,

commodities

3. Long only or short only (dedicated) Both long and short

4. Return is correlated to market averages Return has low correlation to market averages

5. Investor mentality (buy and hold) Trader mentality (opportunistic)

6. Focus on beating a benchmark Focus on absolute return with low volatility

7. Typically unleverage Use of leverage

8. Low degree of risk management High degree of risk management

9. Low sensitivity to personnel High sensitivity to personnel

• The following table highlights the differences between hedge funds and mutual funds.


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Mutual Fund vs. Hedge Fund II

Mutual Fund Hedge Fund

10. Salary-based compensation of staff Performance-based compensation of staff

11. Fundamental analysis (financial accounting) Fundamental, statistical and technical analysis

12. Low sensitivity to price entry and exit point High sensitivity to price entry and exit point

13. Decision and execution of ideas relativelyslow

Decision and execution of ideas relatively fast

14. Low sensitivity to increasing AUM High sensitivity to increasing AUM (to avoiddiluting returns)

15. Management fees Performance fees

16. Heavily regulated Less regulated, but limited to accreditedinvestors

AUM: Asset under management


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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

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.

6.67 %

-20.64 %

-2.72 %

-8.6 %

(25.00)

(20.00)

(15.00)

(10.00)

(5.00)

0.00

5.00

10.00

Hedge Funds NASDAQ 100 DJ IslamicIndex

S&P 500

15.8%

9.2%

11.9%

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

Hedge Funds Mutual Funds S&P 500

Average Annual Performance 2000 - 2002 Compounded Annual Returns 1988 - 2003


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Comparative Performance• 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.


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Comparative Performance

0.73

0.560.52 0.51

1.00

-0.04

-0.11

-0.040.01

0.13

-0.04

1

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

HFR Fund WeightedComposite

HFR Fund of Funds EACM 100 CSFB/Tremont S&P 500 LehmanGovt/Corporate Bond

Index

%

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

Co

rrel

atio

n

Annualized Return Standard Deviation Sharpe Ratio Correlation with S&P 500 Correlation with Lehman/Corporate Bond Index


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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.


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Description of Issues

Opinion on Futures Contracts

Opinion on Options Contracts




IMPORTANT NOTICE


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• 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).

Issues Facing Islamic Investors

Description of the Issues


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• 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.


Description of the Issues II


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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.


34


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.


35







Short Selling

Risk in Short Selling

Short Selling in the Region

Short Selling – Selected Countries

Conditional Sales

An Alternative to Short Selling – Salam Sale

Salam Sale vs. Short Selling

Issues of Salam Sale of Stocks



IMPORTANT NOTICE


36

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.


37

• 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.

Possible Alternatives Short Selling Restrictions


38

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.

Possible Alternatives Risk in Short Selling


39

Country When securitieslending allowed

When Short sellingallowed

Comments

Malaysia Allowed in 1996,Prohibited again in1997.

Allowed in 1996,Prohibited again in1997.

SC issued in December 1995 the Guidelines on SecuritiesBorrowing and Lending, and the SIA 1993 was amended to allowshort sales.

The regulatory changes came into force on March 7, 1996 andallowed Kuala Lumpur Stock Exchange (as previously known) – toenact short-selling rules. With that, regulated short sellingcommenced on September 30, 1996.

However, in August 28, 1997, and in the onset of the Asianfinancial crises, these activities were suspended as interimmeasures to prevent excessive volatility in the markets.

In February 2001, the SC launched the Capital Market Masterplan– that recommended the re-introduction of short selling andsecurities lending activities.

Indonesia Not allowed. Not allowed. No guidelines have been provided BAPEPAM.

Philippines Allowed in 1998. Allowed in 1998. Although the SEC has approved the rules on SBL and shortselling, the rules are not clearly defined in the market.

Singapore Before 1990. Not allowed. Limited onshore lending. Offshore lending is active.

Thailand Allowed in 1999. Allowed in 1999. Short selling is very limited after being allowed in 1999.

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.

Possible Alternatives Short Selling in the Region


40

Country When securitieslending allowed

When Short sellingallowed

Comments

Australia Before 1990 Before 1990 Securities can be borrowed from ASX and counter party.

Cash and non-cash collateral are accepted at 105% - 110% ofthe underlying value of the loan securities. Collateral is marked-to-market daily.

Hong Kong Allowed in 1996 Before 1990 Short selling was prohibited before January 3, 1994. The SEHKthen allowed 17 ut of the 33 constituent stocks of the Hang SengIndex to be sold short subject to several restrictions.

These restrictions were lifted on March 25, 1996 at the sametime that 113 of the firms listed on the exchange, including all theconstituent stocks for the index were allowed to be sold short.

Short selling is allowed for 33 stocks in 1994 and then to a widerange of stocks in 1996.

Japan Before 1990. Before 1990. Allowed for stocks listed on the first section of the exchanges.

South Korea Before 1990. Not allowed. Securities lending and borrowing has not been active.

Taiwan Not allowed. Not allowed. Foreign investors are prohibited from borrowing securities onshore and can only lend securities on-shore to brokers to covertheir fails.

UK Before 1990 Before 1990. Active short selling

USA Before 1990 Before 1990. Active short selling

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.


41

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.


42

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


43

Possible Alternatives Salam Sale vs. Short Sale I

– 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.

• Salam sale shares the same economic result with short sale but differ in the nature of contractual relationship.


44

Possible Alternatives Salam Sale vs. Short Sale II

Salam sale Short sale Differences

Structure

A contract to sell a security or a basketof securities against an immediatepayment for a future delivery.

A contract to sell a security which theseller does not own. The seller deliversit by borrowing the security which hereturns later by buying back from themarket.

Different in philosophy.

Underlying

Can be a security or a basket ofsecurity.

One stock. Seller has to borrow all theshares of the basket to replicate abasket.

More flexibility to Salam sale.

Deal rationale

More oriented towards hedging orreduction of exposure to volatility ordrop in equity market.

Usually used as an aggressiveimplementation of a bear view on astock.

Similar but differentphilosophy.

Risk/Exposure

Seller is exposed to the unlimitedupside in price of the underlying.

Seller is exposed to the unlimitedupside in price of the underlying.

Similar.


45

Possible Alternatives Salam Sale vs. Short Sale III

Salam Sale Short sale Difference

Operations

A pure contract between two partieswith a pre-agreed delivery date.

The borrowing and the sale are twodifferent transactions. The borrowermay call the stock back at anytime.

Different philosophy. Easierfor salam sale.

Credit Exposure and Collateral

The price is paid at inception. The sellerhas to deliver the stock in the future.The buyer may fear the seller will not bein a position to deliver, thus may ask forcollateral to cover the risk.

The lender wants to ensure theborrower will be in position to returnthe stock at anytime, even when thestock price is very high. Thelender/agent will therefore requirecollateral from the borrower.

Similar

Costs

Consists of structuring cost as well asbrokerage, net financing cost andestimated dividend. As costs are paidupfront, early delivery is notadvantageous.

Consist of borrowing fees andbrokerage to sell and buy back theunderlying.

More expensive for salamsale.


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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.


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Single Manager Strategy

Fund of Funds


IMPORTANT NOTICE


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Islamic Hedge Fund

SEDCO - Permal Hedge fund

• Launched in second half of 2003. 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.


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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.


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IMPORTANT NOTICE


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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.


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Thank you


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Contacts

Suryono DarnorAssistant Director, CIMB IslamicCommerce International Merchant Bankers Berhad10th Floor, Bangunan CIMBJalan Semantan, Damansara Heights50490 Kuala LumpurTel: +603-2084 9664Fax: +603-2093 0685Email: [email protected]

Azri ZaharuddinAssistant Manager, CIMB IslamicCommerce International Merchant Bankers Berhad10th Floor, Bangunan CIMBJalan Semantan, Damansara Heights50490 Kuala LumpurTel: +603-2084 9714Fax: +603-2093 0685Email: [email protected]


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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.


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Appendix 1Factors to be considered in determining the domicile of the fund • Factors to be considered:

– 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.


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Appendix 2Common risk for hedge funds

Market risk Liquidity risk Borrow /counterparty credit risk

Although hedge funds typicallyreduce market risk, most d noteliminate entirely either purposely orthey are unable to identify hedges totheir position.

Hedge funds often take very largepositions relative to market liquidity. Inthe event it need to exit a large positionquickly, it may not be able to do so.

Borrow risk is the risk that theborrowed security used in shorting iscalled in by the lender. If replacementborrow cannot be found, shortposition has to be closed or borrowerwill be in default.

Security-specific risk “Herd” risk Financing risk

The risk remaining after the effects ofcommon risk factors have beenremoved

The risk where large proportion of fundmanagers attempt to exit a commonstrategy simultaneously.

Risk from tightening of credit.

Non-market common factor risk “Greek” risk Redemption risk

Risk that arises from factors commonto some but not all, securities. Hedgefunds take on such risk by takinglarge positions in certain types ofsecurities, such as stocks of specificindustries, low-grade debtinstruments or ‘deal stocks’.

Risks arising from the use of options.

Delta, vega, gamma, rho & theta

Hedge funds allow redemption onlyinfrequently. Massive redemptionmay force manager to unwind tradesat wrong time.


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Appendix 3Description of various hedge fund strategies Aggressive Growth

A primarily equity-based strategy whereby the manager invests in companies experiencing or expected to experience strong growth inearnings per share. The manager may consider a company’s business fundamentals when investing and/or may invest in stocks on thebasis of technical factors, such as stock price momentum. Companies in which the manager invests tend to be micro, small, or mid-capitalization in size rather than mature large capitalization companies. These companies are often listed on (but are not limited to) theNASDAQ. Managers employing this strategy generally utilize short selling to some degree, although a substantial long bias is common.

Distressed Securities

The manager invests in the debt and/or equity of companies having financial difficulty. Such companies are generally in bankruptcyreorganization or are emerging from bankruptcy or appear likely to declare bankruptcy in the near future. Because of their distressedsituations, the manager can buy such companies’ securities at deeply discounted prices. The manager stands to make money on such aposition should the company successfully reorganize and return to profitability. Also, the manager could realize a profit if the company isliquidated, provided that the manager had bought senior debt in the company for less than its liquidation value. “Orphan equity” issued bynewly reorganized companies emerging from bankruptcy may be included in the manager’s portfolio. The manager may take shortpositions in companies whose situations he deems will worsen, rather than improve, in the short term.

Emerging Markets

The manager invests in securities issued by businesses and/or governments of countries with less developed economies (as measured byper capita Gross National Product) that have the potential for significant future growth. Examples include Brazil, China, India, and Russia.Most emerging market countries are located in Latin America, Eastern Europe, Asia, or the Middle East. This strategy is defined purely bygeography; the manager may invest in any asset class (e.g., equities, bonds, currencies) and may construct his portfolio on any basis (e.g.value, growth, arbitrage).

Fund of Funds

The manager invests in other hedge funds (or managed accounts programs) rather than directly investing in securities such as stocks,bonds, etc. These underlying hedge funds may follow a variety of investment strategies or may all employ similar approaches. Becauseinvestor capital is diversified among a number of different hedge fund managers, funds of funds generally exhibit lower risk than do single-manager hedge funds. Funds of funds are also referred to as multi-manager funds


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Appendix 3Description of various hedge fund strategies

Futures

The manager invests primarily in futures, which are financial contracts for the buying and selling of an index or commodity at somefuture date. Futures contracts to buy act as long positions while futures contracts to sell may hedge a portfolio. Trading futures canentail particularly high levels of leverage and could therefore pose greater risk than other investment strategies

Income

The manager invests primarily in yield-producing securities, such as bonds, with a focus on current income. Other strategies (e.g.distressed securities, market neutral arbitrage, macro) may heavily involve fixed-income securities trading as well; this category doesnot include those managers whose portfolios are best described by one of those other strategies.

Macro

The manager constructs his portfolio based on a top-down view of global economic trends, considering factors such as interest rates,economic policies, inflation, etc. Rather than considering how individual corporate securities may fare, the manager seeks to profitfrom changes in the value of entire asset classes. For example, the manager may hold long positions in the U.S. dollar and Japaneseequity indices while shorting the euro and U.S. treasury bills.

Market Neutral Arbitrage

The manager seeks to exploit specific inefficiencies in the market by trading a carefully hedged portfolio of offsetting long and shortpositions. By pairing individual long positions with related short positions, market-level risk is greatly reduced, resulting in a portfoliothat bears a low correlation and low beta to the market. The manager may focus on one or several kinds of arbitrage, such asconvertible arbitrage, risk (merger) arbitrage and fixed income arbitrage. The paired long and short securities are related in differentways in each of these different kinds of arbitrage but, in each case, the manager attempts to take advantage of pricing discrepanciesand/or projected price volatility involving the paired long and short security.


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Appendix 3Description of various hedge fund strategies Market Neutral Securities Hedging

The manager invests similar amounts of capital in securities both long and short, maintaining a portfolio with low net market exposure.Long positions are taken in securities expected to rise in value while short positions are taken in securities expected to fall in value.These securities may be identified on various bases, such as the underlying company’s fundamental value, its rate of growth, or thesecurity’s pattern of price movement. Due to the portfolio’s low net market exposure, performance is insulated from market volatility.

Market Timing

The manager attempts to predict the short-term movements of various markets (or market segments) and, based on those predictions,moves capital from one asset class to another in order to capture market gains and avoid market losses. While a variety of assetclasses may be used, the most typical ones are mutual funds and money market funds. Market timing managers focusing on theseasset classes are sometimes referred to as mutual fund switchers.

Multi-Strategy

The manager typically utilizes two or three specific, pre-determined investment strategies, e.g., Value, Aggressive Growth, and SpecialSituations. Although the relative weighting of the chosen strategies may vary over time, each strategy plays a significant role in portfolioconstruction. Managers may choose to employ a Multi-Strategy approach in order to better diversify their portfolio and/or to more fullyuse their range of portfolio management skills and philosophies. (This strategy was originally referred to as “Several Strategies”.)

Opportunistic

Rather than selecting securities according to a single strategy as defined herein, the manager’s investment approach may change overtime to better take advantage of current market conditions and investment opportunities or may combine aspects of differentapproaches at a given time. Characteristics of the portfolio may vary significantly from time to time. Long and short equity positions aregenerally the most common types of positions in these managers’ portfolios.


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Appendix 3Description of various hedge fund strategies

Short Selling

The manager maintains a consistent net short exposure in his portfolio, meaning that significantly more capital supports shortpositions than is invested in long positions (if any is invested in long positions at all). Unlike long positions, which one expects to risein value, short positions are taken in those securities the manager anticipates will decrease in value. In order to short sell, themanager borrows securities from a prime broker and immediately sells them on the market. The manager later repurchases thesesecurities, ideally at a lower price than he sold them for, and returns them to the broker. In this way, the manager is able to profitfrom a fall in a security’s value. Short selling managers typically target overvalued stocks, characterized by prices they believe aretoo high given the fundamentals of the underlying companies.

Special Situations

The manager invests, both long and short, in stocks and/or bonds which are expected to change in price over a short period of timedue to an unusual event. Such events include corporate restructuring (e.g. spin-off, acquisitions), stock buybacks, bond upgrades,and earnings surprises. This strategy is also known as event-driven investing.

Value

A primarily equity-based strategy whereby the manager focuses on the price of a security relative to the intrinsic worth of theunderlying business. The manager takes long positions in stocks that he believes are undervalued, i.e. the stock price is low givencompany fundamentals such as high earnings per share, good cash flow, strong management, etc. Possible reasons that a stockmay sell at a perceived discount could be that the company is out of favor with investors or that its future prospects are not correctlyjudged by Wall Street analysts. The manager takes short positions in stocks he believes are overvalued, i.e. the stock price is toohigh given the level of the company’s fundamentals. As the market comes to better understand the true value of these companies,the manager anticipates, the prices of undervalued stocks in his portfolio will rise while the prices of overvalued stocks will fall. Themanager often selects stocks for which he can identify a potential upcoming event that will result in the stock price changing to moreaccurately reflect the company’s intrinsic worth.


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Appendix 4Biases that affect performance measurements Self selection bias Managers decide themselves what they want to include in the database. Those that have funds

with unimpressive track record will not want to have that information exposed.

Instant history bias When a hedge fund enters a database, it has a track record. Because only hedge funds withgood track records enter the database. This creates a positive bias in past performance in thedatabase.

Survivorship bias Unsuccessful funds and managers tend to disappear over time. Only successful ones presenttheir track record.

Biases also affect risk measures. Funds that exhibit highly volatile returns in the past tend todisappear. Only funds that exhibit low volatility survive. Thus, reported volatility will end to below.

Smoothed pricing Illiquid assets are frequently used by hedge funds. Because prices used are often not up-to-date market price, but estimates of fair value, their volatility is reduced.

Option-like investment Traditional risk measures in performance appraisal assumes normal distributions or at leastsymmetric distribution. Many investment strategies followed by hedge funds have option-likefeatures that violate this assumptions. E.g - Small profit if price converge but huge loss if modelfails.

Fee structure andgaming

Funds charges high fees – base + incentive. Creating an option like compensation structure.

One can argue that they have strong incentive to take huge amount of risk if past performancehave been bad.

One can also argue that because of high water mark provision, hedge fund managers may notwant to take more risk as their performance diminishes.

Past risk measures may be misleading for forecasting future performance and risk for a fund thatas performed badly in the past.

islamic hedge fund cimb

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