Performance of Islamic Funds in the Gulf Area Finance Essay

There is a lengthened chronological association with the growth and development of traditional commercial banking practice and religious conviction. As Brown and Skully (2007) have put it, some of the earliest economic transactions commenced with the storage of gold in religious temples which expanded at a swift pace, thereby, allowing the ancient Greeks to make credit notes which were acknowledged throughout Greece. Islamic banks and financial organizations are operating in accordance with the facilitations and decrees of the Islamic Shariah law, which denies benefits by means of any form of usury. Islamic banks function on the basis of sharing profits and losses with their clientele which is in contrast with the conventional banking systems, whose chief task is to intermediate by lending money at higher rates of interest than paid by the bank on funds which are set down by the borrowers, thereby, obtaining gains from the margin between the two. What is more, Islamic banks operate in facilitating money transactions as well as exchanges, whereas, the conventional banks function on the products that are purchased or sold with the use of interest as well as time. More to it, the Islamic religion forbids trade of money for money, however, allows money to be put to work, and then take part in the profits or losses which are realized (Alford, 2003) which is the base of Islamic funds. Recognized and strict banking has now been existent for nearly a thousand years, with Islamic Banking being associatively a new phenomenon as the first Islamic Bank, Mit Ghamr Local Savings Bank of Egypt, which was established in the year 1963 (Brown and Skully, 2007). However, even then, the actual development of Islamic finance did not commence until the late twentieth century when the Middle East nations went through a giant rise in surplus funds. Since that time, the Muslim investment has extensively spread all throughout Europe and Asia, while Islamic finance is yet to expand. The straight Islamic financing approaches and methods such as with the Islamic bonds [1] are gaining huge prominence in the West similarly as the Islamic based funds management has done so far. With time passing by, there has been an increased demand for Islamic funding provisions all across the Muslim world, chiefly, in the dearth of benefits. In order to function, Islamic bank system became dependent upon the work of Islamic law. Hence, since that time, Islamic funds system has prosperously spread all over the world, as it operated according to this pattern, and as a result, the Islamic banking became one of the largest established bank systems set to compete with the conventional banks (Iqbal and Molyneux, 2004). Eventually, according to Khan and Ahmed (2001), Islamic Banks possess a number of products which are compatible with the Islamic Law, such as Murabha, Musharaka, and Mudaraba (Khan and Ahmed, 2001). In 1981 the Gulf Cooperation Council (GCC) was formed in Dubai joining all six countries (Saudi Arabia, United Arab Emirates, Qatar, Oman, Kuwait and Bahrain) to reach a cooperative frame work in all fields (GCC.org). Each of the GCC nations is autonomous in terms of currency and administration. It is predictable that the entire population of this region is nearly 34 million, and the principal religion in all the nations of the Gulf Cooperation Council is Islam. The GCC nations are affluent in natural reserves, for example, oil and natural gas. The Gulf States have developed into the largest reliant export hubs for oil which is a key requirement in the global market (Saif, 2009).

Aims and Objectives of the Study

Regardless of the increasing consideration given to Islamic mutual funds by practitioners, there has not yet been any rigorous research or analysis with regards to the performance of these funds, and how they fare in comparison with the conventional funds. Hence, through this study, we aim at the analysis of the performance of Islamic funds, investigating whether there is existent any considerable reward or penalty for investing them. This study is carried out to find out the performance of international Islamic indices with an objective to assess if the Islamic funds are perilous or safer than the pertinent benchmarks. Alongside, the key objective of this assessment is to thoroughly study the profitability of Islamic and conventional banks, keeping the GCC region under spotlight. Furthermore, the study aims to find if the Islamic funds in GCC countries outperform or underperform international Islamic indices. The final aim of the study is to find if the Islamic funds are riskier or more safe that the relevant benchmarks. As a result, with due consideration to the increased competition between Islamic banks and the conventional banks at this point of time, chiefly, in the Muslim domain for the reason that it does not take much of the interest, this study is carried out to analyze every commotion associated with the performance of Islamic funds in the Gulf States region. However, we will also discuss about the systems brought into use in other countries. Last but not the least, a thorough assessment of the disparities between financial systems makes it a more striking and fascinating topic of discussion.

Research Methodology and Data

The research methodology for this study is based on the similar variables which have been taken up by studies carried out in the past on fund performance. In this dissertation, the basic Capital Asset Pricing Model (CAPM) [2] will be used to measure the Islamic funds performance in the GCC region by comparing each country Islamic funds with their relative market index. Coefficient of determination and t-statistics will be applied in the process by regressing the monthly excess [3] gain (loss) of the fund with the market monthly excess gain (loss). Other performance determination will be used in this dissertation like: (sharp ratio, Jensen's Alpha, Fama's Ratio and Sortino ratio). The same methodology will be applied for all the GCC Islamic funds but with a non-regional Islamic index like Dow Jones Islamic Market. The data for this research will be provided from secondary data providers. The market indexes and risk free data will be acquired from Datastream and this secondary data is provided through the university laps. The remaining data regarding the Islamic fund in the GCC countries will be acquired from >>>> which is also provided by the university.

Structure of the Dissertation

This dissertation centralizes on performance of the Islamic funds in GCC region, and has been segmented into seven chapters. The structure of this dissertation is as follows:

Chapter 1

The first chapter comprises of an introduction to the research, and also introduced the research questions. The significance of understanding the performance of Islamic funds in the GCC is discussed and enlightened.

Chapter 2

The second chapter provides with an overview of the Islamic Banks, conventional mutual funds and Islamic funds. This is inclusive of a general idea of the history along with the challenges they confront, and what are the fundamental rules and regulations. More to it, this section prefaces some of the most significant Islamic funds types.

Chapter 3

The third section of this dissertation offers a basic concept of the economic life in the GCC, prior to the presentation of the banking industry, and the financial markets in the GCC, followed by the comparison of the evaluation.

Chapter 4

This chapter offers a summary of the studies and researches that have been carried out on the performance of funds. The evaluation is not restrained to Islamic funds, but will be on both the conventional fund and the Islamic funds.

Chapter 5

This section puts forward the data important for this study. Also, the attributes and features which will be brought into use in the analysis of the Islamic funds are thoroughly explained.

Chapter 6

Chapter 6 explains the results and conclusions of the research, thereby, displaying the findings.

Chapter 7

The last chapter confirms and discusses the outcomes of this research. In addition, it covers the section of references and bibliography that have been used. Part 2- LITERATURE REVIEW

Islamic Banking: An Introduction

In this time and age, Islamic Banking system is believed to be one of the premium trades in the banking industry. The industry is comprehended to be 46 years old. We can define Islamic Banking as interest-free banking that works on the exchange of profits and losses. Hence, in this chapter we will talk about the origin and history of Islamic Banking. To start with, we will compare the services that are provided by Islamic Banks along with their activities in association to those of the conventional banking systems. Following it would be a study of the history of Islamic banking, while the last segment would comprise of the acceptance and prohibition of chores in Islamic Banking, followed by the examination of loan contracts in Islamic Banks.

2.1 An introduction to the Islamic Funds

The Islamic funds market is one of the swiftest growing sectors within the Islamic financial configuration. However, when they are put to comparison with the mutual fund industry as a whole, Islamic mutual funds are yet to 'grow up' as they are in their infancy phase of development, chief of them being around for no more than a decade (Elfakhani and Hassan, 2005). Islamic funds are quite diverse for an industry which is somewhat young. It is seen that while the major part of the funds are equity funds, some 86 per cent of the total 126 funds, balanced or secured funds comprise of 14 per cent, and Islamic bond funds comprise of 2 per cent. The other three funds are currently launched (Elfakhani and Hassan, 2005). More to it, amongst the equity funds, various segments and geographical investment areas are efficiently attributed. Islamic funds have undergone tremendous development during the conclusion of the late 1990s for the reason that they efficiently benefited from the boom witnessed in technology, where most of them delineated high positive returns which even transcended their highest targets. Their number incremented from 8 funds before 1992 to 95 funds along with approximately $5 billion in assets by the year 2000. However, it dropped to nearly $4 billion by the conclusion of 2001. It is observed that more funds have been launched ever since the year 2002, with even more striking market opportunities, and more lessons being learnt.

2.2 Rules and Principles of Islamic Investing

An Islamic fund is analogous to a conventional fund in a number of ways, but, unlike its conventional foil, an Islamic mutual fund ought to obey the rules of the 'Shariah' or the Islamic law investment notions. The principles and regulations of Islamic Banking are obtained from the Quran and words of the Prophet Mohammad. According to the Quran, there are three major practices which have been outlawed, and hence, they should not be contracted with in Islamic Banking. These three practices are Riba, in other words, interest; Maysir or Betting' and Gharar or uncertainty. It is well-known amongst the Islamic territories that Riba is prohibited in Islam as it is referred to in the Quran. It is the increase on the loan, irrespective of whether it is a fixed or variable one, or for a short or long term. This is believed to have led to difficulties in the economy along with a lack of efficacy which may be as a result of the lenders suffering huge losses for having collected many of the funds. Also, for the reason that this enables a number of benefits to deal, it is believed to have led to the inflation of the debt pyramid in the world. On the other hand, Gharar or Uncertainty is strictly forbidden in Islam and is also referred to in the Quran. It is believed that Gharar will happen in case the seller is unaware of what he is selling, and the buyer of what he is purchasing. For that reason, there must be an exact provision and explanation in detail of what is being retailed or purchased, and the target is always to eradicate any ambiguities associated with it. The third and the last factor is Maysir or Betting, which is also strictly forbidden in Islam, which construes to gambling or speculation and betting. The reason for averting this activity is due to its mysterious behaviour, and the returns are not assuring re-entry. Hence, we can construe that all of these practices are prohibited and are not used in Islamic banking for specific advantages. The Shariah guidelines and decrees reign over various facets of an Islamic mutual fund, which are inclusive of its asset allocation or port-folio screening, investment and trading commotions, and income dissemination or purification (Elfakhani and Hassan, 2005).

2.3 Conventional and Islamic funds (History):

Islamic mutual funds represent one of the swiftest growing sectors within the Islamic financial industry. With Shariah supervision being an inseparable part of the Islamic industry, its place in association with the Islamic funds performance is undoubtedly no less significant. When picking investments for their portfolio, or asset allocation, conventional funds can autonomously choose between debt-bearing investments and profit-bearing investments, thereby, investing across the gamut of all the accessible industries. However, it is essential for an Islamic fund to set up screens in order to opt for those companies which meet its qualitative as well as quantitative criteria as set by the 'Shania' guidelines (Elfakhani and Hassan, 2005). Also, qualitative screens are brought into use so as to sieve out companies which are based on the conduct of their business or securities which comprise of one of the Shariah forbidden components, as discussed earlier, or companies which carry out unscrupulous business practices as per Shariah law. As a result, the income implements which are barred from the Islamic-approved securities are corporate bonds, treasury bonds as well as bills, certificates of deposits, stocks, warrants, and last but not the least, some derivatives like options, etc (Elfakhani and Hassan, 2005). More to it, it is not possible for Islamic mutual funds to trade on the edge, or in other sense, it is not possible for them to use interest-paying debt to finance their investments. Moreover, it is also not acceptable to get involved in sale or repurchase agreements. These transactions are believed to be of the similar kind as the indirect interest changes. The foundation upon which an Islamic fund operates ought to be Shania compliant, or in other words, its invested funds ought to be free of interest-based debt or conjecture. It is not possible for Islamic mutual funds to trade on the edge. This means that they cannot make use of the interest-paying debt for financing investments. However, conventional funds such as hedge funds, arbitrage funds, and leveraged buy-out funds scrounge enormously in order to finance their investment commotions, and they are forbidden to Muslim investors. In contrast to the conventional mutual fund managers, it is not permissible for Islamic fund managers to speculate. An Islamic financial unit is looked forward to presume risk after making an appropriate assessment of risk with making use of the information and knowledge. Only in the lack of information or under circumstances is speculation considered to be of a kind similar to a game of opportunity, and is culpable.

2.4 Literature on Funds' Performance:

Earlier, mutual fund performance literature could not deal with the performance of the Islamic mutual funds' industry. A study of Hajara Atta (2000) suggests that the Islamic index goes one better than a sample of unscreened ethical benchmark by bringing into use Sharpe, Treynor, and the categorical Jensen measure (Atta, 2000). A number of theoretical inferences result from the Shariah law as well as demographics of Islamic funds. Islamic mutual fund managers are prohibited in their prowess to exploit paramount information or winning markets. Nevertheless, as put by Bollen and Busse (2001), the average mutual fund manager has not been found to delineate his superior proficiencies (Bollen and Busse, 2001). As a result, the argument which is exactly opposite may also infer that Shariah law restraints the potential harm that is caused by a manager. As of December 2001, there were 105 Islamic mutual funds, of which 86 were equity finds, while 16 were balanced or secured funds. The other three were Islamic bond funds which were offered by the Malaysian organizations (Wilson, 2005). The Islamic funds are geographically classified with predominance given to the global equity funds. Akin to socially responsible investment, Shariah compliant investment does not entirely pursue profits. As argued by Levin (2005), such a distraction by concerns with regards to the responsibility would be disadvantageous for financial performance (Levin, 2005). These are supported by evidence that suggests standard sin stocks such as of alcohol, gambling, or tobacco, excluded by Islamic funds so as to deliver considerably positive abnormal returns. The Shariah compliance of products as well as provisions is possibly financially more advantageous in businesses, where consumers and executives go through a higher utility from obedience to the Shariah law. As a result, islamic mutual funds may experience a considerably better financial performance in principally muslim economies as compared to others. According to Christoffersen and Sarkasian (2009), centres which have a high density of economic intermediaries and competitors have a considerably absolute influence on the mutual funds learning profits along with their eventual financial performance. They've also explained the performance pertinent to being located in a financial centre with better knowledge of spill-over effects (Christoffer and Sarkasian, 2009). The patterns of Islamic funds are, perhaps, more homogeneous as compared to their conventional counterparts as a reason of the Shariah law's narrow concept of eligible commotions. Islamic funds may have comparatively lower betas than conventional, may be leveraged funds (Hoepner et al, 2010). Islamic funds also invest quite proportionally in smaller stocks, for the reason that large stocker possess a higher stake of receiving insufferable revenues from activities that are forbidden under the law. Hence, Islamic funds are expected to be more prone to growth stocks as compared to value stocks, for a simple reason that the former is believed to possess a lower leverage in comparison to the latter (Campbell and Vuolteenaho, 2004). Nevertheless, literatures have often failed to find out a significant theoretical reason as to why Islamic funds should be more exposed to momentum and not to the contrarian investment strategies or vice-versa (Hoepner et al, 2010).

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