There is much talk over the size of the Islamic finance industry, and how it has created mainstream investment tools even for non-Muslim investors. This could be true for the sukuk market.

The majority of sophisticated Islamic investment products (such as hedge funds, private equity and structured products) however, are not growing beyond their local few players. Most Shariah compliant money is still in simple Murabaha- or Mudaraba-based deposits while sophisticated Islamic products have little assets under managements.

Middle Eastern ultra high net worth investors today don’t have Islamic investment options available to them which are as good as, and can compete with conventional investment products.

Capital markets structuring teams within several western banks endeavour to create Islamic products that replicate conventional ones by financially engineering Islamic principles into derivatives payouts. While conventional finance is liability driven, Islamic finance is asset backed/real economy-based. This results in focus on form of Islamic principles rather than content, which for many Muslim investors seem hypocritical and demeaning to Islam.

Another reason why sophisticated Islamic products have such little asset under management is that MENA investors are very much interested in leverage. Islamic products don’t offer the leverage they crave. Leverage for the sake of leverage is not Shariah-compliant. Those same investors also have access to offshore bankers and a vast pool of conventional investment products to choose from, in contrast to retail Muslim investors. It is also possible that the lack of consistency in Fatawa rulings and Islamic contracts may have kept investors confused and hesitant about the right Shariah investments.

Asset Allocation in the MENA Region

It is commonly accepted in modern finance that strategic asset allocation and diversification across a portfolio of asset classes reduces risk and increases risk adjusted returns. However, diversification in terms of Shariah-compliant products is rather limited.

Real estate and equity are the backbone of Islamic investments, mainly because both have a natural affinity with Islamic principles, and, because MENA investors have an admirable strong conviction and belief in their local equity and property markets. Familiarity and knowledge of the investment opportunity drives the investment decision.

The remaining asset classes, however, are almost completely off limits to sophisticated Muslim investors. In an industry estimated at around $900 billion in size, there are some long only “international standard” Islamic equity funds, fewer real estate funds, and a couple of Sukuk funds with very little volume or depth (all estimated at $35 billion in size). There are four Islamic Long/Short US equity funds (estimated at $300 million), 20 to 40 private equity funds (at $3 billion in assets under management), and several Islamic issuance programs that can swap conventional structured products payouts in a Shariah way (estimates unknown). All these products, though controversial, still offer an investment option.

Considering the limited and universally disputed Islamic investments available, sophisticated MENA investors don’t have the luxury to think about asset allocation even if they wanted to.  Diversification and strategic asset allocation is not a major consideration.

Those same investors incessantly request investment products that can compete with their own local GCC equity and real estate markets. In rough numbers that amounts to 20 per cent-plus returns per annum with a volatility of around 50 per cent. MENA investors want more of the same.

There is also a strong preference for advisory rather than discretionary relationship with bankers - short-term opportunistic in their investment outlook and traders in their nature to the core. It’s a trading mentality that applies to everyday life from buying carpets, to homes and stock markets. Up until the credit crisis, the average MENA investor relentlessly chased quick returns and tactical opportunities without an investment strategy in place. Conventional offshore Arab money though has been swayed into longer term investment strategies with asset allocation in mind.

Such convictions and beliefs drive MENA investors to appreciate a high degree of leverage (after all if you really believe in the investment, you would like to maximize your return from it). It also drives an approach that does not care about diversification (again, if you believe in your investments, why diversify).

Will MENA investors continue to follow this heavy involvement, high conviction, concentrated approach? Despite historical market blips so much wealth has been created using this entrepreneurial opportunistic approach, in the GCC and elsewhere in the EM markets.

Local market and economy maturity combined with generational wealth transfer may lead to MENA investors taking less of a hands-on approach and relying on asset allocation and diversification.

Limits

Today, however, the limited investment options and trading tendency may marginalize sophisticated Muslim investors and exclude them from participating in the wider economy in a strategic manner. In order to establish a wider range of Islamic investment products, Islamic banks can organically develop Islamic finance principles into modern day finance rather than rely on Western banks, hence developing less controversial and more widely accepted Shariah-compliant investment products.

Another route is to operationalize Islamic finance principles and ethics in a fresh new perspective. Islamic finance has an honourable tradition that is a proponent of social and corporate responsibility and social justice. It also vehemently rejects exploitation and favours profit and risk sharing among investment parities.

Rather than forcing cubes into round structures and mimicking conventional products, Islamic ethical investments can be developed to follow the spirit of Islam within a conventional financial system. Investors can then purge their investments of Haram dealings to charity for example. This may allow the creation of sophisticated and diverse investment products enabling Muslim investors to fully participate as major players in the global economy.