Call for Shariah-compliant equity risk management

By OBIYATHULLA ISMATH BACHA

For the manager of a Shariah-compliant portfolio or mutual fund, there are few, if any, alternatives to protect his portfolio from market turbulence

The recent turmoil in global equity markets is a wake-up call to policymakers and Islamic equity market players. Equity and bond markets, having been fed on a steady diet of artificially low interest rates, particularly, since the global financial crisis 10 years ago, have been at record highs. Now faced with the reality of rate normalisation, both the bond and equity markets have reacted with extreme turbulence. The volatility index, VIX, which had been tepid the last few years, has once again risen.

Equity markets are invariably volatile, which is why a whole range of risk management tools have been developed. Portfolio managers hedge equity risk in several ways, almost all of which use derivative instruments. With futures contracts, portfolio managers can hedge short-term fluctuations with Stock Index Futures (SIF) contracts. Among others, SIF contracts can be used to alter portfolio betas and manage systematic risk, and also replicate synthetic Treasury-bill positions thereby neutralising any volatility.

With equity options, numerous hedge strategies are possible. Spread positions can be used to limit value change within a range, while straddles can be established to take advantage of extremes in market volatility. The most popular hedge strategy using options, however, is Portfolio Insurance.

As the name suggests, the strategy can be used to preserve the value of an underlying portfolio regardless of market volatility. It involves combining the underlying portfolio with index-put options. If the index puts were of three-month maturity, the underlying portfolio’s value is preserved for that period. The fund manager can be assured that a protective floor has been set for his portfolio should markets tank while simultaneously being able to participate in an upside rally, if markets rise. This is the advantage that options have over futures contracts. Options provide downside protection from unfavourable price movements, while also enabling one to take advantage of favourable price movements.

Risk and Exposure

Broadly speaking, with derivatives, one can determine the magnitude and timing of the risk or exposure that one is willing to take. Thus, a hedger could choose to have more protection at some points and less at others.

While risk management techniques and tools have seen tremendous development within the conventional finance space, little has happened within Islamic finance. This lack of risk management tools is particularly true for equity risk management. For the manager of a Shariah-compliant portfolio or mutual fund, there are few, if any, alternatives to protect his portfolio from market turbulence.

As things now stand, the Islamic Mutual fund manager is constrained to two traditional techniques, that of asset allocation and stock selection.

Asset allocation seeks to time the market by allocating different proportions of investible funds among equities, bonds (sukuk) and cash. Thus, when a fund manager sees turbulence ahead, he lightens the equities portion and enhances bonds and cash. He does the opposite when he is optimistic (bullish).

The other traditional strategy of risk management, stock selection, involves identifying and allocating funds between growth stocks when bullish and defensive (low beta) stocks when bearish. Though seemingly obvious, the empirical evidence is that both stock selection and asset allocation are not only difficult and expensive, but downright hazardous. There is an entire school of thought on stock price behaviour, the Random Walk School that debunks these traditional strategies.

Prudence Versus Wealth Preservation
There is no doubt that the Shariah requires one to take risk in order to justify the returns earned. Shariah also prohibits the taking of unnecessary risks, and makes compulsory the preservation of wealth. Prudence is always an emphasis. Yet, prudence and preservation of wealth are not easy when one does have the needed tools of risk management. Today’s financial markets can turn on a dime. Short-term risk events crop up often.

Since the majority of Shariah scholars disallow the use of derivatives, for fear of their use in speculation, Islamic portfolio and mutual fund managers are unable to use the many risk management tools so

heavily relied upon by conventional fund managers. In many ways, the Shariah-compliant fund managers may be competing with their hands tied. Yet, the ordinary investor takes little cognisance of this difference when evaluating Islamic fund managers against their conventional peers. This need not be the case.

Currently, listed stocks go through Shariah screening for compatibility. Shariah-compliant stock indexes made up of stocks that have passed the screening filters already exist. However, there are no futures or options contracts on these indexes.

Yet, Shariah-compliant derivative contracts like forwards and options are available for currency risk management. Hedging contracts based on waád (promises) are being used in many countries for managing exchange rate risk. Though the labelling may be different, these contracts effectively mimic the payoffs of forward/ futures or option contracts. Speculative use of these contracts is avoided by requiring investors to show documentary evidence of their underlying currency exposure.

Inability to Hedge

The inability to hedge exposes investments to unnecessary risk. Aside from wealth preservation, there are larger and more serious consequences to the Islamic fund management industry and Muslim nations.

First, the susceptibility to wild fluctuations increases the required return to the equity investment. Second, individual investors, even those investing through mutual funds will shy away when the returns do not justify the risks. Third, there could be an outflow of funds from the Shariah-compliant to the conventional sector or worse, overseas.

Stock markets of the Muslim world, already tiny by international standards, will not grow but may atrophy. This has huge consequences for developing countries. Volatile and underdeveloped equity markets have higher risk premiums, which translates into higher costs of capital for businesses within. For nations and firms aspiring to compete internationally, this is unnecessary encumbrance.

  • Dr Obiyathulla Ismath Bacha is professor of finance at the Malaysia- based International Centre for Education in Islamic Finance. The views expressed are of the writer and do not necessarily reflect the stand of the newspaper’s owners and editorial board.