Photographer\: Charles Pertwee/Bloomberg

This article first appeared in the 4th quarter 2018 edition of Personal Finance magazine.

Bank deposits remain by far the largest source of Shariah-compliant assets, but other types of assets have become increasingly significant, particularly for the Islamic asset management industry.

Shariah-compliant equity funds were an early diversification from the original bank-based business. Takaful, an Islamic product akin to insurance, has been growing in significance, while financial professionals have been investigating ways to bring waqf, or Islamic endowments (currently largely based on property) into the financial mainstream, either through Waqf-related bonds or equity-based investing.

Perhaps the most dynamic area of development is in sukuk, commonly referred to as Islamic bonds, an asset type that has been seeing rapid growth in the traditional Islamic finance markets. There are also new sovereign sukuk from countries such as the UK, Hong Kong, Luxembourg, Pakistan, Oman, Saudi Arabia and South Africa.

As we see it, the next step in the evolution of the Islamic finance industry is achieving critical size and global reach. At present, the origination and distribution of Shariah-compliant financial products is largely limited to a small pool of firms in the Middle East and Southeast Asia, such as Saudi Arabia and Malaysia. The most established players within the industry are “home-grown” local or, at best, regional, institutions.

The limitation of local firms is that, while they may have a rich product offering focused on their region, they are often unable, on the one hand, to offer their customers investment capabilities that extend beyond that region and, on the other hand, to offer their unique products to customers outside their region. Meanwhile, global players may have the necessary wide distribution network and capabilities to offer truly global financial products in more conventional asset classes across several countries and regions, but many cannot offer a wide range of products covering Islamic finance, nor a long track record in the space.

However, we are starting to see new markets outside of Muslim countries opening the doors to Islamic finance and widening the distribution network for Shariah-compliant financial products. These include markets in London, Dublin, Hong Kong, Singapore and Luxembourg.

The entry of global players, such as Franklin Templeton, has also opened the doors for investors in Muslim countries to access products that are both more globally managed and globally accessible, to diversify their portfolio.

While we see interest in Shariah-compliant products broadening out across the world as the instruments become more mainstream, the fact remains that Islamic financial institutions and wealthy Muslims are still the biggest investors. We believe much more needs to be done to grow and deepen the Islamic finance industry, not just by attracting more faith-based investors, but also by appealing to and creating awareness among non-faith-based investors.

Open to all

The principles of Shariah investing mean that these products lend themselves well to diversify any investor’s portfolio, regardless of faith. Not only are the returns attractive relative to traditional fixed-income assets, volatility has historically been more subdued – something that could prove important in a rising interest-rate environment.

The limit on debt ownership due to Islamic principles also means that a Shariah-compliant equity portfolio may appear higher-quality than more conventional portfolios due to the screening out of highly leveraged companies, and the absence of sectors such as alcohol, tobacco and gaming also makes them more ethical. Indeed, many attributes of a Shariah-compliant product may also appeal to those interested in ethical, environmental or socially responsible investing.

Islamic bonds or sukuk provide exposure to some of the fast-growing and most financially sound economies in the Gulf Cooperation Council (GCC) and Southeast Asia, countries where credit ratings are relatively strong but that are often under-represented in many traditional bond indices and funds.

Due to their unique structure and market dynamics, sukuk tend to be more insulated from market events and have lower correlations to other asset classes, including global bonds, global equity and commodities. We believe all of these factors could make sukuk an appropriate complement to investors’ existing portfolios. Indeed, several so-called “conventional” investors around the world have been pouring funds into the asset class, attracted purely by valuations and fundamentals.

The inclusion of sukuk to emerging-market indices will add to the pool of investors that are benchmark-sensitive in the emerging-market bond space, which is particularly important for the government and corporate sukuk that meet these criteria. Even though some sukuk issued out of the GCC may not meet the criteria for emerging-market index inclusion (due to size, rating or per capita income), even partial inclusions bring light to the sukuk regions that are still under-represented in global fixed-income allocations in spite of a compelling risk-reward investment rationale.

The road ahead

With expansion, the challenge for Islamic finance is to achieve a degree of uniformity in the treatment of assets, providing comfort to international investors, when the underlying principles governing such treatments necessarily have local roots. The Islamic banking system is itself seeing some interesting new developments that could extend the reach of more sophisticated Shariah-compliant products. Evolving banking solvency requirements are driving demand for subordinate, perpetual and lower-tier sukuk as banks that previously held reserves largely in cash deposits at central banks look for more efficient balance sheet structures, which has the effect of widening investment choices for non-faith-based investors.

Sandeep Singh is senior director and regional head: Central Eastern Europe, Middle East and Africa, Franklin Templeton Investments

PERSONAL FINANCE