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Risk and Reward
Islamic
Asset
Allocation By Ahsan Ali, CFA, FRM, MSI

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The credit crisis has exacted its toll on the global markets,
investor confidence, political will and the financial sector. In
the aftermath, Shariah-compliant investments have emerged
as an important alternative to purely conventional investing.
The question remains: Is Islamic investment methodology
superior to conventional means? And more importantly, is
superior risk diversification possible using Shariah-compliant
investments?

Ahsan Ali is head of Wealth Management and SME Banking

for Noor Islamic Bank, UAE. An avid supporter of CSR and
development initiatives, he is involved in mentoring, training and
program management with various public-private partnerships.
He holds an MBA from the Institute of Business Administration,
Karachi University, as well an MS in Financial Economics from
the School of Oriental and African Studies, London. Ahsan is a
CFA Charter Holder, an FRM certified risk manager and a mem-
ber of the Securities and Investment Institute (SII), UK.

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Modern Portfolio Theory (MPT)
Under MPT, unsystematic risk can be diversi-
fied away, as investors strive to reach an “effi-
cient frontier,” which is the best possible combi-
nation of risk and reward.
Expected return/risk
With MPT, any rational investor will have a cer-
tain risk tolerance and will try to maximize the
return for that level of risk.
The concept is equally applicable in Islamic
allocation; in other words, MPT is agnostic!
However, what is often overlooked is the behav-
ioural investment angle of MPT. Simply stated,
the “faith-based” Shariah investor is definitely
not agnostic. Theoretically, in a choice between
a higher-return non Shariah-compliant stock
versus a lower-return Shariah-compliant stock
(with the same risk), the choice will not be
“rational.” This will cause behavioural aberra-
tions for the efficiency frontier. An interesting
comparison could be between ethical investing
impacts on MPT versus Islamic investments.
Though we lack empirical evidence, I would
wager that the “religious” impact would likely
be more.
Universe of Stocks
One of the key differences between Shariah-
compliant and conventional stock selection is
the number of stocks available. Shariah-compli-
ant stocks cannot be from interest- or specula-
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tion-based businesses and are also restricted by
the nature of business activites (no gambling,
pork, arms and ammunition, etc). This excludes
virtually all of the banking and insurance sector,
as well as restricting companies with a substan-
tial component of their income generated from
interest-based earnings.
There are two important impacts to consider:
• Crowding effect: The existence of limited
stocks in the universe might result in a large
amount of money chasing limited securities,
with the result being an overvalued scrip. This is
somewhat similar to excess money supply in a
financial system causing inflation.
• Commonsense investing: The exclusions effec-
tively focus investments on the “real sector,” free
from financial engineering gimmicks and exces-
sive risk taking, as well as following a socially
responsible theme.
The net effect seems to be a conservative mix of
equities with enough investment flows to keep
the values stable to slightly inflated.
Leverage
The concept of leverage (gearing) has been the
underlying principle of generating excess
returns in areas from manufacturing to financial
engineering. The concept of using somebody
else’s money at a fraction of the cost of capital
sounds very enticing. In an economic downturn,
however, this can prove to be disastrous, as it
has!
Islamic investment guidelines by default do not
trust leverage. Above a certain level of gearing,
stocks are excluded or penalised by “cleansing”
the dividend (via payment to charity). This
ensures that fund managers keep their invest-
ments as “real” as possible in stocks that have a
high loss-absorption capacity in an economic
downturn. The impact of the systemic risk is far
less for the Islamic portfolio versus a conven-
tional one.
A brief glance at the levels of leverage over the
last century clearly demonstrate that inordinate-
ly high levels of debt have always resulted in
less-than-desirable impacts on economies. Yet,
as always, the human memory tends to be quite
short.
The key question remains: In
the pursuit of wealth, is there
room for morals and ethics?
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Total Credit Market Debt / U.S. GDP (1)
(1) Source: Ned Davis Research, 2008
Sukuk as Bond Equivalents
Bonds (particularly sovereign instruments) are a
cornerstone of portfolio diversification for conven-
tional investors. They produce a flow of stable
income with relatively safe principal and are per-
ceived to be less risky. Sukuk over the last five years
were said to have filled this space for the Islamic
Investor. However, the Sukuk market is still quite
limited in terms of issues available as well as liquid-
ity (secondary markets).
Fundamentally, Sukuk differ in terms of having a
tangible underlying asset versus what is essentially
a promise to pay in the case of a conventional
bond. Realistically, part ownership of an asset
(such as an airport) is not saleable and effectively,
recourse on the principal and coupon payment lies
with the issuer.
Certain fundamental flaws pointed out by Shariah
scholars (especially with Waad-based structures)
related to Sukuk mean that the future of this
instrument has been thrown into disarray. This
translates to the conventional asset methodology
being superior for bond selection due to the estab-
lished market, a fair degree of liquidity and in-
depth data for rating transitions/credit perform-
ance.
Cash equivalents
Islamic banking suffers from a severe drought of
liquidity-based products. This stems from the
inherent aversion to interest, which is effectively
the construct for most liquidity products. In the last
three years, there have been some creative solu-
tions, primarily through the reverse murahaba and
wakala structures which replicate deposits. There
have also been short-term liquidity solutions intro-
duced; however, the usage of and access to these
remains quite restrictive (especially for overnight
and short-term liquidity).
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On the conventional side, “Cash is king,” with a
variety of options freely available.
Contentment?
A pure intangible is the relative degree of satisfac-
tion derived from the fact that your money is at
worst “inflicting no harm” and at best is in line
with religious obligations.
The proponents of capitalism will argue that there
is “satisfaction” to be derived from making money.
Both approaches seem to have relative merit.
However, the Islamic side seems to win on moral
grounds. The key question remains: In the pursuit
of wealth, is there room for morals and ethics? In
this day and age, public opinion will shape the
response to this over the next few years.
The Best Mix
It is evident that the nascent Islamic asset alloca-
tions offer some interesting options. At the same
time, a pure Islamic portfolio lacks the instru-
ments, market depth and liquidity to rival the con-
ventional setup at this point in time. With the evo-
lution of behavioural influences (ethical, religious,
etc.), soft factors such as contentment and the per-
ception of being socially responsible will gain
ground against the traditional norms of perform-
ance against benchmarks.
Within the equities world, Islamic stocks provide a
conservative and commonsensical approach which
will definitely be a safer haven during recessions
and credit downturns.
However, the best mix seems to be Islamic equities,
with a sprinkling of social responsibility, a dash of
bonds and a sauce of liquidity instruments (con-
ventional). It’s not surprising in this day and age
that the superior allocation mix happens to be one
of “religious tolerance” and harmony.
The views expressed in this article are the personal views of the author.