Islamic Funds in the UK Financial Market - Coursework Example

Introduction The market for Islamic funds is considered as lucrative and growing sectors in the financial markets of the world. The traditional markets for the traditional instruments have declined over the period of last few years due to recent credit crunch however; the market for Islamic funds may not be entirely affected by the current market crisis due to the very nature of the Islamic finance and its various instruments. The overall size of the Islamic funds industry is estimated to be over US $400 Billions of Assets which are being maintained by the Islamic funds. Such large size of the asset under management indicates the overall penetration into the market by Islamic funds. What is however, important to note that the there are more than 250 Islamic funds are in existence in different countries including UK, Malaysia as well as Saudi Arabia. Such diversity of the funds provide unique dynamics to the market and as such the market is considered as expanding and will cater to the needs of traditional markets also. The recent performance of the Islamic funds in UK however, has not performed well considering the overall economic situation in the Region as well as the overall economic downturn in the world. What is also important to note that the most of the Islamic funds that are working within the UK are based in Gulf Countries and are being directly controlled from that Region and especially from Malaysia. In a sense, it is therefore important to note that while analyzing the performance of the Islamic funds in UK, it is relatively more important to also analyze the economies and economic dimension of the countries where they are head quartered. The trends however, reflecting that the overall situation, at least, for UK is improving as more and more funds are being headquartered in the country. UK Economy The performance of the UK’s economy has not been wonderful especially after 2007 in the backdrop of the credit crunch and resulting financial meltdown experienced by the country. The overall growth rates were negative and the expectations are that the economy may not be able to perform better in at least year 2010. The overall consumer spending has dropped down due to which the total economic activity has slowed down and there has been huge unemployment in the country in recent past. These trends indicate that the overall inclination to save may increase for short period of time and Islamic funds may be a better alternative due to the fact that most of the investments made by the Islamic funds are relatively free from speculative activities and as such Islamic funds, till now, avoid to engage themselves into activities which are relatively speculative in nature and the overall probability of loosing the fund money is large. It is also because of this reason that the Islamic finance is largely considered as more preferable mean of investing owing to the fact that Islamic finance instruments are created with a purpose of sharing the profit and loss arising out of any transactions. This therefore makes the unit holders the actual stakeholders in the fund and as such the overall dimensions of performance are relatively different. Performance of Islamic funds in UK Methods In order to analyze the performance of a fund or portfolio, two important measures i.e. average rate of return and variability are of critical importance. The performance of the fund can therefore be effectively measured and analyzed if the average rate of return provided by the fund is consistent over the period of time. Second most important method that can be used for the analysis is the variability of the returns with the help of the calculation of the standard deviation. Standard deviation provides very important insight into the overall riskiness of the portfolio return. As such a comparison between risk and return therefore can provide an effective standard against which the overall performance of the fund can be assessed. Finally, benchmarking is another important method which can be used to assess the performance of any given fund or set of funds. Benchmarking process is used when the average return on any given fund is compared with the overall return provided by the index of that market. Most importantly, S&P 500 is often used to measure the performance of any given fund for benchmarking purposes. It is also important to understand that comparing the performance of an Islamic fund against a traditional benchmark may be relatively arbitrary in nature. This is because of the fact that a traditional benchmark usually comprises of scrips that are traded in a traditional manner whereas Islamic finance instruments are relatively different. Further, traditional benchmarking is based on the interest based trading. Finally, calculating alpha is also one of the most important measures as to how to assess the performance of a fund. Key Assumptions While performing the analysis on the data provided, we considered following: 1. In order to calculate Beta, we have taken FTSE as a benchmark 2. Beta has been calculated based on the 2 years data. 3. All funds in UK have been considered as one fund. Results A closer look at the average return of all the funds in UK would suggest that the average returns have declined over the period of last 12 months or so. What is also however, significant to note that this performance has improved slightly during the initial phase of the year i.e. from Jan 09 to April 09, the performance has improved whereas after April, the overall return has started to decline. This performance graph of the average returns of the Islamic funds over the period of time, indicate that the average return floated in the range of 5 to 7% which may be considered as fair return given the fact that overall market may be relatively more hostile towards the Islamic funds due to the fact that the Islamic finance is a relatively different and alternative mode of finance which do not capture most of the elements of the modern financial system based on the interest rates. What is also significant to note that owing to the very nature of the Islamic funds i.e. practically they are restricted to invest into instruments which are more speculative in nature however, they provide relatively higher returns. The very nature of the Islamic finance therefore may restrict the upper potential of the funds to earn consistent higher returns. It is also important to note that the standard deviation of all the average returns over the period of time is 6.414 which is relatively higher given the fact that overall average rates of returns have been consistent. Such higher standard deviation may indicate that the Islamic funds may not have been able to develop a capacity to provide returns with relatively less variability. This is despite the fact that Islamic funds usually invest into those instruments which are less risky and provide average returns. The overall beta is 0.33 which is computed by taking the data for two years however, this beta also indicates a relatively weaker correlation between the Islamic funds and the FTSE 100. A lower beta however, further corroborates the alpha of the funds also because both the figures indicate a negative correlation with the market. What is also significant to note that the beta may be irrelevant in this situation because it may be a healthy performance indicator for only those funds that invest into equities and may not hold true for funds that invest into less risky instruments such as government securities etc. A deeper analysis of this fact may indicate that the overall performance of the funds in UK has been good owing to the historical performance of these funds. Since their introduction into the UK economy, Islamic funds have been able to consistently provide net positive results to the unit holders. However, these returns have relatively higher risk which may nullify the overall performance of these Islamic funds specially in developed markets. Various studies also confirm that the Islamic equity funds in developed countries such as UK and US tend to trail the performance of the traditional equity benchmarks therefore it may be interesting to conclude that the overall Islamic funds tend to invest into instruments which are as risky as they are perceived in traditional markets in a bid to achieve maximum returns thus defying their true characteristics. Benchmarking If even one compares the performance of the Islamic funds with that of the market as well as other risk free investments, what is evident is the fact that average returns on Islamic funds are relatively in line with the overall market premium. For example, in the month of August 2009, there is a widespread difference of almost 3% in the market risk premium as well as the average return provided by the Islamic funds indicating that the overall returns provided by the funds are over and above the market risk premium. What is however, also significant to note that during certain periods, the risk premium as well as the returns provided by the Islamic funds converges. This behavior may be explained by the fact that the overall investment strategies of the Islamic funds may not be entirely Islamic in nature and Islamic funds may be investing into high risk instruments thus violating the overall essence and basic characteristics of the Islamic mode of financing. Alpha is negative indicating that the performance of the Islamic funds has not been good compared with the other investments. However, if alpha is taken as a measure of the riskiness of the portfolio with that of the market, it is showing a negative correlation indicating that at the time when market was not performing well, Islamic funds were performing better and vice verse. It is also important to note that during last two years, the performance of the UK market is not good due to the credit crunch and negative growth. This may therefore be taken into consideration while analyzing and assessing the performance of the Islamic funds. The average growth rate during 2009 was negative and forecasts for 2010 are not healthy too therefore the market may not perform well creating an strong negative correlation between the returns provided by the Islamic funds and the return generated by the market. This factor therefore will play most critical role if one is willing to perform benchmarking for the performance of the Islamic funds. Conclusion The results indicate that the overall performance of the Islamic funds in UK has remained consistent however, the overall returns are in lower range. What is also significant to note that the overall variability of these returns is relatively large indicating that the performance of the Islamic funds have remained relatively more volatile and there may be periods when Islamic funds have invested into more risky instruments in a bid to earn higher and consistent returns. Thus a deeper analysis of the overall composition of the portfolio of the Islamic funds will lead to a better understanding of the investment policies of the Islamic funds in UK. As discussed above that most of the funds working in UK are based in Islamic countries including Gulf Countries as well as Malaysia therefore considering the overall lack of knowledge of the market by the fund managers in these countries, the Islamic funds may not have been able to out perform other funds consistently over the period of time. The greater variability of the results therefore may be considered as one of the biggest indicators of the overall performance of the Islamic funds in UK. In nutshell, the performance of the Islamic funds in UK is mediocre in nature and in most of the cases; it can be trailed to the performance of the mainstream equity indexes in cases where Islamic funds invest into equities. Recommendations Islamic funds are important alternative sources of investment for the investors who have very well defined risk profile. Those investors who are risk averse may find Islamic funds important alternative investments in terms of the overall risk as well as consistent returns. However, given the fact that most of the Islamic funds in UK invest into mainstream instruments therefore they may provide relatively less benefit to the investors as compared to the other modes of financing. However, in order to diversify the portfolio, investing into the Islamic funds may be a good option to exercise. It must be kept in mind however, that the overall risk variability is high for the average returns generated by the Islamic funds therefore their true risk profile may be relatively higher therefore investment into such instruments may not be entirely feasible if assumption is that they can provide a risk free investment opportunities due to their true characteristics and mandate. Limitations As discussed above that comparing a traditional benchmark with the average return generated by the Islamic funds may be relatively arbitrary due to the overall nature of both the investments. Traditional markets are based on the interest whereas Islamic finance is based on non-interest based modes of financing therefore it will logically difficult to compare the performance of the two and draw logical conclusions. What is also significant to note that the Islamic funds are relatively smaller part of the overall market of UK thus they may not account for or capture the sentiment of whole market therefore their performance may not be correctly assessed in the presence of such situation. Read More