Hong Kong: Shari’ah Funds – A Bermuda Perspective

Last Updated: 7 January 2010
Article by Jeffrey Kirk

Prior to the global financial crisis, the Islamic banking, finance, insurance (takaful) and investment markets were riding a wave of unprecedented growth.

Banking was growing 15-30 percent annually, with trading levels having increased from US$70 billion in 2005 to US$300 billion in 2008. The takaful industry was growing at an annual rate of 20 percent. The asset growth rate in the Islamic finance industry from 2005-2008 was 400 percent with the industry worth more than one trillion dollars in early 2008.

The global financial crisis may have put an end to that rapid growth, but Islamic finance however may be moving toward providing a new mainstream alternative to western banking and investment products. This development is fuelled partly by the belief that Shari'ah compliant products may not be as vulnerable as conventional products. For instance, the residential sub-prime mortgage backed securities would not have been permissible under Shari'ah investment principles.

An illustration of the movement of Islamic finance structures into the mainstream recently emerged in Sweden where a co-operative has formed a members' bank that has opted for the Islamic finance feature of not charging interest on loans. All bank activities occur outside the capital market – member savings are the sole source of finance for loans.

Explaining Islamic Finance

Islamic finance is the conduct of trade and enterprise in accordance with Shari'ah, which is the Islamic law principles and jurisprudence, the primary sources of which are the Qur'an and the Sunnah (the recorded 'example' of the life and deeds of the prophet Mohammed).

Shari'ah dictates that wealth and prosperity is shared within the community through morally acceptable business practises and that risk in trade and business should also be shared.

For example, the payment of interest (Riba Al Nasiah) is prohibited, as is the excessive or unjustified compensation in the exchange or sale of specified commodities such as gold, silver, barley, or wheat (Riba Al Fadi). Speculation or uncertainty must be avoided (Maisir Gharar). There is also a prohibition on dealing in items that are not halal, including both kinds of riba, pork, pornography, tobacco, alcohol, weapons, conventional financial services, speculation and uncertainty, and biotechnology (e.g. stem cell research).

Shari'ah Investment Funds

Shari'ah investment funds are joint pools wherein investors contribute for the purpose of earning halal (Shari'ah-compliant) profits. The basic objectives are:

  • the return on investment constitutes pro-rata profit actually earned by the fund
  • neither the principal nor the return can be guaranteed (i.e. no guaranteed fixed return investment products)
  • the pooled investment funds must be invested in a business including terms agreed, that are acceptable under Shari'ah

Shari'ah investment funds may be broadly classified as:

  • Shari'ah Equity Funds
    Shari'ah equity funds invest in the shares of listed companies or instruments. Unlike conventional equity funds, the businesses in which these listed companies are engaged must be halal.
  • Shari'ah Real Estate Funds
    Shari'ah compliant investment in real estate funds often involves investment in leased commercial properties, whereby the fund is the lessor to whom the lessee pays rent. Often, such funds (conventional and Shari'ah) are established as a closed fund, thereby ensuring that investors will only be paid their capital upon the disposal of the underlying property.
  • Shari'ah Private Equity or Venture Capital Funds
    Private equity or joint venture investment assumes, for the most part, risk in real economy ventures. Provided that it is a non-leveraged transaction (including the debt position of the target) and that the nature of the acquisition (i.e. whether achieved via an auction or other bidding process) and the nature of the target's activities are Shari'ah compliant, then there is no restriction as to such private equity or venture capital funds being Shari'ah funds.
  • Shari'ah Hedge Funds
    The prohibitions on the payment or receipt of interest, selling of property that the vendor does not legally own, financial speculation and the requirement that financial returns are derived from physical assets would, on the face of it, preclude the use of three of the key techniques traditionally employed by hedge fund managers, namely leverage, short-selling and derivatives.

A number of intrepid investment managers have been working with Islamic scholars in developing Shari'ah compliant techniques that seek to replicate those used by conventional hedge funds. The development of Shari'ah hedge funds is reflected in the launch, in January 2009, of the Dubai Shari'ah Hedge Fund Index, the first internationally recognised index comprised exclusively of Shari'ah compliant hedge funds.

Purification of Earnings

The purification of earnings refers to the methodology employed by the Shari'ah funds to deduct from their returns, any non-permissible income (e.g. interest income), which is earmarked and removed from the permissible income so as not to taint the latter. A Shari'ah supervisory board may either allow the non-permissible income to be credited to the net asset value of the fund and simply reported to investors so that each investor may decide how they wish to deal with the non-permissible income, or insist that the non-permissible income be donated to a charitable trust established by the Shari'ah investment fund's sponsor, or its fund managers for that purpose, or be donated directly to charities as directed by the Shari'ah supervisory board.

In circumstances where the non-permissible income is to be funnelled to charitable causes, the amount of non-permissible income for each share or instrument is to be determined and then deducted from the dividend and transferred to the charitable causes.

Shari'ah Supervisory Boards

If the funds and/or the fund managers are members of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), then the reviews undertaken and reports prepared by the Shari'ah supervisory boards would ordinarily be performed in accordance with AAOIFI standards and requirements.

The interpretations applied to investment products by different Shari'ah supervisory boards have differed substantially, particularly in regard to the jurisdiction of practise of the individual Islamic scholars sitting on each board. The result is that what may be regarded as Shari'ah compliant by a Shari'ah supervisory board based in Malaysia may not be regarded as Shari'ah compliant by a Shari'ah supervisory board based in Saudi Arabia.

In August 2009, AAOIFI's secretary general, Dr Mohamad Nedal Alchaar, announced that AAOIFI will determine the Shari'ah compliance of a product. Such proposed standardisation in Shari'ah rulings is to be welcomed as a stimulus to the development of new Shari'ah products.

A Bermuda Perspective

Bermuda's funds industry has been hit hard by adverse conditions in the global financial markets. However, being on the cusp of a possible recovery in the markets, presents an opportunity for funds jurisdictions in general and Bermuda in particular to aggressively market its position, infrastructure and benefits.

Bermuda is already home to a large institutional Shari'ah compliant fund, and now the marketers are moving in. In December 2007 the Bermuda International Business Association (BIBA) undertook an initial foray into the Gulf region. This has been followed up by a number of subsequent activities by BIBA, the most notable of which was its participation in the second annual Fund Forum, Middle East in Bahrain in December 2008.

The certainty, efficiency and flexibility offered by Bermuda have always drawn the funds industry. A key attraction is the ability to obtain prompt approval, if necessary, for a fund from the Island's leading financial services regulatory authority, the Bermuda Monetary Authority.

In addition, Bermuda is a well-regulated jurisdiction with an established infrastructure and professional services providers. Additional factors that enhance Bermuda's attractiveness as a funds domicile include:

  • the ability to structure Bermuda umbrella funds as segregated account companies with the resultant segregation of assets and liabilities between the segregated accounts;
  • the ability to list funds on the Bermuda Stock Exchange, which is recognised by the United States Securities and Exchange Commission as a Segregated Offshore Securities Market under Regulation S, granted "Designated Investment Exchange" status by the United Kingdom's Financial Services Authority, and designated as a "recognised stock exchange" by the UK's HM Revenue and Customs;
  • typically, no restrictions on investment objectives or strategies;
  • recent amendments to the Bermuda Companies Act 1981 facilitate the delivery of electronic records, including by publication on a website and reduce the requirements for officers or representatives resident in Bermuda; and
  • the ability to use non-roman characters as a second name.


The development of Islamic finance and particularly Shari'ah funds represents an opportunity for Bermuda and other offshore jurisdictions. Bermuda's ability to adapt to specific requirements, and to offer flexibility to investors, as well as the island's sophisticated infrastructure and professional services provider support network can unquestionably support the development of this market.

Appleby has recognised this growth, and in July 2009 it opened a representative office in Bahrain for the purposes of serving clients in the Middle East, including in the area of Islamic finance.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Jeffrey Kirk
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