Creating a Shariah-compliant asset management system

Muslims represent nearly a quarter of the world’s population and yet less than 1% of financial assets are Shariah-compliant, according to a recent PricewaterhouseCoopers study. With an annual growth rate of 15%, the USD 1 trillion Islamic finance industry simply cannot be ignored by companies providing back-office solutions to fund managers.

Servicing this growing market comes with difficulties. They arise mainly from the fact that compliance with Shariah is not a fixed, centralized process. It can be challenging for fund managers to decide which Shariah-compliant assets to pick for their portfolio,

so companies such as software vendors handling the processes in their back-offices have to be flexible and be able to tailor their product to the needs of their clients as opposed to offer a one-for-all solution. It is a slow, expensive process.

However, because the Shariah-compliant asset management sector is rather immature, the payoffs are potentially immense for the software companies that decide to embark on this treacherous journey.

Advent, which provides investment management software and services for the funds management community, says it is seeking to improve its offer for Islamic banking players.

The challenges are great, explains Martin Engdal, Director of Product Marketing at Advent EMEA, but ignoring the market’s needs would be a mistake, as the growth potential of Islamic finance is high.

The main difficulty in becoming ‘Shariah-compliant’ for a company like Advent, Engdal says, is that the definition is often left to interpretation, and varies from one organisation to another.

“We have learnt that there is no such universal thing as being ‘Shariah-compliant’, as no global standard exists. We’d prefer to say that we are strategically moving more towards making it easier for our clients to handle Shariah-compliant investment products on our platform.

How you look at what’s Shariah-compliant or not depends on the client. They normally recruit external consultants and internal Shariah committees to decide what fund product qualifies as Shariah-compliant.

“In Malaysia, Islamic banking is very different to the Middle-East. As a software vendor, you can’t be fully compliant as what it means varies from organisation to organisation and from one geographical region to another,” Engdal adds. ”

It is an interesting learning process. Even our clients are not sure what it takes; they organise committees with Shariah scholars, of whom many only speak Arabic. So we need Arabic speakers to help us understand. It’s not always straightforward.”

To move towards its goal of servicing Islamic banking clients better, Advent has started a strategic initiative to include related items in its software, and has had to incorporate the handling of certain Islamic products like sukuk musharakah and mudharabah. However, the practicalities of updating or changing the software so it complies with Shariah law can be complex at times.

“Some terminologies have to be removed from the client’s reporting base, like ‘fixed income’, ‘interest’, ‘profit’,” explains Engdal. “There are Islamic indices encompassing Shariah-compliant companies. You need to develop interfaces to include Islamic indices in the software.”

Other examples of difficulties include incorporating the dividend purification process into the software. “With Shariah, for instance, dividend income from equities needs to be ‘purified’. Shariah investors only receive 95% of the dividend, 5% needs to go to a charity.”

Advent’s clients in the region are mostly in wealth and asset management. They range from some of the largest investment management firms like Jadwa Investment, Emirates NBD, Shuaa Capital and ANBInvest to new entrants like United Financial House and other medium-sized organisations.

Islamic banking clients normally have a conventional investment banking arm and an Islamic banking arm with Shariah-compliant investment products, Engdal notes.

“We are looking at incorporating a screen for Islamic banking functionality into our core product suite allowing clients to run both Shariah and non-Shariah businesses on the same platforms simultaneously,” he says.

“In our April 2012 releases, we’ll already be introducing Shariah specific functionality. However, it is key to understand that this is a long-term process and a strategic commitment. We’re talking to AAOIFI [Accounting and Audit Organisation for Islamic Financial Institutions], our client base, external consultants etc…

We are taking measures to update our product platform and setting up interviews and meetings with Islamic institutions and organisations in the MENA region. It evolves over time.”

Despite the many challenges, there are advantages to providing back-end services to a fund management company. The first is obviously the potential of the market: “The Islamic banking world is growing at a high rate in the Middle East and across Asia, particularly Malaysia and Singapore.

In the UK it seems to experience growth too. We see our commitment to this area as a strategic advantage in years to come. Currently we literally have no focused competitors in that field. It is a bit of a niche, a product that is flexible,” says Engdal.

“Figures from various industry reports suggest that AUM [assets under management] invested in Islamic banking products have grown 10%-20% a year in the Middle East. This is a significantly higher growth than the traditional investment products show. At the moment, we are expanding our footprint in the Islamic banking world,” he adds.

Clearly the Islamic banking world offers significant potential to back-office service providers like Advent, but there are downside risks too.

“It is fair to say a lot of firms struggle, there are concerns about political tension in the region, also concerns about whether the boom in oil and gold prices is sustainable, whether capital inflows will continue.

Other concerns are about the increased level of regulation in the region – it has an impact on our clients. However, the MENA region is still perceived as a growth market, there is still a certain degree of optimism,” says Engdal.

In a 2011 survey of fund management companies, 52% projected better business performance in 2011 compared with 2010. Over 60% of the respondents planned to hire new staff during the year, and 87% said their companies would obtain net inflows in 2011.

To be prepared to benefit from the growth in the local fund management industry, Advent expanded its operations in Dubai in November last year.

And whilst Islamic finance may not be totally immune to the turmoil of general financial markets, at least its players are better equipped to weather the storm and avoid the consequences of corporate scandals. Islamic funds make ‘ethical’ investments and avoid companies with highly leveraged balance sheets such as Enron and WorldCom.

This means more and more conventional managers have started to adopt Shariah law for strategic purposes, and that can only be good news for this market’s growth.