A LITTLE INTRODUCTION ON STRUCTURED INVESTMENT PRODUCTS

The range of structured investment products available on the market has increased enormously in recent years. The market growth has been mainly investor-driven.

Islamic investment emerged as a response to rising investor demand in the Middle East in the 1970s and is now growing at an estimated annual rate of 15%. Over the years, liberalization of state policies in most Middle East and South East Asian countries have benefited the institutions; Islamic investment has also allegedly further developed in the wake of socially responsible investment and a revival of Islamic ideology as applied to investment ethics.

A structured investment product has no particular definition and generally, it involves the combination of various legal structures to achieve a certain solution or products matching investors’ requirements. Structured investment products are designed to facilitate highly customized risk-return objectives and used most often to protect principal, enhance returns and more closely align the investment with the investor's market and economic views. The ultimate goal is to develop an investment with a better risk-return outcome than its original underlying market exposure.

Structured investment products help investors pursue diversified portfolios without the complex credit, legal and operational issues that surround the execution of derivative strategies; address various market conditions and risk management objectives, e.g., protection, optimization, enhancing returns and leverage.

The range of structured investment products available is extensive. Most structured investment products fall into one of the four basic categories, ranging from relatively conservative investments to those that offer greater potential returns while taking on more risk, which are :

1) Principal protection

Principal protected structured products may be more appropriate for conservative investors seeking market exposure with principal preservation. A principal protected investment may be appropriate for investors unwilling to risk their principal or who have long-term financial obligations. These investors are willing to forgo some upside potential or yield in exchange for principal protection at maturity. These investments generally offer a return at maturity linked to an underlying such as a broad-based equity index or a qualified basket of stocks. Investors typically give up a portion of the equity appreciation in exchange for principal protection. Maturities often range from five to seven years, and clients should intend to hold the investments to maturity.

2) Enhanced yield

Enhanced yield structures may be appropriate for more risk tolerant investors seeking higher returns than comparable debt instruments. Payment at maturity on investments is determined by the performance of an underlying asset or group of assets and principal may be at risk. Here, investors generally forfeit partial or full principal protection at maturity in exchange for the potential to earn a higher participation. In exchange for accepting full downside exposure in the underlying, an enhanced yield investment offers double or triple the equity returns up to pre-specified maximum. Therefore, investors can be exposed to downside risk and may lose part or all of their original investment. Additionally, investors may receive shares of stock at a value below the original principal amount at maturity. Coupon payments and payment at maturity is subject to the credit risk of the issuer.

3) Access

Structured investment products can provide investors with access to an asset or group of assets not readily available to private investors. These products can offer exposure to markets or strategies that may be inefficient or difficult for investors to obtain, such as foreign exchange rates or commodities. Since these products may not provide for full repayment of principal at maturity and are typically linked to sophisticated underlying assets, they may be more appropriate for moderate to aggressive investors.

4) Leverage

Structured products that utilize leverage may be generally more appropriate for aggressive investors wanting to capitalize on a particular market view. These short term products provide partial or no principal protection but do offer the potential to receive leveraged returns on the value of the underlying asset. Some structures may offer additional leverage in exchange for capped or limited upside potential. Investors are exposed to downside risk of the underlying investment and may lose part or all of their original investment.

Islam encourages people to take business risks in return of reward and also encourages the earning of income rather than leaving funds inactive (which is the foundation of the legal maxim, al-ghorm bil ghonm). Since structured investment product, by its nature, is something that can deliver diverse risky cash flows to investors, it is a huge business. Thus, the Islamic structurers are also looking for ways to deliver the same cash flows, by using Islamic investment structured products to the Shariah-conscious Muslim investors. The main challenge for banks lies in structuring products in a Shariah compliant way, that requires strong innovation capabilities as well as a robust infrastructure to satisfy risk management and booking requirements of such investments.

In Malaysia, the first Shariah compliant structure was approved by the Securities Commission in 2006 and to-date, more than RM23 billion has been approved, where majority of the Islamic structured investment products are linked to performance of equities, profit rates, foreign exchange rates and fixed income instruments.

Usually, structured investment products need to be “wrapped” so that it could be used to create securities, making it legal and tax efficient. The same applies to Islamic structured investment products, where “wrapping” is necessary to make the product Shariah compliant.

Another pertinent fact to consider when structuring Islamic financial products is that not only must the desired payout profiles with their risk-return features be optimised, but strict care must be taken to ensure that the tripartite harmony with Shariah is observed, which means that the following three elements must all conform with Shariah, i.e.:

a) underlying

b) trading mechanism or investment strategy

c) packaging structure

In Malaysia, the regulatory requirements for issuance of Islamic investment structured products are clearly spelt out in the Bank Negara Malaysia and Securities Commission of Malaysia. Islamic products need to comply with the general regulatory requirements which include requirement for disclosures, suitability and fair dealing requirements and rating requirements; and most importantly, to adhere to the Shariah specific requirements.

The future looks bright for Islamic structured investment products. Financial institutions in countries such as Bahrain, the United Arab Emirates and Malaysia have been gearing up for more Shariah compliant financial instruments and structured finance, both on the asset and liability sides.

Shariah compliant products have long been treated as “Muslim only,” however, such perceptions no longer carry any weight as leading financial centres located in “non-Muslim” soils, e.g., Hong Kong, London, New York and Singapore, are making significant progress in establishing the legal and prudential foundations to accommodate Islamic finance side by side with the conventional financial system.

NEW PROPAGANDA OF THE WEST

I was just browsing the internet when I came across an article on Shariah, Law and ‘Financial Jihad’: How Should America Respond? – and I was shocked to the core when I read further on one of the objectives of the project, i.e., to examine the extent to which Shariah amounts to a criminal conspiracy to overthrow the government of the United States by undermining and ultimately replacing the Constitution with Islamic law. In the process, every effort is made to document evidence of jihadist sympathies or teachings since such activities are tactics for advancing Shariah.

My first response was – this article is full of crap… (forgive my language, here..) and does not have any substance whatsoever but there should be a stop to all these ridiculous propaganda/attack on Islam. Here, the article linked prominent Shariah scholars to terrorists :

1. Sheikh Yusuf al-Qaradawi - issue fatwas advocating suicide bombing and terrorism.

2. Mufti Muhammad Taqi Usmani – affiliated with jihad-centred education institutions

3. Sheikh Yusuf Talal DeLorenzo - member of an organization that provides funds to terrorist groups

Since they have no grounds (or have wasted all their resources) to find faults and start new wars with Afghanistan, Iraq, Iran and Syria, they are now starting to attack Shariah compliant products and services. Yes, they are creative but they must realize that generally, people are no longer stupid to follow their ideology…whether they like it or not, Islamic finance is progressing very well and have the full backing of emerging markets. Islamic finance is not there to convert non-Muslims to Muslims (therefore, such pickets and demonstrations held in London, Birmingham and Manchester are really not necessary).

Change is necessary, however, one must have an open mind – finance and religion are two separate issues. Yes, Shariah encompasses all aspects of life, however, what is only projected in finance is just the muamalat aspects (dealings between man and man).

The prominent scholars are well respected in their own rights – they have the Islamic background and the breadth of knowledge in modern finance – I guess by attacking them personally like this show that the authors are really out of ideas to add credibility to their so-called “study”.

My advice to my readers out there – open your heart, open your eyes, open your minds, evaluate for yourself – who is right and who is wrong. All I can conclude is that the article is just a “cheap” way of getting attention and to steer away the attention of the Americans on the real economic situation in their own country – the easy way out is just to blame others (or finding other scape goats for the troubles that have been created by “capitalism”).

SPECULATION VERSUS GAMBLING

One knows that gambling (maysir) is prohibited in Islam – but what about speculation? Are these two the same or are they different? I’ve asked a few of my Professors and they have different opinions on the subject.

According to legendary investor, Benjamin Graham, "The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. We have often said that Wall Street as an institution would be well advised to reinstate this distinction and to emphasize it in all dealings with the public. Otherwise the stock exchanges may someday be blamed for heavy speculative losses, which those who suffered them had not been properly warned against.".

Martin Fridson divided the definitions of speculation into four categories - the definitions either implied the use of or involved (1) price changes, (2) quick profits, (3) high risk, or (4) some combination all three elements. Fridson was quick to point out that definitions can be dangerous and makes two points in attempting to prevent misunderstandings. "First, there is no inherent contradiction in acknowledging that a deviation from the market portfolio in pursuit of capital gains is, by definition, speculation, while rejecting the claim that securities markets are perfectly efficient . . . At any given time, however, judging which securities are misvalued involves a certain amount of conjecture. 'Speculation' is therefore a fair term for attempts to exploit pricing anomalies. Again, it should be regarded as a description, rather than a pejorative appellation. Second, a genuinely usable definition of speculation must take into account that many portfolio managers concentrate within subsets of the universe of assets."

Bodie, Kane & Marcus (on their text book, Investments) argued that the primary difference between speculation and gambling is "commensurate gain." They reason that "a gamble is the assumption of risk for no purpose but enjoyment of the risk itself, whereas speculation is undertaken in spite of the risk involved because one perceives a favourable risk-return trade-off. To turn a gamble into a speculative prospect requires an adequate risk premium for compensation to risk-averse investors for the risks that they bear. Hence risk aversion and speculation are not inconsistent."

Regardless of how you define the terms, it is likely to be a worthwhile activity to estimate your expected returns on both an absolute basis as well as relative to an appropriate benchmark. And if you find yourself enjoying the activity of investing or if you find yourself addicted to the speed and excitement of the trading game, perhaps you should seriously consider whether you've crossed the line between investing and speculation, or worse yet, maybe you are really gambling with your money.

From an Islamic viewpoint, a good article has been written by Rafic Yunus Al-Masri titled “Speculation between Proponents and Opponents”, which was published in the Journal of Islamic Econ., Vol. 20 No. 1 (year 2007), pp: 43-52 where the author summarized the two viewpoints of speculation versus gambling and the exceprts are reproduced here:

“The proponents of speculation differentiate between speculation and gambling on the basis that speculation depends upon information, experience and study unlike gambling that leans merely on fortune and coincidence. Yet, some believe that there are two types of speculation:

- The first type depends upon experience. This type is few in number (speculationof big professionals).

- The second type which is more popular depends upon fortune (speculation of small amateurs).

Despite the differences between them, both types are considered speculation. Likewise, modern gambling could also depend upon information, experience and study.

The proponents of speculation believe that the gambler himself creates risks, while the speculator only transfers risks as he undertakes existing ones. On the other hand, the opponents of speculation believe that there is no difference between speculation and gambling, but rather it is a new version of it. They argue that in speculation as well as in gambling a few people gain huge and rapid fortunes while the majority loses and whatever is gained by the minority comes at the expense of the majority. In addition, the chances of the minority’s making a profit is very small, very close to their chances of winning the lottery. Accordingly, they are more liable to loss in both cases. On the other hand, big speculators' profits are huge and guaranteed at the expense of small speculators who are being exploited in the stock market to act as its fuel and victims at the same time. “

What interests me most about the article is when the author wrote in one of the conclusions, “Speculation, gambling and monopoly are the characteristics of Capitalism, even if capitalism pretends to stand against these practices. Capitalism either calls things with other names or mentions something theoretically and violates it in practice. It does not abide by religion or ethics unless they serve the tycoons even if this leads to the small investors’ destruction. They want to impose upon us their system so that we lose the best we have and to receive the worst of what they have. This way they guarantee we stay behind in what they are already behind in.”

Well, that is something to think/discuss about…..