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Normally, hedge funds are so-called because they are highly leveraged, use derivatives and are able to employ short selling. They have no ethics-based restrictions, which is not meant as an insult. Islamic finance grates against all of these supposed freedoms. Despite that, Islamic hedge funds have begun to trickle into the sharia funds marketplace lately.

Among the most high-profile is a sharia-compliant hedge fund platform launched in 2008 by Barclays Capital and Shariah Capital. The latter is a US-based firm creating sharia financial products, including a sharia-accepted “shorting” methodology and a software for electronic screening of stocks for sharia compliance.

The platform, called Al Safi Trust, contains separately managed, sharia-compliant investment accounts. The platform is distributed under the DSAM (Dubai Shariah Asset Management) Kauthar label.

The DSAM Kauthar Commodity Fund is a sharia fund of hedge funds domiciled in the Cayman Islands. It contains four hedge funds employing long/short equity strategies to achieve absolute returns. Each fund invests into a specific commodity sector: gold, energy, natural resources and mining.

The Dubai Multi Commodities Centre Authority invested US$50 million into each of these four funds at the fund of funds’ inception. The authority is an indirect shareholder of DSAM, which is a joint venture between Dubai Commodity Asset Management, a wholly owned unit of the authority, and Shariah Capital.

In 2009, the DSAM Kauthar Commodity Fund gained 41.19%. In January 2010, it declined 4.9%. Last year, sharia hedge funds took another step closer to becoming an industry, with the launch of the Shariah Hedge Fund Index. It is another product of the Dubai Multi Commodities Centre Authority and Shariah Capital. The index mirrors the returns of the DSAM Kauthar Commodity Fund and is calculated by Thomson Reuters.

Eurekahedge, which tracks around 8,600 hedge funds and 3,500 funds of hedge funds, does not have an Islamic hedge fund index, ostensibly because there are too few. Among Islamic fund assets, 88% are mutual fund structures. Only 6% are funds of Islamic funds, 3% are exchange-traded funds, 2% structured products and 1% other structures.

The firm’s Overview of 2009 Key Trends in Islamic Funds concludes that most Islamic funds are mutual funds, because sharia principles make it difficult to operate an Islamic hedge fund. “Launching a well-received Islamic hedge fund… is difficult as hedge funds employ speculative instruments and therefore cannot be seen as sharia-compliant. Furthermore, Islamic law requires transactions to be asset-backed, which limits the range of strategies that hedge funds can use.”

The firm does, however, track sharia funds. It estimates there are about 700 Islamic funds worldwide managing approximately US$70 billion. Most Islamic funds invest in the Middle East and Africa because these regions have the largest concentration of sharia-compliant companies. According to Eurekahedge, 51% of Islamic fund assets are invested in these two regions, 25% are invested globally, 13% in Asia Pacific, 8% in North America, 2% in Europe and 1% in emerging markets.

But newly-raised funds have focused on the Asia Pacific. Eurekahedge’s data shows that most of the funds launched in 2009 invested in Asia. The firm reasons that the Asia Pacific is attractive as a growth region as Middle Eastern investors seek geographical diversification.

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