Institutions obliged to invest all their assets in a Sharia-compliant manner, such as Islamic endowments (awqaf) and Islamic insurers (takaful), often invest less than half of their assets. This phenomenon is understandable among awqaf because most awqaf donations are physical real estate. But among takaful firms, the prevalence of cash and money market holdings indicates insufficient Sharia-compliant investment opportunities for their risk appetite.

Take Malaysia’s 13 takaful companies, including re-takaful, for example. From 2005 to 2009, the latest data available from Bank Negara Malaysia, only 43% to 57% of general takaful assets were invested. And there is a preference for fixed income: In 2009, 44% of general takaful assets were allocated to Islamic private debt securities and equities, 10% to government Islamic papers, 28% to Islamic money markets and 2.6% to cash.

Family takaful assets were similarly allocated: 51% to Islamic private debt securities and equities, 10% to government Islamic papers, 26% to Islamic money markets and 2.7% was held in cash. Anecdotal evidence also suggests that most of the fixed income and equity allocations go to domestic issuers.

The Malaysian takaful’s asset allocation closely reflects that of their peers worldwide. A 2010 paper by Ernst and Young shows global takaful’s US$8 billion was allocated 30% to equities, 20% to fixed income, and 40% to cash and money markets in 2009. Ernst and Young estimates that 2010 allocations would be 33% to equities, 34% to fixed income and 26% to cash and money markets. The consulting firm also reports that awqaf institutions would maintain 80% of assets in real estate and 5% each in cash or money markets, equities and fixed income for both years. Ernst and Young concludes that institutional investors, both Islamic and non-Islamic, only have US$477 billion at most intended for Sharia-compliant assets, much smaller than retail investors’ US$1.75 trillion “Sharia-sensitive” assets.

Among Malaysian Islamic institutions, there is an element of home bias in their investment preferences. But where fixed income is concerned, there simply is little choice beyond Malaysian sukuk. As of end July 2011, Malaysia-domiciled issues took up 63% of US$178 billion in global outstanding sukuk. The second largest group, 14%, are domiciled in offshore centres such as the Cayman Islands and Bermuda. Qatar-domiciled issues constitute 6%, Saudi Arabia 5.8%, Indonesia 6%, and UAE 2%.

That means that most sukuk portfolios have a concentrated exposure to Malaysia’s economic dynamics because most of the Malaysia-domiciled issuers operate primarily in the country. But Islamic institutions may be increasing their allocations to Sharia-compliant equities and diversifying geographically.

Zeid Ayer, chief investment officer of CIMB-Principal Islamic Asset Management says his firm has 11 mandates totaling about US$700 million from Malaysian takaful companies, government institutions and pension funds. Of these, seven are equity mandates to invest in global markets, emerging markets, Asia ex-Japan and Association of Southeast Asian (ASEAN) economies. They are benchmarked to indices such as the Dow Jones Islamic Market series and the FTSE Shariah series.

The index providers select Sharia-compliant equities by first screening for industry sectors, followed by financial ratios such as leverage below 33% which is the generally accepted threshold in Sharia, liquidity and efficient use of capital. “The companies we choose shouldn’t have too much cash because that’s not an efficient use of capital,” Ayer explains.

IPA understands that the Malaysian institutions which pioneered the Sharia mandates are satisfied with performance so far. Ayer says his firm’s mandates have outperformed their benchmarks since inception. 

The Dow Jones Islamic Market (DJIM) Asia/Pacific Index had three-year annualized returns of 4.85% as of end July 2011 and one-year returns of 18.75%. The index’s conventional counterpart had three-year returns of 3.9% and one-year gain of 18.61%. The DJIM Emerging Markets Index gained 3.3% on an annualized basis over three years to July 2011 and 16.83% over one year. Dow Jones’ conventional emerging market index returned 6.97% over three years and 19.03% over one year.

Real estate and infrastructure assets may be the next areas to be developed for Sharia-compliant investors. Being tangible assets that earn real economic returns, they have a natural affinity with Sharia principles. Sharia-compliant real estate investment trusts have been appearing in Malaysia, Singapore and Middle East markets in the last two or three years but infrastructure is still a relatively unfamiliar asset class to most Islamic institutions.

That could change if more governments and multi-lateral agencies lead the way to fund infrastructure projects in a Sharia-compliant way. The Asian Development Bank estimates that Asia will need to invest US$8.2 trillion in infrastructure from 2010 to 2020. In 2009, ADB partnered the Islamic Development Bank to establish the US$500 million Islamic Infrastructure Fund. The fund has so far purchased a stake in a Kazakh power generation company, the Central Asian Electric Power Corporation.

“The emergence of infrastructure investment will provide a demonstrable alternative for Sharia investors who in many cases are heavily exposed to the real estate sector,” says Jonathan van Rooyen, head of Gulf-Asia region at infrastructure asset manager Hastings Funds Management,.

He suggests that certain types of infrastructure align most closely with Sharia requirements for risk and profit sharing, avoidance of derivatives, benefit to the community and income generated from economic activity. These include toll roads, ports, hospitals and power plants with a secure income stream or long-term concessions. Airports in non-Muslim countries, however, may present a challenge because no more than 5% of an asset’s income can come from prohibited activities such as selling alcohol and pork. The 5% ceiling is accepted in the Middle East, but may vary in other jurisdictions.

Gearing is another area that may need adjustments. Sometimes, conventional infrastructure projects have significant borrowings and associated interest charges, which help to augment returns, but which Sharia proscribes. Van Rooyen says the average 30% to 40% gearing of conventional projects can be reduced to Shariah’s limit of 33% by issuing sukuk. But van Rooyen remarks that “this strategy requires the investor to control 100% of the capital structure and that is not always possible given the magnitude of infrastructure investment.”

Perhaps the most attractive proposition to institutions, whether from an Islamic background or not, is renminbi-denominated assets. John Yip, senior vice president at Islamic Bank of Asia, says his bank wants to issue dim sum sukuk denominated and settled in RMB. Yip, who was speaking at the World Islamic Banking Conference in Singapore, remarked: “We find high demand from GCC investors for RMB as an asset class. Islamic finance needs to move away from a two-song ensemble, namely murabaha and ijara.”