wealth planning & management: a comparative analysis ... creation from conventional using...
TRANSCRIPT
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Wealth Planning & Management: a Comparative analysis between
Conventional & Islamic Systems
Prepared and Submitted by: Khalid Mohamed Mohamud
SIRES Staff Member
Abstract
One of the most remarkable phenomenon in the Middle East and other Muslim
countries‘ financial world in recent years has been the growth of Islamic Financial
Institutions with their performance and capacity in rise of Islamic wealth management
due to the growth in global development of Islamic Capital Markets in the last thirty
years. This study aims to analyze the basic concepts of how Islamic Wealth Planning is
different from Conventional system. In this regard, the study aims to compare how
Islamic Wealth Planning differentiates from Conventional Wealth Planning as applied
by private bankers in the West.
This research questions are as follows: What are the basic features of Islamic
wealth management system? Is it something different from the conventional wealth
management system?
In terms of the terminology, there is no fundamental difference between Islamic
and mainstream financial system. Notwithstanding this fact, Islamic financial system is
different from its conventional counterpart in terms of principles and objectives. The
Muslim investors are therefore, looking for alternative wealth management system
based on Sharia principles. However, despite the very rapid growth of Islamic Finance,
there has hardly been any rigorous qualitative research investigating wealth planning
and management and comparative analysis between Islamic and conventional system.
SOMALI INSTITUTE FOR RESEARCH IN ECONOMICS &
STRATEGY
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We do this by addressing the following key questions; how can we differentiate Islamic
wealth creation from conventional using phenomenological model of unity of
knowledge derived from the Qur‘an? The ultimate phenomenological model of unity of
knowledge derived from the Qur‘an which is Wealth Creation. How Islamic Wealth
management differs from the Conventional? What are the key goals and instruments for
investment and wealth accumulation, for retirement planning and Schemes, for wealth
and life style protection, Role of Insurance and Takaful in Wealth planning and
transferring wealth? How (Wealth) Asset Allocation and Performance compare between
Risk-Return Profile of Optimized Portfolio of Islamic and conventional equities and
commodities? What are the key investment decisions process for the private (wealth
management) banks? And how they manage portfolios of private clients? And what are
the key differences of Islamic wealth managements structurally?
To provide answers to above mentioned questions, the author of the thesis
collected data from different sources of wealth management like books, articles and
research papers as well as an observation of J.SAFRA SARASIN Bank as a field
research. This Bank is one of the oldest private banks in Switzerland which offer both
Islamic and conventional wealth management services. In Islamic perspective of wealth
management suggests requirement of understanding the goals and principles of sharia,
and realize the objectives of Islamic law (Maqasid al-shariah) to safeguard the faith,
self, intellect, posterity and wealth, other than just fulfilling the legal injunctions. The
application of Islamic wealth to the private banks, suggests that to use Sharia as
screening process for Muslim client and to employ two methods in screening processes,
which are sector based and accounting based.
Keywords: Wealth Planning and Management, Islamic Wealth Management,
Conventional Wealth Management, Wealth creation in Islam, Asset Allocation Process,
Portfolio Management, and Investment decision
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Contents ABSTRACT .................................................................................... Error! Bookmark not defined.
LIST OF TABLES .................................................................................................................. vii
LIST OF FIGURES ................................................................................................................ vii
ACKNOWLEDGEMENT...................................................................................................... viii
ABBREVIATIONS ................................................................................................................. ix
CHAPTER ONE: INTRODUCTION ....................................................................................... 1
1.1 Problem Statement ............................................................................................................. 1
1.2 Research Questions ............................................................................................................ 2
1.3 Objectives of the study ....................................................................................................... 2
1.5 Methodology ...................................................................................................................... 3
1.5.1 Research Approach ...................................................................................................... 3
1.5.2 Field Research ............................................................................................................. 4
1.6 Major Findings of the Study ............................................................................................... 5
CHAPTER TWO: THEORETICAL FOUNDATION OF WEALTH PLANNING AND
MANAGEMENT .................................................................................................................... 6
2.1 Introduction ....................................................................................................................... 6
2.2 Definition of Wealth........................................................................................................... 7
2.2.1 Frontier Wealth ........................................................................................................... 8
2.2.2 Intermediate wealth ..................................................................................................... 8
2.2.3 High Net Worth Individuals (HNWI) ..........................................................................10
2.2.4 Ultra-high net worth individuals (UHNWI) .................................................................12
2.3 The Right to Wealth ..........................................................................................................13
2.4 Distribution of wealth across individuals and Global wealth ..............................................15
2.5 Methods of Wealth Accumulation .....................................................................................18
2.6 Islamic View of Wealth Accumulation ..............................................................................21
2.7 Elements of Wealth Planning in Conventional Banking .....................................................26
2.7.1 Private banking technology .........................................................................................26
2.7.2 Customer Relationship Management ...........................................................................27
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2.7.3 Wealth Planning tools .................................................................................................28
2.8 The Process of Wealth Planning ........................................................................................28
2.9 Summary of the Chapter ....................................................................................................29
CHAPTER THREE: WEALTH (ASSET) ALLOCATION PROCESS ....................................30
3.1 Introduction ......................................................................................................................30
3.1.1 Introduction to Wealth Allocation Process (Establishment of the objectives) ...............31
3.1.2 Identifying and Specifying the Investors objectives and Constraints ............................33
3.1.3 Creating the Investment Policy Statement ...................................................................34
3.1.4 Forming Capital Market Expectations .........................................................................36
3.1.5 Creating the Strategic Asset Allocation .......................................................................36
3.1.6 The Execution Step ....................................................................................................36
3.1.7 The Feedback Step .....................................................................................................37
3.1.8 Performance Evaluation ..............................................................................................37
3.1.9 Monitoring and Rebalancing .......................................................................................38
3.2 Investment Objectives and Constraints ..............................................................................38
3.3 Formulating Return Objectives ..........................................................................................39
3.4 Establishing Risk Objective ...............................................................................................41
3.5 Identifying Potential Investment Opportunities ..................................................................42
3.6 Shariah Compliance of Asset Class ...................................................................................44
3.7 Possible Investment Asset Classes .....................................................................................45
3.8 Summary of the Chapter ....................................................................................................60
CHAPTER FOUR: ASSET ALLOCATION STRATEGIES ...................................................61
4.1 Strategic Asset Allocation as an Asset Allocation Process .................................................61
4.3 Insured Asset Allocation as an Asset Allocation Strategy ..................................................65
4.3.1 Manager Selection ......................................................................................................67
4.3.2 Fund Selection ............................................................................................................68
4.3.3 Investment Objectives ................................................................................................70
4.3.4 Ranking Asset Classes ................................................................................................70
4.3.5 Selecting Individual Funds .........................................................................................71
4.4 Ways of Measuring Returns (Portfolio Performance Evaluation) .......................................73
4.4.1 Dollar-Weighted Returns ............................................................................................73
4.4.2 Chain-Linked Returns.................................................................................................74
4.4.3 Annualized Time-Weighted Returns ...........................................................................76
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4.4.4 Simple Cash flow-Adjusted Returns ...........................................................................77
4.4.5 Time-Weighted Return Approach ...............................................................................77
4.5 Ways of Adjusting Returns for Risks .................................................................................81
4.5.1 Sharpe Ratio ...............................................................................................................81
4.5.2 Treynor Ratio .............................................................................................................83
4.5.3 Jensen‘s Alpha or Excess Return ................................................................................84
4.5.4 Modigliani-Square or M² Measure and the Treynor–Square or T² Measure..................85
4.5.5 Information Ratio, also known as Excess Return to Non-systematic Risk Ratio or
Appraisal Ratio ...................................................................................................................86
4.5.6 Downside Deviation or Risk of Loss Measure .............................................................86
4.5.7 The Sortino Ratio .......................................................................................................88
4.5.8 Value at Risk (VAR) ..................................................................................................88
Summary of the chapter ..........................................................................................................91
CHAPTER FIVE: ANALYSIS AND DISCUSSION ...............................................................92
5.1 Islamic Financial System and participants .........................................................................92
5.2 Sharia compliant vis-à-vis Conventional Investments ........................................................95
5.3 Asset Allocation and Performance (Risk-Return Profile of Optimized Portfolio)................96
5.3.1 Analysis of Return to risk ratio .................................................................................101
5.4 How Islamic Wealth Management differs from Conventional ..........................................107
5.4.1 Instruments and goals for Islamic Wealth Management .............................................108
5.4.2 Investments and Wealth Accumulation .....................................................................108
5.4.3 Retirement Planning and Schemes ............................................................................109
5.4.4 Wealth and Lifestyle Protection ................................................................................110
5.4.5 Role of Insurance and Takaful in Wealth planning ....................................................112
5.4.6 Transferring Wealth..................................................................................................116
5.5 How can we differentiate Islamic wealth creation from conventional using
phenomenological model of unity of knowledge derived from the Qur‘an? ............................117
5.5.1 Formal description of the Qur‘anic phenomenological model: wealth creation ..........120
5.5.4 An integrative view of wealth creation according to the Tawhidi worldview .............126
5.5.5 Wealth creation the complete Tawhidi phenomenological model of unity of Qur‘anic
knowledge ........................................................................................................................132
5.6 Banks are shifting capital away from risky institutional businesses to wealth management
but challenges remain: What is the key investment decision processes for the private (wealth
management) banks? And how they manage portfolios of private clients? What are the
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differences from the Islamic wealth managements structurally? A case of J.SAFRA SARASIN
Private Bank in Switzerland. .................................................................................................133
5.6.1 Investment Goal .......................................................................................................133
5.6.2 Investment Philosophy..............................................................................................133
5.6.3 Decision and Investment Process .......................................................................134
5.6.3.1 Security Selection ..............................................................................................134
5.6.3.2 Alternative investments and Bond Selection(AIBOS) .........................................135
5.6.3.3 Stock Selection ..................................................................................................135
5.6.3.4 Fund Selection ...................................................................................................135
5.6.3.5 Portfolio Construction/ Model portfolio .............................................................136
5.6.3.6 Portfolio Implementation ...................................................................................136
5.6.3.6 Documentation and communication of Investment decisions ..............................137
5.6.3.7 Specific Mandates ..............................................................................................137
5.6.3.8 Implementation Guidelines ................................................................................138
5.6.3.9 Risk Management and Controlling .....................................................................138
5.7 Offerings Shariah Applied Investment .............................................................................139
5.7 Muslim Clients Sharia Screening ...............................................................................140
5.8.1 Sector Based screening. ............................................................................................140
5.8.2 Accounting Based screening .....................................................................................141
Major Findings of the Study ..................................................................................................141
CONCLUSION AND SUMMARY OF FINDING ................................................................143
Conclusion ............................................................................................................................143
Summary of the Findings ......................................................................................................144
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LIST OF TABLES
Table 1 Primary concepts of wealth from various perspectives ................................................13
Table 2 Interaction between Willingness and Ability to Take Risk ..........................................42
Table 3 Portfolio Allocation Scoring System (PASS) ..............................................................48
Table 4 Risk Tolerance Factor (Determined from arbitrarily assigned values) ..........................53
Table 5 : Possible Efficient Sets ..............................................................................................54
Table 6 Maximizing Utility Associated with Efficient Sets ......................................................54
Table 7 Time Series of Return of Portfolio A and B ................................................................56
Table 8 Level of Returns .........................................................................................................56
Table 9 Cumulative Probability of Returns ..............................................................................58
Table 10 Solving the Decision Hierarchy by Fund Selection ....................................................71
Table 11 the cumulative return for five years. ..........................................................................74
Table 12 Cumulative Returns Over a 5-Year Period ............................................................75
Table 13 Cumulative return relative ........................................................................................79
Table 14 Total No of Days During the Period: 212 days ..........................................................80
Table 15 Modified Dietz Return ..............................................................................................81
Table 16 Portfolio asset allocation and performance (Conventional equity: 1996-2003 ............97
Table 17 Portfolio asset allocation and performance (Conventional equity: 2004-2012) ...........98
Table 18 Portfolio asset allocation and performance (Islamic equity: 1996-2003) ....................98
Table 19 Portfolio asset allocation and performance (Islamic equity: 2004-2012) ....................99
Table 20 Portfolio asset allocation and performance (Conventional equity plus commodity:
1996-2003) .............................................................................................................................99
Table 21 Portfolio asset allocation and performance (Conventional equity plus commodity:
2004-2012) .............................................................................................................................99
Table 22 Portfolio asset allocation and performance (Islamic equity plus commodity: 1996-
2003) ....................................................................................................................................100
Table 23 Portfolio asset allocation and performance (Islamic equity plus commodity: 2004-
2012) ....................................................................................................................................100
LIST OF FIGURES
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Figure 1 The global Wealth Holder‘s Outlook in 2014.............................................................. 9
Figure 2 Personal income in the Muslim world ........................................................................10
Figure 3 the Distribution of wealth range ................................................................................11
Figure 4 ultra-high net worth individuals 2014 in selected countries ........................................13
Figure 5 Regional Composition of Global Wealth Distribution in 2014 ...................................15
Figure 6 Effects on How Long Wealth Will Last with Constant Withdrawal ............................19
Figure 7 Private banking growth in Asia..................................................................................26
Figure 8 Overview of Wealth Planning Process .......................................................................29
Figure 9 Portfolio Management Process ..................................................................................33
Figure 10 Efficient Frontier .....................................................................................................52
Figure 11 Efficient Frontiers ....................................................................................................52
Figure 12 Second Degree Stochastic Dominance .....................................................................59
Figure 13 Asset Allocation Approach – Schematic Plan ..........................................................66
Figure 14 Integrating Security Selection, Group (or Sector) Selections and Asset Allocation ....66
Figure 15 Decision Hierarchies for Fund Selection ..................................................................69
Figure 16 Dollar Growth Presentation .....................................................................................76
Figure 17 Downside Deviation ................................................................................................87
Figure 18 Modified Mudharabah Model ................................................................................111
Figure 19 Mudarabah Model-Family Takaful. .......................................................................111
Figure 20 Conventional Insurance .........................................................................................114
Figure 21 Modified Mudarabah Model-General Takaful. .......................................................114
Figure 22 Mudarabah Model-General Takaful .......................................................................115
Figure 23 Elementary circular causality between embedded wealth concepts induced ............119
Figure 24 Continuous learning processes in the Tawhidi phenomenological model of unity of
knowledge ............................................................................................................................122
Figure 25 Extending the learning relations of wealth creation ................................................124
Figure 26 Simulation of Social Wellbeing Function subject to circular causation ...................131
ACKNOWLEDGEMENT
Praise be to Allah the Almighty and may peace and blessings be upon Prophet
Muhammad (s.a.w) and his family, who enabled me to complete this work. I would like
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to express my sincere gratitude and deepest appreciation to Asst. Professor Dr. Vahit
Ferhan BENLI, my principal supervisor, for his insightful and overall guidance, and his
material, spiritual and moral support throughout this Master‘s thesis. His supervision,
indeed, is an invaluable contribution to this study. I am pleased to have an advantage of
gaining and benefiting, from his profound knowledge, in both Conventional and Islamic
Finance.
I would also like to convey my deepest thanks and appreciation to Professor
Bulent PAMUKÇU, Director of Institute of Banking and Finance of Istanbul Commerce
University, and vice director Asst. Professor. Serkan CANKAYA for their continuous
support, generosity, and valuable advice throughout my Masters study. In addition, I
would like to express my sincere thanks to all other Professors specially Asst. Professor.
Hicabi ERSOY, and other professors and lecturers for their kind help and contribution
during my Master study. Sharing knowledge and extending cooperation among
colleagues are important in a successful Master‘s program. I am ever thankful to all of
my wonderful Masters colleagues; I would like also to thank Dr. Ahmed Ibrahim
Nageeye, who supported me some computers program applications during writing my
thesis. My acknowledgement would remain incomplete without extending my deepest
and sincere thanks and gratitude to the Turkish Government Scholarships, who awarded
and support my master‘s program.
Finally, I would like to express special thanks and appreciation from the bottom of my
heart to my wonderful family members for their continuous efforts, contribution,
patience and sacrifice during my higher education studies abroad including my Master‘s
program.
ABBREVIATIONS
(TAAC) Tactical asset Allocation Committee
(SUC) The Security Universe COMMITTEE
(SAA) Strategic Asset Allocation
(IWM) Islamic Wealth Management
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(HNWI) High Net Worth Individuals
(UHNWI) Ultra High Net Worth Individuals
(SAAP) strategic asset allocation plan
(IPS) Investment Policy Statement
(TSR) Tawhidi String Relations
(REITs) Real Estate Investment Trust
(PASS) Portfolio Allocation Scoring System
(MPT) Modern Portfolio Theory
(MPM) Markowitz Portfolio Model
(IEFs) Islamic Equity Funds‘
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CHAPTER ONE: INTRODUCTION
1.1 Problem Statement
Wealth planning and management involves integrated financial services
incorporating financial planning as well as portfolio management as part of
comprehensive advisory and management of a client‘s wealth. High Net Worth
Individuals (HNWIs), business owners of big and small Companies and families can
benefit from wealth management service by engaging qualified specialists to assist them
with integrated services, banking and financial services, law, tax, investment
management, estate, However, Industry experts and high net worth individuals seek to
understand the application of Sharia principles in the area of wealth management, to
preserve their wealth and grow it on the basic principles of risk, return relationship.
In response to this problem, the Islamic wealth management sector is likely to
begin by catering to the ultra-rich Clients, in Islamic countries, but will eventually
broaden out to encompass a wide range of clients, with Shariah compliant wealth
management services gradually trickling down to the affluent US$100,000+ sector as
well as serving high net worth individuals. "If you look at high net worth customers in
markets like Brunei, Malaysia, Singapore and Indonesia, and the Middle East –(Qatar,
Kuwait and Saudi Arabia), there are big opportunities," says (Wasim Saifi), the global
head of Islamic banking at Standard Chartered Bank in Singapore. "People are
extremely wealthy and are increasingly seeing the need to be Sharia compliance."1
Within the Gulf Cooperation Council countries wealth has been on the rise, driven by
oil and gas revenues. Collective private wealth in the GCC alone is pegged at US$1.5
trillion, according to estimates from the International Monetary Fund.2 The central
question of the study is: What is essentially distinctive about Islamic wealth
management? How Islamic wealth management is distinguished from conventional
wealth management? Though conventional wealth management focuses on the
relatively well-off and ultra-Affluent clients, How Islamic wealth management would be
expected to serve the needs of people from all income groups? An important goal of
Islamic wealth management is to preserve and plan for transference of wealth to
progeny. This study would like to investigate the comparative benefits between Islamic
1 Omar Farooq, Islamic Wealth Management and the Pursuit of Positive-Sum Solutions, 2009. P.5 2 International Monetry Fund, Islamic finance fact sheet,jan,2015.p.16
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and conventional wealth management and appraise and articulate the Islamic
dimension of wealth planning and management to meet the wealth management needs
of all sections of the population.
1.2 Research Questions
In this regard, our research comprises of the following questions:
1. How can we differentiate Islamic principles of wealth creation from conventional
using the ultimate phenomenological model of unity of knowledge derived from the
Qur‘an in wealth creation?
2. How Islamic wealth management differs from the conventional? What are the key
goals and instruments for Investment and wealth accumulation, for retirement
planning and Schemes, for wealth and life style protection, role of insurance and
Takaful in Wealth planning and transferring wealth? Analysis
3. How (Wealth) Asset Allocation and Performance compare between Risk-Return
Profile of optimized portfolio of Islamic and conventional equity and commodities?
4. Banks are shifting capital away from risky institutional businesses to wealth
management but challenges remain: What is the key investment decision processes
for the private (wealth management) banks? And how they manage portfolios of
private clients? What are the differences from the Islamic wealth management
structurally?
1.3 Objectives of the study
1. To examine the wealth creation from Islamic perspective and it is difference from
the conventional wealth management system?
2. To investigate the key goals and instruments for Investment and wealth
accumulation, retirement Planning and Schemes, wealth and life style protection,
role of insurance and Takaful in wealth planning and transferring wealth comparing
it applicability in sharia?
3. To investigate the asset (wealth) allocation of optimum portfolios and risk-return
profiles of the optimized portfolios combining equities (conventional and Islamic)
and commodities.
4. To investigate investment decision process of private banks who manages wealthy
of High Net Worth Individuals which has double window system of conventional
and Islamic?
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1.4 Significance of the study
This study is very important for comparing two systems of wealth management,
which are the conventional and Islamic system and the extent to which wealth planning
and management operations are Shariah compliant. As such, it will definitely contribute
to ensuring adequate Islamic wealth management operations in the international wealth
management system.
This study is significant in suggesting ways for managing wealth according to
Islam, should be more comprehensive than the conventional method of wealth
management, in the sense that it includes the generation, protection, distribution, and
purification of wealth based on Shariah rulings. Also this study aims to bring different
perspective to the non-sharia compliant wealth management system. It should help
scholars, practitioners and students to a deeper understanding of the Sharia issues in
Islamic wealth management.
1.5 Methodology
1.5.1 Research Approach
There are four types of approach used in conducting the research: analytical,
descriptive, empirical and exploratory3. Analytical researches often use descriptive
approach for the purpose of suggestion or explanation on why or how something
happen. Normally, it is describe on the causes of research study. Description research
used to identify and classify the elements or characteristics of the subject usually
concerned with describing a population with respect to important variables. While
exploratory research is in which the major emphasis is on gaining ideas and insights
where theories are used as a basis for understanding and explaining practices or
procedures (Scapens, 1990)4. Empirical research is a way of gaining knowledge by
means of direct and indirect observation or experience.
All these types of research are commonly used by the researchers. Thus, in this
study, all these types of research are being applied by the author to study in this field.
3 (Collin, 2007) 4 (Scapens,1990).
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Majority of the study used descriptive and Analytical method to conduct their studies
followed by analytical approach.
In this thesis employs a qualitative research method comprised of analysis on Islamic
Wealth management in comparing to the Conventional Wealth management mode
operation.
Markowitz portfolio model (MPM), and Sharpe Ratio Portfolio asset allocation
& performance (conventional and Islamic equity :( 1996 – 2003)(2004-2012) data
collected from S&P Global BMI is a comprehensive based index measuring global
stock market performance.
1.5.2 Field Research
The main issue of this study is to investigate combining processes of investment
decision of High Net Worth individuals, however, the author contacted with bank of
J.SAFRA SARASIN Private Bank in Switzerland in order to know more about the field
of investment decision process of Private Banks as well as their portfolio management
of private clients. The author got more information which relates on their Investment
goal, Investment Philosophy, Investment style-approach, Decision and Investment
process, Implementation guidelines, Risk Management and Controlling, portfolio
management Teams and Committees, including Investment policy private banking. It
helped a lot to know inside about the field. The author of the thesis compared the
Muslim High Net Worth Individuals preferences of Sharia point of view, with that
western style investment process.
As a prerequisite, the study would like to examine the extent of integration
between the two disciplines and will analyze the issues and provide the alternative
solutions.
The following sources using investment processes are:
A. J.Safra Sarasin Macro-Equity, Fund, Credit and Strategy Research.
B. Bank J.Safra Sarasin Asset Allocation Scorecard.
C. J. Safra Sarasin Sustainable Research and the sustainability Matrix.
D. Third Party Research by brokers (Sector, Industry and company research).
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E. External info providers: Bloomberg, DataStream, Reuters and MSCI/Benchmark
constituents.
F. Public resources as well as special journals.
1.6 Major Findings of the Study
In response to the major issues, the overall findings indicate that the extent of
correlation and comparison of wealth management (Conventional and Islamic). In terms
of the terminology, there is no fundamental difference between Islamic and mainstream
of wealth management system. Notwithstanding this fact, Islamic wealth management
system is different from its conventional counterpart in terms of principles and
objectives.
The major findings of comparing Asset (wealth) Allocation and Performance of
(Risk-Return Profile of Optimized Portfolio) of Islamic and Conventional system,
suggest (a) that Islamic equities are more vulnerable to a financial turmoil caused by the
deterioration of the real sector in the economy. Conversely, mainstream equities are
suspected to be more vulnerable to the catastrophe in the financial sector.
This happens because of the exclusion of the financial sector in the Islamic
equities through Shariah screening criteria, (b) that equities from the European and
North American markets would be superior investment instrument and thus better
portfolio components in terms of higher marginal benefits during the 1997 Asian
financial crisis, (c) that Asian equities would be superior diversifier in terms of higher
marginal benefits during the 2008 global financial crisis, (d) that gold would be a major
diversifier when all equities in general and Islamic equities in particular experience
major downturn and (e) that most of the commodities except for gold gradually became
less important components for a diversified portfolio.
If we look at the primary objective, to determine the Islamic perspective of
wealth management would require understanding the goals and principles of sharia, and
realize the objectives of Islamic law (Maqasid al-shariah) to safeguard the faith, self,
intellect, posterity and wealth, Other than fulfilling the legal injunctions5 (chapra2008
and ibnuAshur 2006).
5 chapra2008 and ibnu Ashur 2006
6
The objective of Islamic commercial law would be to protect and enhance one or
several of these goals. Commercial transactions are sanctified and encouraged as these
enhance and support wealth and progeny.6
According to the wealth creation In Islamic highlights the comprehensive TSR
as the Qur‘anic phenomenological Model with Wealth Creation Which is expanding the
socioeconomic domain of complementarities linked with wealth formation at higher
levels of moral consciousness in Islam, and setting of policy and development financing
instruments in Islamic wealth creation.
We addressed investment strategies and decisions for investments of the bank of J.safra
Sarasin, of Private wealth manager‘s banks which have also double window as it offers
Islamic wealth management using sharia screening process for Muslim clients, and they
employ these two methods for screening: Sector Based Screening of Instruments:
Certain businesses offer products and services that are considered unacceptable or
noncompliant. Examples of these activities include gambling, investment management,
pornography, and alcohol.
Accounting Based Screening of Instruments: Certain company financial ratios
may violate compliance measure; three areas of focus are leverage, cash, and the share
of revenues derived from noncompliant business activities. As some of these restrictions
may not be absolute, the Shariah Supervisory Board makes compliance determinations
on an index-by-index, stock-by-stock, or similar.
CHAPTER TWO: THEORETICAL FOUNDATION OF WEALTH PLANNING AND
MANAGEMENT
2.1 Introduction
What is wealth planning and management? It involves integrated financial
services incorporating financial planning as well as portfolio management as part of
comprehensive advisory and management of a client‘s wealth. High Net worth
Individuals (HNWIs), business owners – big and small, and families can benefit from
wealth management service by engaging qualified specialists to assist with integrated
services, coordinating the role of those providing services related to banking, law, tax,
investment management, estate, etc.
6 (Hallaq 2004).
7
Wealth management presupposes existence of wealth. Therefore, it is geared not
just toward a smaller segment of overall population, but also with special bias toward
those with high net worth. Notably, effective employment of wealth management
strategies generally requires that the client has significant net worth. At one level, it is
also alternatively known as Private Banking, especially for wealthy clients. Though the
focus on this niche developed during last 2-3 decades of the twentieth century, it has
become an important area of investment and financial expertise, where both
professional and higher education are available for those who seek relevant
specialization.
How is essentially Islamic wealth management different from Conventional system?
The new discipline of Islamic finance is primarily focused on Sharīʿah-compliance,
which strictly means that it is legalistically distinctive due to adherence to certain
prohibitions (e.g., ribā – commonly equated with interest in a blanket manner; gharar –
excessive risk and uncertainty; maysir – gambling; and a few things that are prohibited
on their own, such as pork, intoxicant, pornography, etc.)7.
Islamic Wealth Management has emerged as part of Islamic finance and broadly
shares the features, underlying principles, advantages as well as limitations. Except the
legalistic distinctions, just as Islamic finance is broadly based on conventional finance
to the extent that currently it can hardly function without embracing or depending on
interest-based tools, such as LIBOR as a benchmark; Islamic Wealth Management also
faces similar limitations and constraints8.
2.2 Definition of Wealth
In general terms, wealth is an abundance of items of economic value, or the state
of being in control or possession of such items. Wealth may comprise of money, real
estate and personal properties. In many countries wealth is also measured by reference
to access to essential services such as health care, or the possession of crops and
livestock. An individual who is wealthy or rich is someone who has accumulated
substantial wealth relative to others in their society or reference group. Therefore, being
7 Alsayyed, Nidal (2009). ―Sharīʿah Parameters of Islamic Derivatives in Islamic Banking and Finance:
Sharīʿah Objectives vs. Industry Practitioners,‖ ISRA, May 2009,
http://www.kantakji.com/fiqh/files/finance/n362.pdf. 8 M Omar Farooq2009, Islamic Wealth Management. P.7.
8
wealthy is relative; this state not only varies between societies, but often, in a particular
society, varies between different sections or regions. We can classify in here as follows:
2.2.1 Frontier Wealth
The ―frontier wealth‖ range from USD 5,000 to 25,000 per adult covers the
largest area of the world and most of the heavily populated countries including China,
Russia, Brazil, Egypt, Indonesia,the Philippines and Turkey. The band also contains
many transition nations outside the EU (Albania,Armenia, Azerbaijan, Bosnia, Georgia,
Kazakhstan, Kyrgyzstan, Macedonia, Mongolia and Serbia),most of Latin America
(Argentina, Ecuador, El Salvador, Panama, Paraguay, Peru and Venezuela)9
Wealth is also considered as a reservoir of all past net savings embodied or
―invested‖ in those enduring objects (assets) or skills that make us more productive and
fulfilled. For example, investment in education by an individual would constitute
wealth as well since the education one has acquired has helped increase the skills and
competencies of the individual. Generally, wealth increases with production and
decreases with consumption10
.
Wealth can also be defined as surplus income. It is an income beyond the daily
and basic requirements of a family. Income and wealth are two different things; they are
related but are not the same. Wealth is a stock of all items of economic value at any
point in time. However, income represents an inflow of assets over a period of time, say
a month or a year. In other words, income is the amount of assets one currently has
coming in, whereas wealth is the amount of assets one has accumulated over a period of
time.
2.2.2 Intermediate wealth
The ―intermediate wealth‖ group covers countries with mean wealth in the USD
25,000 to USD 100,000 range. Some European Union (EU) countries (Portugal and
Slovenia) are situated at the top end of the band, while more recent EU entrants (Czech
Republic, Estonia, Hungary,Poland and Slovakia) tend to be found lower down. The
9 Credit Suisse, Global wealth report 2014, p.26 10 Datuk Dr. Syed Othman Alhabshi(2011), wealth planning and management. P.44
9
intermediate wealth group also encompasses a number of Middle Eastern nations
(Bahrain,Oman, Lebanon and Saudi Arabia) and important emerging markets in Asia
(Korea, Malaysia) and Latin America (Chile, Colombia, Costa Rica,Mexico and
Uruguay).
Source: James Davies, Rodrigo Lluberas and Anthony Shorrocks, Credit Suisse Global
Wealth Databook 2014.
In this figure we mentioned how global wealth is distributed across households
and individuals rather than regions or countries. We combine our data on the level of
household wealth across countries with information on the pattern of wealth distribution
within countries. This estimate for 2014 indicates that once debts have been subtracted,
a person needs only USD 3,650 to be among the wealthiest half of world citizens.
However, more than USD 77,000 is required to be a member of the top 10% of global
wealth holders, and USD 798,000 to belong to the top 1%. Taken together, the bottom
half of the global population own less than 1% of total wealth. In sharp contrast, the
richest decile hold 87% of the world‘s wealth, and the top percentile alone account for
48.2% of global assets.11
11
Source: James Davies, Rodrigo Lluberas and Anthony Sharrock‘s, Credit Suisse Global Wealth
Report 2014, p11.
Figure 1 The global Wealth Holder’s Outlook in 2014
10
2.2.3 High Net Worth Individuals (HNWI)
To estimate the pattern of wealth holdings above USD 1 million requires a novel
approach, because at high wealth levels the usual sources of wealth data, official
household surveys, tend to become less reliable. We have overcome this handicap by
exploiting well-known statistical regularities to ensure that the top wealth tail is
consistent with the annual Forbes tally of global billionaires and similar rich list data
published elsewhere. This produces plausible estimates of the global pattern of asset
holdings in the high net worth (HNW) category from USD 1 million to USD 50 million,
and in the ultra-high net worth (UHNW) range from USD 50 million upwards. While
the base of the wealth pyramid is occupied by people from all countries at various
stages of their lifecycles, HNW and UHNW individuals are heavily concentrated in
particular regions and countries, and tend to share more similar lifestyles, participating
in the same global markets for luxury goods, even when they reside in different
continents.
The wealth portfolios of these individuals are also likely to be more similar, with
more of a focus on financial assets and, in particular, equity holdings in public
companies traded in international markets. For mid-2014, there were 35 million of
HNW adults with wealth between USD 1 million and USD 50 million, of whom the
vast majority (30.8 million) fall in the USD 1–5 million ranges. There are 2.5 million
adults worth between USD 5 million and 10 million, and1.4 million have assets in the
USD 10–50 million range12
. From 2007 to 2009, Europe briefly overtook North
America to become the region with the Greatest number of HNW individuals, but North
America regained the lead in 2010 and now accounts for a much greater number – 15
million (44% of the total) compared to 11.7 million (34%) in Europe. Asia-Pacific
countries, excluding China and India, have 5.6 million members (16%), and we estimate
that there are now 1.2 million HNW individuals in China (3.4% of the global total). The
remaining 925,000 HNW individuals (2.7% of the total) reside in India, Africa or Latin
America.
12 Source: James Davies, Rodrigo Lluberas and Anthony Shorrocks, Credit Suisse Global Wealth Report
2014, p14.
11
In this figure, we mentioned that, the number of High Net Worth Individuals is
increasing. And that is why there is need for Sharia compliant wealth management is in
need. When you look some countries like Qatar, wealth is very high.
Figure 3 the Distribution of wealth range
12
Source: Credit Suisse Global Wealth Databook 2014.
In here, this figure shows that also increasing wealth in parallel there is also
increasing wealth range of adults.
2.2.4 Ultra-high net worth individuals (UHNWI)
According to the Credit Suisse estimation Worldwide there are 128,200 UHNW
individuals, defined as those whose net worth exceeds USD 50 million.13
Of these,
45,200 are worth at least USD 100 million and 4,300 have assets above USD 500
million. North America dominates the regional rankings, with 65,500 UHNW residents
(51%), while Europe has 31,400 (24.5%), and 16,600 (13%) live in Asia-Pacific
countries, excluding China and India. Among individual countries, the United States
leads by a huge margin with 62,800 UHNW adults, equivalent to 49% of the group
total. This represents an increase of 9,500 compared to mid-2013, an astonishing rise for
a single year –more than the total number of UHNW residents in China, which occupies
second place with 7,600 residents (6% of the global total). The United Kingdom gained
the second largest number of UHNW individuals (up 1,300 to 4,700) consolidating
fourth place, behind Germany (5,500), but ahead of France (4,100). Taiwan (2,000) and
Korea (1,900) each added about 550, while Brazil (1,900), Canada (2600) and Hong
Kong (1,500) gained 200 apiece. The numbers for Russia (2,800) and India (1,800)
were almost unchanged14
.
13 Credit Suisse, Global wealth report 2014 14 Source: James Davies, Rodrigo Lluberas and Anthony Shorrocks, Credit Suisse Global
Wealth report2014,p.28
13
Figure 4 ultra-high net worth individuals 2014 in selected countries
Source: James Davies, Rodrigo Lluberas and Anthony Shorrocks, Credit Suisse Global
Wealth Databook 2014,p.28
2.3 The Right to Wealth
Wealth is essential for every rational human being, to provide for his or her
basic needs such as security and peace of mind. It is only the irrational who pursues and
desires unlimited wealth as their objective in life.
Table 1 Primary concepts of wealth from various perspectives
Source: Wealth Planning and Management, p.8
In a capitalistic economy ―wealth‖ is almost anything of monetary value that
one accumulates in sufficient quantity. The right to wealth determines the relative
power and status of a person. As a result, primary concepts are actually the generic
concepts with philosophical themes, either based on laissez faire (capitalism), socialism
14
or Islam, as described in Figure 5. When these primary concepts are stratified, it will
help to develop a particular worldview of wealth management as a whole. It can be
translated into wealth planning at every stage: creation, accumulation, protection,
distribution and purification of wealth.
People may have wealth that may be enduring (subsisting for subsequent
generations) but that wealth may not necessarily be beneficial to the owner or the
society at large (endearing). Islam enjoins Muslims to acquire wealth which is enduring
and endearing. Therefore Muslims are encouraged to earn a legitimate source of income
for themselves and for the subsistence of their families whilst at the same time ensuring
that the wealth they have acquired is good, useful and beneficial to themselves, their
families and society15
.
From the Islamic perspective all wealth ultimately belongs to God and man is only a
trustee. The Qur‘an says, “To Him (God) belongs what is in the heavens and what is on
the earth, and all that is between them, and all that is beneath the soil)16
. The Qur‘an
further says, “… and give them something out of the wealth that God has bestowed
upon you.” (Qur‘an 24:33)17
. The verses explain that God is the absolute owner of
wealth, Who has the unquestionable right to bestow it on whomever He pleases. Man‘s
role is as a trustee, holding the wealth in trust for Allah as evident in the Qur‘anic verse,
“Lo! We offered the trust unto the heavens and the earth and the hills, but they shrank
from bearing it and were afraid of it. And man assumed it. Lo! He hath proved a tyrant
and a fool.”18
A contemporary scholar, Sheikh Yusuf Al-Qaradawi, interpreted the above
verses thus, “It is a part of that great trust which Allah offered to the heavens, the earth,
and the mountains, which they declined but which man accepted. This trust requires
man to carry out the duties placed on him by Allah as His vicegerent on earth and to
assume accountability concerning them. This responsibility is the basis on which the
human individual will be judged by Allah and given his reward or punishment. Because
of this trust, Allah gave man Intellect, will power, and freedom of choice; because of
15 al-Zuhayli, Wahbah (2002), Al-Fiqh al-Islami wa Adillatuh. Juz. 4, Damsyik: Dar al-Fikr 16 .(Qur‘an: 20:6) 17 (Qur‘an 24:33) 18 Sheikh Yusuf Al-Qaradawi ,(Qur‘an, 33:72)
15
this, He sent His messengers and revealed His Books.”
The first right to wealth goes to God, Himself, but God does not need ―wealth‖
as we perceive it and He has prescribed conditions on the utilization of the wealth that
He has bestowed on us. Muslims therefore, should follow the guidelines and injunctions
of God in their daily undertakings. As mentioned above, Islam considers wealth as
something given to us in trust and thus Muslims would be accountable for the manner in
which it has been created, how it has been amassed and how it has been spent. For this
purpose, Islam prescribes ways to carry out the trust. For example, Islam provides
guidelines on how Muslims should spend their wealth whilst they are alive and how it
should be distributed when they pass away. Only by doing so, the wealth we have
acquired would be blessed.
A blessed wealth in this context is wealth that brings benefits to oneself and
others. The Prophet Muhammad S.A.W. said “the upper hand is better than the lower
hand”. The upper hand is the hand that gives benefits to others whereas the lower hand
is the hand that receives the benefit. Thus, in Islam, wealth is vital for the enhancement
and development of the economic system. With wealth, Muslims will be able to serve
God through giving alms (one method of wealth purification). The Prophet Muhammad
(peace and blessings be upon him) said: “Blessed is the wealth of a Muslim from which
he gives to the poor, the orphans and the needy travelers”. Islam has always
emphasized the significance of attaining God‘s blessings (pleasures) by giving alms to
those in need.
2.4 Distribution of wealth across individuals and Global wealth
Figure 5 Regional Composition of Global Wealth Distribution in 2014
16
Source: Global wealth report 2014, p.12
This figures determines, how global wealth is distributed across households and
individuals, rather than regions or countries, we combine our data on the level of
household wealth across countries with information on the pattern of wealth distribution
within countries. According to the estimates made by Credit Susie for mid-2014
indicate that once debts have been subtracted, a person needs only USD 3,650 to be
among the wealthiest half of world citizens. However, more than USD 77,000 is
required to be a member of the top 10% of global wealth holders, and USD 798,000 to
belong to the top 1%. Taken together, the bottom half of the global population own less
than 1% of total wealth19
.
In sharp contrast, the richest decile hold 87% of the world‘s wealth, and the top
percentile alone account for 48.2% of global assets. According to the credit Suisse in
2014 breaking, there is new ground by reporting annual values for median wealth and
other distributional indicators back to the year 2000. These estimates indicate that
global median wealth (i.e. the minimum net worth of the top half of global adults) has
decreased every year since 2010, a surprising result given the robust rise in mean
wealth.
In contrast, the minimum wealth of the top decile has changed little since 2010,
while USD 163,000 more is needed now to belong to the top percentile compared to
2008 when the minimum requirement was USD 635,000. These findings hint at rising
global wealth inequality in recent years. However, these results also suggest that the
reverse trend happened in the run up to the financial crisis, with median wealth rising
faster than the minimum wealth of the top percentile groups in the period from 2000 to
2007. Assigning individuals to their corresponding global wealth decile (i.e. population
tenth) enables the regional pattern of wealth to be portrayed, as in Figure 8. The most
19
Source: James Davies, Rodrigo luberas and Anthony shorrocks, credit suisse global Wealth Databook
2014, p.13
17
prominent feature is the contrast between China and India. China has very few
representatives at the bottom of the global wealth distribution, and relatively few at the
top, but dominates the upper middle section, accounting for 40% of the worldwide
membership of deciles 6–8. The sizeable presence of China in the upper middle section
reflects not only its population size and growing average wealth, but also wealth
inequality which, despite recent increases, is not high by the standards of the developing
world. China‘s position in the global picture has shifted towards the right in the past
decade due to its strong record of growth, rising asset values and currency appreciation.
China now has more people in the top 10% of global wealth holders than any other
country except for the USA and Japan, having moved into third place in the rankings by
overtaking France, Germany, Italy and the United Kingdom. In contrast, residents of
India are heavily concentrated in the lower wealth strata, accounting for over a quarter
of people in the bottom half of the distribution. However, its extreme wealth inequality
and immense population mean that India also has a significant number of members in
the top wealth echelons.
Residents of Latin America are fairly evenly spread across the global wealth
spectrum. The Asia-Pacific region (excluding China and India) mimics the global
pattern more closely still. However, the apparent uniformity of the Asia-Pacific region
masks a substantial degree of polarization. Residents of high-income Asian countries,
such as Hong Kong, Japan and Singapore, are heavily concentrated at the top end: half
of all adults in high-income Asian countries are in the top global Wealth decile. In
contrast, inhabitants of lower income countries in Asia, such as Bangladesh, Indonesia,
Pakistan and Vietnam, tend to be found lower down in the wealth distribution20
.
when high-income countries are excluded from the Asia Pacific group, the
wealth pattern within the remaining countries resembles that of India, with both
regional groupings contributing about one quarter of the bottom half of wealth holders.
Africa is even more concentrated in the bottom end of the wealth spectrum: half of all
African adults are found in the bottom two global wealth deciles. At the same time,
wealth inequality within and across countries in Africa is so high that some individuals
are found among the top global wealth decile, and even among the top percentile.
20 credit suisse global Wealth Databook 2014
18
In sharp contrast, North America and Europe are heavily skewed toward the top
tail, together accounting for 64% of adults in the top 10%, and an even higher
percentage of the top percentile. Europe alone accounts for 38% of members of the top
wealth decile, a proportion that has risen considerably over the past decade alongside
the euro appreciation against the US dollar.
2.5 Methods of Wealth Accumulation
Wealth accumulation is considered by many conventional professional wealth
planners and managers as the most important function of wealth management. The
major concern here is to accumulate the capital sum required to meet one‘s financial
needs and objectives in life as fast as possible21
.
Wealth accumulation definitely means more than achieving the maximum rate of
return for accumulated wealth and savings. It is an investment strategy to preserve the
invested capital so that it cannot be lost under all circumstances. Most generally, the
accumulation of wealth refers simply to the gathering or amassment of objects of value;
the increase in wealth; or the creation of wealth. Success in wealth accumulation is very
much dependent on asset allocation strategies to minimize risk and maximize returns on
accumulated wealth by diversifying the portfolio into diverse and uncorrelated asset
classes.
The primary objective of wealth accumulation is to preserve accumulated
wealth. Rather than focusing on achieving capital growth, more time and effort should
be spent on allocating assets in such a way that the accumulated wealth is preserved
under all circumstances. Most high net worth individuals have attained more than
enough of their financial needs. Normally the critical mistake would be to
underestimate the risk of losing the accumulated wealth.
The more principal capital we lose, the higher the return on investment we will
21 Dalton and Fisher, Personal Financial Planning: Theory and Practice.p.47.
19
need to achieve our accumulation target. The higher return on investment would also
mean higher level of risk we need to take. Thus, careless loss of existing accumulated
wealth would make the job of wealth accumulation more challenging. As such, many
wealth planners are of the opinion that the primary objective in wealth creation should
be capital preservation rather than capital growth.
However, this does not mean that we have to put all accumulated wealth in fixed
deposits that will guarantee our capital. Other factors need to be considered too.
Loss of purchasing power is a serious Problem in wealth accumulation despite its
intangibility. Inflation and time value of money also have to be considered at the same
time. Inflation does not only erode and shrink the existing value of accumulated wealth;
it also decreases the return on wealth and thus reduces the net returns22
. Investments
that beat inflation, like equities, carry the biggest risk of loss of principal capital.
Although wealth accumulation is often equated with investment, especially in real
capital goods, it can also refer to either real investment in tangible means of production,
or financial investment in paper assets, or investment in non-productive physical assets
such as residential real estate, or ―human capital accumulation,‖ i.e., new education and
training to increase the skills of the (potential) labour force.
5% WITHDRAWAL
WITHOUT GROWTH
5% WITHDRAWAL
WITH 2.5% GROWTH
5% WITHDRAWAL
WITH 6% GROWTH
Source: Wealth Planning and Management, p.13.
22 Suze Ormon , The Road to Wealth : A Comprehensive Guide to Your Money, 2003, p.p25-27.
Figure 6 Effects on How Long Wealth Will Last with Constant Withdrawal
20
According to some experts, wealth is what sustains you when you are not
working23
. It is net worth, not income, which is important when you retire or are unable
to work. The key question is how long would a certain amount of wealth last. Ongoing
withdrawal research seems to suggest that sustainable withdrawal rates lie anywhere
between approximately 3 percent and 8 percent, depending on the researchers‘
assumptions. The period of how long the wealth would last then depends on how many
times the percentage of withdrawal rate is factored into all the assets. For example,
withdrawing 3 percent a year from 100 percent makes the asset lasts for33.3 years; 4
percent lasts for 25 years; 8 percent lasts for 12.5 years, etc. This ignores any growth or
return on the capital, which presumably would be used to offset the effects of inflation.
Growth would extend the time assets may last while no growth or negative growth
would reduce the time assets may last.
There are three main reasons why saving is important and contributes to wealth
accumulation.
• The more we save, the more we accumulate.
This very simply means the more we save, the more resources we would
have to invest and grow our assets to achieve the accumulation target.
• The more we save, the less we spend.
When we force ourselves to save more we would definitely have less to
spend. As such, we would be able to control our standard of living and
live within our means. We would be able to accumulate a substantial
amount of assets through prudent spending and disciplined saving. When
we do not have too high a standard of living, our retirement goals would
be easier to attain. But if we never plan to save, we would just spend it
all no matter how much our income is.
• The more we save the less the rate of investment we need.
In fact the more we save, the less the risk we need to take in wealth
accumulation planning. The less the risk we need to take, the more
peaceful our lives would be. If the saving and contribution are less than
planned, then the wealth accumulation strategy would become
misaligned. If the gap continues, the chances for us to achieve our
original financial goals would be even lower.
23 David Bach, The Finish Rich Workbook: Creating a Personalized Plan for a Richer Future, 2003
21
2.6 Islamic View of Wealth Accumulation
There is a view among some scholars that the term wealth creation is not an
appropriate term to be used. This is because the only true creator is Allah Almighty
Who creates everything from nothing, whereas man uses the creations of Allah
Almighty to generate something. Man has no capacity to create something out of
nothing. As an example, man may be able to clone a living thing, but he cannot create
life out of nothing. Based on this concept, it is felt more appropriate to use the term
―generating wealth‖ instead of ―creating wealth‖.
There is nothing wrong in using the concept of ―wealth accumulation‖ which
means to increase one‘s wealth by adding more wealth to what already exists from time
to time. However, what is frowned upon is accumulation with the intention of hoarding
and not spending. This is because hoarding will stop the wealth from circulating into the
economy and hence will stifle the growth of the economy. Spending will cause the
wealth to flow into the economy and hence allow the generation of more wealth.
Regarding wealth accumulation, the Qur‘an says, ―They who accumulate gold
and silver and spend it not in the way of God, unto them give tidings of a painful doom.
On the day when it will (all) be heated in the fire of hell, and their foreheads and their
flanks and their backs will be branded therewith (and it will be said unto them): Here is
that which ye accumulated for yourselves. Now taste of what ye used to accumulate.‖24
This verse clearly condemns those who accumulate wealth and do not spend it in the
way of God. What is being condemned is not the act of accumulating wealth, but the act
of not spending part of it in the way of God.
Spending in the way of God also includes spending on oneself, the next of kin,
dependents, distant relatives, neighbours and others, in that order. Not spending in the
way of God also implies the act of hoarding of wealth and not allowing it to circulate in
the economy which is harmful to the economy. This is also the reason why the hoarded
wealth is being reduced by the amount of zakat.
24(Qur‘an, 9:35)
22
The Qur‘an also condemns those who accumulate wealth wrongfully by usurping the
rights of others. The Qur‘an says, ―Lo! Those who devour the wealth of orphans
wrongfully, they do but swallow fire into their bellies, and they will be exposed to
burning flame.‖25
The Qur‘an also says, ―Who hoard their wealth and enjoin avarice on
others, and hide that which Allah hath bestowed upon them of His bounty. For
disbelievers we prepare a shameful doom‖26
Indeed there are many other verses in the
Qur‘an that warn against devouring other people‘s wealth, and which is likened to
killing one‘s brother in the process.
What has been alluded to above does not in any way imply that Islam is against
private ownership. Having wealth is a sign of strength and freedom and is also a
characteristic of humanity - animals have nothing to possess. To respect man‘s nature
and his right to freedom and humanity is certainly in line with the teachings of Islam. In
other words, Islam not only allows, but sanctions the right to private ownership.
Denying one all rights to private ownership and giving the fruits of one‘s own
hard work to others who may not be as active as one is not fair at all. Justice dictates
giving all people the chance to work and to acquire wealth by lawful means, and when
one proves to be a hard worker and efficient in this regard, one becomes worthy of
success. In this respect the Qur‘an says, ―Is the reward of goodness ought to save
goodness?‖27
. This verse tells us that goodness has to be rewarded and the reward for it
has to be goodness as well.
Hence, according to Islam, one may acquire wealth as much as one desires, so
long as one acquires it through lawful means and spends and invests it in lawful ways.
God has created man to be His vicegerent on earth. This implies that one is not to
succumb to illicit means of acquiring wealth, or squander one‘s money, or withhold
from giving others their rights, or usurp the rights of others. Here, Qur‘an teaches us to
place more importance on obtaining God‘s mercy rather than accumulating wealth in
unlawful ways. In this respect the Qur‘an says, ―Is it they who apportion their Lord‟s
mercy? We have apportioned among them their livelihood in the life of the world, and
25 (Qur‘an, 4:10) 26 (Qur‘an, 4:37). 27 (Qur‘an, 55: 60)
23
raised some of them above others in rank that some of them may take labour from
others; and the
24
mercy of thy Lord is better than (the wealth) that they accumulate.‖(Qur‘an, 10:58)28
What it
means is that it is much better to get God‘s blessings or mercy in the accumulation of wealth than
the wealth itself. For whatever amount of wealth we have, if we are not blessed, we will not find
wealth to be useful to us.
Wealth generation through spending is very much encouraged by Islam. There are many
verses of the Qur‘an and Hadith that show this to be the case. Among others the Qur‘an says,
―Give not unto the foolish (what is in) your (keeping of their) wealth, which Allah has given you
to maintain; but feed and clothe them from it, and speak kindly unto them.‖ In Islam, wealth must
not be kept idle, but should be invested. For example, if gold is kept idle, one must pay alms on
the idle gold. In a hadith the Prophet said, ―Whoever develops an idle land, it belongs to him‖29
.
A good example of a committed Muslim who created and generated wealth lawfully is (`Abdur-
Rahman ibn `Awf ), who started off with nothing in his pocket, yet his wives inherited 80,000
dinars (about $ 5.6 million in today‘s currency) when he died. This proves that Islam does not
prohibit acquiring wealth, so long as it is acquired lawfully and spent lawfully, without
miserliness or extravagance. It was also reported that once `Abdur-Rahman ibn `Awf sold a
piece of of his land for 40,000 dinars ($ 3 million in today‘s currency) and distributed all this
money among his relatives of the Banu Zahrah, the poor Muslims, and gave a portion to the
wives of the Prophet Muhammad S.A.W.
It was also reported that he donated a caravan of 700 camels all carrying supplies of
different kinds. Moreover, before his death, he bequeathed 50,000 dinars ($ 4.2 million in
today‘s currency) of his wealth to be given in Allah‘s cause, and all this was only a small part of
what he gave in charity, besides the obligatory zakah he paid, and the expenses he was
responsible for. This is an example of blessed wealth in the hands of a good, righteous person,
and consistent with the Prophet Muhammad‘s saying, ―A true and honest trader, on the Day of
Judgement, would be in the ranks of the Prophets, the Truthful and the Martyrs‖ (Bukhari)30
.
Islam not only sanctions the right to acquire personal property, it also encourages people to seek
and to acquire lawful wealth and it lays down laws for protecting this wealth and giving it in
inheritance. Thus, it motivates people to work and exploit their own energy. In this way, Islam
also instills confidence in them and enables them to exercise mastery over their lives.
28 .‖(Qur‘an, 10:58) 29 (Sahih Bukhari), Volume 4, Book51, No.11 30 (Bukhari), 51, no.11.
25
Dispossessing people of their properties renders them slaves in their own land. Tyrant states that
enslave people in this way do not pay attention to the teachings of religion or the dictates of
ethics; the subjects of these states, having nothing of their own, lack the ability to resist the
despotism that dominates everything.
Furthermore, Islam‘s sanctioning of the right to personal property benefits the economy
and the nation as a whole. The private sector is likely to generate wealth more than the public
sector, because the personal incentives given in the private sector generally encourage people to
be more efficient and productive, this is the opposite of the public sector.
A wealth generation activity is not restricted even during a sacred day. In this respect the
Qur‘an says, ―O ye who believe! When the call is heard for the prayer of the day of
congregation, haste unto remembrance of Allah and leave your trading. That is better for you if
ye did but know. And when the prayer is ended, then disperse in the land and seek of Allah‟s
bounty, and remember Allah much, that ye may be successful.‖ (62:9-10)31
The above verses of
the Surah Al-Jumu‘ah, clearly shows that even on a Friday, Muslims are exhorted to seek wealth
through lawful means after they have performed their Friday prayers. In Islam, wealth must be
accumulated in an absolutely honest manner. Muslim religious officials as well as Islamic
scholars are not discouraged from acquiring wealth. However, they have to practice a higher
level of reasonableness compared to ordinary Muslims. This is to rightfully reflect their higher
degree of faith to Allah and their role as religious leaders who must establish good examples.
The general perception therefore that Islam discourages acquiring wealth is totally wrong.
Thus wealth should not only be circulated, but it should also be circulated as widely as
possible. Allah forbids circulation of wealth only among the rich, which would result in small
groups of wealthy men becoming even richer, while the majority of the community would
stagnate or become even poorer. Circulation of wealth, or in other words, spending of wealth
should spread in a manner that involves as many members of the community as possible. It is
worthwhile to repeat here Allah‘s revelation. One of the means of circulation of wealth by the
rich is through generous consumption. That is why Allah has prohibited monasticism and allows
good food, beautiful clothing, spacious houses, etc for those who can afford them. It is also for
this reason that reasonable and proper adornments of beautification are regarded as mubah
31 Quran Surah Al-Jumu‟ah, (62:9-10)
26
(allowed) in Shariah rulings.
Most unfortunately, even many Muslims themselves have the perception that they should
not seek to be wealthy. This is due to the misinterpretation of the following:
• The repeated warnings of Allah and the Prophet Muhammad S.A.W. that wealth
could weaken a Muslim‘s faith in Allah.
• The warnings that many of the wealthy may not enter Paradise.
Some Muslims who attain a high level of faith in Allah feel no real need for wealth
generation. Less knowledgeable Muslims could misinterpret such warnings as discouragement
for wealth generation. Those who see Islam as a threat could have deliberately encouraged such
an attitude, thus making it widespread. Muslims themselves have therefore a solemn duty to fully
understand that Allah allows any amount of wealth provided that the more wealth they acquire
the more responsible and generous they become. However, wealth is discouraged if the more
wealth a Muslim acquires the more exploitative and tight-fisted he becomes.
2.7 Elements of Wealth Planning in Conventional Banking
Wealth planning consist of three (3) main elements, i.e. use of the private banking
technology, customer relationship management and financial planning tools.
2.7.1 Private banking technology
Source: RBC Capgemini 2013 World Wealth Report, p.17
A critical engine powering holistic wealth planning is aggregation technology. This
Figure 7 Private banking growth in Asia
27
technology brings together important financial information from scattered sources into a single,
accessible source. Combined with a robust planning platform, this technology allows holistic
wealth planning advisors to have an all-inclusive view of their clients‘ holdings. More important,
the advisor can manipulate the data to create `what-if scenarios,‘ plans, reports, and cash flow
analyses over time.
Private banking and wealth management tend to focus almost exclusively on the
relationship between manager and client.32
Little has been reported on the technology
underpinning the relationship, which in many cases determines the effectiveness of the
relationship. Recent global surveys of HNWIs – a segment that appears to be growing despite
recession – have tended to focus on customer satisfaction levels. Banks are not always capable of
balancing their own needs to produce as much profit as possible from each HNWI – with the
client‘s needs to be treated individually – and achieve high performance levels. As the world‘s
wealthy investors become more and more demanding, banks need to re-invent their client service
models through the smart use of the latest technology in relationship management advice and
investment modeling. Thus, support systems for reporting, accounting and portfolio
administration must also be integrated.
2.7.2 Customer Relationship Management
Customer Relationship Management (CRM) is becoming the new buzzword among
private bankers. Surveys abound which tell the market that the demands of HNWIs are growing
by degrees – their demand for web-enabled communication and information shows no signs of
abating; their use of higher risk and alternative investment instruments would continue
indefinitely; and their appetite for higher risk/higher returns is insatiable. Banks need to
incorporate all of these demands into their service and at at an affordable price. CRM is a broad
area: it includes provision of services in such diverse areas as data interactive voice response
instruments or it can be simply the provision of greater choice for the customer. One significant
example is the growing use of wealth portals and fund supermarkets, where technology has
enabled greater choice for customers.
The conclusion is that CRM solutions have increased the efficiency of banks in reaching
32 RBC Capgemini 2013 World Wealth Report, p.19
28
and servicing customers, as the administrative workload is lowered and the collation of data is
streamlined. Cost to the bank is a major focus of the CRM. Therefore, it is aimed at raising the
retention rate for customers that are profitable, redefining the relationship with customers that are
not, as well as delivering information that is indispensable to decide on the marketing strategy
for attracting new customers that meet predefined criteria.
2.7.3 Wealth Planning tools
Wealth planning based on one-to-one consultation has always been a major tenet of
wealth planning. However, the ideas that a program can be constructed to assist in managing a
client‘s future wealth is still in its infancy and ideas on the subject are only just beginning to take
shape.
Tools designed to manage the wealth objectives of an ageing population have become more of an
imperative. The reasons for this are manifold. The number of mass affluent investors is growing
and in need of advice. This segment of wealth creators is undoubtedly the most significant; they
tend to be more active, using a larger and more sophisticated array of financial instruments.
However, in many cases the products available are short term in range, tending to focus on
immediate investment returns. Added to that is the re-organization of government pension
schemes in some countries like Malaysia, which have prompted investors to take greater
responsibility for their own retirement, education and health care. The greater challenge for long-
term planning is how to fulfill the demand for sharia-compliant high quality financial tools or
instruments with combined factors of demographics, changing investment styles and the
volatility of markets through a holistic approach.
2.8 The Process of Wealth Planning
The process of financial planning is a technique used to build, execute, and monitor a
plan designed to enable a person to achieve his or her financial goals. Most wealth planning and
management professionals recommend a five-step process, as follows:
1. Taking inventory;
2. Analyzing and evaluating;
3. Designing the plan;
4. Implementation; and
29
5. Monitoring and reviewing.
Although the above process of five steps is considered water-tight, many plans fail
because of liquidity. In addition, one also needs to look at the wealth planning process from the
perspective of the wealth planning and management professional. Apart from that one also needs
to look at it from the Islamic angle33
.
Figure 8 Overview of Wealth Planning Process
Source: “The Portfolio Managemetn Process and The Investment Policy Statement.” CFA Level
III Candidate Readings Book 2.30-32.
2.9 Summary of the Chapter
We mentioned that, wealth is an abundance of items of economic value, or the state of being in
control or possession of such items. Wealth may comprise of money, real estate and personal
33
Affandi, M (2001), Islam and Wealth: The balance approach to Wealth Creation, Accumulation and
Distribution. Pelanduk Publications, Selangor, p.67
Taking İnventory
Analysing & Evaluting
Designing the plan
Implement the Plan
Monitoring & Reviewing
Data Collection
Develop Objectives
Analysis & Alternatives Investmnt Plan
Tax Plan
Retirement Plan
Estate Plan
Education Plan
30
properties. Following that we discussed in this chapter wealth ranges and their categories which
frontier, intermediate, High and Ultra High Net worth Individuals of wealth holder in the world
and their percentages.
We also analysed the concept of Islamic wealth management as it based on and primarily
focused on Sharīʿah-compliance, which strictly means that it is legalistically distinctive due to
adherence to certain prohibitions (e.g., ribā – commonly equated with interest in a blanket
manner; gharar – excessive risk and uncertainty; maysir – gambling; and a few things that are
prohibited on their own, such as pork, intoxicant, pornography. Though we showed that there is
growth of personal income and High Net Worth individuals of Selected Muslim countries, our
study mentioned that is why there is need for Sharia compliant wealth management. The author
also discussed tools for wealth management like private banking technology, customer
relationship management and wealth planning tools.
With regard to this we analyzed on how global wealth is distributed across households and
individuals, rather than regions or countries, we combine our data on the level of household
wealth across countries with information on the pattern of wealth distribution within countries.
In the last, but not least we observed that as we included in this chapter there is a view among
some scholars that the term wealth creation is not an appropriate term to be used. This is because
the only true creator is Allah Almighty Who creates everything from nothing, whereas man uses
the creations of Allah Almighty to generate something.as we discussed and analyzed in chapter
four, there is the process of wealth creation in Islamic from the sources some Muslim scholars.
At the end, we concluded our chapter the process of wealth planning, which is a technique used
to build, execute, and monitor a plan designed to enable a person to achieve his or her financial
goals. Most wealth planning and management professionals recommend a five-step process, as
follows: taking inventory, analyzing and evaluating, designing the plan, implementation, and
Monitoring and reviewing.
CHAPTER THREE: WEALTH (ASSET) ALLOCATION PROCESS
3.1 Introduction
Wealth allocation is a very important component of financial planning. It deals with the
way the assets of a client are being placed in various forms of investments, so that his/her
financial goals are met. Before the financial planner can advise how his client‘s asset should be
31
allocated, he must find out firstly, what sort of assets the client has, his financial goals, his time
horizon, his requirements in terms of liquidity, tax, education of his/her children, etc. Secondly,
he must also know the different types of investment instruments available in the market, the
potential of each of these instruments as well as the risks associated with them so that he can
forecast the kind of return that could be achieved at the end.
From the above, it is clear that the asset allocation involves two main components. The
first is the Investment Policy Statement (IPS) and the second is the portfolio management
process. IPS is a written document that clearly sets out the client‘s return objectives and risk
tolerance over the client‘s relevant time horizon, along with applicable constraints such as
liquidity needs, tax considerations, regulatory requirements, and unique/Shariah circumstances.
On the other hand, a portfolio management process is an integrated set of steps taken consistently
to create and maintain an appropriate portfolio to meet the client‘s goals34
.
Hence, the purpose of this chapter is to provide a clear understanding of both
conventional and Shariah compliant wealth allocation process. To achieve this objective, we
shall divide the chapter into four (4) main subtopics as follows:
(1) Establishing objectives of the client;
(2) Identifying potential investment opportunities;
(3) Identifying risks and constraints; and
(4) Potential investment channels.
Wealth allocation is an important process in the financial planning but people tend to
forget that it is a dynamic and continuous process. According to Watson Wyatt, a consulting
firm, around 50% of Britons in their defined-contribution pension plans never changes the
allocation of assets. One-third has not even reviewed them for several years.
3.1.1 Introduction to Wealth Allocation Process (Establishment of the objectives)
Before a wealth planner could assist his investor in establishing the objectives, he should
first have a thorough understanding of the portfolio management process and also be familiar
with the basic principles of finance. Modern portfolio management is too complex to rely on ad
34John L. Maginn, Donald L. Tuttle, Dennis W. McLeavey, Jerald E. Pinto. 2005. ―The Portfolio Management
Process and The Investment Policy Statement.‖ CFA Level III Candidate Readings Book 2.pp. 4-30.
32
hoc approaches. The historical roots of portfolio management date back to (1952), where the
Nobel laureate Harry Markowitz and subsequently other researchers have established the
Modern Portfolio Theory (MPT) – the analysis of rational portfolio choices based on the efficient
use of risk. Modern portfolio theory has played an important role in the investment/wealth
management industry. First, practitioners began to incorporate disciplines which recognized the
importance of the portfolio perspective for the achievement of investment objectives.
Second, the quantitative emphasis of MPT helped spread the knowledge and use of quantitative
methods in portfolio and wealth management.
Managing Investment Portfolios: A Dynamic Process” in 1983. The process view of Portfolio
management is a dynamic and flexible concept, and it is an accurate description of any portfolio
function, be it investments in stocks, bonds, real estate, gold, collectibles; as it is also, regardless
of the organizational type – trustee company, investment advisory firm, insurance company, unit
trust fund; regardless of customer orientation – personal, pension, endowment, foundation,
insurance, bank; and regardless of manager, location, investment philosophy, style, approach,
Shariah or non-Shariah. Portfolio management is a continuous, systematic and a closed loop
process with feedback, monitoring and adjustment.35
The process can be as loose or as
disciplined, as quantitative or as qualitative, and as simple or as complex as its operators wish it
to be.
The portfolio management process is an integrated set of steps undertaken in a consistent
manner to create and maintain appropriate combinations of investment assets. Needless to say, it
is the responsibility of the Islamic financial planner to ensure that the process is Shariah
compliant and all the returns/incomes derived from the process are permissible or halal.
35 Datuk alhabsi, Islamic wealth planning and management,p.302
33
Figure 9 Portfolio Management Process
Source: “The Portfolio Managemetn Process and The Investment Policy Statement.” CFA Level
III Candidate Readings Book 2.pp. 4-30.
As with any business process, planning, execution and feedback are also the three
elements that form the basis of portfolio management process (Figure 10).
The planning step is represented by the four leftmost boxes in Figure 10. The top two boxes
represent investor-related input factors, while the bottom two boxes represent economic and
market input factors.
3.1.2 Identifying and Specifying the Investors objectives and Constraints
The first sub-step is to set investment objectives. The basic elements in investment
objectives are return requirements and risk tolerance levels. In short, investment objectives are
desired investment outcomes. These must be suitable for the investor. They must be realistic.
Formally specifying the objectives may be difficult in that words can obscure objectives. Words
like growth, income, reasonable rate of return mean different things to different people. This is
especially difficult if the investing party turns out to be a pool of individual investors and hence
the portfolio has multiple beneficiaries. It should be recognized that the person entrusted with
achieving these objectives, if different from the investor himself/herself, may need to exercise
34
some degree of discretion due to the subjectivity of the objectives themselves36
. Care must be
taken not to set objectives that may be contradictory or mutually exclusive.
For individual investors, the main factors that determine return requirements are the life
cycle stage of the investor and the individual investors‘ risk aversion or risk tolerance level.
Given identical risk tolerance levels, individuals and institutions still choose different portfolios
due to circumstances that differ between them. These circumstances act as constraints. Simply,
constraints are limitations on the ability to take full or partial advantage of particular
investments. For example, Muslims must avoid investment in Usury (riba), gambling (maisir),
ambiguous (gharar), immoral, exploitive and prohibited (haram) food and beverages activities
for investment purposes. Constraints can be both internal (due to the situation and/or preferences
of the client) such as liquidity needs, time horizon, and unique client circumstances (Shariah
compliance) or external such as tax issues and legal and regulatory requirements.
3.1.3 Creating the Investment Policy Statement
Objectives and constraints together determine an investment policy, which serves as the
governing document for all investment decision-making. Moreover, the investment policy
statement may also cover issues such as reporting requirements, rebalancing guidelines,
frequency and format of investment communication, manager fees, and investment strategy, or
the investment style of the manager, purification method, action and its time frame should an
investment become non-Shariah compliant37
. A typical investment policy statement includes the
following elements:
1. Brief client description;
2. Purpose regarding establishment of policies and guidelines regarding objectives,
goals, restrictions, and responsibilities;
3. Identification of duties and investment responsibilities of parties involved (e.g. the
client, any investment committee, any Shariah advisor, the investment manager
and the trustee) particularly regarding fiduciary duties, Shariah compliance,
purification, communication, operational efficiency and accountability;
4. Statement of investment goals, objectives and constraints;
36James W. Bronson, Matthew H. Scanlan, Jan R. Squires. 2005. ―Managing Individual Investor Portfolios.‖ CFA
Level III Candidate Readings Book 2. 31-110. 37
Susan Trammell. 2005. “Islamic Finance.” CFA Magazine. March-April 2005. 17-23.
35
5. Schedule for review of Shariah compliance, investment performance and of the
IPS itself;
6. Asset allocation considerations to be taken into account in developing the
strategic asset allocation; and
7. Rebalancing guidelines for portfolio adjustments based on feedback.
The investment policy acts as an investment strategy that reflects the preferred risk-return
profile, liquidity needs, income generation and tax strategy. The result is a set of portfolio
choices between risky and safe assets. The allocation of resources between types of assets is
called the asset allocation decision and is the most fundamental of investment decisions. In
practice, one may see investment policy statements that include strategic asset allocations.
Once the broad asset classes are determined, the choice of specific securities can then be made.
In the broadest sense, the Islamic wealth planner should assist the investor in understanding
passive, active and semi-active investment strategies38
.
In a passive investment approach, portfolio does not react to changes in expectations. For
example, a portfolio indexed to the Shariah Index, an index representing Shariah compliant
companies listed in Bursa Malaysia, might add or drop a holding in response to a change in the
index composition, but not in response to changes in expectations concerning the security‘s
investment value. Indexing refers to the holding of a portfolio of securities designed to replicate
the returns on a specified index of securities – and is a common passive approach to investing. A
strict buy and hold strategy, which holds say a fixed portfolio of Islamic bonds, is the second
type of passive investing.
In contrast, an active investment approach is based on responding to changing
expectations. Active managers establish a benchmark or comparison portfolio used to evaluate
their performance. Holdings differ from the benchmark in an attempt to produce positive excess
risk-adjusted returns or positive alpha.The semi-active, risk-controlled active or enhanced index
approach makes very controlled use of changes in expectational data. As an example, an index-
tilt strategy seeks to track closely the Shariah Index while adding a targeted amount of
incremental value by tilting portfolio weightings in some direction that the manager expects to be
profitable.
38 Ibid, p.31-110.
36
At this juncture, the asset allocation decision may have been made. Market timing
techniques may be introduced at this level. Lower level portfolio managers fill in the next stage
in the decision process by making security selections. Below the level of the asset allocation
decision stage, investors will need to decide whether or not to adopt an active or passive
approach to security selection.
3.1.4 Forming Capital Market Expectations
This sub-step involves the forming of capital and/or Islamic capital market expectations.
Long run forecasts of risk and return characteristics for various asset classes form the basis for
choosing portfolios that maximize expected return for given levels of risk or minimize risk for
given levels of expected returns.
3.1.5 Creating the Strategic Asset Allocation
The final sub-step of the planning process is the creation of the strategic asset allocation.
The IPS and capital market expectations are combined to determine strategic asset allocation
targets or maximal and minimal permissible asset class values as a risk control mechanism39
.
The risk/return characteristics of the asset allocations could be single or multi period. Traditional
Mean-variance analysis is a starting point while possible complexities include after-tax
allocation, Liquidity constraints and time horizon constraints. In fact, time horizon issues will
further raise issues such as whether a long-term portfolio choice will remain Shariah compliant
or not.
3.1.6 The Execution Step
This is the step is where the manager constructs and revises a portfolio within the
guidelines of the strategic asset allocation. In the execution step, investment strategies are
integrated with expectations to build a portfolio (the portfolio selection/composition); the
portfolio decisions are initiated by portfolio managers and implemented by trading desks or the
managers (portfolio implementation); and subsequently. The portfolio is revised as investor‘s
circumstances, Shariah compliance or capital market expectations change.
39 Ibid p.103-116
37
Portfolio optimization uses quantitative tools to combine assets efficiently in order to
achieve the return and risk objectives. It is important in integrating the strategies with
expectations and also often used as a tool to determine asset allocation.
Although Islamic wealth planner and/or portfolio managers‘ duties may not extend to the
portfolio implementation, it is nevertheless equally, if not more important. The planner should
understand that transaction costs of negative performance. Poorly managed transaction costs can
reduce the fund performance and thus negate any advantage an investor may have.
Transaction costs include all costs of trading, including explicit transaction costs, implicit
transaction costs, and missed trade opportunity costs. Explicit transaction costs include
commission paid to brokers, fees paid to exchanges and taxes. Implicit transaction costs include
bid-ask spreads and market price impacts of large trades. Missed trade opportunity costs can
arise due to late Shariah certification and thus unable to buy at a much lower price.
3.1.7 The Feedback Step
Investing is a dynamic process, even when investment objectives and constraints do not
change. Differing rates of return between specific asset classes result in shifts in portfolio
composition. Evaluation of any change in investment constraints and the effectiveness of the
investment methodology may be undertaken periodically and revised if necessary. The feedback
step consists of two components: performance evaluation as well as monitoring and rebalancing.
3.1.8 Performance Evaluation
Investment performance must be periodically evaluated to assess progress toward
achievement of investment objectives and to assess the skill of the manager. Performance
evaluation is subdivided into performance measurement, performance attribution and
performance appraisal.
Performance measurement is the calculation of rates of return for the portfolio.
Performance attribution is the analysis of why the portfolio performed as it did and involves a
determination of the factors to which the rate of return can be accounted for. Performance
appraisal, on the other hand, is the evaluation of whether the manager is doing a good job or not
38
based on how the portfolio performed relative to a benchmark40
. In performance evaluation, the
wealth manager should ask questions such as what decisions led to the manager‘s results and
what were the rationales for these decisions. Normally, a portfolio‘s absolute return could be
attributed to strategic asset allocation decision, market timing and security selection. Besides
evaluating of the manager, a review of the benchmark should also be an ongoing process.
3.1.9 Monitoring and Rebalancing
Monitoring and rebalancing is an action that uses feedback to manage ongoing exposures
to available investment opportunities so that the client‘s current objectives and constraints
continue to be satisfied.
In sum, portfolio management is an ongoing process in which the investment objectives
and constraints are identified and specified, investment strategies are developed, the portfolio
composition is decided in detail, portfolio decisions are initiated by portfolio managers and
implemented by traders, portfolio performance is measured and evaluated, investor and market
conditions are monitored, and any necessary rebalancing is implemented.
3.2 Investment Objectives and Constraints
Return and risk are two sides of the coin and are mutually dependent. The choice of
which objective to begin with is purely arbitrary. Here we begin with return first.
Return objectives are typically financial objectives that are not goals in themselves, but they
enable investors to achieve long term goals. Long term investors‘ goals may be divided into four
categories as follows:
1. Specific goals e.g. funds to buy a new home, put children through university,
2. Increase current income,
3. Accumulate wealth and attain financial security,
4. Provide funds during retirement years.
Exact objectives may be couched in different terms by different investors or investment
managers but are basically of four main types:
Stability of Principal
40Rusell L. Olson 1999. The Independent Fiduciary. John Wiley & Sons, Inc.p.17
39
Here the emphasis is on preserving the original value of the fund. Some beneficiaries
cannot afford any loss at all. This may be because the investor is an institution required
by statute to earn a certain positive rate of return, or because of the investor‘s attitude
towards risk.
Income
This objective does not specifically preclude occasional decline in principal value, but
focuses on deriving a stable or reasonably reliable stream of returns. Temporary declines in
principal value may be quite acceptable in the case of marketable fixed income securities,
particularly when they return to their nominal value on maturity.
Growth of Income
Earning a stable nominal return in each period may not be desirable due to the fact
that inflation erodes the value of that nominal sum in returns. An alternative, longer
term objective may be to seek growth of income. This way, the real rate of return is
maintained. This objective may require some sacrifice of payouts in the early part of
the program so that the retained amount, when reinvested, will generate a rate of
growth that eventually allows the nominal payout to overtake the annual payout under
a level payout program. The target for this objective is commonly spelled out as
achievement of a rate of growth of income that is at least equal to the rate of inflation.
Capital Appreciation
Some investors need no interim income stream from their investments. Such investors
may simply seek to see the value of their investments grow over time. Their investments
may represent resources over and above what their periodic needs are for spending. There
may be different tax treatments in different jurisdictions for periodic income earned as
opposed to lump sum returns on maturity, so tax considerations are important here41
.
3.3 Formulating Return Objectives
In formulating the return objectives, a wealth planner must address the following questions:
41 Hakan Saraoglu, Miranda Lam Detzler. 2002. ―A Sensible Mutual Fund Selection Model.‖ Financial Analysts
Journal.May/June 2002. Pp.60-72.
40
How is return measured? The usual measure is total return, the sum of the return from
price appreciation and the return from investment income. Return may be stated as an
absolute amount, such as 8 percent per year, or as a return relative to the benchmark, such
as Sharia Index return plus 3 percent per year. Nominal returns, i.e. returns unadjusted for
inflation, must be distinguished from real returns which are also known as inflation
adjusted returns. Also pre-tax/pre-purification returns should be distinguished from post-
tax/post-purification returns.
How much return does the investor say he wants? This is the stated desired return, which
may or may not be realistic. It is very common that an investor may have higher than
average return desires to meet higher consumption desires or a high ending wealth target.
The wealth planner must continually evaluate the desire for higher returns versus the
ability to take risk and the reasonableness of that desire relatively to capital market
expectations.
How much return does the investor need to achieve, on average? This in essence is the
required return. Requirements here are more stringent than desires since investors must
achieve these returns, at least on average. For example, annual spending of $200, 000 per
year, non-investment income of dollar 100, 000 per year, and a capital base of $1, 000,
000 means a 10 percent annual required rate of return. If inflation is 2 percent per year
and non-investment income is growing at the inflation rate, then the required rate of
return would be 12 percent.
How is the return objective set? The return objective incorporates the required return, the
stated return desired, and the risk objective into a measurable annual total return
specification. Financial planners must note that the return objective should be consistent
with the risk objective. A high return objective, for example, may suggest an asset
allocation with too high a risk level in relation to the risk objective.
The wealth planner should take due care that the anticipated return should be sufficient to
meet wealth objectives or liabilities that the portfolio is intended or required to fund.
Moreover, for investors with current investment income needs, the return objective should be
sufficient to meet spending needs from capital appreciation and/or investment income. On the
other hand, if a well-considered return objective is not consistent with risk tolerance, it may be
necessary to make other adjustments, such as increasing savings or modifying wealth objectives.
41
3.4 Establishing Risk Objective
Since returns are typically commensurate with the degree of riskiness of the investment, it is
the duty of the wealth planner to address following issues while formulating the risk objective:
How do I measure risk? The measurement, or quantifying of risk, is not an easy job
because risk may be measured in absolute terms or in relative terms with reference to
various risk concepts. Modern portfolio theory uses variance, which is often referred to as
volatility, of return as the measure of risk. However, other risk factors, such as exposures
to specific economic sectors, may be relevant as well. Moreover, downside risk concepts,
such as Value at Risk (VAR), may be important, particularly to individual clients.
What is the investor‟s willingness to take risk? This is the investor‘s stated willingness to
take risk. It normally differs very much between individual and institutional investors. As
for individuals, it involves the understanding of behavioural and personal factors of the
clients.
What is the investor‟s ability to take risk? The willingness and ability to take risks
normally differ due to practical or financial limitations. For example, if the wealth levels
are high relative to probable worst-case short-term losses scenarios and/or long term
wealth targets or obligations, then more risk can be taken.
How much risk is the investor both willing and able to bear? This is known as risk
tolerance. Risk tolerance is the capacity to accept risk and is a function of both
willingness and ability. Another way to describe this is risk aversion, that is, the degree of
inability and unwillingness to take risk. Most often than not, a wealth planner may need
to educate a client before helping him to convert the willingness and ability to take risk
into a risk tolerance that reflects both. However, it is also very common that a mismatch
between willingness and ability occurs. In such situations, the determination of the risk
tolerance requires resolution of conflict. The interactions of these two risks are shown in
Table 1.
What are the specific risk objective(s)? The difference between specific risk objective and
risk tolerance is the level of specificity. For example, the statement that a person has a
―lower than average risk tolerance‖ may be translated into ―the loss in any one year is not
to exceed percent of portfolio value‖ under specific risk objective.
42
Table 2 Interaction between Willingness and Ability to Take Risk
Willingness to Take Risk Ability to Take Risk
Low High
Low Low Risk Tolerance Resolution/education needed
High Resolution/education Low Risk Tolerance
Needed
Source: Keith C. Brown. 2003. “Investment Analysis And Portfolio Management.” Thomson
Learning
However, as a rule of thumb, investors seeking safety of principal will invest in safer
instruments. Those who seek capital appreciation typically enjoy greater flexibility in the range
of instruments they can invest in, including investing in higher risk portfolios that offer higher
returns on the average in the longer term42
.
3.5 Identifying Potential Investment Opportunities
After drawing up an Investment Policy Statement for the client, the wealth planner and/or
the manager have to decide the asset allocation and construct the portfolio. The entire premise
which these processes rest is the principle of diversification. The benefits from diversification
have been well documented and are based on the principle of a less than unity coefficient of
correlation between returns from investments in different assets.
Investors can begin the portfolio construction process by dividing potential investment
channels into asset classes. In a very general sense, asset classes can be divided into financial
assets and real assets. Real assets are physical assets that contribute to human wealth. They are
42 James W. Bronson, Matthew H. Scanlan, Jan R. Squires. 2005. “Managing Individual Investor Portfolios.” CFA
Level III Candidate Readings Book 2. 31-110
43
used to directly generate income. They include land, buildings, machines, and people skills and
knowledge. In the balance sheet of individuals and firms, real assets appear only on the assets
side.
Financial assets are assets that appear on both the assets as well as the liabilities side of
the balance sheet. They are created and invariably consumed during the ordinary course of doing
business. The wealth planner can advise his clients on investment policies based on an estimate
of the total global investable market (GIM). For example, Figure 9 shows the estimated
composition of the GIM denominated in U.S. dollars at the end of 2004. This could represent the
foundation market estimate that a financial planner uses to assess the capital market expectations
of asset classes around the world.
Capital market expectations are expectations about the future distributions of returns to
asset classes, including their expected returns, volatility and their correlations. Capital market
expectations can be short-term or long-term. By combining long-term capital market
expectations with the return/risk objectives and constraints of his client, the wealth planner is
able to formulate an appropriate strategic asset allocation plan (SAAP). If the expectations are
fulfilled, the strategic asset allocation plan should achieve his client‘s return objectives with an
acceptable risk level.
Capital market expectations are always discussed in relation with historical returns.
However, a wealth planner should be aware that in using historical data to formulate capital
market expectations, he assumes that the future will reflect past average performance. Therefore,
the planner may want to adjust historical performance to better reflect current capital market
conditions. Although historical data is simple and widely accepted, it has certain limitations such
as (1) lack of accuracy in estimates of mean returns when the volatility of return is large in
relation to mean, and (2) the risk of including data not economically relevant to the present
environment.
Current market data can provide a second perspective on capital market expectations
about expected return and volatility. For example, the yield to maturity of a government Islamic
bond is a forward-looking estimate of the perspective government bond market returns. Equity
market expected returns can be estimated as the yield to maturity of current long-term
government bond plus a risk premium, or on the basis of a discounted cash flow model such as
44
constant growth dividend discount model.
3.6 Shariah Compliance of Asset Class
Like other investors, Muslims look for stocks, mutual/unit trust funds, Islamic bonds and
real estate to add to their portfolios except these assets must be Shariah compliant.
Islamic law identifies business activities as haram when they generate profits in unacceptable
ways. Haram business activities include the manufacture or marketing of any of these products:
alcohol, gambling or gaming activities, interest-based financial products, pork and
pornography43
.
Other businesses, such as those that harm the environment, have poor track records with regard
to labor or developing countries, or produce and market tobacco, weapons, or defense products,
may also be unacceptable to some Muslim investors.
Islamic legal scholars use several conventions to determine when a business activity is a
core source of revenue and when it is not. The 5 percent rule says that a core business is one that
accounts for more than 5 percent of a company‘s revenue, or gross income. For example, if the
sale of explosives accounts for less than 5 percent of a chemical manufacturer‘s revenue,
explosives are not a core business and investing in that company‘s stock is generally acceptable.
A somewhat less stringent rule sets the standard for a core business at 10 percent. This reasoning
applies to the Islamic prohibition on riba, or interest, as well. If a company‘s interest-based
profits or holdings exceed certain limits, then investing in the company is forbidden. Even when
these are found to be within tolerable limits, purification of earnings from these companies must
take place.
In Islamic law, riba is defined as excess, either in quantity or term, in the counter values of
whatever is exchanged—currency, commodities, goods, or anything else — in a variety of sales,
purchases, swaps, or loans.
In one explanation, riba is forbidden because it is predatory or exploitative, and produces
profit at another person‘s expense. Another view is that the prohibition applies to money made
on money, as opposed to money made by working or by investing through equity partnership or
trade.
43 Mohamad Nabil Mohamad Shukri, Huzairi Mohd Mansor, Razli Ramli, Ahmad Tarmidzi Al-Muttaqi Mahmood,
Muhammad Hadi Abdullah.2005. “Joint Tenancy with The Right Of Survivorship and Shariah: A Brief Discussion.”
Islamic Finance Bulletin. Rating Agency Malaysia. March 2005. 1-7.
45
Different types of ratios are used to measure the amount of riba and to evaluate whether
or not investment is permissible. Some of the more common ratios include:
• Ratios to measure the amount of a company‘s liquidity;
• Ratios to measure a company‘s interest income; and
• Ratios to evaluate how much a company pays in interest on its corporate debt.
Sometimes it is relatively easy to identify the gain that derives from riba (Interest),
especially when investing in countries that require corporations to provide regularly updated
financial information44
.
Islamic schools do agree that if a portion of the investment income can be traced to riba, then
that portion can be donated to charity to cleanse/purify the investment earnings45
.
3.7 Possible Investment Asset Classes
The aim of the portfolio manager is to achieve the highest returns commensurate with the
chosen level of portfolio risk in compliance with the objectives and constraints the investor has
identified. This is translated into decisions on the mix of assets types which will be invested in
and within each asset class, which specific groups of securities or specific securities will in turn
be invested in. The asset classes include, though not exclusively:
1. Cash/Near-cash assets;
2. Bonds;
3. Common stocks;
4. Foreign stocks;
5. Real Estate/REITs; and
6. Precious metals and alternative investments.
The types of investable assets may be divided at the simplest level, to include cash (and
near-cash financial assets), equity and fixed income. This can be extended to include foreign
stocks, real estate and precious metals or alternative investments, if the investor wishes to
44 Mohamad Nabil Mohamad Shukri, Asharul 45 Huzairi Mohd Mansor, Razli Ramli, Ahmad Tarmidzi Al-Muttaqi Mahmood, Muhammad Hadi Abdullah,
Hasleenda Onn. 2005. “Short-Selling, Securities Borrowing and Lending: Shariah Perspective (Part 1).” Islamic
Finance Bulletin. Rating Agency Malaysia. June 2005. 1-4.
46
expand the scope of the financial plan to a more inclusive level.
According to Mark Kritzman, an asset class must:
• Be independent of other asset classes as evidenced by its tracking error.
• Raise the expected utility of a portfolio without superior asset selection within the asset
class.
• Be internally homogeneous.
• Be investable i.e., must be able to absorb a meaningful proportion of an investor‘s
investment portfolio.
However, these criteria seem to make the definition of an asset class fluid. Hedge funds
are often classified as an asset class by industry practitioners, but fail to meet criteria 1, 2 and 3
above. Secondly, the requirement that asset classes must be homogenous fails to stand up to test
when observations like the lack of internal asset class correlation between long term bonds and
short terms bonds are brought in. They appear to behave like different asset classes. Finally,
internal instability in the demand and supply for some instruments like REITs sometimes result
in their behaving like shares and sometimes like income instruments. Of particular issue is the
use of static inputs to the decision process in a dynamic market.
Asset class expected returns, standard deviation of returns, and coefficients of correlation
are not stable over time. Compared to the average bond price-share price correlation coefficient
of –0.55% since 1970 for the US, this coefficient had converged to 94% in the second quarter of
2002, threatening to violate Criteria 1. Measuring the inputs required to be entered into the asset
allocation process thus seems a difficult challenge.46
Not only are the data challenging in their lack of reliability, they may also be difficult to
procure. This is particularly true in the case of alternative investments such as venture capital,
hedge funds, commodity resources, etc. There is a lack of historical data, because performance
has been recorded for approximately 15 years only. Data may lack accuracy, because many
private equity investments or hedge funds do not survive and their reports are not incorporated in
the data series (a ―survivor bias‖). Some alternative fund managers especially those who gather
capital privately, choose not to report their returns, so these funds are not reflected in the general
data (―selection bias‖). Private equity or real estate investments are not priced efficiently and
46 Wealth management book,p.98
47
often utilize inaccurate or stale pricing. Asset prices in the alternative asset class therefore do not
accurately reflect the lack of liquidity, risk and correlation of these assets. Incorrect pricing
causes a systemic underestimation of the volatility of these asset classes.47
Asset allocation models utilize normal distribution return performance to analyze
traditional investments. But alternative asset returns do not exhibit the same pattern of normal
distribution. They are subject to large scale event risks - which may cause large swings in prices
more frequently than anticipated. Standard asset allocation models do not incorporate this risk
into the solution. Alternative investments may also be segmented and not fully integrated with
global capital markets. Many are regional in origin, and suffer illiquidity, thus requiring a
liquidity premium in pricing structures.
Recommendations involving too many asset classes should be avoided as they will
contain too specific and too small percentages in recommendations implying unrealistically high
levels of precision48
. Because the returns for each asset class always has some degree of
correlation with the returns in other asset classes, whether or not the investment manager is going
to manage the individual‘s entire wealth pool or just a portion therefore makes a difference in the
investor‘s financial objective, and the set of constraints, the investment manager faces.
The bull market of the pre-Asian Crisis period has left many people with the illusion they
could dispense with asset class diversification. This left Malaysian investor‘s open to extreme
losses of the magnitude they have faced in recent years.
In principle, the security selection process involves prediction of expected returns,
standard deviations, and covariance for all available securities. This enables an efficient set to be
generated. The investor‘s risk-return preference may be established (an indifference curve is
plotted and the point of tangency of the indifference curve to the efficient set may be established
that indicates the optimal portfolio)49
. The advent of vastly improved data collation and
computing power has made the computation of expected returns, standard deviations and
covariance possible, but in Some countries like Malaysia, the short trading history of many
47 Ibid p.104 48 Michelle McCarthy. 2000. Risk Budgeting: A New Approach to Investing. Risk Waters Group Ltd. 2000.pp.
103-130. 49 Ibid p.106
48
stocks and of the main market indices themselves (<20 years) reduces the reliability of this
approach.
Table 3 Portfolio Allocation Scoring System (PASS)
THE PORTFOLIO ALLOCATION SCORING SYSTEM
(PASS)
Investment
Importanc
e Total Asset mix percentages
Objective Most
Ver
y Some Little
N
o
n
e Score
money market/fixed
income/equities
1. High long-
term 5 4 3 2 1 35 5/5/90
total return
29-34 10/10/80
2.
Accumulatio
n
5 4 3 2 1
of deferred 23-28 20/20/60
capital
gains
17-22 30/30/40
3. Tax
advantages 5 4 3 2 1
11-16 40/40/20
49
4. High
current
1 2 3 4 5
Income 7-10 50/40/10
5. Low total 1 2 3 4 5
Return
Fluctuatio
n
6. Low
single- 1 2 3 4 5
period loss
Probability
7. High
degree 1 2 3 4 5
of liquidity
Source: Islamic Wealth Planning book, p.273
In addition, the indifference curve of the investor may not be observable except by way of
responses to questionnaires, a procedure of questionable reliability. Questionnaires of suggested
design can be found, amongst them, one suggested by William Sharpe in his landmark book,
―Asset Allocation Tools‖. For many years, the American Institute of Certified Public
Accountants personal financial planning division used a Portfolio Allocation Scoring System
(PASS) questionnaire issued under Practice Aid No.1 to assist members in providing investment
advice (Figure 12) One set of suggested systematic strategies for implementing assets allocation
was suggested by William Sharpe in 1987 and expanded on in 1990. The first one we look at is
the integrated approach detailed below as a series of decision steps50
.
50 Zvi Bodie. 2003. ―Applying Financial Engineering to Wealth Management.‖ Investment Counseling for Private
Clients V. AIMR 2003. 3-8.
50
1. Assess investor assets, liabilities and net worth,
2. Establish investor‘s risk tolerance function,
3. Use tolerance function to estimate risk tolerance levels and derive an Investment
Policy Statement, using above information.
4. Identify the available asset classes and assess capital market conditions,
5. Establish prediction procedures for returns, risks, and correlations associated with
asset classes,
6. Predict returns, risks, and correlations associated with available asset classes to
derive an efficient set.
Combine information from above steps to select an optimal portfolio.
Assess Returns
After enough time has elapsed, assess the portfolio‘s performance,
Compare with expectations,
Assess reasons for deviation,
Relate deviations to capital market conditions, as in B1, and considering the impact of
returns on investor assets, liabilities and net worth as in A1, begin anew the
process from A1 and from B1.
The manner the optimal portfolio is determined usually takes three steps.
a. The advisor chooses a function to maximize which requires inputs about investor-
specific prospective portfolios and investor specific risk attitude information,
b. Historical time series data is used along with computer optimization algorithms,
To generate a set of prospective portfolios,
c. Input is obtained from investor to derive a portfolio allocation decision.
In assessing the suitability of a portfolio given a client‘s objectives, the iterative process
above can be used as a part of a process of elimination to determine the appropriate portfolio that
the client may hold.
First, the investment horizon plays a key role in determining whether the expected rate of
return for an asset portfolio can reasonably allow the achievement of financial objectives given
the variability of returns. The financial advisor needs to be wary of the frequently promoted idea
that the variability of returns in the long term for any asset or a portfolio falls over time (there are
51
time diversification benefits)51
. Although the variability of returns does indeed fall over time, the
risk that a financial objective such as a target wealth level will fail to be achieved gets magnified
over time, especially if there is an adverse outcome in the early years of the tenure of an
investment. In addition, if withdrawals for income are made in the interim, the likelihood of
failure to achieve financial objectives such as an end period wealth target gets magnified very
sharply.
In computing the statistical distribution of returns, more attention must therefore be
placed on the risk of lower bound of likely outcomes not being achieved. Failures by a long shot
to meet more stringent risk specifications or worst scenario outcomes eliminate the prospective
portfolio from consideration.
Secondly, by setting cut-off levels for acceptable risk and return outcomes before a set of
efficient portfolios are determined that allows the elimination of some of the prospective
portfolios available for consideration.
Figure 12 (a) Efficient Frontier
Sources: Applying Financial Engineering to Wealth Management.‖ Investment Counseling for
Private Clients V. AIMR 2003
In Figure 12(a), the acceptable portfolios of A, B, C, D and E are initially all flagged as
acceptable portfolios in the first round selection; on account of their meeting the minimum return
51
Frank J. Travers. 2004. ―Investment Manager Analysis: a comprehensive guide to portfolio.pp.107-122
52
criteria set by the investor.
In the second round sieving, the portfolios, Portfolios D and E are eliminated due to their
risk characteristics, lying to the right of (exceeding) the maximum risk tolerance level. Only
Portfolios A, B, and C are deemed acceptable, but which portfolio is to be recommended is
subjective although C offers the highest returns within acceptable risk levels.
Figure 10 Efficient Frontier
Sources: Applying Financial Engineering to Wealth Management.‖ Investment Counseling for
Private Clients V. AIMR 2003
In Figure 10 there is no ambiguity. Portfolios D and E are eliminated due to their risk
characteristics, lying to the right of (exceeding) the maximum risk tolerance level. Portfolios A
and B, are deemed unacceptable as although they feature risk characteristics that are acceptable,
being below risk tolerance thresholds, they offer returns lower than the required level. Portfolio
C is the only portfolio that meets the criteria of the minimum rate of return and the maximum
accepted risk.
53
Sources: Applying Financial Engineering to Wealth Management.‖ Investment Counseling for
Private Clients V. AIMR 2003
In Figure 11, no portfolio can be recommended as a feasible efficient set, as all portfolios
either fail to meet minimum return or the maximum risk tolerance criteria52
. The investment
manager must then refer back to the investor and guide the investor on what is a feasible set of
objectives. Either the investor‘s long term objective needs to be revised lower or the investors
risk tolerance level must be revised higher.
Table 4 Risk Tolerance Factor (Determined from arbitrarily assigned values)
Source: Portfolio construction, management, & protection.‖ 2nd edition Cincinnati, Ohio, South
Western College.p.71
One difficulty in the implementation is an objective way to define the risk tolerance
function. Approaches such as using the questionnaire in the previous section may be of some
assistance and sources such as the utility level associated with each risk-return level is not easy
52 Zvi Bodie. 2003. ―Applying Financial Engineering to Wealth Management.‖ Investment Counseling for Private
Clients V. AIMR 2003.pp. 3-8.
Investor Risk Tolerance Score
Johan 1 (extremely risk-averse)
Mariam 50 (more amenable to risks)
54
to define. One approach is to first attempt to assign a risk tolerance factor (say for example, a
score that is higher the more tolerant an investor is to risks) to each investor, then deducting as
penalty from the expected percentage return, a risk penalty on that return that is higher the higher
the risk level as measured by the standard deviation of returns is (say for example, by dividing
the standard deviation by the risk tolerance factor above).
The resultant function is of the form μ = α - γ δ2 where μ represents the utility level, α the
expected return, γ the risk tolerance factor and δ2 the variance or standard deviation, or some
other measure of risk.
The higher the risk tolerance level is, the smaller the value of the penalty is and the lower
the penalty on the level of return. The resultant return less the penalty is taken as the level of
utility. A worked sample is appended below for hypothetical investors Johan and Mariam:
Table 5 : Possible Efficient Sets
Portfolio Portfolio Expected Return Standard Deviation of
Bonds Equity Returns
Portfolio A 70% 30% 6% 5%
Portfolio B 50% 50% 8% 15%
Portfolio C 30% 70% 10% 20%
Source: Portfolio construction, management, & protection.‖ 2nd edition Cincinnati, Ohio, South
Western College.p.74
Table 6 Maximizing Utility Associated with Efficient Sets
Portfolio Return Johan Mariam
Risk Penalty Utility Level Risk Penalty Utility Level
55
Portfolio A 6% = 5/1 = 5%
=
6.0 – 5.0 = 1.0 = 5/50 = 0.1%
=
6.0 - 0.1 = 5.9
Portfolio B 8% = 8/1 = 8%
=
8.0 – 8.0 = 0.0 = 15/50 = 0.3%
=
8.0 - 0.3 = 7.7
Portfolio C 10%
= 10/1 =
10.0% = 10.0 – 10.0 = 0.0 = 20/50 = 0.4% = 10.0 - 0.4 = 9.6
Source: Portfolio construction, management, & protection.‖ 2nd edition Cincinnati, Ohio, South
Western College.p.75
In the above somewhat exaggerated example, the efficient set that maximizes the utility
level turns out to be Portfolio A for Johan and Portfolio C for Mariam.
Quantitative software can assist in deriving expected returns, standard deviation of
returns. In a scientifically valid manner but software on assigning risk tolerance information and
assigning a value to γ in a scientific manner is hard to locate. It is also by no means certain that
the mean-variance criteria are the best approach to determining investor utility. Others such as
Rabin and Thaler (2001) 53
also argue that the coefficients of risk aversion (1+ γ) are meaningless
as people do not display a consistent coefficient of risk aversion.
A second approach to eliminating portfolios from a group of theoretically possible
alternatives is to select a group of factors whose combination will most closely approximate a
desired result. The process is called establishing stochastic dominance. A simple example is
discussed below:
The first step is to identify the dominant portfolios, i.e., those portfolios whose risk or
return characteristics make them superior to all other possible alternatives. For example, a
portfolio that provides the highest level of expected returns for a given level of risk taken
compared to all other alternatives is the dominant portfolio. Alternatively, a portfolio that offers
53 Rabin and Thaler (2001)
56
the lowest level of risk for portfolios of a given level of return is also a dominant portfolio.
The process involves establishing the first degree stochastic dominance first. For an
investment portfolio, this can mean first tabulating the times series of returns of the portfolios
under consideration as in the Table 7:
Table 7 Time Series of Return of Portfolio A and B
Source: Portfolio construction, management, & protection.‖ 2nd edition Cincinnati, Ohio, South
Western College.p.71
Table 8 is then constructed ordering the level of returns for each portfolio to obtain the first
degree stochastic dominance:
Table 8 Level of Returns
Year Returns
Portfolio A Portfolio B
1995 29.1% 90.3%
1996 49.5% 10.7%
1997 -2.7% 11.6%
1998 -1.1% 20.2%
1999 79.5% 0.7%
2000 19.9% -9.0%
2001 -20.1% -8.9%
2002 19.1% 40.9%
2003 38.0% 41.8%
2004 -10.3% 1.6%
57
Observation (In Returns
Order of Returns) Portfolio A Portfolio B
1 -20.1% -9.0%
2 -10.3% -8.9%
3 -2.7% 0.7%
4 -1.1% 1.6%
5 19.1% 10.7%
6 19.9% 11.6%
7 29.1% 20.2%
8 38.0% 40.9%
9 49.5% 41.8%
10 79.4% 90.3%
Mean 20.1% 20.0%
Source: Portfolio construction, management, & protection.‖ 2nd edition Cincinnati, Ohio, South
Western College.p.78
58
A table (Table 9) of cumulative probability of returns is then constructed:
Table 9 Cumulative Probability of Returns
Return Cumulative Probability
Portfolio A Portfolio B
< -30.0% 0.0% 0.0%
< -20.0% 10.0% 0.0%
< -10.0% 20.0% 20.0%
< 0.0% 40.0% 20.0%
< 10.0% 40.0% 40.0%
< 20.0% 60.0% 60.0%
< 30.0% 70.0% 70.0%
< 40.0% 80.0% 70.0%
< 50.0% 90.0% 90.0%
< 60.0% 90.0% 90.0%
< 70.0% 90.0% 90.0%
< 80.0% 100.0% 90.0%
Return Cumulative Probability
Portfolio A Portfolio B
< 90.0% 100.0% 90.0%
< 100.0% 100.0% 100.0%
< 110.0% 100.0% 100.0%
The table of the cumulative probability of achieving a certain level of returns or lower is
plotted against intervals of levels of returns to establish the second degree stochastic dominance
that may be necessary to decide dominance if there are overlapping areas between the two line
59
graphs in
Source: Strategic asset allocation process for fund managers p. 15
In the example above, this step is not necessary because the line representing cumulative
probability of returns for Portfolio B always lies to right of the corresponding line for Portfolio
A. There is thus a higher return associated with each cumulative probability level for
Portfolio
B. It is therefore clearly the dominant portfolio. If on the other hand, there are some
sections where the two lines cross each other, with some portions of the line for
Portfolio B being to the right of the line for Portfolio A and some to the left, then the
total area in between the lines but to the right of the Portfolio B line is designated a
negative value and the area to left is designated a positive value. The areas are
summed up, and if the net value is positive, then Portfolios B are still determined to
be dominant under the second degree stochastic dominance rule. In the example
above, the area between the two lines always lies to the left of the line for Portfolio B
and is therefore designated a positive value. Portfolio B is therefore dominant.
It is clear from the example above that portfolio selection based on stochastic dominance
will not necessarily result in picking the portfolio that offers the highest expected returns. In the
example above, the mean (expected return) of Portfolio A of 20.1% is slightly superior to that of
Portfolio B but Portfolio B is still picked for the reason it displays second degree stochastic
dominance.
Figure 12 Second Degree Stochastic Dominance
60
It is possible to derive third degree stochastic dominance using an extension of the above
process, but there will be new underlying assumptions in the use of third degree dominance for
selection procedures.
Some authorities argue that maximizing the inflation-adjusted growth rate of wealth may
be a more persuasive way, specifying an investor risk-wealth utility function (the CRRA or
Constant Relative Risk-Aversion Utility of Wealth approach) to be maximized. It is also
recognized that it is difficult to scientifically apply any set of utility function derived via
questionnaires to assess differently scaled risks. The third approach is to dispense with the mean-
variance approach altogether and specify the portfolio by simply minimizing the probability that
the return from a chosen portfolio will fall short of the target rate of return. Establishing
investable benchmarks may however pose a problem.
3.8 Summary of the Chapter
In this chapter, we focused more, about Investment objectives, risk and return, that we
mentioned, are specific and measurable outcomes and constraints, furthermore, limitations on the
ability to make use of particular investments. We also recognized that, Constraints can be
external and internal. We addressed an investment policy statement, which is a document that
governs all investment decision making of the client. It incorporates a client‘s needs, preferences,
and circumstances to form an integrated statement of that client‘s objectives and constraints.
Wealth (Asset) allocation establishes exposures to available investable asset classes that meet the
client‘s long-term objectives and constraints; Capital market expectations and its risk and return
characteristics; Passive, semi-active and active investment approach. We analyzed three elements
of performance evaluation, which are performance measurement, attribution and appraisal;
Portfolio monitoring and rebalancing. At the end Sharia Compliance of Asset Class and assessed
returns.
Like other investors, Muslims look for stocks, mutual/unit trust funds, Islamic bonds and
real estate to add to their portfolios except these assets must be Shariah compliant.
Islamic law identifies business activities as haram when they generate profits in unacceptable
ways. Haram business activities include the manufacture or marketing of any of these products:
61
alcohol, gambling or gaming activities, interest-based financial products, pork and pornography.
Other businesses, such as those that harm the environment, have poor track records with regard
to labor or developing countries, or produce and market tobacco, weapons, or defense products,
may also be unacceptable to some Muslim investors.
Different types of ratios are used to measure the amount of riba and to evaluate whether
or not investment is permissible. Some of the more common ratios include: ratios to measure the
amount of a company‘s liquidity, ratios to measure a company‘s interest income, and ratios to
evaluate how much a company pays in interest on its corporate debt. Sometimes it is relatively
easy to identify the gain that derives from riba (Interest), especially when investing in countries
that require corporations to provide regularly updated financial information.
CHAPTER FOUR: ASSET ALLOCATION STRATEGIES
4.1 Strategic Asset Allocation as an Asset Allocation Process
In this asset allocation approach, a long term policy asset mix is decided upon and
adopted, although this does not mean minor adjustments are not made in the short term (a
62
dynamic element in this mainly static approach). To arrive at this, long term mean returns,
variability of returns (riskiness) for the asset classes, and covariance of returns between asset
classes are established and along with forecasts of future capital market conditions over the
planning horizon, used as estimators of future capital market returns, risks, and covariance. The
portfolio manager uses the forecasts to choose an asset mix appropriate for the investor‘s needs
during the planning horizon. The planning procedures lead to a constant-mix asset allocation,
with only minor rebalancing exercises to make adjustments to counter the effects of different
rates return between asset classes54
.
Many fund managers have learned through experience the difficulty in successfully
anticipating changes in capital market conditions, and do not attempt it any more. In particular, if
the markets are efficient, one would not expect tactical asset allocation strategies to outperform
properly executed strategic asset allocation.Some fund managers use a rule of thumb that they
only re-balance if the asset composition strays more than 5% from target.55
Others may use a rule
that re-balancing be made only on a movement of more than a certain standard deviation from
the prescribed percentage compared to the integrated approach; there is no feedback loop to
allow changes to either the portfolio or investment policy.
Such rebalancing may also be subject to frequencies of not more than once a quarter or
some other intervals. The cost of rebalancing is a major consideration, even for relatively liquid
assets. Where they involve illiquid assets such as properties, it is not certain how, with the added
tax and transaction costs, it can be economically undertaken keeping the aim of rebalancing in
mind.
There is no question of adjustments in the short term, as the major premise is that the
long term planning horizon already takes into account what is best in the long term, after riding
out short term variations in market conditions. The asset allocation mix decided at the outset is
one portfolio in the efficient set, meaning the computed long term returns, standard deviation of
returns and covariance of long term returns have already reduced the portfolio risk to systematic
(undiversifiable) risk. The portfolio mix chosen by the investor represents the optimal portfolio
54
Eric H. Sorensen, Keith L. Miller, Vele Samak. 1998. ―Allocating between active and passive management.‖
Financial Analysts Journal. Sep/Oct 1998.p.18 55 39. Waggle, Doug, Moon Gisung. 2005. ―Expected returns, correlations, and optimal asset allocations.‖
Financial Services Review. Fall 2005. 253.
63
within the efficient set given risk tolerance levels. This embodies the basic trade-off between
returns (opportunity) and risk exposure that the investor faces56
.
In a practical sense, strategic asset allocation is the same as integrated asset allocation
except that there is no need for feedback. The interesting observation is that portfolio managers
for many large pension funds in the US adopt this strategy, and consistent with this, do not
materially alter their asset mix when tracked over short term intervals of three years or even
more.
In direct contrast to the strategic asset allocation strategy, the tactical asset allocation
strategy takes a clearly more active asset management approach, constantly adjusting the asset
class mix, attempting to derive incremental returns from changes in capital market conditions.
In a two-asset class portfolio, if stocks are expected to outperform bonds, the proportion
of the portfolio in stocks would be raised relative to bonds. This process is called asset class
appraisal.57
Asset class appraisal involves assessing the merit of holding each asset class given
current capital market conditions and expected changes in the coming period. The difficulty lies
in correctly anticipating which asset class will perform best in the coming period. Ineffectively
shuffling assets around incurs costs and leaves the fund manager open to accusations of
churning.
Investor risk tolerance and investor-specific information are assumed to be unchanged
unlike under the strategic allocation approach. A continuous feedback loop is assumed to allow
investor preferences to undergo changes that require revisions in the investment policy. In a
practical sense, tactical asset allocation is the same as integrated asset allocation.
4.2 Tactical Asset Allocation Strategies
The tactical asset allocation strategy is premised on market cycles repeating themselves.
Therefore if capital market conditions are far removed from their long term mean, they must
eventually revert to their long term averages. This can be thought of as meaning markets have a
tendency towards mean reversion. Supposing under current market conditions, bonds prices are
56 William Jahnke. 2003. ―Active asset allocation.‖ Journal of Financial Planning. Jan 2003. P.38 57 Ibid p.43
64
cheap (interest rates are high) compared to equity (price-earnings ratios are high), then the asset
class mix will shift towards an allocation in excess of benchmark for bonds (the expectation that
economic conditions will weaken, forcing interest rates lower) and an allocation short of the
benchmark in respect for equity (the expectation is that share prices will fall as economic
conditions weaken)58
. Since asset prices are lowest when they are most out of favour, and highest
when they are most sought-after, such an approach is inherently contrarian in nature.
The frequency the shifts in asset mix is made will depend on the perceived relative degree
of over or under-valuation of securities in each asset class as measured by equity risk premium,
credit spreads, the liquidity premium or the slope of the yield curve, the general degree of
volatility in asset prices, and changes in the macroeconomic outlook.
In order to implement asset class appraisal, the fund manager must:
1. Establish the portfolio‘s normal mix (benchmark mix) jointly with the investor e.g. 40%
bonds and 60% equity.
2. Establish a normal range or mix range which sets the tolerance limits for deviations from
the normal mix by each asset class e.g. the bonds portion will be allowed to rise by as
much as 10% or drop by as much as 10%. A swing component of 10% of the portfolio is
thus specified.
If capital market conditions are expected to be ―normal‖, the normal mix is adopted. If
capital market conditions are expected to be in favour of equity, the proportion of the portfolio
invested in equity will be allowed to rise to 70%, and the bond portion allowed dropping to 30%.
The clear criticism here is it is inconsistent with the idea that markets are efficient. Even
if markets are not efficient, it is not clear if large scale asset switching exercises can be profitable
after deducting for costs. Most unit trust managers allow investors to undertake some form of
tactical asset allocation indirectly by allowing for a number of free switches per calendar year
58 James D. MacBeth, David C. Emanuel. 1993. “Tactical asset allocation: Pros and cons.” Financial Analysts
Journal. Nov/Dec 1993. 30.
65
between funds designed with different asset allocation benchmarks59
.
4.3 Insured Asset Allocation as an Asset Allocation Strategy
This is a reactive asset strategy, sometimes known as a constant proportion strategy
because the strategy calls for shifts in asset mix as investor wealth and net worth changes have
already been set in motion. Like tactical asset allocation strategies, it calls for active management
of the asset mix.
However, the premise here is that capital market conditions, risks and returns do not
change or do not matter. Instead, the investor‘s objectives and constraints change along with the
investor‘s wealth/net worth. In a period of rising equity valuation, the investor‘s wealth may rise
along with the rise in the stock market indices. Rising wealth improves the ability of the investor
to handle risk. This calls for an increase in the proportion of risky assets in the portfolio. This
may mean not just an increase in the proportion invested in equity, but also bonds, and a
corresponding drop in the allocation for T-bills.
The combination of short selling with long positions, in relation to dynamic hedging
techniques in an attempt to duplicate put options will result in portfolio protection (insurance). It
is a common method of achieving an insu6 red portfolio. As the stock market falls, larger short
sale positions are attempted. The result is adjustments to asset mix under the insured asset
allocation strategy may call for shifts in asset mix that are opposite to that which a tactical asset
allocation strategy calls for.
59 Michael C. Ehrhardt, John M. Wachowicz, Jr. 1990 ―Tactical Asset Allocation (TAA): A Tool for the
Individual Investor.‖ Review of Business. Winter 1990/1991. 9.
66
Figure 13 Asset Allocation Approach – Schematic Plan
Source: Wealth Planning and Management P. 112
Security selection sector—Group selection---Asset classes---Asset Allocation
Figure 14 Integrating Security Selection, Group (or Sector) Selections and Asset Allocation
Source: ibid, p.189
These two figures are explaining security selection process, the first one explaining
overall portfolio of security selection in risk and riskless asset classes, while the second one
explaining two portfolios, which are bond portfolio and stock portfolio, containing securities in a
long term and short term bonds and stocks.
67
4.3.1 Manager Selection
Once the planner has developed the client‘s IPS (Investment Policy Statement) and its
asset allocation, then he must assist the client in either choosing the funds and/or the managers.
We will first look into issues to consider when selecting fund managers.
While the number of fund managers is not that large, globally there are literally thousands of
managers and thus it is definitely challenging in choosing fund managers. Some of the selection
criteria are as follows:
1. Investment approach. Do the assumptions and principle underlying the manager‘s
investment approach make sense?
2. Expected return. Other than expected return, financial planner should also look into past
performance. A 10 years performance that is consistently strong relative to a valid
benchmark should give a better predictability than an erratic performance.
3. Expected impact on the volatility of client‘s portfolio.
4. Liquidity. This means how readily in the future the account can be converted to cash.
5. Legal issues.
6. Trust. Is the selection of the manager appropriate? Can the manager be trusted?
A typical fee structure is based on a percentage of the account‘s market value payable
quarterly. Wealth planners should note that paying higher fees does not assure the client of better
long-term performances. Some planners/clients favour performance fees, which could come in
multiple flavours. As an example, a manager may charge a fixed annual fee of 0.5% of market
value, plus 10% of the past year‘s return in excess of a benchmark, often capped at a maximum
percentage the manager can earn in any one year, and normally include a high water mark as
well. This means that if the fund manager fails to qualify for a performance fee in year 1, he
must earn an excess return in the following year equal to the shortfall in year 1 before he can
begin to accrue a performance fee in year 2.Such a high water mark may work the other way as
well, If the manager earns more than his maximum performance fee for any one year, the excess
can be carried over to year 2. Otherwise, the manager would lack incentive to add value once he
has reached his yearly maximum.
One drawback to performance fees is the administrative complexity and thus a planner may
68
have to audit the fees thoroughly, which can be complicated work.
4.3.2 Fund Selection
Unit trust/mutual funds provide diversification, divisibility, low transaction costs, record
keeping, and professional management for the individual investor. These features have helped
propel the popularity of unit trust/mutual funds among individual investor. The proliferation of
unit trust/mutual funds has made choosing the right funds a challenge to many investors although
performance statistics and fund attributes, such as information on fund managers, expense ratios,
and turnover are now easily available. However, an individual investor seldom has the time or
the expertise to analyze the vast amount of data available and thus relies on the assistance of a
professional financial advisor. The financial planning process typically begins with the investor
filling out a questionnaire to pinpoint the investor‘s risk aversion, investment horizon,
investment experience, tax status, and financial status. Based on this information, the financial
advisor recommends an asset-allocation strategy and suggests specific funds (or stocks and
bonds) for each asset class. A structural approach that a financial planner can adopt in selecting
funds is the analytic hierarchy process (AHP). The AHP model has the following distinct
uniqueness.
First, it provides a systematic approach to ranking mutual funds for individuals based on
each individual‘s unique investment objectives and constraints.
Second, the AHP prevents the investor from making inconsistent preference assignments.
Fund selection involves more than one parameter (for example, it may involve investment
objectives, tax efficiency, risk, and expense ratios), and thus enforcing consistency in the
decisions is difficult if the selection method is unstructured.
Third, this approach minimizes the amount of technical input required from investors.
Financial planners should note that an important distinction between the AHP and the MPT
approaches is that in the AHP, the focus is on the preferences of the investor, whereas in the
MPT approach, the focus is on only two dimensions of an individual‘s preferences—risk and
return60
.
60 Christian S. Pedersen, Ted Rudholm-Alfvin. 2003. ―Selecting a risk-adjusted shareholder performance
69
The AHP methodology consists of the following four major steps:
1. Develop the hierarchical structure:
• Mission
• Selection criteria
• Alternatives
2. Assign a relative importance of each selection criterion to the mission.
3. Rank alternatives under each criterion.
4. Rank each alternative‘s contribution to the mission.
The first step in the AHP framework is to represent the problem in a hierarchical
structure. Figure 16 presents the two hierarchies in the fund selection problem. Each hierarchy
consists of three levels—the mission of the hierarchy (given at the top), the selection criteria, and
the available alternatives. In the first hierarchy, the mission is to obtain a suitable asset-allocation
recommendation for an investor. The selection criteria are the investor‘s investment objectives
and constraints, and the alternatives are the asset classes. In the second hierarchy, the mission is
to obtain the most suitable mutual fund within each asset class; Figure 1 uses as an example the
―growth and income‖ class.
The selection criteria are based on the structural and operational characteristics of the
funds, and the alternatives are the funds available in each asset class. The hierarchical structure
in Figure 3.12 is intended to be a simplified model for demonstrating the AHP framework; it can
be easily modified to include additional objectives and constraints. Table 3.10 summarizes the
process of solving the problem represented by each hierarchy.
measure.‖ Journal of Asset Management. Oct 2003. 152.
Figure 15 Decision Hierarchies for Fund Selection
70
Hierarchy 2 Selecting Funds for each Asset Class
4.3.3 Investment Objectives
The decision process for fund selection starts with the investor‘s investment objectives
and constraints. The investor assesses the relative importance of the investment objectives by
using a pairwise comparison scale as mentioned in the scale used in the AHP.
4.3.4 Ranking Asset Classes
The decision alternatives for the first hierarchy of the mutual fund selection model are the
asset classes. Once the relative importance of investment objectives and strength of each asset
class‘s contribution to each objective have been determined, they are combined to obtain the
asset-allocation weights suitable for the investor.
71
4.3.5 Selecting Individual Funds
Once the relative importance of the asset classes has been determined, the next step
involves the second hierarchy — evaluating individual funds within each class. Hierarchy 2 in
table 8 shows the ranking of individual mutual funds in the growth and income asset class. The
mission, the top level of the second hierarchy, is to obtain a ranking of growth and income funds.
The selection criteria, the second level of the hierarchy, are based on the fund structural and
operational characteristics. The available alternatives, the third level, are all the mutual funds
from the database in the growth and income asset class.
The asset allocations recommended by the AHP model are customized to fit the
investment objectives and constraints of a particular investor. Financial planner should
understand that the AHP model is not intended to create a portfolio to provide superior future
performance alone but to ensure that the asset allocation is consistent with the objectives and
preferences of the investor. However, an advantage of the AHP approach is that it helps advisors
explain the fund selection process to investors because it requires the advisor to list the selection
criteria and the advisor‘s beliefs about the relative importance of each criterion.
Hierarchy 1. Selecting a portfolio of asset classes
Table 10 Solving the Decision Hierarchy by Fund Selection
Investment objectives - Investor fills out a questionnaire based on the
pairwise comparison
- The consistency of investor responses is tested
- If inconsistency is observed, investor can revise his
answers until consistency is achieved
- Investor‘s response are Transformed into
relative-importance weights of investment objectives
Major asset classes - Empirical data are used to obtain normalized
performance scores that represent the relative
72
strengths of asset classes
Ranking major asset classes - Relative-importance weights of investment objectives
and relative strengths of asset classes are used to
calculate the ranking of asset classes
Hierarchy 2. Selecting funds for each asset class
Fund selection criteria - Financial planner determines the relative importance
of fund selection criteria through pairwise
Comparison
- The consistency of financial planner‘s response is
Tested
- If inconsistency is observed, financial planner can
revise his answers until consistency is achieved
- Financial planner‘s responses are transformed into
relative-importance weights for fund selection
Criteria
Fund performance under each - Empirical data are used to obtain normalized
Criteria performance scores that represent the relative
strengths of funds
Ranking funds - Financial planner uses relative-importance weights of
fund selection criteria and relative strengths of funds
to calculate the ranking of funds under each asset
Class
73
4.4 Ways of Measuring Returns (Portfolio Performance Evaluation)
Portfolio managers are required to meet 3 major requirements in discharging their
duties:
1. Meet objectives spelled out in the clients‘ investment policy statement,
2. Earn superior returns for each given risk class,
3. Achieve portfolio diversification to eliminate unsystematic (diversifiable)
risks.
Historically, the focus in the asset management industry has been on returns.
Performance evaluation should not focus on returns alone. It should give due recognition to
both returns and the riskiness of the investments61
.
Superior performance can be achieved by either superior security selection or superior
timing. From the perspective of asset allocation, this can be thought of in terms of superior
asset allocation strategies, such as tactical asset allocation.
Performance in terms of returns can be thought of in two ways. First, it can be thought
of in absolute terms i.e., how much money was made or lost. Second, it can be measured in
relative terms i.e., compared against a bogey or benchmark, or against the average returns for
similar investment products, or against a peer group or universe comparison.
4.4.1 Dollar-Weighted Returns
This simple format takes the difference between the beginning and end values of the
portfolio and divides it by the beginning value. The answer in decimal form is then converted
into percentage form by multiplying it by 100:
Dollar Weighted Return (%) = End Value - Beginning Value X 100
Beginning Value
All dividends or other forms of distribution received in the interim period are included
61
Suze Orman, The Road To Wealth: A Comprehensive Guide to Your Money, 2003, p.148-52
74
in the end value of the portfolio.
4.4.2 Chain-Linked Returns
This step is necessary to establish the compound return for an investment held over
several investment periods during which returns for each period were calculated using the
Dollar Weighted Returns method described above.
Chain-Linked Returns = [ (1+ PR¹) x (1 + PR²) + (1 + PR³) x……… x (1+PRⁿ)] – 1
Where PR is the decimal form return for the respective periods 1, 2, 3,…..n
The periods need not be of equal lengths of time. For example, PR1 may be the return
for a 1-month period and PR2 in respect of period 2 may be for a period of 6 months.
The cumulative return is simply specified by chain-linking the total returns up to the
previous period to the next period‘s return as illustrated below (Table 8 and table 9):
Table 11 the cumulative return for five years.
Year Return Return Return Cumulative Return Formula Cumulative
(decimal) (%) Return
1 $1 0.1 10.0% $1 10.0%
2 $2 0.091 9.1% =(1+$1) x (1+$2) - 1 20.0%
3 $3 0.034 3.4% =(1+$1) x (1+$2) x (1+ $3) - 1 24.1%
4 $4 0.12 12.0% =(1+$1) x (1+$2) x (1+ $3) x (1+$4) - 1 39.0%
5 $5 0.23 23.0% =(1+$1) x (1+$2) x (1+ $3) x (1+$4) x 70.9%
(1+$5) – 1
Source: Financial Analysts Journal
Applying the chain-linked returns concept allows us to spell out the cumulative
75
returns for an investment. This information can be relayed to the investor in 2 ways (table 8).
Actual growth in absolute Dollar terms - use the returns to show how one Dollar in
value of the original investment would have grown over the period reviewed. Displaying the
cumulative percentage return over time. By this means, we can display the end value return
expressed as a percentage of the initial investment.
Table 12 Cumulative Returns Over a 5-Year Period
Year Return Return Return Cumulative Return Cumulative Dollar
(decimal) (%) Formula Return Growth
1 $1 0.1 10.0% $1 10.0% 0.100
2 $2 0.091 9.1% =(1+$1) x (1+$2) - 1 20.0% 0.200
3 $3 0.034 3.4% =(1+$1) x (1+$2) x 24.1% 0.241
(1+ $3) – 1
4 $4 0.12 12.0% =(1+$1) x (1+$2) x 39.0% 0.390
(1+ $3) x (1+$4) - 1
5 $5 0.23 23.0% =(1+$1) x (1+$2) x 70.9% 0.709
(1+ $3) x (1+$4) x
(1+$5) - 1
Source: Financial Analysts Journal
76
Figure 16 Dollar Growth Presentation
Source: Financial Services Review. Fall 2005. 253
4.4.3 Annualized Time-Weighted Returns
The returns for a period shorter than one year may be expressed in annualized return
form. Also, the absolute return over a number of years may be averaged over the period to
arrive at annualised returns. Simply averaging the cumulative returns over the number of
years will yield misleading results. Instead, the best results are yielded by geometric average
returns derived by taking the nth root of the return relative in decimal form arrived at by
dividing the end of period portfolio value less interim cash inflows by beginning value of the
portfolio, then subtracting 1.00 from it, where n is the number of years the original portfolio
has been invested.
Annualised Return =
77
Using the preceding numerical example of cumulative dollar returns for 5 years
expressed in decimal form and computed on the original investment,
Annualised Return =
= 11.32%
4.4.4 Simple Cash flow-Adjusted Returns
Where there are interim cash flows, cash flow-adjusted Dollar weighted returns
(CFADWR) can be calculated:
CFADWR = End Market Value - Beginning Market Value - Net Interim Cash Inflows
Beginning Market Value - Net Interim Cash Inflows
This method takes no cognisance of the timing of the cash flows within the period
invested. As a result, it is more accurate only if the interim cash lows occur in the early part
of the investment period. More accurate formulae incorporating the timing of interim cash
flows are discussed below.
4.4.5 Time-Weighted Return Approach
The first form of the time-adjusted cash flow method we look at is the Daily
Valuation Approach to determining the Time-Weighted Return. In this approach, the
portfolio is valued at the end of the business day before each interim cash flow occurs and
accrued income is included in the value of the portfolio. The return for the period between
initial investment and the day before the first interim cash flow is derived. This process is
repeated for the period between the first interim cash flow and the day before the second
interim cash flow.
78
Time-Weighted Return = [(1+R₁) x (1+R₂) x (1+ R₃) x (1+R₄) x………….. x (1+Rn)]¹⁄ⁿ - 1
However, where the interim cash flow is very large and cannot be immediately
invested in the underlying securities, or if investment of a large sum without driving up the
prices of relatively illiquid securities is not possible, or if the interim cash flows or payouts
are fixed by contractual agreements between the investment manager and the investor (such
that the investment manager is forced to sell securities at the appointed but inopportune point
in time)62
, valuing the portfolio on business days prior to the interim cash flows under this
approach may be unfair.
The use of the Daily Valuation Method results in the exact Time Weighted Returns
but is extremely involved, requiring calculating the value of the portfolio every time a cash
flow occurs, whether due to fresh funds received to be invested or due to withdrawals. In the
example tabulated below in Table 3.14, beginning with a portfolio carried forward from 2004
valued at $7,560.08, the portfolio receives $100 approximately once a month from the
investor, who evidently uses the dollar cost averaging strategy. On 23rd March 2005, he
makes a withdrawal of $5, 000. At the end of the period on 1st August 2005, the portfolio is
valued at $5, 452.93 before the cash inflow of $100.
The beginning market value (MVB) is always based on the number of shares
immediately prior to the inflow/outflow of cash in the current period. The MVE is the
number of shares owned at the end of the previous period (which is the same as the number at
the end of the period before purchases/sales resulting from cash flows) multiplied by the
price on the date of the valuation (i.e., the date the fresh cash flows occur). The cumulative
return, derived from the return relative in the extreme right column, is in this example,
33.3%.
62
Steven R. Thorley. 1995. “The time-diversification controversy.” Financial Analysts Journal. May/Jun
1995. 68.
79
Table 13 Cumulative return relative
Date Cash Reason Price of Number Value of MVB MVE MVE/
Cumulativ
e
flow Shares Of Portfolio (Beginning (End MVB Return
($) ($) Shares ($) Market Market Relative
Owned Value) Value)
($) ($)
1-Jan b/f 0.090 84,001 7,560.08 -
3-Jan 100.00 investment 0.090 85,112 7,660.08 7,560.08 7,560.08 1.0000
1-Feb 100.00 investment 0.095 86,165 8,185.64 7,660.08 8,085.64 1.0556 1.0556
1-Mar 100.00 investment 0.100 87,165 8,716.46 8,185.64 8,616.46 1.0526 1.1111
23-Mar 5,000.00 withdrawal 0.110 41,710 4,588.11 8,716.46 9,588.11 1.1000 1.2222
3-Apr 100.00 investment 0.105 42,662 4,479.56 4,588.11 4,379.56 0.9545 1.1667
1-May 100.00 investment 0.100 43,662 4,366.25 4,479.56 4,266.25 0.9524 1.1111
1-Jun 100.00 investment 0.110 44,572 4,902.87 4,366.25 4,802.87 1.1000 1.2222
1-Jul 100.00 investment 0.115 45,441 5,225.73 4,902.87 5,125.73 1.0455 1.2778
1-Aug 100.00 investment 0.120 46,274 5,552.93 5,225.73 5,452.93 1.0435 1.3333
An approximation that allows by passing involved computations above is the Modified Dietz
approximation formula described below:
Modified Dietz = End Market Value - Beginning Market Value - Net Inflows
Beginning Market Value + ΣTime Weighted Cash flows
where each Time Weighted Cash flow =
No. of Days Invested
X Cash flow
Total No. of Days in the Period
80
In the example above, the returns estimated using the Modified Dietz formula are calculated
as follows:
End Market Value = 5,552.93
Beginning Market Value = 7,560.08
Total Inflows = 800.00
Total Outflows = 5,000.00
ΣTime Weighted Cash flows are calculated as follows (Table 11):
Table 14 Total No of Days During the Period: 212 days
Cash flow Dated No of Days Invested Amount ($) Time Weighted Cash flow
3-Jan 210 100.00 99.06
1-Feb 181 100.00 85.38
1-Mar 153 100.00 72.17
23-Mar 79 5,000.00 -1,863.21
3-Apr 120 100.00 56.60
1-May 92 100.00 43.40
1-Jun 61 100.00 28.77
1-Jul 31 100.00 14.62
1-Aug - 100.00 -
Total 212 -1,463.21
81
Table 15 Modified Dietz Return
Numerator 5,552.93 – 7,560.08 + 4,200 = 2,192.85
Denominator 7,560.08 - 1,463.21 = 6,096.87
Modified Dietz Return = 2,192.85 ÷ 6,096.87 = 35.97%
The result of Modified Dietz Return in Table 3.16 is reasonably close to the value of
33.33% obtained using the Daily Valuation Method. If absolute accuracy is not required, this
method allows a handy rule of thumb computation to be made and the return estimated63
.
4.5 Ways of Adjusting Returns for Risks
Portfolio performance is based not only on the return but also on the risk associated
with it. Hence we have to use measures of portfolio performance that takes care of these
risks. The following are the tools that can be used to adjust returns for risks:
1. Sharpe ratio
2. Treynor measure
3. Jensen‘s alpha
4. Modigliani‘s square and Treynor square
5. Information ratio or non-systematic risk ratio
6. Downside deviation of risk of loss measure
7. Sortino ratio, and
8. Value at risk
4.5.1 Sharpe Ratio
63
Donald L. Tuttle, John L. Maginn. 1983. ―Managing Investment Portfolios: A Dynamic Process.‖ Warren,
Gorham & Lamont.p.26
82
The Sharpe Ratio adjusts the excess return of the portfolio over the risk-free rate of
return using the standard deviation of the portfolio‘s returns:
Sharpe Ratio =
Annualised Portfolio Return - Risk Free Rate of Return
Annualised Standard Deviation of Return
In symbols we can write
SR = [E (rp ) – rf ]/ σp
Where
E (rp) = Expected portfolio return
Rf = risk free rate
Σp = portfolio standard deviation
What does Sharpe ratio mean? The ratio which was developed by Nobel Laureate
William F. Sharpe measures risk-adjusted performance of the portfolio. It is calculated by
taking away the risk-free rate, such as that of the Treasury bonds from the portfolio‘s rate of
return and dividing the result by the standard deviation of the portfolio returns.
The Sharpe ratio is very useful in telling us if the good portfolio‘s performance is
because of smart investment decisions or because of taking too much risk. We may have a
case where one portfolio or fund gets very high returns compared to others. Such high returns
may not be good if it is done with too much additional risk. The greater the Sharpe ratio of a
portfolio, the better its risk-adjusted performance has been. A negative Sharpe ratio means
that a risk-less asset would perform better than the security being analyzed.
Suppose manager A generates a return of 16% while manager B generates a return of
12%. At the outset it looks like manager A performs better than manager B. However, it
83
could be the case that manager A took much larger risks that manager B. If it is known that
the risk-free rate is 4% and manager A‘s portfolio has a standard deviation of 8% while
manager B‘s portfolio has a standard deviation of 5%. The Sharpe ratio for manager A would
be 1.5 while that of manager would be 1.6 which shows that manager B performed better
than manager A.
To give some insight to users, a ratio of 1 or better is considered good, 2 and better is
very good and 3 and better is considered excellent. The whole idea of the Sharpe ratio is to
find out how much additional return one is receiving for the additional volatility of holding
the risky asset over a risk-free asset, the higher the better.
4.5.2 Treynor Ratio
The Treynor ratio or sometimes called the reward-to-volatility ratio or Treynor
measure named after Jack L Treynor measures the returns of portfolio earned over and above
that which could be earned on an investment with no diversifiable risk (e.g. Treasury Bills or
a completely diversified portfolio), per each unit of market risk assumed. It relates excess
return over the risk-free rate to the additional risk taken. Instead of total risk, systematic risk
is used. The higher the Treynor ratio the better the performance of the portfolio under
analysis.
Treynor Ratio =
Annualised Portfolio Return - Risk Free Rate of Return
Portfolio Beta
Because the denominator contains the factor Beta, the validity of the measure is also
dependent on the index used as a proxy for the market portfolio.
In other words, the Treynor ratio is a risk-adjusted measure of return based on
systematic risk. It is similar to the Sharpe ratio, with the difference being that the Treynor
ratio uses beta as the measurement of volatility.
84
4.5.3 Jensen’s Alpha or Excess Return
A risk-adjusted performance measure that represents the average return on a portfolio
over and above that predicted by the capital asset pricing model (CAPM), given the
portfolio's beta and the average market return. This is the portfolio's alpha. In fact, the
concept is sometimes referred to as "Jensen's alpha64
."
Jensen‘s measure is calculated as
α p = E(rp) - [rf + βp {E(rm ) – rf }]
where
E( rp ) = expected total portfolio return
Rf = risk free rate of return
β p = Beta of the portfolio
E( rm) = expected market rate of return
For example, if
Expected Market Rate of Return E(rm ) = 15.8%
Risk-free Rate of Return (rf ) = 3.0%
Portfolio beta βp = 0.95
Actual Mean Portfolio Return E(rp )
=
19.70%
Then the Expected Rate of Return for our portfolio E (rp ) = rf + βp (rm -
rf ) = 3.0 + 0.95 x
(15.8 – 3.0) =
15.16%
And Jensen‘s alpha = 19.70 – 15.16 = 4.54%
64
Ton van Welie, Ronald Janssen, Monique Hoogstrate. 2004. “An Integral Approach to Determining Asset
Allocations” Journal of Financial Planning. Jan 2004. P.50
85
The basic idea of Jensen‘s alpha is to analyze the performance of an investment
manager. To do that you need to look not only at the overall return of a portfolio, but also at
the risk of that portfolio. For example, if there are two mutual funds that have the same return
of 12%, a rational investor would want to have a fund that is less risky. Jensen‘s measure is
one of the measures to help determine if a portfolio is earning the proper return for its level of
risk. If the value is positive, then the portfolio is earning excess returns. In other words, a
positive value for Jensen‘s alpha means a fund manager has done better than the market with
his or her stock picking skills.
4.5.4 Modigliani-Square or M² Measure and the Treynor–Square or T² Measure
The former measure is named after the authors of the formula, Nobel laureate Franco
Modigliani and his niece, Leah Modigliani, a Morgan Stanley strategist. Like the preceding
approaches, the M² ratio attempts to adjust the returns for risks. The M² approach is to
leverage/de-lever the portfolio until its volatility matches that of its benchmark. This follows
from the CAPM methodology that assumes that the investor will leverage (borrow or lend at
the risk-free rate). The effect is that the investor can mix one risky asset with a risk-free asset
to obtain the same standard deviation of returns as the market portfolio.
Suppose the market rate of return was 15.0%. If an investor had just one risky asset A,
which offered an expected return of 25.0% and had a standard deviation of returns of 51%
compared to 33% for the market portfolio, the investor must lower the standard deviation of
his portfolio of risky assets. He can do this by buying riskless assets offering say for example,
returns of 3.0% such that a 33/51 or 64.7% proportion is made up of A and a (1 – 0.647) or
35.3% is made up of riskless assets.
The expected return of the new portfolio is then (0.647 x 25.0%) + (0.353 x 3.0%) =
17.2%. This is higher than the market rate of return of 15.0%, leaving the M² measure at
(17.2 – 15.0) = 2.2%. A similar operation can be made to adjust the beta of a portfolio of
risky assets to the market portfolio. This approach is called the T² Ratio calculated as follows:
Suppose the market rate of return was again, 15.0%. If an investor had the same one risky
86
asset A, which offered an expected return of 25.0% (hence an excess return of 22% over the
risk-free rate of 3.0% and had a beta of 1.7 compared (the beta of the market portfolio is
always 1.0), the investor must lower the beta of his portfolio of risky assets. He can do this by
buying riskless assets which have a beta of 0.0, offering excess returns over the risk-free rate
of 3.0% such that a 1.0/1.7 or 58.8% proportion is made up of A and a (1 – 0.588) or 42.2%
is made up of riskless assets. The excess return of the portfolio made up entirely of A,
denoted as RA is 25% - 3% = 22% while the excess return of the constructed portfolio RP =
22% x 0.588 = 12.94%.
The T² measure of the constructed portfolio = (Rp – excess return of market portfolio)
= 12.94% - (15%-3%)
4.5.5 Information Ratio, also known as Excess Return to Non-systematic Risk Ratio or
Appraisal Ratio
The information ratio measures the investment manager‘s performance against a
benchmark. It measures the consistency by which a portfolio or fund beats the benchmark.
The ratio is therefore alpha (measured by the average of a fund‘s excess monthly return over
a benchmark), divided by the standard deviation of the alpha. The formula is of the form
Information Ratio =
mean excess monthly return
standard deviation of excess monthly return
4.5.6 Downside Deviation or Risk of Loss Measure
The downside risk measures just one portion of the area under the normal distribution
curve that is used to define the standard deviation of returns. In Figure 3.14, it is represented
by the portion under the probability distribution curve shaded in red lying to the left of the
vertical line NN that sets the frequency distribution or probability of 0% return. The area
measures the cumulative probability of a loss and measures the Downside Deviation Risk.
87
Probability
Source: Investment analysis and portfolio management, 2004
The associated formula is computed as follows:
DownsideDeviationRisk=
Where N is the number of observations where the losses occurred or where the portfolio
underperformed the mean returns.
Where the Downside Deviation Risk is computed based on periods other than yearly
(i.e., monthly or quarterly) data, an adjustment is required if annualised results are to be
obtained:
Annualised Downside Deviation Risk = Downside Deviation Risk x √(No of periods required
to make up one year)
For example, if quarterly data is used, the Downside Deviation Risk will be multiplied by a
Figure 17 Downside Deviation
88
factor of √4 = 2.
4.5.7 The Sortino Ratio
This ratio adopts the downside deviation risk as a measure of portfolio risk. Unlike the
Sharpe Ratio, the Sortino Ratio measures the excess return not over the risk free rate but over
a target or expected rate and adjusts the annualised portfolio excess return over the mean or
annualised target return by a factor represented by the Annualised Downside Deviation
Risk65
:
Sortino Ratio = Annualised Portfolio Return - Annualised Target Return
Annualised Downside Deviation
A negative value indicates expected portfolio returns lower than the target rate of return.
Generally, the higher the value the better the risk-adjusted return. A large positive
value for a numerator will be negated if the denominator was large as well, leaving the risk-
adjusted return the same. The interpretation of this ratio may lead to conclusions conflicting
with that of the Sharpe Ratio since focusing just on the standard deviation of returns may
result in the selection of a portfolio for a client who may in fact be averse to losses more than
outright volatility of returns, in which event, the Sortino Ratio may be a useful gauge to
determine which is the preferred portfolio.
4.5.8 Value at Risk (VAR)
The VAR concept was developed by US banks in the 1980s to address the increasing
need for a single measure to gauge the risk of complex financial instruments like derivatives.
It is a powerful tool since it can be used at the single security as well as at the portfolio level
and can cover all asset classes. It aims to answer the question how much is the maximum loss
over a period of time given a level of probability?
65
Greer, R. J. (1978). Conservative Commodities: A Key Inflation Hedge. The Journal of Portfolio
Management, 4(4), p.26 -29.
89
Example 1 – a single-security portfolio
Assuming the aim is to determine the VAR for a 180-day period in respect of a
$20mln portfolio made up of just 1 stock. The recommended steps to determine this are as
follows:
Step 1
Determine the Daily Standard Deviation of the stock A‘s price (DSDA) for a reasonable
period of say, 1 or 2 years historically (preferably over at least one market cycle) expressed
as a percentage of the daily stock price e.g. our hypothetical stock has a Daily Standard
Deviation of 1.6% daily.
Step 2
Multiply the original Value of the Invested Sum by the percentage representing the historical
Daily Standard Deviation of the portfolio to obtain the Daily Dollar Standard Deviation
(DDSD) of the investment A e.g., DDSD (A) = $20 million x 1.6% = $0.32 million
Step 3
Determine the time horizon and derive an adjustment factor. To derive it, multiply the Daily
Standard Deviation by an adjustment factor equal to the square root of the number of trading
days. In our example, this is equal to √180 = 13.42
Standard VAR for 180 days = 0.32 x 13.42 = $4.3 million
Step 4
Read off from statistical tables the value of the cumulative probability of the one-tail test at
the required confidence level and multiply the adjusted VAR by this factor. e.g. at the 90%
confidence level, the reading is 1.28.
VAR for 180 days @90% confidence level = 4.3 x 1.28 = $5.5 million
At the 99% confidence level, the cumulative probability is 2.33.
VAR for 180 days @99% confidence level = 4.3 x 2.33 = $9.8 million
90
In the above example, we are dealing with a very volatile market, where you have
99% likelihood that the portfolio value will not fall by $9.8 million within 180 days.
Example 2 - a 2-stock Portfolio
Suppose we added another stock B with a value of $15 million to the portfolio above.
The covariance of returns between A above and this new stock B is determined to be 0.7. For
Stock B, the Daily Standard Deviation (DSDA) over the same one market-cycle period is
1.5%. The
Daily Dollar Standard Deviation (DDSD) is then computed as above, by multiplying the
Value of the Sum Invested in Stock B by the percentage representing the historical Daily
Standard Deviation of the daily prices of Stock B.
DDSD (B) = $15 million x 1.5% = $0.225 million
The Daily Dollar Standard Deviation of the portfolio DDSB (P), with a value of $35
million made up of $20 million in Stock A and $15 million in Stock B is given by the
formula:
DDSB (P) =
[DSDA2+DSDB
2]+[N x Covariance x DSDA x DSDB]
Where N is the number of securities in the portfolio
VAR for 180 days @90% confidence level = DDSB(P) x confidence level factor
= √[(0.32 x 13.42)2 + (0.225 x 13.42)2 + (2 x 0.7 x 0.32 x 13.42 x 0.225 x 13.42)] x
1.28
= $8.652
If a $35 million portfolio was constructed with stock A alone, the VAR for 180 days
at 90% confidence level would have been 5.5 x (35÷20) = $9.625 million, indicating a higher
value for the VAR. Risk reduction has been achieved via diversification.
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Summary of the chapter
Regarding, this chapter we dealt on strategic asset allocation as an asset allocation process
Tactical Asset Allocation Strategies as well as Insured Asset Allocation as an Asset
Allocation Strategy how to determine a risk and a return objective, A time horizon which is
the time period associated with an investment objective, also we differentiated between
Markowitz model and Samuelson-Merton model. In addition we discussed Strategic and
tactical asset allocation, and the approaches of selecting fund manager, as we analyzed
hierarchy processes of selecting fund, and alternative investments and structured products for
portfolio monitoring and rebalancing.
In here, assessing structural approach that a financial planner can adopt in selecting
funds is the analytic hierarchy process (AHP). We discussed in the AHP model which has
these distinct uniqueness. First, it provides a systematic approach to ranking mutual funds for
individuals based on each individual‘s unique investment objectives and constraints. Second,
the AHP prevents the investor from making inconsistent preference assignments. Fund
selection involves more than one parameter (for example, it may involve investment
objectives, tax efficiency, risk, and expense ratios), and thus enforcing consistency in the
decisions is difficult if the selection method is unstructured. Third, this approach minimizes
the amount of technical input required from investors. Financial planners should note that an
important distinction between the AHP and the MPT approaches is that in the AHP, the focus
is on the preferences of the investor, whereas in the MPT approach, the focus is on only two
dimensions of an individual‘s preferences—risk and return However, The term ―maximizing
return‖, in fact, again has direct linkage with the level of risk undertaken by the investors.
The risk-return relationship, in general, ought to be the same for both Islamic and mainstream
(conventional) capital markets. Mainstream capital markets provide stocks, bonds, mutual
fund, exchange traded funds, various hybrid funds, derivative securities etc. for investment,
financing and risk management. Well-developed Shariah compliant capital markets provide
similar financial instruments for investment,financing and risk management but designed on
Shariah rules and stipulations. Shariah compliant securities must be free from riba, gambling,
gamming, mayasir, gharar, and all other types of haram (prohibited) goods and services. we
92
conclude this chapter, Performance measurements and ways of measuring return and risks
including Treynor measure, Sharpe measure, Jensen alpha, Information ratio, M2 measures,
T2 measures, Risk of Loss measure; and Global Investment Performance Standards (GIPS).
CHAPTER FIVE: ANALYSIS AND DISCUSSION
5.1 Islamic Financial System and participants
Previous empirical investigations through a number of studies show that the Islamic
Financial system, which has been growing rapidly, could be an alternative to stop the
93
bleeding of the financial markets in the fragile mainstream financial system. It has been one
of the fastest growing sectors of the financial markets over the last 7 years and is expected to
continue expanding at an even faster rate (Ahmad, 2010). The author argued that because of
the unique features such as close linkage between productivity and financial flow, profit and
risk sharing etc., Islamic finance has experienced major transformations and growth
especially since 2000, and its volume has reached almost $1.7 trillion. What are the basic
features of Islamic financial system? Is it something different from the conventional financial
system? In terms of the terminology, there is no fundamental difference between Islamic and
mainstream financial system. Notwithstanding this fact, Islamic financial system is different
from its conventional counterpart in terms of principles and objectives. If we look at the
prime objective, financial stability and economic growth are at the top of the list for the
mainstream system. The Islamic financial system targets the same objectives through
ensuring justice and equity through the satisfaction of Allah the Almighty because one of the
most important objectives of Islam is to realize greater justice in human society. According to
the Qur‘an a society where there is no justice will ultimately head towards decline and
destruction (Al-Qur‘an, 57:25)66
. Justice requires a set of rules or moral values, which
everyone accepts and faithfully complies with. The financial system may be able to promote
justice if, in addition to being strong and stable, it satisfies at least two conditions based on
moral values (Chapra, 2008)67
. One of these conditions is risk sharing and the other is that an
equitable share of financial resources mobilized by financial institutions should become
available to the poor to help eliminate poverty, expand employment and self-employment
opportunities and, thereby, help reduce inequalities of income and wealth. In addition to risk
sharing and an equitable distribution of financial resources, institutions in Islamic financial
system must comply with some other key principles. For example, Islamic financial
institutions (IFIs) must avoid riba (interest), gharar (excessive uncertainty) and qimar
(gambling) in their business operations. Furthermore, IFIs must not deal with any business
involving prohibited (haram) items according to Shariah rules, such as pork, pornography etc.
How is the Islamic financial system suitable to handle the functions of the modern financial
system? Significance of Islamic financial system has been accentuated particularly, amid the
66
(Al-Qur‘an, 57:25) 67
(Chapra, 2008)
94
2008 global financial crisis when Islamic banking and other financial institutions were
relatively more stable as compared to their conventional counterparts. For example, Ahmad
(2010) claimed that Islamic banking could play an increasing role in global financing, its
expansion relatively unaffected by the financial crisis.
Similar to the mainstream financial system, Islamic financial system is composed of
institutions, instruments and regulators. However, here regulators must be regulated first by
laws from the Holy Quran and Hadith of our beloved Prophet Muhammad (PUBH) and
second by the state laws. Major institutions in Islamic financial systems are Islamic banks,
Islamic capital markets and takaful organizations. How do these organizations compare with
their conventional counterparts in terms of managing risk? Regulations are required to
minimize the degree of risk by establishing sound risk management system in both the
Islamic and the conventional financial institutions in order for the best interests of the
stakeholders of these institutions. In addition, risk management is more important in Islamic
financial institutions since their need to satisfy not only the customers but also Allah the
Almighty. With regard to risk management strategies in Islamic banks, study by Ismail et al.
(2013) addressed that all seventeen Islamic Financial Institutions in Malaysia have greatly
improved before and after the 2008 global financial crisis as per their risk management
disclosure. As for the significance of Islamic finance, Ahmad (2010) shows that the
international dimension of Islamic finance have rapidly gained significance due to its
increasing participation in the international financial system and contribution towards greater
global financial integration. Furthermore, expansion of Islamic finance networks among
financial intermediaries and markets across the regions would contribute towards a more
efficient allocation of financial resources and thus contribute to enhancing global growth
prospects. Dogarawa (2012)68
advocated that the profit-risk sharing features and socio-
economic functions, more effective regulation and supervision of Islamic finance can help
inject greater discipline into the system and, thereby, substantially reduce financial instability
and promote faster development. Parashar and Venkatesh (2010)69
showed that Islamic banks
have suffered more than conventional banks during recent global financial crisis in terms of
capital ratio, leverage and return on average equity, while conventional banks have suffered
68
Dogarawa (2012) 69
Parashar and Venkatesh (2010)
95
more than Islamic banks in terms of return on average assets and liquidity. Over the four
years period, i.e. 2006-2009, Islamic banks performed better than conventional banks.
Regarding investment in Islamic funds, Rubio et al. (2012) articulated that despite having
some level of inefficiencies, it could be safely concluded that Islamic funds remain highly
efficient and they show smallest number of inefficiencies amongst the subgroups. Derigs and
Marzban (2009)70
revealed that on the same asset universe, current basic Shariah- compliance
strategies result in much lower portfolio performance than portfolios without considering
Shariah-compliance. The authors have proposed new concepts for defining Shariah-
compliance leading to strategies by which portfolios can be constructed that achieve better
portfolio performance than current Shariah strategies. They also proposed and justified a new
paradigm which measures compliance on a portfolio level rather than individually for each
asset. This standard results in portfolios which perform much better than their asset-based
counterparts in terms of return and risk. However, a few studies argued against the
superiority of Islamic financial system over the mainstream counterpart. For example, Hayat
and Kraeussl (2011), in their study of Islamic Equity Funds‘ (IEFs) performance, revealed
that on average during 2000-2009 periods IEFs substantially underperform both their Islamic
and conventional benchmarks even before considering management fees. They also claimed
that globally invested IEFs have the worst performance, while IEFs invested locally did
slightly better. Charles et al. (2010) in their study showed that both Islamic and conventional
indexes have been affected to the same degree by variance changes. This similar variance
change may be caused by the same market shocks affecting both Islamic and conventional
indices at the same time that may lead to higher correlation between these two indices. The
study also pointed out that there is reason to support the conventional wisdom that the Islamic
finance principles are tantamount to a financial model that would be less exposed to shocks
than the conventional model.
5.2 Sharia compliant vis-à-vis Conventional Investments
Islamic finance, since its inception in the mid-seventies, has been considered a part of
ethical finance. Among the Shariah principles those guide Islamic finance, the most
70
Derigs and Marzban (2009)
96
significant are profit and loss sharing, the prohibition of riba (interest), the principle of asset
backing, and the prohibition of excessive uncertainty. In addition to these principles, Islamic
financial institutions and products must not be involved (either directly or indirectly) with
any business producing unethical products and services such as alcohol, pornography, pork-
related activities, tobacco, gambling, etc. On the top of these religious principles, Islamic
financial Institutions and products should take limited leverage in their asset-liability
structures in order to ensure financial stability and avoid potential defaults. Following these
Islamic principles and stipulations, Shariah compliant equities (indices) have been designed
and developed as a counterpart of the mainstream equities (indices) to create ethical
investment opportunities for the investors. Even though the primary concept of equity is the
same both in Islamic and mainstream finance, it requires further processes to create Shariah
compliant equity (indices). Shariah compliant equities are screened subset following the
Islamic principles and rules approved by their respective Shariah boards. In order to meet the
growing demand for ethical products and services, Shariah-compliant indices were
introduced by globally reliable index providers including Dow Jones, FTSE, Standard &
Poor‘s, Stoxx and Morgan Stanley vis-à-vis their mainstream equity indices. In terms of
Shariah screening process, Dow Jones is the most stringent in qualifying Islamic equities.
Equities to be accepted as Islamic must pass through two types of screening: qualitative and
quantitative. Qualitative screening approach requires an equity to be Shariah compliant must
not be involved in any activities related to sale and production of alcoholic beverages;
broadcasting and entertainment; conventional financial services; gambling; hotels; insurance;
media agencies (except newspapers); pork related products; restaurants and bars, tobacco;
weapons and defense. Meanwhile, the quantitative approach requires the following ratios
must be less than 33 percent: the total debt divided by the trailing 24-month average market
capitalization; taking the sum of a company‘s cash and interest-bearing securities divided by
the trailing 24-month average market capitalization; accounts receivables divided by the
trailing 24-month average market capitalization. Above all, most Shariah scholars agree that
buying and selling corporate stocks is lawful under Islamic legislation since stocks and shares
represent real assets and dividends are proportional revenues out of profits of the companies.
5.3 Asset Allocation and Performance (Risk-Return Profile of Optimized Portfolio)
97
We apply the Markowitz Portfolio Model in order to find out the optimum portfolios
and to investigate the risk-return profile of the portfolios under review in different episodes.
Harry M. Markowitz (1952; 1959)71
first developed the modern portfolio theory describing
the relationship between expected return and risk of assets. The theory suggests that investors
should attempt to maximize the portfolio expected return given the same level of risk or
minimize risk of the portfolio given the same level of return. We construct efficient frontier
through optimization process, which is the locus of all efficient portfolios. Efficient portfolio
refers to that which contains only systematic risk and provides the maximum expected return
for a given level of risk (volatility) or
Minimum level of risk for a given level of expected return (Berk & DeMarzo, 2011)72
.
Theoretically, the efficient portfolio cannot be diversified further. It is assumed that
an investor selects an optimal portfolio from a number of efficient portfolios. We select the
portfolio that gives the highest return-to-risk ratio from a set of efficient portfolios combining
equities (conventional and Islamic) and commodities across all episodes (subperiods)
considered by the study. Then we find the basic features and performances of those highest
return-to-risk efficient portfolios. We use average 3-month US T-Bill rate per episode as the
risk free rate and S&P Global Broad Market Index (S&P Global BMI) as the bench mark
throughout the analysis. The S&P Global BMI is a comprehensive rule based index
measuring global stock market performance, which comprised of the S&P Developed BMI
and S&P Emerging BMI. It is regarded as the only global index that fits with a transparent,
modular structure that has been fully float adjusted since 198973
.
The following tables (a) – (h) present comparative portfolio asset allocation and
Performances of conventional equities, Islamic equities, conventional equities and
Commodities, and Islamic equities and commodities respectively across six episodes.
71
Harry M. Markowitz (1952; 1959) 72
(Berk & DeMarzo), 2011 73 Fact Sheet, S&P Global BMI equity indices,2012
Table 16 Portfolio asset allocation and performance (Conventional equity: 1996-2003
98
Source: Dow jones Turkey and GCC Islamic indices.2004.
Source: Down jones Turkey and GCC conventional indices,2012
Table 13: (C)
Table 17 Portfolio asset allocation and performance (Conventional equity: 2004-2012)
Table 18 Portfolio asset allocation and performance (Islamic equity: 1996-2003)
99
Sources: Down jones of Turkey and GCC Islamic indices,2004.
Sources: Down jones of Turkey and GCC conventional indices,2004
Table 19 Portfolio asset allocation and performance (Islamic equity: 2004-2012)
Table 20 Portfolio asset allocation and performance (Conventional equity plus commodity: 1996-
2003)
Table 21 Portfolio asset allocation and performance (Conventional equity plus commodity: 2004-
2012)
100
Sources: Down jones of Turkey and GCC of conventional indices, 2012
Sources: Down jones of Turkey and GCC Islamic indices, 2003
Table 22 Portfolio asset allocation and performance (Islamic equity plus commodity: 1996-
2003)
Table 23 Portfolio asset allocation and performance (Islamic equity plus commodity: 2004-
2012)
101
Sources: Down jones of Turkey and GCC Islamic indices, 2012.
5.3.1 Analysis of Return to risk ratio
We compute return to risk ratio by dividing the annualized returns by the annualized
risks of the all the portfolios. If we form portfolios only with conventional equities, we
observe from table 12(a) that the highest return-to-risk ratio is 1.25 (15.93%/12.78%)
produced by the portfolio during episode 1, the time before the 1997 Asian financial crisis.
This portfolio comprises of equities from UK (57.26%), Canada (19.32%), Japan (12.72%)
and USA (10.71%). This result could be caused by low return correlation, better performance
and relative resiliency of those equity markets, which may encourage the investors and
portfolio managers to invest in these equity markets. However, we notice that the lowest
return-to-risk ratio is 0.52 (8.18%/15.67%) in episode 3, which is the post 1997 Asian
financial crisis period. This portfolio is composed of 54.31% Canadian and 45.69%
Malaysian equities, both of which were adversely affected by the financial crises. Malaysian
equities were hit by the 1997 financial crisis and Canadian equities by the Internet bubble
bust and other crises.
These findings suggest that conventional equity portfolios are performing relatively
better before the outset of 1997 Asian financial crisis. How is the performance of the Islamic
equity portfolios if the investors like to invest in Islamic equities due to religious or other
ethical reasons? Now we look at the reward-to risk ratio of the Islamic equity market during
the same tenure in order to investigate the performance of Islamic equity portfolios.
Following the conventional equity portfolios, Islamic equities provide the best portfolio
associated with the return-to-risk ratio of 2.54 (22.29%/8.77%) during episode 1.
Surprisingly, this portfolio follows its conventional counterpart in terms of composition as
well. This portfolio consists of the Islamic equities from UK (44.86%), Canada (28.35%),
USA (24.13%) and Japan (2.65%). We suspect the same factors, which affect its
conventional counterpart, to affecting its return-risk performance. Conversely, we perceive
the lowest return-to-risk ratio of 0.22 (3.56%/16.22%) for the portfolio is composed of
Islamic equities from Malaysia (52.55%), Japan (28.00%) and Canada (19.45%) during the
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episode 3, which is the post 1997 Asian financial crisis period. As a matter of fact, a severe
downturn is observed in all these three markets in episode 3. Interestingly, Islamic equity
portfolios are performing better (2.54 vs. 1.25 in episode 1 and 1.37 vs. 1.15 in episode 2)
than the conventional counterpart in terms of return-to risk ratio. In contrast, conventional
equity portfolios are better performer (0.52 vs. 0.22) than Islamic portfolios in episode 3.
These findings suggest that Islamic equities perform better and thus regarded as safer
investments than the conventional equities during 1997
crisis period in general. This claim would not be surprising if we look into the causes and
effects of 1997 Asian financial crisis. In brief, currency crisis was the main issue that
triggered the intensity of this crisis in the major Asian economies such as Korea, Japan, Hong
Kong, Taiwan, Malaysia and Thailand. In other words, overall financial sector of these
economies experienced a major down turn because of this crisis. Consequently, mainstream
equity markets were the main victims and Islamic equity markets were less affected by this
financial crisis. This happened because financial sectors are excluded from the Islamic
equities during the screening stage to maintain Shariah compliance. What happens to these
Islamic and conventional equity portfolios in episodes 4, 5 and 6 –the pre, in and post 2008
Global financial crisis? This crisis was caused by the successive failures of the residential
mortgages initiated by the multi-layering process of mortgages of the financial institutions. In
other words, failure of the real estate loans caused by the bearish regime in the real estate
market in the USA, which afterwards, was extended to other markets. This failure of the real
estate loans was the main reason of the 2008 global financial crisis. Accordingly, we expect
that the Islamic equity markets would be more affected as compared to its conventional
counterpart during this crisis period since this crisis was initiated in the US real estate market.
What happened in reality? The results in episode 4 show that risk-to-return ratio is 1.25
(13.49%/10.82%) for the conventional equity portfolio as compared to 1.11(14.48%/13.06%)
for the Islamic portfolio, i.e. conventional equity portfolio performed better, by 12.61%, than
the Islamic equity portfolio. In this episode, conventional portfolio is composed of equities
from GCC (39.87%), Canada (39.07%), Malaysia (14.16%) and Turkey (6.90%). Conversely,
composition of Islamic portfolio is similar to the conventional portfolio except for the
additional equity from the UK market. However, the proportion of equities are different the
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Islamic portfolio. Result of episode 5, during the 2008 global crisis period, is not significantly
different from that of episode 4, rather the performance of Islamic equity markets was
recorded at about 500% worse than their conventional counterpart. The results also reports
that return-to-risk ratio of the Islamic equity portfolios was recorded as 0.31 (6.14%/19.83%)
in comparison with 1.91 (21.97%/11.48%) of the conventional equity portfolios. The results
also demonstrate that conventional portfolio is composed of equities from GCC (86.73%) and
Malaysia (13.27%). Alternatively, Islamic equity is composed of equities from Malaysia
(76.76%) and Turkey (23.24%). We may notice from the findings that neither conventional
nor Islamic portfolios are accounted for equities from either North America or Europe, since
markets in both continents were severely plunged by the 2008 financial crisis and 2010
Eurozone crisis.
Portfolio managers and investors, now, would be interested to know about the
portfolio performance in the last episode i.e. post 2008 financial crisis. Interestingly,
performance of both Islamic and conventional equity portfolios is almost the same in episode
6. We record return-to-risk ratio of 0.82 (12.20%/14.91%) for the conventional portfolio,
which is composed of equities solely from the Malaysian market. This finding highlights that
Malaysian equity market was least affected by the 2008 global crisis. Conversely, return to-
risk ratio was 0.83 (10.59%/12.70%) for the Islamic portfolio, which is composed of equities
from Malaysia (80.82%), Turkey (11.52%), GCC (5.63%) and USA (2.03%). These findings
again accentuate the better performance of the Malaysian Islamic equity market over other
markets under review. The contribution of GCC Islamic equities in this portfolio appears to
be very small, may be due to poor performance of the Islamic equities. This happened
because of the Dubai financial crisis originating from the default in sukuk market. We
already presented the fundamental price behavior of all the concerned commodities and
equities undertaken by the study in the earlier sections. Accordingly, we notice that on an
average, commodity prices are inversely related with that of equities except for a few cases.
Consequently, we need to investigate the return-risk behavior of the new hybrid portfolios
combining equities (conventional and Islamic) and commodities. These portfolios combining
equities and commodities are expected to provide diversification benefits for the depressed
and bankrupt portfolio managers and investors during the financial crises. For example,
104
Jessica et al (2012), in their paper stated that there is no doubt that investors would like, and
are trying, to achieve diversified returns by allocating their capital to non-traditional and non-
standard investment instruments.
First, we look at the risk-return profiles of the portfolios combining conventional and
Islamic equities with commodities in episodes 1, 2 and 3. These episodes are basically pre, in
and post 1997 Asian financial crisis. The results in episode 1 reveal that risk-to return ratio is
1.50 (16.74%/11.15%) for the portfolio combining conventional equity with commodities as
compared to 2.70 (21.27%/7.89%) for the portfolio combining Islamic equities with
commodities. Therefore, Islamic equity-commodity portfolio performed better, by 80%, than
the conventional equity-commodity portfolio. Comparing the risk-return profile of these
diversified portfolios with the non-diversified equities (conventional and Islamic) portfolios,
we notice interesting findings. The results show that the portfolio volatility has been reduced
by 1.63% (12.78% - 11.15%) for the conventional equity-commodity portfolio in comparison
with the Islamic equity commodity portfolio, for which volatility has been reduced by 0.88%
(8.77% - 7.89%).We should mention that this volatility reduction through diversification is
not cost free rather return has been reduced with lower volatility. Moreover, higher
transaction costs are involved with diversification process. Investors might be interested in
knowing which diversified portfolio performed better? Apparently, in terms of the return-to-
risk ratio, Islamic equity-commodity portfolio performed better than the conventional
counterpart because of higher return-to-risk ratio (2.70 > 1.50). Meanwhile, in terms of
reduction in volatility, conventional equity-commodity portfolio performed better in
comparison with Islamic equity-commodity portfolio (1.63% > 0.88%). In order to know the
causes behind such interesting findings, we better look at the portfolio composition. Asset
allocation results demonstrate that the conventional equities-commodities portfolio is
composed of four equities from UK (39.62%), USA (12.37%), Japan (8.73%) and Canada
(7.89%), and two commodities, cocoa (29.65%) and crude oil (1.65%). Similarly, the Islamic
equities-commodities portfolio consists of four Islamic equities from UK (38.74%), Canada
(23.86%), USA (18.79%) and Japan (4.01%), and two commodities, cocoa (12.65%) and
crude oil (1.95%). We may notice that the contribution of the UK equities is the highest and
105
that of the crude oil is the lowest in both cases, which is consistent with the UK equity
contribution in both non-diversified portfolios.
These findings highlight the superior performance of the UK equities, both
conventional and Islamic, in episode 1, i.e. before the start of the 1997 Asian financial crisis.
Now we look at the performance of the diversified portfolios in episode 2, during the 1997
financial crisis. Results reveal that the return-to-risk ratio is 1.44 (20.98%/14.53%) for
Islamic equities-commodities portfolio, which is higher than the return-to-risk ratio of 1.23
(15.82%/12.81%) of conventional equities-commodities portfolio by 17%. This increment is
about 63% (80% - 17%) less than the same sort of performance of Islamic equities-
commodities portfolio in episode 1. The results also report that portfolio volatility has been
reduced by 1.84% (14.65% - 12.81%) for the conventional equity commodity portfolio
against the Islamic equity-commodity portfolio, for which volatility has been reduced by
2.02% (16.55% - 14.53%). Therefore, according to the results, it would not be overwhelming
to claim that Islamic equities-commodities portfolio performed better than its conventional
counterpart during the 1997 Asian financial crisis period. This finding is interesting but not
surprising because failures in financial sectors do not affect the performance of Islamic
equities since financial sectors are excluded from the Islamic equities through the process of
Shariah screening. Asset allocation wise, the contribution of the UK equities is still the
highest (42.68% for conventional vs. 43.10% for Islamic) in the equity-commodity portfolios
in episode 2 when crude palm oil could be regarded as the major commodity to contribute
(16.73% for conventional vs. 17.26% for Islamic) in the diversified portfolios. This asset
selection depends on the low return correlation and overall performance of the assets.
After the 1997 Asian financial crisis, in episode 3, results report that return-to-risk
ratio is 0.75 (9.39%/12.54%) for Islamic equities-commodities portfolio, which is less than
the return-to-risk ratio of 0.86 (9.90%/11.48%) of conventional equities-commodities
portfolio by 14.67%. Although, the performance of Islamic equities-commodities portfolio
has declined, we are still interested to see the extent of diversification benefits in both
portfolios in episode 3. According to the results, portfolio volatility has been reduced by
4.19% (15.67% - 11.48%) for the conventional equity-commodity portfolio compared to the
106
Islamic equity-commodity portfolio, for which volatility has been reduced by 3.68% (16.22%
- 12.54%). Therefore, in line with the results, it would be safer to claim that conventional
equities-commodities portfolio performed better than the Islamic equities-commodities
portfolio after the 1997 Asian financial crisis. Interestingly, gold is now appearing as a major
diversifier contributing the highest 36.17% and 47.17% in conventional equities-commodities
and Islamic equities-commodities portfolios respectively. In addition to gold, crude oil,
natural gas and cocoa are other commodities that contribute in both conventional and Islamic
diversified portfolios. In addition to the commodities, both conventional and Islamic equities
of Malaysia contribute to the diversified portfolio.
Now we look at the episodes 3, 4 and 5 when failures in the US real estate market
played the key role in the global economic meltdown triggered by the 2008 financial crisis.
Before starting of the 2008 Global financial crisis, in episode 4, return-to-risk ratio is 1.48
(14.74%/9.98%) for conventional equities-commodities portfolio, which is higher than the
return-to-risk ratio of 1.37 (14.09%/10.30%) of Islamic equities-commodities portfolio by
about 8%. With respect to the extent of portfolio diversification benefits, the results show that
portfolio volatility has been reduced marginally by 0.84% (10.82% - 9.98%) for the
conventional equity-commodity portfolio as compared to the Islamic equity-commodity
portfolio, for which volatility has been reduced by 1.30% (13.06% - 10.03%). Therefore, in
spite of higher return-to-risk ratio of the conventional equitiescommodities portfolio, Islamic
equities-commodities portfolio provides higher diversification benefits as compared to its
conventional counterpart by reducing portfolio volatility in episode 4.
Following the results in episode 4, diversified conventional equities-commodities
portfolio performs better than the Islamic equities-commodities portfolio with respect to
return-to-risk ratio in episode 5. The results depict that return-to-risk ratio is 2.06
(22.12%/10.76%) for conventional equities-commodities portfolio, which is higher than the
return-to-risk ratio of 0.73 (16.12%/21.96%) for Islamic equities-commodities portfolio by
about 182%. The results further explain that portfolio volatility has been reduced marginally
by 0.72% (11.48% - 10.76%) for the conventional equity-commodity portfolio as compared
to the Islamic equity-commodity portfolio, for which volatility has increased by 2.13%
107
(21.96% - 19.83%) after adding commodities into the portfolio. This higher volatility
increases return by 10%. This increased return is achieved by the higher contribution of gold
(72.90%) in the diversified Islamic equities-commodities portfolio
5.4 How Islamic Wealth Management differs from Conventional
The key goals and instruments for Investment and wealth accumulation, for
retirement planning and Schemes, for wealth and life style protection, and Role of Insurance
and Takaful in Wealth planning and transferring, is usually associated with private banking
that serves the financial needs of the relatively wealthy. This is apparent in the definition of
wealth management by Maude (2006:1) who defines it as ‗financial services provided to
wealthy clients, mainly individuals and their families‘. Mindel and Sleight (2010)74
identify
four key goals of wealth management: investments and wealth accumulation, retirement and
retirement income, wealth and lifestyle protection and transferring wealth. Achieving these
goals would require appropriate range of products and services. Specifically, products for
investments and wealth accumulation would include core banking products, lending products
and a menu of financial and non-financial assets. Similarly, retirement income is ensured by
using a variety of investment vehicles and pension schemes. Wealth and lifestyle can be
protected by different types of insurance products such as property, health and life
insurance/assurance. Finally, inheritance and estate planning are used to transfer wealth to
achieve desired distributive goals. Different client segments would have diverse risk-return
preferences and wealth management objectives. Their needs can be satisfied by the wealth
management service providers in advisory or discretionary forms (Maude 2006)75
.
In the former, the wealth manager gives advice to clients on how to achieve their
wealth-related goals by using different instruments and the clients make their own decisions.
In a discretionary mandate, the service provider not only advises the clients but also actively
manages their wealth, goals of wealth management from an Islamic perspective and the
instruments that can be used to achieve these goals.
74
Mindel and Sleight (2010) 75
Maude, David (2006), Global Private Banking and Wealth Management: The New Realities, John Wiley &
Sons, Inc.
108
5.4.1 Instruments and goals for Islamic Wealth Management
Though Islamic banking started its operations in the 1970s to provide Shariah-
compliant services to Muslims, the industry has since then expanded, and diversified to
become a global phenomenon offering various products and services to both Muslim and
non-Muslim clients. One relatively new area of operations of the industry is wealth
management. Determining the Islamic perspective of wealth management would require
understanding the goals and principles of Shariah.The overall goal of an Islamic financial
system is to realise the objectives of Islamic law (maqasid al-Shariah) (Siddiqi 2006)76
.Other
than fulfilling the legal injunctions related to transactions in Islamic finance, maqasid at a
broader level would imply inclusion of social dimensions77
. The financial sector can achieve
the social goals by not only avoiding activities that are exploitative and harmful to the
society, but also engaging in ones that promote social welfare (Grais and Pellegrini
2006a).The specific goals of maqasid at the microlevel are to safeguard the faith, self,
intellect, posterity, and wealth (Chapra 2008 and Ibn Ashur 2006)78
. Accordingly, the
objective of Islamic commercial law would be to protect and enhance one or several of these
goals.Commercial transactions are sanctified and encouraged as these enhance and support
wealth and progeny (Hallaq 2004)79
. Given these overall goals of Shariah, Islamic wealth
management would entail strategies and mechanisms to protect and develop wealth for
different segments of the population and provide a sound framework for transferring it in a
Shariah-compliant manner. The Islamic instruments that can be used to meet the different
wealth management goals are analyzed in the following sections.
5.4.2 Investments and Wealth Accumulation
76
Siddiqi, M. Nejatuallah (2006), "Islamic Banking and Finance in Theory and Practice: A Survey of State of
Art." Islamic Economic Studies 13 (2): 1-48. 77
Chapra, M.Umer (2008), The Islamic Vision of Development in Light of Maqasid al Shari'ah, International
Institute of Islamic Thought, London. 78 Ibn Ashur, M.A. (2006), Treatise on Maqasid al-Shari‟ah, International Institute of Islamic Thought,
Herndon. 79
Hallaq, Wael B(2004) A History of Islamic Legal Theories: An Introduction to Sunni Usul al-Fiqh,
Cambridge University Press, Cambridge.
109
The basic financial services provided by the financial sector are the core banking
products that include different types of deposits, credit cards, etc. While bank accounts are
traditional means of saving, there are several other opportunities available for investments
and accumulating wealth. Key among these investment vehicles are a variety of funds
available that can be classified as traditional and alternative investments.Traditional
conventional funds include investments in common stock, bond, money market and balanced
portfolios. Categories of asset classes in alternative investments include real estate,
infrastructure, and private equity/venture capital, hedge funds, commodities, managed futures
and distressed securities (Leiter et.al. 2007 and DBS 2011)80
. To enable Muslim clients to
accumulate wealth would require availability of a range of Shariah-compliant assets. Islamic
banks provide the basic banking services and various Shariah-compliant savings and
investment accounts, Also there are some conventional banks who engage in Islamic banking
activities as a double window banks( Islamic and Conventional), like the Bank of J.Safra
Sarasin in Switzerland and works, Some Muslim Countries like GCC Gulf countries. They
introduce Islamic Wealth Management for Muslim High net Worth Individuals, the author
observed their Process of Investments decisions process for Conventional and Differences
from Islamic, and it is as follows:
In our Study, we observed After the Islamic Fiqh Academy‘s (IFA) ruling on the
legitimacy of investments in stocks, the Islamic mutual funds sector witnessed a rapid growth
in the 1990s. The traditional assets classes include Shariah-compliant stocks, sukuk and
money market instruments.Similarly, alternative Islamic investment assets would comprise
real estate/infrastructure, commodities, private equity funds and some newly established
hedge funds. Whereas Islamic funds covering the traditional assets classes have expanded in
many countries, in some jurisdictions the alternative funds are also being offered. In July
2011, assets managed by Islamic funds are estimated to be USD77 billion spread among 717
investments schemes (Eurekahedge2011)81
.
5.4.3 Retirement Planning and Schemes
80 DBS (2011), Alternative Investments: An Introduction, CIO Office, 21 November 2011, DBS. 81Eurekahedge (2011), “2011 Key Trends in Islamic Funds”, September 2011, www.eurekahedge.com
110
Closely linked to wealth accumulation, the second goal of wealth management is to
offer services related to retirement planning. Pension systems existed historically in the
Islamic world with the first one introduced by Umar bin Khattab in the 7th century (Manjoo
2012)82
. These schemes provided annual stipend to individuals from the baitulmal and also
from waqf. Contemporary Shariah -compliant retirement schemes, however,are relatively
new. Present-day pension schemes invest in a pool of investment vehicles that can provide
diverse risk-return combinations to satisfy the preferences of clients.
Contributions for retirement can be made through personal, company or public
pension schemes. An individual may have one or a combination of these schemes to plan and
prepare for retirement. Retirement planning from an Islamic wealth management perspective
would entail Shariah-compliant schemes providing investment opportunities and products to
clients. The Islamic pension schemes would participate in a combination of Shariah-
compliant traditional and alternative asset classes identified above to provide a desired
income stream to the retirees. One example of a private pension scheme is Discretionary
Portfolio Service (DPS) offered by Islamic Bank of Britain that provides clients access to
different Shariah-compliant investment portfolios. These investment portfolios can be held
within Self-Invested Personal Pension (SIPP) in a tax efficient manner.
5.4.4 Wealth and Lifestyle Protection
A key instrument of wealth and lifestyle protection is using different insurance
services. The OIC Fiqh Academy in a resolution 9 (9/2) 1985 declared conventional
insurance to be prohibited due to uncertainty (gharar) in the object of sale and outcome of the
contract. The Islamic alternative, takaful, using principles of ta‘awun (mutual assistance) and
tabarru‘ (gift or donation) are operating under the mudarabah (partnership) and wakala
(agency) based models.
The industry has since grown, providing protection against various types of risks to
clients. There are two main types of takaful, general and family. While the former provides
82
Manjoo, Faizal Ahmad (2012), ―The UK legal reforms on pension and the opportunity for Islamic pension
funds‖, Journal of Islamic Accounting and Business Research, 3 (1), 39-56.
111
short-term protection against accidents and losses of property, the latter provides saving
opportunities and long-term protection arising from death or disability. The types of products
under family takaful have become diverse providing a variety of products that can be used for
wealth and lifestyle protection.The products under family takaful include investment-linked
family takaful, mortgage takaful, hospitalization takaful, group medical takaful and group
takaful (Oracle 2008)83
.
83 Oracle (2008), Takaful – Meeting the Growing Need for Islamic Insurance, Oracle White Paper, May
2008.
Figure 18 Modified Mudharabah Model
Figure 19 Mudarabah Model-Family Takaful.
112
Source: Islamic wealth Planning and Management book, 2011
The global takaful industry grew at the rate of 19% in 2010 and total contributions are
expected to reach USD12 billion in 2012 (Ernst & Young 2012)84
.
5.4.5 Role of Insurance and Takaful in Wealth planning
When we think about saving and building a strong financial foundation, we often
forget about the value of protecting those assets. One way to protect those assets is through
insurance. We remember to insure our homes and our vehicles, but we often forget to cover
our most important asset—our ability to earn a salary. Remembering to plan for the
unexpected today may help you avoid unpleasant surprises in the future.
The role played by insurance and takaful in wealth planning cannot be ignored. Many
a time, when all other instruments fail, insurance and takaful seem to be the best solution.
Insurance/takaful is one of life‘s necessities and probably the least-understood financial
product. Insurance and takaful reimburse people for insured/covered losses in the event of an
untoward incident such as an illness, accident, or death. At the same time, it can provide
investment capital, lend money, and help to reduce anxiety for individuals and society at
large.
As a wealth planning mechanism against loss of income and a means of safeguarding
assets, most individuals involved in the wealth planning and management industry have
insurance or takaful in one form or another. These coverages may include public coverage,
such as disability insurance under the social security system, a health care policy from an
employer, or personal insurance or takaful to protect property such as homes, and cars.
84 Ernst & Young (2012), The World Takaful Report 2012, Industry growth and preparing for regulatory
change, April 2012, Ernst & Young.
113
We may save money in our pension and other investments and have capital in our
home. But if we do not have adequate and appropriate insurance or takaful cover, we are
neglecting an important aspect of our wealth plan. The primary reason for buying life
insurance or takaful is to allow the survivors and heirs of the deceased to continue with their
lives free from financial burden that death can bring. The need for insurance or takaful will
change during a person‘s life cycle: for example during early childhood or when one is
unmarried there is little need for insurance but the arrival of children greatly increases the
need for life insurance or takaful. Moreover, insurance or takaful helps in wealth preservation
and wealth distribution as it creates an instant estate with a small premium. In general
insurance and takaful provide financial security against premature death and disability.
When premature death occurs especially the death of the head of a family there could
be many unfulfilled financial obligations. The loss of income due to death can result in
financial problems such as to support dependents, to settle liabilities arising from housing or
car loan, or even to cover the education costs of school-going children. Premature death also
causes financial insecurity to the family of the deceased because of the loss of earned income
to the dependents. If the family lacks additional sources of income or has insufficient
financial assets to replace the lost income, financial hardship may result. The family may also
incur sizable additional expenses because of burial costs and expenses of the last illness. In
addition, certain non-financial costs are also incurred, such as emotional grief and pain of the
surviving dependents and the loss of counseling and guidance for the children. Although
insurance and takaful cannot replace non-financial costs, it can alleviate the problems with a
lump-sum or continuous income after the death of the deceased.
Apart from death, disability, whether temporary or permanent, may also result in
reduced income which may, in turn affect the financial position of the family. A serious
illness or injury for example, can create serious financial problems for the disabled client and
his dependents. Medical expenses must be paid, and health care is expensive. In cases of
long-term or permanent disability, there is a substantial loss of earned income, medical
expenses are still being incurred, savings often are depleted, employee benefits may be lost or
reduced, and someone must care for the disabled person. Unless there is adequate
114
replacement income from other sources during the period of disability, considerable
economic insecurity will prevail. This is where insurance and takaful playing a role.
In terms of creating an instant estate in the event of death of the client or an instant
cash in the event of disability or medical condition, no other instrument can match that of
insurance or takaful. Furthermore, in many countries the insurance benefits are protected
against debt and do not form part of the estate.
In short, life insurance and takaful, payable when one dies, can provide a surviving
spouse, children, and other dependents the funds necessary to help maintain their standards of
living, help repay debt, and fund education.
Figure 20 Conventional Insurance
115
Source: Islamic Wealth Planning and Management book, 2011
Figure 22 Mudarabah Model-General Takaful
116
5.4.6 Transferring Wealth
An important goal of Islamic wealth management is to preserve and plan for
transference of wealth to progeny in a Shariah-compliant manner.While the distribution of
wealth among the heirs will be determined by Islamic inheritance law, there may be a need
for inheritance/estate planning to avoid unplanned problems and ensure transfer of assets in
an orderly manner. One way to do this, particularly in countries that have non-Islamic
inheritance laws (such as the UK), is to use wills to guarantee the distribution of wealth
according to the principles of Shariah.
Another instrument used for inheritance planning during contemporary times is a
trust. Trusts can be used for different reasons such as protection of assets from irresponsible
and squandering heirs, ensuring management and distribution of income according to wishes
of the trustor and Islamic inheritance law, and protection from claims and liability after the
death of the trustor. An important issue related to inheritance is the creation of waqf from the
wealth of a deceased. According to Islamic inheritance law, a person has the right to donate a
third of one‘s wealth. As historically waqf provided many social goods and enhanced
welfare, the creation of waqf can potentially help in fulfilling the social goal of Islamic
wealth management.Thus, an integral component of Islamic wealth management relating to
transferring wealth would be to provide an advice and facilitate the creation and management
of waqf. Inheritance and estate planning is relatively new for the Islamic financial sector with
very few institutions offering these services. Amanah Raya Berhad based in Malaysia is one
of the few institutions providing Sharia compliant wealth transfer services. Unlike
conventional wealth management that focuses on the relatively well-off, Islamic wealth
management would be expected to serve the needs of people from all income groups.
117
Though Islamic finance is a relatively new industry, its growth in its short history has
been impressive. However, there is a general perception that the industry is focussed on legal
compliance and is not fulfilling the maqasid. One implication of fulfilling the maqasid in
wealth management is that all sections of the population should have access to services to
enhance and protect their wealth and leave assets for their progeny. Thus, unlike conventional
wealth management that focuses on the relatively well-off, Islamic wealth management
would be expected to serve the needs of people from all income groups.To meet the wealth
management needs of all sections of the population would require coming up with innovative
and efficient
Shariah-compliant solutions and instruments.While this will require investment in
research and development, some of the solutions may be simple requiring small changes in
the features of a product. For instance, the minimum subscription rates of mutual funds
determine the target client group for the product. A large minimum subscription (say
USD10,000 or more) would imply that the funds are targeted towards the wealthier clientele.
The same product can be made available to a wider client base by simply lowering the
subscription rate to reasonable levels. A good example of an investment product that is
accessible to people with meagre means is the Amana Mutual funds in the USA. With a
minimum subscription requirement of USD250 only, the funds can fulfil the investment
needs for a large section of the population. The study shows that while the Islamic financial
sector has developed various instruments to meet the goals of wealth accumulation and
wealth/lifestyle protection, the development of Shariah-compliant pension schemes and
wealth transference services are still in their infancy. One way in which these two goals can
be realized is to integrate waqf in Islamic wealth management. By facilitating the creation of
waqf through wealth transfer services, a part of the resulting endowments can be potentially
used to provide for the pensions to the elderly with poorer means (as was done historically).
Consequently, encouragement and development of waqf will be one of the key instruments
for fulfilling the maqasid al Shariah in an Islamic wealth management framework.
5.5 How can we differentiate Islamic wealth creation from conventional using
phenomenological model of unity of knowledge derived from the Qur’an?
118
The ultimate phenomenological model of unity of knowledge derived from the
Qur‘an: wealth creation. The subject of wealth creation and its dispensation in Islam follows
from the central theme of unification between the social and economic domains in terms of
the Moral Law. This approach involves the understanding of the general phenomenological
model of unity of knowledge in the Qur‘an. An explanation of Figure 1 is in place. The
domain of Tawhidi purity and completeness of the divine unity of knowledge is treated as
super-cardinal topology (Maddox, 1970). This premise remains primordial in knowledge
formation and its induction of the socioeconomic artifacts, causing thereby, the diverse
domains and their representative variables to be interdependent. The emergent
interrelationships between systemic entities convey the meaning of learning according to
circular causation between both -- the set of state variables and the set of policy and
institutional variables, including the preferences and technology underlying the market
mechanism and choices by which Wealth is formed, exchanged and transferred inter
temporally.
Figure 1 depicts an elementary part of the ultimate phenomenological model of unity
of knowledge (Tawhid). Basic understanding of Tawhid, coming from the study of the
Qu‘ran, leads us to understand that Private Wealth and Social Wealth are not separate. They
are both subjected to ethical considerations that raise further understanding as to how they
can best be used to serve Allah‘s purpose in earth.
Phase 1 in Figure 1 shows that the Moral Law impinges upon Private and Social
Wealth in an interconnected way shown by two-way arrows. Such relations starting from the
epistemological origin (Ω, S) are well-defined (implied by the f-functions). In Phase 2 the
same experience of Phase 1 is repeated but now with evolutionary learning according to unity
of knowledge, i.e. [(Ω, S) →θ] →… Such learning processes combining Phase 1 and Phase 2
continue on in perpetuity.
119
Source: Dispensation of Wealth in Islam
Figure 23 Elementary circular causality between embedded wealth concepts induced
120
5.5.1 Formal description of the Qur’anic phenomenological model: wealth creation
The totality of the Moral Law comprising the super-cardinal topology is the origin of
the theory of knowledge in Islam conveying the unity of the worlds in the light of Tawhid
(Ω). The transmission of Ω in bits takes place through the guidance given to the Prophet
Muhammad (S). S is therefore the transmission mechanism, without which, comprehension
of the sudden entirety of Ω would be impossible. The universe could not hold such an
entirety (Qur‘an, 42:52,53; 59:21). Therefore, the primal origin is combined with the
ontological mapping of S to bring bits of Ω into the world-system.
The world-system, here specified to the theme of wealth, is spanned by the totality of
the market variables, social variables, institutional variables and policy and development
financing instruments affecting wealth creation. All of these are taken up in the light of
simulating a wellbeing objective criterion. The wellbeing criterion measures the degree of
unity of the system attained by learning processes between the variables. This is shown in
Figure 1. Simulation of the wellbeing criterion is necessarily subject to the principle of
pervasive complementarities between the diverse system-variables. The estimated wellbeing
function and circular causation relations undergo improvements to reflect higher levels of
unification of learning relationships between the variables, their agencies and the relational
causality.
Since the functional realization of unity of knowledge is premised on both (Ω, S) and
encompasses all systems, therefore, (Ω, S) is the unique and universal epistemology of the
Islamic universe (Choudhury, forthcoming). From this topological space arise specific
relations denoted by fi. fi conveys the ith relationship connecting the consciousness of (Ω, S)
in the formation of ith form of wealth, i = 1 (Private), 2 (Social), as shown in Figure 1.
fij, i,j = 1,2 denote the causal relationships between Private and Social variables of wealth.
The components of wealth formation are denoted by (X1(θ), X2(θ)).
121
Since the Moral Law is unique to both components of wealth and their systemic
interrelationships, therefore, a common knowledge-flow (θ) is derived from a set of
discoursed values. θ-values represent know-how and ways and means of bringing about
complementary relationships between the private and social kinds of wealth, i.e. in terms of
their variables.
A common θ-value is thereby developed discursively by means of interaction and
integration (consensus) between the entities involved in the discourse and by noting the
ontological relations of the complementarities formed by the selected wealth and wealth-
related variables that play critical role in wealth creation according to the general system of
ethical causality between the variables. Thus the consensual (integrated) θ-value denotes the
limiting value of many discursive θ-values over learning spaces by interaction, on the issues
at hand. The formation of such a limiting θ-value also determines simultaneously the
corresponding X(θ)-vector. We then have the tuple of the world-system pertaining to the
theme of wealth. With X(θ) = (X1(θ), X2(θ)) and θ-value we denote the learning tuple by Z(θ)
= (θ, X(θ)).
In Islam, the discourse medium is referred to as the Shura. The ontological insight for
understanding the unity of knowledge in the study of pervasively complementary variables is
known as Tasbih. Degrees of Tasbih inculcated represent the worshipping consciousness in
all things, including man who searches for it. Tasbih is the attribute of knowledge. It enables
the worshipping and ontological potential of moral becoming in the unified world-systems.
The Shura (thus, θ) induced by Tasbih (T), that is the formation of θ(T), leads to the
determination of ways and means, the policy-instruments and moral guidance according to
the divine law of unity of knowledge gained from (Ω, S).
By combining the elements of the Tawhidi epistemology we obtain the following
primal relationships. The entire system of interrelations shown here is also referred to as the
Tawhidi String Relations (TSR).
122
Source: Dispensation of Wealth in Islam
In the case of wealth creation we need to study the specific interrelations between
selected policy and development financing instruments that together play key roles in
bringing about complementarities between the variables of various learning relations.
5.5.2 Preference formation, market mechanism and instruments of wealth creation in
Islam
Having explained the meaning of wealth in Islam and its pervasively complementary
relations in the Private and Social domains according to the Moral Law, next we examine the
methods by which wealth is generated using expression (1) in the light of Figure 1. The
vector Z(θ) is now extended with more interaction involving limiting {θ}-values (= θ)
Pertaining to the individual components of Z(θ). These additional entries denote
complementary socioeconomic variables and development-financing instruments for wealth
creation. In this wider description of
Z(θ) = (θ, X1, X2, P1, P2, P3, P4, M1, M2, M3)[θ] (2)
Figure 24 Continuous learning processes in the Tawhidi phenomenological
model of unity of knowledge
123
The following extra variables are defined: P1 denotes trade. P2 denotes spending in the
good things of life. P3 denotes charity. P4 denotes the inversion of the rate of interest towards
zero, resulting from the exercise of participatory development-financing instruments. M1
denotes Profit-sharing, cost-sharing financing contract. M2 denotes equity-participation.
M3denotes trade financing and cost-plus financing contracts. M4 denotes secondary Islamic
financing instruments, e.g. unit trust shareholding. The appearance of [θ] outside the bracket
means that each of the inner variables is induced by the limiting θ-value derived from the
Moral Law of unity of knowledge through Shura discourse. The systemic interrelationships
between the components of the extended Z(θ)-vector establish the pervasively
complementary and hence symbiotic learning system. The model of this complementary, and
hence participatory learning system, is derived from the Qur‘an within expression (1) in light
of Figure 1.
We refer here to the verses of the Qur‘an (2: 161 – 175). A summary of the
socioeconomic general ethico-economic model in respect of wealth formation as derived
from these verses is provided in Figure 3. The complex nature of joint and compounding
relations among the socioeconomic variables and the financing instruments are represented
by the functions gijkl, g‘ijkl, hijkl, h‘ijkl, qijkl, q‘ijkl, tijkl, t‘ijkl, wijkl, w‘ijkl; i,j,k,l = P-vector, M-
vector as shown in Figure 2. These relations are logically interconnected by compound maps.
The result is decreasing interest rates ‗i‘. The learning processes continue.
Figure 3 points out the compound effect of the socioeconomic variables supporting
wealth creation and complementarities in the Private and Social domains. Such extensive
complementarities are established by applying the development-financing instruments as
mentioned above. These together, through their participatory nature, help to mobilize
financial resources, as by the P-vector, into the real economy rather than being held-up in
savings. Deepening linkages between money, participatory financing instruments and the real
economy present the sure way of reducing interest rates toward zero, while increasing the
124
productive and morally mandated use of financial resources into cooperative ventures
Figure 25 Extending the learning relations of wealth creation
The continuously learning processes of Figures 1 and 2 combine with the choice of
dynamic basic-needs regimes to set up the development model of the Islamic socioeconomic
order. In it, individuals and socioeconomic entities play their conformal roles in Islamic
transformation. It is logical that with heightened resource mobilization the circular causation
between increasingly spending in the good things of life, trade, charity and the dynamic
basic-needs regimes of development will militate against interest rate. Interest rate is thus
phased out in the above-mentioned ethico-economic general equilibrium system according to
a learning process.
Wealth is thus created by productive transformation in an extensively participatory
economy with pervasive complementarities. The latter characteristics signify systemic unity
of knowledge caused by interrelations. This is the result of the Tawhidi unity of knowledge in
the organization of economic, financial and social sectors with complementary linkages
between them. The rate of return on spending in the good things of life represents the
productive growth factor that accumulates wealth. Mobilizing money into the real economy
in view of the extensively participatory, productive and ethical consequences of the general
system of interrelationships bring about accumulation of capital. Thus wealth accumulates
thereon once it is formed by means of enhancing the learning linkages between
socioeconomic and policy instruments that promote systemic unification over subsequent
phases of learning. The formulas for wealth creation, accumulation and evaluation are given
below.
125
5.5.3 Valuation of wealth according to the Tawhidi worldview
The accumulative valuation formula for wealth in Islamic perspective is,
W(θ, t) = I0,ijkl Σt[(1+rijkl)[θt]]t (3)
t is time period at the time financial returns are declared.
Expression (3) is a simplified form of a single rate of return across i,j,k,l kinds of
investments and resource mobilization outlets using the complementary financing means.
When the rate of return is variable according to time-dependent θt-values then with the net-
of-deduction rate, dt, the wealth valuation formula is,
W(θ, t) = I0,ijkl Σt[Πt(1+rijkl)[θt]](1-dt) (4)
Other specific formulas can be constructed. The important point to note is that r ijkl is a
profit-sharing rate in the case of individual shareholders of Islamic wealth creation outlets,
such as Islamic banks. In the case of Social Wealth, rijkl denotes profit rate. But since Private
and Social Wealth are complementary entities under the Tawhidi worldview, therefore, the
profit-sharing rate must be a definite function of the profit rate. This is shown as follows:
Let π denote total profit over all complementary projects (i,j,k,l) attained by resource
mobilization.
πijkl denotes total profit in any one set of (i,j,k,l) compounded project.
πijklI denotes πijkl for the Ith individual.
I denotes the Ith individual‘s share of π.
By definition πijklI = ρijkl
I . π
Thereby, rijklI = dπijkl
I/πijkl
I = r + dρijkl
I/ρijkl
I.
r denotes the profit rate (dπ/π); dρijklI/ρijkl
I denotes rate of change in the profit-
126
sharing ratio over (i,j,k,l)-compounded projects for Ith individual. Furthermore, if the
rates are summed over all individual, the result is over (i,j,k,l) complementary, that is
interlinked projects:
rijkl = n.r + dρijkl/ρijkl, n being the total number of individuals.
In other words, average rate of return for each individual over the (i,j,k,l)
compounded projects is given by,
rijkl/n = r + (1/n).(dρijkl/ρijkl) (5)
(1/n).(dρijkl/ρijkl) denotes the average rate of change in the profit-sharing ratio. This is the case
of variable type M1, M2, M3, M4 mentioned earlier.
5.5.4 An integrative view of wealth creation according to the Tawhidi worldview
Extension to the wealth vector of the form in expression (2) now results in a further
development of Figures 1, 2 and 3. The resulting complete picture incorporates growing
interaction between the elements of the wealth vector. According to the Qur‘anic
phenomenological model, Interactions (I) lead into socioeconomic complementarities. Such
an attained complementary state is referred to as Integration (I). Interaction leading to
Integration (thus II) in learning processes yields co-Evolution (E) of similar II-processes
across expanding ranges of the learning relations between knowledge-induced variables in
the wealth-vector (Sztompka, 1991). Hence the learning phases shown in Figures 1 and 2 are
characterized by the IIE-processes of learning in unity of divine knowledge in the light of the
Qur‘an. Now the entire wealth creation phenomenon is shown to be induced by the
epistemology of Tawhidi unity of knowledge as described above.
This study refers to such a complete relational learning model as the
127
phenomenological model of unity of knowledge. It is universal and unique in nature. It is
distinct from all received citations in the literature. The distinctiveness is particularly due to
the primal epistemological string relation, [(Ω,S) →] → {θ(T)}, which is permanently
‗recalled‘ in every social action and response across evolutionary learning processes.
Subsequent to this epistemology, the problems of social equity, distribution and participation
by sharing among all are addressed in the light of Tawhid in reference to the
phenomenological model.
Figure 4 shows that between phases of learning in continuum there is socio-scientific
evaluation of the degree of unification of knowledge that was realized in the previous phase
of learning. The evolutionary processes chart out how one level of learning in unity of
knowledge (complementarities) can be further improved by considering fresh socioeconomic
variables, policy variables and development-financing instruments according to their
relational specifications. The objective criterion is called the Social Wellbeing Function of
the common good in the light of the Qur‘an. Shatibi (trans. Draz, undated; Biraima,
1998/1999) wrote on such an Al-Maslaha wa al-Istihsan Function.
In this way, wealth creation becomes a simulation exercise. It shows how wealth, seen
as all possible material acquisitions with value, is utilized for the common good according to
the Islamic Law, and is generated by means of complementary relations expressed by circular
causation between the critical variables. The knowledge-induced simulation proceeds on
repeatedly across IIE-phases of learning along the TSR from the beginning to the end. The
Qur‘an declares (92:13): ―To Him belongs the End and the Beginning‖. An interpretation of
this is the closure of the TSR as the representation of a complex topology of continuous
relations (Maddox, 1970).
128
129
ρijk
l
130
131
In the case of wealth creation the simulation model of Social Wellbeing Function
(SWF) is formalized as:
Figure 26 Simulation of Social Wellbeing Function subject to circular causation
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5.5.5 Wealth creation the complete Tawhidi phenomenological model of unity of Qur’anic
knowledge
Source: Dispensation of Wealth in Islam, 2012
In light of the building blocks of the Qur‘anic phenomenological model, Thıs Figure
delineates that model as applied to wealth creation in the light of the foregoing discussions.
Figure 5 is understood as a combination of previous figures.
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5.6 Banks are shifting capital away from risky institutional businesses to wealth
management but challenges remain: What is the key investment decision processes for the
private (wealth management) banks? And how they manage portfolios of private clients?
What are the differences from the Islamic wealth managements structurally? A case of
J.SAFRA SARASIN Private Bank in Switzerland.
The case of Investment decision process: Private banking discretionary mandates,
Organizational unit: Portfolio management of Private clients of High Net Worth Individuals
(HNWI).
5.6.1 Investment Goal
Returns are expected to be comparable with a certain benchmark (relative).Every profile
has a Strategic Asset Allocation (SAA), see benchmark for the following table: which provides
the basis for investments and performance calculations. Annual and Long-term returns should
mirror the selected risk profiles by clients.
5.6.2 Investment Philosophy
Our way of thinking about the economy and markets is best reflected in our cyclical
approach. While this is a fundamentally-driven and easily-explainable investment approach, it
can also be reflected in an asset allocation model (Scorecard). This disciplined Model is
important for process-driven institutional clients and ever more sophisticated private clients. We
distinguished between four different asset classes: cash, bonds, equites, and alternative
investments.
Cash is only foreseen in home currency for SAA and TAA performance calculations.
In bonds, the SAA comprises of home bonds, Emerging Market and High Yield Bonds,
both on a hedged basis. (As in BM overview).
In equities, roughly weight home equities by 60% world by 40%, whereof developed
and emerging equities have as well a 60/40 regional split.
Alternative investments can include any liquid investment according to BM overview.
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Private clients tend to be asymmetrical in their risk tolerance and risk steps to protect
capital in adverse market conditions. An absolute performance dimension should be considered
in setting the investment policy as in the following sections in Asset Allocation and Portfolio
hedging.
5.6.3 Decision and Investment Process
Asset Allocation
In house developed asset allocation model of the bank( Scorecard) is at the core of our
disciplined investment process. While the historical back testing of the model shows a strong
outperformance and is very robust, we aim to contiously improve the model. In the investment
process we use the models signal as a compass for our investment decisions: if the signal is
positive equities are likely to outperfom bonds, if the signal is negative equities are likely to
underperfom bonds. The quantitative input from the model is challenged by the qualitative input
of the investment proffesionals in the investment committee Bank J.Safra Sarasin (ICBJSS). The
IC BJSS decides on the level of conviction for the equity weighting, which is between neutral
and the respective maximum deviation(three notches).
The decision is taken on the basis of quantitative and qualitative factors in a democratic
voting process. Each of the voting members has one vote. Decisions are valid if the majority of
votes is present in person or by telephone. In case of a tie the chairman has a casting vote.
The Tactical asset Allocation Committee (TAAC) is a sub-committee of the IC BJSS and
defines the TAA for private Client portfolios in more detail. The target is to outperform the
benchmark with relative over/underweight positions in the different asset classes.
5.6.3.1 Security Selection
General Guidelines
Every asset class committee selects all securities for any model portflolio from the
respective buy list. The list will be approved by TAAC and is regularly monitored for
performance management and absolute and relative risks. ETFs shall allow switt TAA shifts in
any asset class. Diversified holdings are weighted more heavily than single securities.
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5.6.3.2 Alternative investments and Bond Selection(AIBOS)
Fixed income management in home bonds is performed by AMBO and the Fixed income
committee (FIC) According to the IDP fixed income portfolios by AMBO, Private client
accounts hold home bonds via a building block.
The AIBOS Committee (some of its memebers are attending the FIC) meets on a monthly
basis (or more frequently if needed) has performance responsibility and selects and develops
structured fixed income and alternative products, funds (own and third party funds). Emerging
market bonds (EM), high yield bonds (HY),and foreign exchange denominated bonds(Fx), for all
sub asset classes a maximum overweight of 10% each is allowed. The AIBOS decides upon the
method of implementation and exit of any security.
Single bonds issues should have at least a minimum rating of BBB+ (Baa1) to be
purchased. Diversified products may comparise lower rated bonds down to ccc but should on
average be rated as investement grade (except EM and HY bonds). Bonds, money market
instruments and structured products are chosen according to issuer, yield level, rating, and
duration.
5.6.3.3 Stock Selection
SPM Equity meeting (SEM) meets monthly (or more frequent if needed) has performance
responsibility and selects and develops structures, funds, ETFs and maintains together with the
regional strategy meetings the equity portfolios for switzerland, Euroland, US and UK. A list of
Avaloq portfolios is attached (MoPo card). For equities world (Developed and Emerging) a
uniform approach across all model portfolios is applicable.
5.6.3.4 Fund Selection
All funds which are proposed to the TAAC for the buy list must be analysed by
portofolio management and fund research. Both porttofolio management and fund reasearch can
make proposals to include or exclude a fund from the fund buy list. All funds on the buy list are
checked and reviewed regularly. Entire SPM should not hold more than one third of a J. Safra
Sarasin Fund, not more than 20% of a third party fund. For now fund launches , these levels can
be exceeded for a period of 12 months. Selecting ETFs requires the consideration of counterparty
risks and security lending.
Security Universe Committee
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The Security Universe COMMITTEE(SUC) oversees the conformaity and legitimacy of
all invested securities for all SPM mandates. All holdings of OekoSar Equity Global (Avaloq BP
XYOEKEQUG) or one of the fixed income sustainable funds are approved automatically. For
any securities which don‘t qualify an internal rating shall be assigned by research (REES,
AMSR). These securities are maintained on Avaloq BP 5161421. Procedures for security
approval: The SUC meets on demand interim approval by email are valid with at least 3
overlapping yes-votes (eg. 5:2 or 3:0 depending on availability).
5.6.3.5 Portfolio Construction/ Model portfolio
Based on the TAA decided by the TAAC. SPM derives model portfolios for all SPM
Investment profiles. Model portfolios must be closely aligned to the strategy views of the IC
BJSS and reflect the current TAA as closely as possible.
Each model portfolio is monitored by a portfolio Manager who is responsible for content
of the portfolio, Position sizes, attractiveness and competitiveness as well as performance
monitoring and explaining deviations from SAA/TAA on a realtive basis. Quantative results of a
portfolio construction tool or risk analysis versus benchmark shall be used in optimizing each
model portfolio . The model portfolio meeting (MoPo meeting) is chaired by the head SPM or
his deputy and generally meets weekly. Our model portfolios with daily upload on SaraNet are
maintained on Avaloq (virtual) and are used as a feeder into offerttool. Furthermore the
performance are published monthly basis. All availabe sales documentation, handouts and
investment proposals rely on thesis portfolios.
5.6.3.6 Portfolio Implementation
Primarly, the SPM Implementation Team is resposnsible for adherence to policy
according to the transaction execution process. However, each PM is asked to manage all
assigned portfolios according to the respective Avaloq model portfolio. Ashift in asset allocation
has to be implemented within 5 days. Intended trades are implemented within 2 days. All
portfolios must be with within a tolerance band of +/-5 percentage points of the respective TAA
for any given asset category. The SPM Implementation Team will execute any trade for all
accounts with the same risk/return charecteristics unless a written instruction prevents from
doing so (e.g . signed client restriction, portfolio on hold by written CRM request).
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When a mandate is opened or a risk profile changed , the portfolio should conform to the
actual TAA and Model portfolio within one month unless the client has given written
instructions to proceeddifferently.
5.6.3.6 Documentation and communication of Investment decisions
After the meeting the chairman of the ICBJSS is resposible for the translation of the
decision in the TAA framework and the communication of the decisions. The IC BJSS decisions
are documented in the meeting minutes. The current TAA and all publications are available on
SaraNet and in printed version. All investment decisions taken in the selection committees are
documented and stored. The performance will be measured by AMS or another department.
Porfolio Hedging
The absolute performance orientation shall further be achieved in allowing hedges by
using derivatives, Futures, options, forwards and other instruments might be suitable to
accomplish investment calls.
The TAAC can specifically demand hedging A. the equity portion down to lower band
of SAA. B. the currency exposure. C. the exposure in fixed income securities (credit, duration),
all of these steps should generally be seen as risk reductions or implentation easiness for a client
portfolio.
5.6.3.7 Specific Mandates
Capitalised mandates:
Capitalised mandates follow the investment process of normal SPM accounts. Investment
exposure is achieved via capitalised funds across all asset classes. All income and any kind of
distribution are prohibited. Liquidity may be not investments in fiduciary calls or deposits. Fixed
income investment must be via mutual fund (SICAV) and exclude all European savings directive
status for Redemtion and status for distribution. Equity only SICAV funds with no distribution.
Equity funds with dept exposure, max 25% dept, structured products allowed if they do not
distribute and do not contain embedded short option Hedging allowed.
Capital/income separation mandates:
Capital/income mandates follow the investment process of normal SPM accounts and are
designed for clients who report capital and income gains separtely. Capital and income gains are
taxed differently incertain legislations notably the united kingdom and in common law trusts.
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Direct equity and bond investment are fine as long as no form of income or distribution is
capitalised. Funds are allowed if they are distribution only. Commidity funds invested in futures
that use bonds as colleteral are prohibited as income generated is reinvested. Structured products
are acceptable if only coupon is distributed.
5.6.3.8 Implementation Guidelines
Benchmark/Strategic Asset Allocation
The current investment policy private banking is attached to this IDP. A review is
undertaken annually by the Research, portfolio management and the IC BJSS.
Portfolio Restrictions
The TAA exposures may deviate from SAA by a maximum of +/-20 percentage points
for bonds and Equities and +/-10 percentage points for alternatives.The maximum allocation per
security and by issuer is 10%, except for investment funds. Government bonds, state guaranteed
bonds, special guaranteed structured products so called colletral secured instruments (COSI) and
exposure with Bank J.Safra Sarasin (maximum 20%, excluding liquidity) aggregate holding in
structured products and bonds are subject to above mentioned issuer limitations.
Bonds downgraded to below BBB (E.g Baa3, BBB-) require a sell within 30 working
days.
Securities which are no longer rated investable by the J. Safra Sarasin Sustainability
Matrix have to be sold within 30 working days for the pure offering.
Stocks which are rated (reduce) by AMSR may not be kept in accounts unless client
instructions or restrictions in wrting request holding. They have to be sold within 5
working days.
5.6.3.9 Risk Management and Controlling
Compliance Risk
The portfolio manager is responsible for the pro-trade compliance of the transactions with
the portfolio‘s investment guidelines.
The main controlling instruments are:
Monitoring by portfolio manager.
Ex-post compliance control on mandates by MFC using AVALOQ.
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Main focus is given for fulfilment of client restrictions, maximum countarparty Risk and
concentration risk in single securities, leverage and bandwidths. All guidelines have to be in
compliance according to the directive. Within Equities, the bandwidth of +/-5% for the control of
the regional breakdown of Home/World (Developed/Emerging) is not applicable as too many
collective investments constituents from several regions (e.g waterfund, sector ETFs, Stoxx600).
Any violation in accounts has to be reported and corrected with 10 working days, for
subsequent failings line management must be advised on the misbehaivior both in Private
banking, trading and family offices and APS.
Operational Risk
The portfolios operational Risk is determined by the standard risks associated with the
investments. Where efficient and appropriate security orders are placed with the execution desk
which guarntees best execution standards. Performance risk of a client portfolio is monitored on
an ongoing basis versus a comparabe portfolio and sample portfolios on Avaloq.
As this Bank have customers from Muslim countries of High and Intermediate Net Worth
Individuals, in the point of view of Investment decision process of the Bank is Shariah Screening
process, they use in this process of S&P Shariah Index
5.7 Offerings Shariah Applied Investment
Shariah application enables Muslim and even non-Muslim investors to create a Shariah
substitute based on existing transparent solutions. They use mostly S&P Shariah compliant index
which provides investors with a comparable and investable index while adopting explicit
investment criteria defined by Islamic law as defined by the Koran. The wide range of indices
caters to all kinds of investor needs, including capital protection, and geographic and sector
diversification. The three main Shariah Index Series available are listed below.
• The S&P Global Benchmark Shariah Index Series is comprised of developed and emerging
benchmark indices.
• The S&P Global Investable Shariah Index Series includes regional and country indices that are
both representative of each market and have high correlations to their underlying indices.
• The S&P Global Strategy Shariah Index Series includes indices in specific strategy, property,
infrastructure, and healthcare sectors.
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5.7 Muslim Clients Sharia Screening
All underlying index constituents are screened for compliance with the laws of the Koran
to be eligible for inclusion. The Bank uses with reference of Shariah screening carried out by
Ratings Intelligence Partners (RI), a Kuwait-based consulting company specializing in solutions
for the global Islamic investment market. RI works directly with a Shariah Supervisory Board, a
board of Islamic scholars who interpret business issues and recommend actions related to the
indices. Both groups collaborate with the bank Committee in applying a set of independent and
objective guidelines for the day-to-day maintenance of each Shariah index.
Shariah compliance screenings for the underlying index constituents occur continuously, and
typically fall into two main categories:
5.8.1 Sector Based screening.
Certain businesses offer products and services that are considered unacceptable or
noncompliant. Examples of these activities include gambling, investment management,
pornography, and alcohol.
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5.8.2 Accounting Based screening
Certain company financial ratios may violate compliance measure; three areas of focus
are leverage, cash, and the share of revenues derived from noncompliant business activities. As
some of these restrictions may not be absolute, the Shariah Supervisory Board makes compliance
determinations on an index-by-index, stock-by-stock, or similar basis.
Major Findings of the Study
In response to the major issues, the overall findings indicate that the extent of correlation
and comparison of wealth management (Conventional and Islamic) In terms of the terminology,
there is no fundamental difference between Islamic and mainstream of wealth management
system. Notwithstanding this fact, Islamic wealth management system is different from its
conventional counterpart in terms of principles and objectives.
The major findings of comparing Asset (wealth) Allocation and Performance of (Risk-
Return Profile of Optimized Portfolio) of Islamic and Conventional system, suggest (a) that
Islamic equities are more vulnerable to a financial turmoil caused by the deterioration of the real
sector in the economy. Conversely, mainstream equities are suspected to be more vulnerable to
the catastrophe in the financial sector. This happens because of the exclusion of the financial
sector in the Islamic equities through Shariah screening criteria, (b) that equities from the
European and North American markets would be superior investment instrument and thus better
portfolio components in terms of higher marginal benefits during the 1997 Asian financial crisis,
(c) that Asian equities would be superior diversifier in terms of higher marginal benefits during
the 2008 global financial crisis, (d) that gold would be a major diversifier when all equities in
general and Islamic equities in particular experience major downturn and (e) that most of the
commodities except for gold gradually became less important components for a diversified
portfolio. If we look at the primary objective, to determine the Islamic perspective of wealth
management would require understanding the goals and principles of sharia, and realize the
objectives of Islamic law (Maqasid al-shariah) to safeguard the faith, self, intellect, posterity and
wealth, Other than fulfilling the legal injunctions85
(chapra2008 and ibnuAshur 2006).
85 chapra2008 and ibnu Ashur 2006
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The objective of Islamic commercial law would be to protect and enhance one or several
of these goals. Commercial transactions are sanctified and encouraged as these enhance and
support wealth and progeny86
(Hallaq 2004). According to the wealth creation In Islamic
highlights the comprehensive TSR as the Qur‘anic Phenomenological Model with Wealth
Creation Which is expanding the socioeconomic domain of complementarities linked with
wealth formation at higher levels of moral consciousness in Islam, and setting of policy and
development financing instruments in Islamic wealth creation.
We addressed investment strategies and decisions for investments of the bank of J.safra
Sarasin, of Private wealth manager‘s banks which have also double window as it offers Islamic
wealth management using sharia screening process for Muslim clients and the employ these two
methods for screening: Sector Based: Certain businesses offer products and services that are
considered unacceptable or noncompliant. Examples of these activities include gambling,
investment management, pornography, and alcohol.
Accounting Based: Certain company financial ratios may violate compliance measure;
three areas of focus are leverage, cash, and the share of revenues derived from noncompliant
business activities. As some of these restrictions may not be absolute, the Shariah Supervisory
Board makes compliance determinations on an index-by-index, stock-by-stock, or similar.
86 Hallaq 2004
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CONCLUSION AND SUMMARY OF FINDING
Conclusion
This study, taking into account the main issues, investigates the wealth planning and
management from Conventional and Islamic perspectives. Furthermore, this study would like to
investigate how Islamic wealth management (IWM) is distinguished from conventional wealth
management?
In order to support the main objectives of this study, which are, to investigate the asset
(wealth) allocation of optimum portfolios and risk-return profiles of the optimized portfolios
combining equities (conventional and Islamic) and commodities? And to know the key goals and
instruments for Investment and wealth accumulation, retirement Planning and Schemes, wealth
and life style protection, Role of Insurance and Takaful in wealth planning and transferring
wealth comparing it applicability in sharia, as well as to examine the wealth creation from
Islamic perspective and it is difference from the conventional system, finally to investigate
investment decision process of private banks who manages wealthy of High Net worth
Individuals which has double window system of Conventional and Islamic. This study employed
most appropriate methods for collecting data such as Markowitz Portfolio Model (MPM), Sharpe
ratio of Portfolio asset allocation & performance (conventional and Islamic equity :( 1996 –
2003) (2004-2012) data collected from S&P Global BMI is a comprehensive based index
measuring global stock market performance, which comprised of Developed and Emerging, also
Highlights diversification benefits of the concerned portfolios of Islamic and Conventional vary
across time in general and squeezes gradually over the study period. The composition of
optimum portfolios varies across episodes, in minimizing the risk level of the portfolio also
Islamic equities-commodities portfolios according to results, failed to provide higher
diversification benefits in comparison with their conventional counterpart due to the smaller
asset universe of Islamic equities owing to quantitative and qualitative Sharia screening process.
This study suggests also that in order to determine the Islamic perspective of wealth
management would require understanding first the goals and principles of sharia, and realize the
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objectives of Islamic law (Maqasid al-shariah) to safeguard the faith, self, intellect, posterity and
wealth, Other than fulfilling the legal injunctions related to wealth management.
In Islamic wealth creation highlights the comprehensive TSR as the Qur‘anic
Phenomenological Model with wealth creation which is expanding the socioeconomic domain of
complementarities linked with wealth formation at higher levels of moral consciousness in Islam,
and setting of policy and development financing instruments in Islamic wealth creation. We also
find that Private wealth manager‘s bank which has also double window system, as it offers
Islamic wealth management using sharia screening process for Muslim clients and employs two
methods for screening of Muslim client‘s investments: Sector Based: Certain businesses offer
products and services that are considered unacceptable or noncompliant. Examples of these
activities include gambling, investment management, pornography, and alcohol.
Accounting Based: Certain company financial ratios may violate compliance measure;
three areas of focus are leverage, cash, and the share of revenues derived from noncompliant
business activities. As some of these restrictions may not be absolute, the Sharia Supervisory
Board makes compliance determinations on an index-by-index, stock-by-stock, or similar.
Summary of the Findings
Methods Objective Major Finding
Markowitz
portfolio model
(MPM), Sharpe ratio Portfolio
1.To investigate the asset
(wealth) allocation of
optimum portfolios and risk-
Highlights that diversification
benefits of the concerned
portfolios of Islamic and
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asset allocation &
performance (conventional
and Islamic equity:(1996 –
2003)(2004-2012) data
collected from S&P Global
BMI is a comprehensive
based index measuring global
stock market performance,
which comprised of
Developed and Emerging.
return profiles of the
optimized portfolios
combining equities
(conventional and Islamic)
and commodities.
Conventional vary across
Time in general and squeezes
gradually over the study
period.
The composition of optimum
portfolios varies across
episodes, in minimizing the
risk level of the portfolio also
Islamic equities-commodities
portfolios according to results,
failed to provide higher
diversification benefits in
comparison with their
conventional counterpart due
to the smaller asset universe of
Islamic equities owing to
quantitative and qualitative
Shariah screening process.
Used Data collected from
different sources of wealth
management like books,
articles and research papers.
2.To investigate the key goals
and instruments for
Investment and wealth
accumulation, retirement
Planning and Schemes, wealth
and life style protection, Role
of Insurance and Takaful in
wealth planning and
transferring wealth comparing
it applicability in sharia?
Suggests that in order to
determine the Islamic
perspective of wealth
management would require
understanding first the goals
and principles of sharia, and
realize the objectives of
Islamic law (Maqasid al-
shariah) to safeguard the faith,
self, intellect, posterity and
wealth, Other than fulfilling
the legal injunctions related to
wealth management.
SOMALI INSTITUTE FOR RESEARCH IN ECONOMICS & STRATEGY +252-615868651-Somalia - +90-5532645616- Turkey
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Used (TSR) Tawhidi String
Relations as the Qur‘anic
Phenomenological Model with
Wealth Creation
3.To examine the wealth
creation from Islamic
perspective and it is difference
from the conventional system?
In Islamic wealth creation
highlights the comprehensive
TSR as the Qur‘anic
Phenomenological Model with
Wealth Creation Which is
expanding the socioeconomic
domain of complementarities
linked with wealth formation
at higher levels of moral
consciousness in Islam, and
setting of policy and
development financing
instruments in Islamic wealth
creation.
Field Research 4. To investigate investment
decision process of private
banks who manages wealthy
of High Net worth Individuals
which has double window
system of Conventional and
Islamic?
Private wealth manager‘s bank
which has also double window
system, as it offers Islamic
wealth management using
sharia screening process for
Muslim clients and employs
two methods for screening of
Muslim client‘s investments:
Sector Based: Certain
businesses offer products and
services that are considered
unacceptable or noncompliant.
Examples of these activities
include gambling, investment
management, pornography,
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and alcohol.
Accounting Based: Certain
company financial ratios may
violate compliance measure;
three areas of focus are
leverage, cash, and the share
of revenues derived from
noncompliant business
activities. As some of these
restrictions may not be
absolute, the Shariah
Supervisory Board makes
compliance determinations on
an index-by-index, stock-by-
stock, or similar.
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