Managing a Shariah-Compliant Capital Protected Fund through Turbulent Times

Discussion Questions

It was 2 July 2009, 13 months since the launch of the first Shariah-compliant Meezan Capital Protected Fund (MCPF) by Al Meezan Investment Management on 18 May 2008. During this period, the colossal decline in the equity markets as investors rushed to less risky investments on the back of the global financial crisis seriously dented investors’ confidence in the financial system. The MCPF was targeted at the conservative investors seeking principal protection along with upside exposure to equities through Shariah-compliant products and securities. Farhan Lakhani, the fund manager of MCPF, had successfully steered the fund through its inception, but its lacklustre performance to-date was a source of concern. Unlike most equity funds, which had experienced an unprecedented drop in value during this period, the MCPF had not only preserved its capital but also managed to generate a small positive return of over 1 per cent in terms of net asset value (NAV). ¹ After that, Farhan was challenged to enhance fund’s returns to meet investor expectations as equity markets recovered from their historic lows. The fund’s investment committee meeting was scheduled two days later. The committee had asked Farhan for an update on MCPF’s performance and to present his investment strategy to ensure a healthy return to the fund investors going forward. Farhan’s immediate task was to carefully review some of the key strategy choices and share his recommendations with the investment committee in the upcoming meeting.

Al Meezan Investment Management Limited

Al Meezan Investment Management Limited (Al Meezan Investments) was established in 1995 as a joint venture between Pakistan Kuwait Investment Company, National Investment Limited and Jardine Fleming Investment Management International Limited. It was a non-banking finance company (NBFC) that was licensed to perform asset management and investment advisory. ² Al Meezan Investments was one of the pioneers in the private sector mutual funds and the only exclusively Shariah-compliant asset management company in Pakistan. Its vision was to make Shariah-compliant investments the first choice for investors and the mission to be recognized as a leading and trusted brand for savings and investments by offering innovative Shariah-compliant solutions. ³

Al Meezan Investments specialized in investment management. The company was involved in developing, launching and managing both open and closed-end funds. It provided investment advisory and portfolio management to institutional as well as high profile clients. It had allowed its clients to meet their investment requirements in a truly Shariah-compliant manner. Al Meezan Investments offered a wide range of equity and income funds along with other investment products such as balanced funds, cash fund, and pension fund. The capital protected fund (CPF) was established, especially to cater to the needs of investors with low-risk tolerance. Al Meezan Investments had achieved phenomenal growth in assets under management (AUM) over the past several years. The company had a total AUM of PKR13 billion as of June 2009 in mutual funds and discretionary portfolios.

All the Al Meezan investment products, mandates, and solutions were completely aligned with Shariah principles as approved by the eminent scholars on its Shariah supervisory board. The Shariah board typically provided guidance on investment products and fund structuring to ensure the Shariah compliance. Any decision given by the board pertaining to Shariah matters was binding on the fund manager. More details on relevant Shariah guidelines are provided in Table 1.

As a leading asset management company of Pakistan, Al Meezan was assigned a high management quality rating of AM2+ by JCR-VIS credit rating agency. Al Meezan also complied with the Global Investment Performance Standards and made it the only company operating in Pakistan that was compliant with CFA Institute’s asset manager code of professional conduct. These awards and compliance with global standards assured its clients that asset managers practiced the highest professional and ethical standards and clients’ interests first in their decisions. ⁴

Meezan Capital Protected Fund (MCPF)

MCPF was an open-end fund structured according to the Shariah guidelines and launched on 18 May 2008. It was the first Shariah-compliant CPF offered in Pakistan that catered to the needs of investors seeking exposure to equities while preserving their investment principal amount. The terminology ‘capital protection’ implied that the net realizable value of the investment at the time of maturity would not fall below the principal investment plus a front-end sales load of the fund. In the conventional space, a capital-protected product was typically structured by packaging a zero-coupon bond and a call option on equities or an equity index. The zero-coupon bond provided the capital protection as its discounted value grew to its par value at maturity without periodic interest payments. The discount from the par value of a zero-coupon bond was then used to purchase call options to gain upside exposure on the target equity index.

In the absence of zero-coupon Islamic bonds or Sukuks and ambiguity regarding the acceptance of the available option-like Islamic products across different schools of Islamic scholars, Farhan and the product development team at Al Meezan had a challenging task of structuring a viable principal-protected fund. They devised a simple solution by packaging a Murabaha ⁵ placement deposit and investment in Shariah-compliant equities or other high-risk instruments. The Murabaha placement with an Islamic bank (having a minimum ‘A’ rating) was to secure the investment principal amount at the maturity of the fund. At the inception of the fund, Murabaha deposit funds were placed for three years with Meezan Bank Limited at a rate of 11.75 per cent under the Murabaha structure. Based on the available rate, this discounted value of around 71.66 per cent of total investment accounted for the Murabaha placement was placed in Murabaha deposit, and the remaining 28.34 per cent was used to gain exposure to risky investments (primarily Shariah-compliant equities) to enhance fund’s returns. However, a wide variety of high-risk Shariah-compliant equities and other instruments were permitted as per terms and conditions of the fund and approval by the Shariah committee. The interim returns on Murabaha placement were reinvested in similar deposits or other short-term instruments until the maturity of the fund.

In case of redemption from the fund before its maturity, no capital protection was guaranteed, instead, the investor would receive the prevailing NAV net of the back-end-load surcharge. During the life of MCPF, the returns to investors were to be paid in the form of dividends with the principal amount payable at the maturity. The management company had the discretion in terms of how the profit/returns would be distributed; either in the form of additional units of fund or cash dividends. The dividends were to be paid on the accounting dates. ⁶ For the year ended 30 June 2009, Al Meezan Investments announced a distribution of PKR 0.35 dividends per unit in the form of bonus shares. Table 2 contains a sample of the fund’s NAV from inception to 2 July 2009. In addition to preserving the capital, the fund had managed to generate a positive return of circa 1.13 per cent after adjusting for the bonus shares since inception.

MCPF was launched on 18 May 2008, when the Karachi Stock Exchange (KSE) 100 Index had retracted slightly from its all-time peak value of 15,760 on 20 April 2018. Having locked-in the Murabaha rate to preserve the principal amount at the inception of the fund, Farhan was very optimistic about generating significant positive returns from the fund’s exposure to Shariah-compliant equities. But then the second half of 2008, proved to be the most disastrous year for the global financial markets and a nerve-racking year for the fund manager. ‘In such a turbulent period, investors are somewhat reassured that at least their principal amounts are intact’, Farhan observed. However, as equity markets started to recover from their historic lows in the second quarter of 2009, investors became somewhat sanguine about the prospects of their investments putting pressure on the fund managers to perform. Farhan assembled the KMI 30 data (Table 3) for the period following the lifting of the floor value on the KSE 100 Index to ascertain if any meaningful trends in the data were discernible to formulate an appropriate return enhancing strategy. He also collected the Karachi Interbank Offered Rate (KIBOR) data (Table 4) as a proxy for the Murabaha rate and estimated the likely quarterly returns until the maturity of the fund.

The Global Financial Crisis and the KSE Debacle

The global financial crisis of 2007–2008 was arguably the worst year for financial markets since the great depression of the 1930s. The crisis began in 2007 with the US subprime mortgage market collapse followed by the fall of Lehman Brothers on 15 September 2008. The Dow Jones Industrial Average dropped to 10,917 the next day from its highest value of 14,164 on 9 October 2007. To prevent the collapse of the world financial system and its cascading effect, massive bailouts of financial institutions and fiscal policy adjustments were deployed by the national governments to stem the fallout effect. The crisis led to business failures, loss of wealth, and a downturn in the global economy, which among other troubles contributed to the European sovereign debt crisis.

The effects of the global financial crisis did not spare Pakistan. The year 2008 proved to be a very difficult year for the KSE. As panic engulfed the equity market, on 28 August 2008, KSE management, with the approval of Securities and Exchange Commission of Pakistan (SECP), overreacted imprudently and decided to fix a floor of 9,144 points, below which the index was not allowed to fall. The floor was set to halt the plunging market that had wiped off around USD $36.9 billion of market value since the market had crossed the 15,000 barriers. Essentially, the ‘floor’ ensnared the investor who wanted to exit the market. According to Sim Cox of Emerging Markets Stock Fund (Hong Kong) ⁷ :

I have gone through the record of stock exchanges and never since the oldest stock exchange in the world at Amsterdam was established in 1602, I could locate one example where a stock exchange had ever blocked the exit in violation of basic principles of the free-market mechanism.

The investors’ capital was trapped, and it further aggravated the intensity of crash and when finally the floor was lifted on 14 December 2008, after 108 days, the KSE 100 tumbled to around 4,800 within three weeks as frenzied investors closed their positions. The market declined by almost 68 per cent from its peak level in April 2008. According to Yasin Lakhani, the six-time president and chairman of KSE ⁷ , ‘2008 was the most disastrous year in the history of financial markets in Pakistan’. The exact magnitude of the loss to the economy was difficult to quantify, but estimates suggested that roughly PKR 1.4 trillion had evaporated off the market capitalization. This debacle drowned many small and mid-tier investors, and eight brokers were expelled, and two directors of KSE were declared defaulters as a fallout of the debacle.

The abysmal performance of the equity market had dampened the expectations of any significant positive return at the maturity of the MCPF in June 2011. However, Farhan believed that the financial crisis had created an extraordinary opportunity for capital protected funds to carve out a permanent space among an assortment of funds to mitigate risk for investors with low-risk appetite. In the backdrop of the financial crisis and a lukewarm recovery, Farhan had to explore alternative strategies to maximize the fund’s returns during the next two years while persevering its capital base.

Dynamic Asset Allocation Strategies

In preparation for the upcoming meeting with the investment committee, Farhan pulled out his notes on asset allocation strategies from a portfolio management executive course that he had recently attended at the leading business school of Pakistan. The aim was to choose an asset allocation strategy that protected the principal and maximized the upside potential. The market fluctuations that changed the values of the assets gave rise to strategies that dynamically adjust the asset allocation of the portfolio in response to market performance. Farhan found the following outline of various asset allocation strategies in his class notes.

The B&H Strategy ⁸ was the one in which an initial mix of asset classes in a portfolio was bought and then held without any rebalancing. The B&H investment strategy was essentially a passive strategy where the investor bought a mix of assets and held them for the long haul without worrying about the short-term market fluctuations. Conventionally, the investment was premised on the assumption that high-risk equities provided higher returns than bonds if kept for a longer time horizon. The value of a B&H portfolio was linearly related to the market value of underlying securities that comprised the portfolio. The strategy minimized the transaction costs of the portfolio. It outperformed a CM strategy in a trending market; outperformed CPPI in a flat but oscillating market.

CM Strategy ⁸ was a dynamic strategy to investment decision-making and based on keeping a constant proportion of wealth in stocks and other asset classes. Whenever there was a change in the stock prices, a rebalancing of the portfolio was required to rebalance the mix to the pre-determined constant ratio. The strategy forced the investor to sell the stocks when they were priced higher than the initial value of the stocks, allowing the investor to earn profit on the investment. Similarly, if the stock market was not performing well and the stock values were declining, the investor would have to increase the exposure to stocks to keep the CM. The CM strategy outperformed a comparable B&H strategy in a flat but oscillating market.

The CPPI strategy ⁸ allowed the fund manager to dynamically allocate funds in high-risk and low-risk assets to ensure the protection of capital invested. The goal was achieved using the following investment rule:

Dollars in stocks or risky assets = m (Assets – Floor),

Where m was a fixed multiplier which was usually greater than 1 – a multiplier of 2 was widely used to implement CPPI strategy. The multiplier was a number representing a nature of strategy that was being pursued by the fund manager. The higher the number, the more aggressive the strategy. The investor in a CPPI strategy selected the floor and multiplier depending on the investor risk tolerance. The floor amount was less than the total assets value and was invested in safe securities. If the value of the stocks fell, the dollar investment in the stocks also reduced. This meant that a sale of some of the stocks was required. In a sense, CPPI was a strategy where the investor would sell when the price of the stocks fell and buy the stock when the price increased. The strategy protected the downside risk of the investment while allowing for good returns by investing in risky assets. The CPPI strategy outperformed a comparable B&H strategy, which, in turn, outperformed a CM strategy in trending markets.

An investor could also choose call options in implementing the CPPI strategy. Once the initial floor was decided, the cushion (that is, Assets – Floor) was invested in the call options. The use of options allowed investors to minimize the loss, while retaining the upside potential of the risky asset. However, lack of consensus of religious scholars on Islamic option-like contracts had generally limited their use in principal-protected notes and funds.

Decision

It was already 2 July 2009. Farhan thought he had collected enough material to prepare a comprehensive presentation for the upcoming investment committee meeting on 4 July 2009. However, his major challenge was to project the equity market returns and to assess the performance of dynamic strategies given the limited choices of Shariah-compliant securities. As a first step, he had to simulate the equity returns using the KMI 30 data and estimate KIBOR rates as a proxy for Murabaha rates over the remaining life of the fund. What strategy should Farhan recommend to the investment committee that would preserve capital yet retain meaningful upside return potential?