Bank Negara Malaysia Hedge Funds Discussion

Strictly Private & Confidential
1
Bank Negara Malaysia
Hedge Funds and Islamic Finance
- Discussion Material
4 November 2004

2
An Overview
Section 1 Background
Section 2 What is a Hedge Fund ?
Section 3 Hedging, Risk and Strategies
Section 4 The Case for Hedge Funds
Section 5 Issues facing Islamic Investors
Section 6 Possible Alternatives
Section 7 Islamic Hedge Funds
Section 8 Conclusion
IMPORTANT NOTICE

3
 Asset Allocation Strategies
 A Short History
 Number of Global Hedge Funds
 Hedge Funds Assets
IMPORTANT NOTICE

4
Background
Asset Allocation Strategies
30
50
28
10
30
10
10
10
2
0
10
5
2
3
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Conventional Investor Islamic Investor
PercentAllocation(%)
Cash Bonds Equities Real Estate Private Equity Hedge Funds Others

5
Background
A Short History
• The first hedge fund was set up by Alfred Jones in 1949.
– Eliminated a part of market risk by short-selling.
– First to use short sales, leverage and incentive fees.
• A ‘Fortune’ magazine article in ’66 about a fund shocked every one:
– The Jones’ fund had outperformed all the mutual funds even net of a hefty 20% incentive fee.
– The first rush into hedge funds followed and the number of hedge funds increased to over a
hundred.
• Losses & bankruptcies of many managers in the late 60s.
– Michael Steinhardt and George Soros survived the contraction of 69-70 and 73-74.
• ‘The Institutional Investor’ reported the incredible performance of Julian Robertson’s funds in ‘86.
– High performance in 1987-1993 helped boost the new hedge funds.
• The fall of the British Pound in ’92 was believed to have been caused by George Soros. The same
allegations were stated during the Asian crisis.
• The bond market crash in ‘94 (following the US rate hikes) led to huge losses. But the industry recovered
in 1995-96.
• The widely publicized failure of LTCM and the poor performance of star managers, Julian Robertson and
G. Soros caused a slowdown in ‘98.

6
Background
Number of Global Hedge Funds
• There are over 8,000 hedge funds available from nearly 3,000 managers.1
• Over 56% of all hedge fund managers are located in the United States, with 38% in Europe and 3% in
Asia. 2
• Long/short equity managers represent an estimated 1/3 of global hedge fund strategies. 3
• For Asia Pacific Hedge Fund Managers, it is estimated that 67% pursue the long/short equities
strategy. 4
Notes
1 2004 Van Hedge Fund Advisors International
2 Dow Jones News Wires 10 May2004
3 2002 Van Hedge Fund Advisors International

7
Background
Hedge Funds Assets
• The global hedge fund industry broke above the USD1 trillion level for the first time in May
2004.1
• There is at least USD1.16 trillion under management in hedge funds today, up from USD745
billion in mid-2003. 2
• Hedge fund assets were 46% invested in the US, 40% in Europe and 9% in Asia.3
Notes:
1 Dow Jones News Wires 10 May 2004

8
 A Definition
 Common Characteristics
 Legal Structure
 Fee Structure
 The Main Players
IMPORTANT NOTICE

9
What is a “Hedge Fund”
A Definition
 It is difficult to provide a general definition of hedge fund.
 Originally... hedge fund was to offer plays against the markets, using short selling, futures and other
derivative products.
 Today... Funds using “hedge fund” appellation follow all kinds of strategies and structure.
 Clearly... hedge fund cannot be considered as a homogeneous asset class.
 Some are highly leverage; others are not. Some engage in hedging activities; others do not. Some
focus on macroeconomics bets on commodities, currencies, interest rates and so on. Some funds are
mostly “technical” taking advantage of mispricing of some securities in their markets.

10
 Hedge fund managers can go LONG or SHORT.
 Hedge fund managers use gearing or LEVERAGE.
 Hedge fund managers are paid through a PERFORMANCE or INCENTIVE FEE.
 Hedge funds are often registered OFFSHORE or within LIMITED PARTNERSHIP structure.
 Hedge fund managers often invest their OWN MONEY in their funds.
 Hedge fund managers aim for ABSOLUTE RETURNS rather than benchmarking performance.
Common Characteristics

11
 Key issues in the process of fund structuring is flexibility, taxation and investors preference.
 Typically set up as a limited partnership, limited liability corporation or as an offshore corporation.
 These legal structures allow the fund manager to take short and long positions in any asset, use all
kinds of derivatives and to leverage the fund without restrictions.
 Hedge fund is also typically open-ended allowing investors to subscribe and redeem their investments
usually at net asset value at a regular interval. However, there may be variations in terms of
redemption fees, redemption notice period or other redemption limitations etc.
 Close ended fund structures - where investment is limited to an initial and then subsequent placing of
interests in the fund - allow for a more efficient and cohesive strategy from the viewpoint of the fund
and its investment manager but are not popular with investors and have a number of practical
disadvantages. No routine redemption mechanism. Procedure for issuing new tranches is more
cumbersome.
 A hedge fund may also consider using “feeder”, vehicles that have an ownership interest in the hedge
fund that enable the hedge fund to solicit funds from investors in different jurisdiction. These feeders do
not keep the money; they are used as conduits that channel the money to a master fund.
Legal Structure

12
A company structure I.e. limited liability company issuing shares.
Familiar to investors and relatively low risk to fund manager and easy to operate.
Trusts Investors put his money into a trust.
The trust owns the money and run by the trustee, advised by the beneficiary.
Collective investment
schemes
Known as unit trust, mutual fund or UCITs.
Pooling of money to invest in the markets
Hedge fund unlikely to use this as a vehicle.
Partnerships Hedge funds based in US often take the form of a LIMITED PARTNERSHIP under
the section 3(c)(1) Investment Company Act which allows for exemption from most of
US SEC regulations. However, the fund is limited to no more than 100 partners, who
must be an “accredited investors” and the fund is prohibited from advertising.
Some are organized under section 3(c)(7) which are also exempt from most US SEC
regulations. In that case, the fund is limited to no more than 500 investors, who must
be a “qualified purchasers” and is also prohibited from advertising.
Managed funds Account managed by a money manager on a discretionary basis.
A flexible structure but lack the security of a fund.
Legal Structure (cont.)

13
Legal Structure (cont)
• Another main consideration is choosing the domicile for the fund.
• There is considerable competition between the different jurisdiction.
• Current practice suggest that the Cayman Island is the domicile of choice, followed by British Virgin
Island and Bermuda.
• For those seeking investors just in the US, Delaware is a key option.
• Meanwhile, Ireland and Luxembourg have a niche for hedge fund managers looking to establish funds in
‘regulated jurisdiction e.g. If the primary focus is European institution.
• Key factors taken into consideration in choosing the domicile for the fund includes familiarity of the
jurisdiction with hedge funds, reputation, degree of local regulation; local tax and double tax treaties,
and availability of service providers such as accountancy firms, legal firms, local banks and
administrators.

14
 Fee Structure - Typically comprise of base fee + incentive fee.
 Base Fee -
 Is based on value of asset under management.
 Typically 1% of asset base.
 Paid regardless of the performance of the fund.
 Incentive / Performance Fee -
 Proportional to the realized profits.
 Typically between 15 - 30 %.
 Normally applied to profits measured above a risk-free rate before incentive fee is activated.
 High Water Mark -
 A fund valuation below which performance fee will not be paid.
 Hurdle Rate -
 A return that the fund must generate before performance fee is paid.
Fee Structure

15
The Main Players
Offshore Administrator
Offshore AdministratorPrime Broker
Offshore AdministratorExecuting Broker
Offshore AdministratorFund Manager Offshore AdministratorInvestors
Accounting reports
Accounting reports
Accounting reportsTrade notification
Buy/Sell
Affirm trades
Affirm trades
Global custody
International trade clearing
Securities lending
Reporting
Financing
Performance reports
 Pre-launch administrative work
 Launch phase admin.
 Accounting function -
production of NAV
 Corporate secretarial and
Compliance
 Other admin. services
Other Main Players
(1) Accountant
(2) Legal Adviser
(3) Tax Adviser
(4) Technology provider

16
 What is Hedging
 Risk from Leveraging
 Common Risk for hedge funds
 The Various Strategies
 Fund of Funds or Multi-Manager Strategy
IMPORTANT NOTICE

17
Hedging, Risk and Strategies
What is hedging
• Hedging is a strategy to offset investment risk.
• Perfect Hedge vs Partial Hedge
– A perfect hedge in theory is a strategy that offset gains and losses fully, therefore resulting in
being completely neutral.
– All else will be partial hedge.
• Direct vs. Cross Hedge
– A direct hedge is hedging with another asset of similar price movement.
• For example - hedging common stock with its call option.
– A cross hedge is hedging an instrument with an unalike instrument.
• For example - buying preferred stock and hedging with interest rates driven treasury futures.
• Dynamic vs Static Hedge
– A dynamic hedge involves changing strategies over time according to market conditions.
– A static hedge hedge a portfolio without consideration to the market condition over time.

18
Risk from Leveraging
• A common characteristics for hedge funds.
• Why leverage?
– Return from strategy employed (e.g.: arbitraging) is too small, leverage is needed to amplify the
profits.
– However, leverage is a double-edge sword - it also magnifies the losses on the downside.
• How to leverage?
– Borrowing external funds to invest more or sell short more than the equity capital they put in;
– Borrowing through a brokerage margin account; and
– Using financial instruments and derivatives that require posting margins in lieu of trading in the
cash securities that require full payment.

19
Common risk for hedge funds
• Market risk
• Security-specific risk
• Non- market common factor risk
• Liquidity risk
• Borrow/ counter-party risk
• “Herd” risk
• Financing risk
• “Greek” risk
• Redemption risk

20
The Various Strategies
• There are various hedge fund strategies,
each offering varying degrees of risk and
return.
• The categorization of these strategies into
directional, relative value and event driven is
arbitrary, may also overlap and may vary
occasionally depending on which industry
source one uses.
• A hedge fund may also have multiple
strategies.
Directional strategies
Long / Short Equity
Global Macro
Managed futures
Emerging markets
Futures funds
Short sellers
Relative value strategies
Market Neutral
Fixed Income Arbitrage
Convertible Bond Arbitrage
Warrant arbitrage
Mortgage arbitrage
Statistical arbitrage
Event Driven
Risk Arbitrage
Distressed securities
Special situation

21
The Various Strategies II
Fund of Funds
17%
Value
17%
Market Neutral Arbitrage
12%
Aggressive Growth
11%
Opportunistic
10%
Market Neutral Securities
Hedging
6%
Emerging Markets
6%
Special Situations
5%
Distressed Securities
3%
Income
3%
Multiple Strategies
3%
Macro
3%
Short selling
1%
Market Timing
3%
Short selling
Fund of Funds
Value
Aggressive Growth
Opportunistic
Market Neutral Securities Hedging
Emerging Markets
Special Situations
Income
Multiple Strategies
Market Timing
Macro
Source: 2004 Van Hedge Fund Advisors International

22
Fund of Funds or Multi-Manager
Advantages
⇒ For same amount, investor can get exposure to a
large number of hedge fund
⇒ FOF better equipped to perform due diligence
⇒ Risk control through diversification
⇒ Asset allocation expertise of manager of FOF
⇒ Access to managers not accessible individually (e.g
fund closed)
Disadvantages
⇒ High fees – The fee charged by FOF manager is in
addition to that charged by each hedge fund.
⇒ Lack of transparency
⇒ Lower overall return due to diversification
 One that invests in other hedge funds or allocates
among multiple managers.
 Rather than investing in individual securities, a
fund of funds is an investment vehicle that invest
in other hedge funds.
 Fund of funds currently represent 17% of all
hedge fund strategies and, according to industry
sources, between 20-25% of all hedge fund
assets. 1
 Eureka Hedge lists 1134 fund of funds today. Of
these, 114 are specifically global long/short equity
fund of funds. 2
 The amount of assets invested in fund of funds is
expected to grow steadily. Multi-manager assets
(fund of funds) are expected to maintain a 14%
compound annual growth rate through 2008. 3
Note:
1 2004 Van Hedge Fund advisors International
2 eurekahedge.com
3 Cerulli & Associates (IPE.com) - 27 August 2004

23
 Mutual Funds vs. Hedge Funds
 Comparative Performance
 Caveat
IMPORTANT NOTICE

24
The Case for Hedge Funds
Mutual Fund vs. Hedge Fund I
Mutual Fund Hedge Fund
1. Directional Strategy ↔ Directional, arbitrage and spread strategies
2. Two asset classes: stocks, bonds
↔ Four asset classes: stocks, bonds, currencies,
commodities
3. Long only or short only (dedicated) ↔ Both long and short
4. Return is correlated to market averages ↔ Return has low correlation to market averages
5. Investor mentality (buy and hold) ↔ Trader mentality (opportunistic)
6. Focus on beating a benchmark ↔ Focus on absolute return with low volatility
7. Typically unleverage ↔ Use of leverage
8. Low degree of risk management ↔ High degree of risk management
9. Low sensitivity to personnel ↔ High sensitivity to personnel
• The following table highlights the differences between hedge funds and mutual funds.

25
Mutual Fund vs. Hedge Fund II
Mutual Fund Hedge Fund
10. Salary-based compensation of staff ↔ Performance-based compensation of staff
11. Fundamental analysis (financial accounting) ↔ Fundamental, statistical and technical analysis
12. Low sensitivity to price entry and exit point ↔ High sensitivity to price entry and exit point
13. Decision and execution of ideas relatively
slow
↔ Decision and execution of ideas relatively fast
14. Low sensitivity to increasing AUM ↔ High sensitivity to increasing AUM (to avoid
diluting returns)
15. Management fees ↔ Performance fees
16. Heavily regulated ↔ Less regulated, but limited to accredited
investors
AUM: Asset under management

26
Comparative Performance
• Traditional mutual funds and long equity portfolios, including those based on the Dow Jones Islamic
Index, have under-performed compared to hedge funds, both in recent markets and over the long term.
Hedge Funds Outperform . . .
in difficult market and over the longer term
Note:
Hedge Funds data from CSFB/Tremont Hedge Index. NASDAQ 100, DJII
and S&P 500 data from Reuters
Note:
Hedge Funds data from van Hedge Fund Index. Mutual fund data from
Morningstar. S&P 500 data from Bloomberg.
6.67 %
-20.64 %
-2.72 %
-8.6 %
(25.00)
(20.00)
(15.00)
(10.00)
(5.00)
0.00
5.00
10.00
Hedge Funds NASDAQ 100 DJ Islamic
Index
S&P 500
15.8%
9.2%
11.9%
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
Hedge Funds Mutual Funds S&P 500
Average Annual Performance 2000 - 2002 Compounded Annual Returns 1988 - 2003

27
• The case for investing in hedge funds is based on their historical record and managerial talent.
• Hedge funds use their track record to support the claim of superior returns, with low risk and low
correlation with conventional investments.
• It is difficult to talk about the performance of hedge funds as an asset class because of their
heterogeneity.
• However, based on indexes of hedge fund performance available from consultants or fund managers,
there is a strong case for investing in hedge funds (as illustrated in the graph in the next slide):
1. Hedge funds tend to have a net return (after fees) that is higher than equity and bond markets.
2. Hedge funds tend to have lower risk (measured by the volatility of return or standard deviation)
than equity investments. Their investment strategies appear to provide more stable return than
traditional equity investments.
3. The Sharpe ratio was higher than that of equity investments and bonds (except HFR fund of
funds).
4. Correlation of hedge funds with conventional investments is generally low though still positive.

28
0.73
0.56
0.52 0.51
1.00
-0.04
-0.11
-0.04
0.01
0.13
-0.04
1
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
18.00
HFR Fund Weighted
Composite
HFR Fund of Funds EACM 100 CSFB/Tremont S&P 500 Lehman
Govt/Corporate Bond
Index
%
-0.20
0.00
0.20
0.40
0.60
0.80
1.00
Correlation
Annualized Return Standard Deviation Sharpe Ratio Correlation with S&P 500 Correlation with Lehman/Corporate Bond Index

29
Caveat
• Investors should exercise caution when using the historical track record of hedge funds as it does not
adhere to rigorous performance presentation standards. Also biases in historical performance data can
make it difficult to interpret hedge fund performance.
• Among the biases which may affect performance and risk measures are listed below:
1. Self selection bias
2. Instant history bias
3. Survivorship bias
4. Smoothed pricing
5. Option-like investment strategies
6. Fee structure and gaming
• Because of various biases, judging the average performance of the hedge fund industry by using the
indexes discussed can be difficult.
• To appraise the funds, investors need to look at their persistence of performance.

30
 Description of Issues
 Opinion on Futures Contracts
 Opinion on Options Contracts
IMPORTANT NOTICE

31
• Islamic investors could not invest in hedge funds because Shariah-compliant equivalents for options,
short selling or balance sheet leverage are not available - critical elements of hedge fund strategies that
mitigate performance volatility. Most, if not all, strategies used by hedges funds have Sharia'h issues.
• Short Selling
– Selling something you do not own.
– Leverage / element of interest or Riba.
• Derivatives generally are off limits (more in next slide)
– Conventional derivatives are presumptively invalid. Shariah rules -particularly bans on Gharar and
on “ba’i dayn bi-dayn” – pose challenges for finding Shariah-compliant alternatives.
– An option is generally considered not acceptable due to being not an obligation, and payment is for
some ‘right’ not a property.
• If it was a promise to buy or sell, there is not a problem.
• The essence or the locus of the transaction is buying/selling of ‘right’ not the property.
• A right, without an obligation, makes it dependent upon future events and creates Gharar
(uncertainty) , Maysir (a game of chance).
– A Forward may be acceptable but its non-payment in full creates the problem of selling promises
(ba’i dayn bi-dayn).
Issues Facing Islamic Investors
Description of the Issues

32
• Macro and Global Strategies and Distressed Securities are not permissible due to the Riba.
• Equity hedge funds:
– Usual equity constraints
– Tool problems: short selling and leverage
• Global asset allocations.
– Tool problem: futures
• Relative value hedge funds
– Usual asset constraints on long positions
– Tool problems: Short-selling & leverage
• Designing a Sharia’h compliant hedge fund is a major challenge but solutions may be possible.
Description of the Issues II

33
Opinions on Futures Contracts
• SAC of the SC, Malaysia
– Futures trading of commodities is approved as long as underlying asset is halal.
– CPO futures contract are approved for trading.
– Stock Index Futures contract - concept is approved. However, since KLCI has non-halal stock, it is
not approved.
• Ustaz Ahmad Allam (Islamic Fiqh Academy - Jeddah)
– Stock Index futures contract trading is haram since some of the underlying stock are non-halal.
• Mufti Taqi Usmani (Islamic Fiqh Academy - Jeddah)
– According to Shariah, sale and purchase cannot be affected for a future date.
– In most futures transaction, delivery or possession is not intended.

34
Opinions on Option Contracts
• SAC of the SC, Malaysia
– No formal opinion on options.
– However, SAC has approved trading of Warrants/TSR as long as the underlying stock is
designated as halal stock.
• Mufti Taqi Usmani (Islamic Fiqh Academy - Jeddah)
– Promises as part of a contract is acceptable in Shariah but the trading and charging of a premium
for the promise is not acceptable.
• Hashim Kamali (IIUM)
– Invokes Hanbali tradition, cites Hadith of Barira r.a. And Habban Ibn Munqidh r.a.
– He finds options acceptable. Draws parallels with al-arbun in arguing that premiums are
acceptable.
– Cites contemporary scholars such as Yusuf al-Qardawi and Mustafa al-Zarqa have authenticated
al-arbun.

35
 Short Selling
 Risk in Short Selling
 Short Selling in the Region
 Short Selling – Selected Countries
 Conditional Sales
 An Alternative to Short Selling – Salam Sale
 Salam Sale vs. Short Selling
 Issues of Salam Sale of Stocks
IMPORTANT NOTICE

36
Possible Alternatives
About Short Selling
• A short sale is generally a sale of a security by an investor who does not actually own the stock. To
deliver the security to the purchaser, the short seller will borrow the security. The short seller later
closes out the position by returning the security to the lender, typically by purchasing securities on the
open market.
• When you sell short, your brokerage firm loans you the stock. The stock you borrow comes from either
the firm’s own inventory, the margin account of another of the firm’s clients, or another brokerage firm.
As with buying stock on margin, your brokerage firm will charge you interest on the loan, and you are
subject to the margin rules. If the stock you borrow pays a dividend, you must pay the dividend to the
person or firm making the loan.
• In general, short selling is utilized to profit from an expected downward price movement, to provide
liquidity in response to buyer demand, or to hedge the risk of a long position in the same or a related
security.

37
• Short selling is subject to many restrictions on size, price and types of stocks you are able to short.
• For example, you may only short sell stocks that a certain minimum average market capitalization, you
may not short sell penny stocks and short sales need to be done in round lots.
• In addition, the "tick test" provides that an exchange-listed security may only be sold short:
(i) At a price above the immediately preceding reported price ("plus tick"), or
(ii) At the last sale price if it is higher than the last different reported price ("zero-plus tick").
• These rules exist so that investors cannot sell short in a declining market, as continuous short selling
will make a falling stock keep falling.
• Broker/dealers effecting sell orders for exchange-listed securities are also required to mark such orders
"long" or "short."
• There are other restrictions on short selling, including margin requirements, net capital requirements for
broker-dealers, capital and risk management standards, and costs imposed by the equity lending
market.
Short Selling Restrictions

38
1. In general, stocks have an upward drift and over the long run most stocks appreciate in price. For that
matter, even if a company barely improves over the years, inflation should somewhat drive its stock
price up. What this means is that shorting is betting against the overall direction of the market.
2. When you short sell, your losses are infinite. A short sale loses when the stock price rises, and a stock
is (theoretically at least) not limited on how high it can go. On the other hand, a stock can't go below 0,
so your upside is limited. In other words, this means that you can lose more than you initially invest,
but the best you can earn is a 100% gain if a company goes out of business.
3. Shorting stocks involves using borrowed money otherwise known as margin trading. Just as when you
go long on margin, it's easy for losses to get out of hand because you must meet the minimum
maintenance requirement. If your account slips below this you'll be subject to a margin call and will
either have to put in more cash or liquidate your position.
4. If a stock starts to rise and a large number of short sellers try to cover their positions at the same time,
it can quickly drive up the price even further. This phenomenon is known as a "short squeeze."
Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large
number of shorts in a stock will attempt to induce one. This is the reason it's advisable to not short a
stock with high short interest. A short squeeze is one way to lose a lot of money extremely fast.
5. The final, and most important problem, is being right too soon. Even though a company is overvalued,
it may take a long time for it to come back down. In the meantime you are vulnerable to interest,
margin calls, and being called away.
Risk in Short Selling

39
Country When securities
lending allowed
When Short selling
allowed
Comments
Malaysia Allowed in 1996,
Prohibited again in
1997.
Allowed in 1996,
Prohibited again in
1997.
 SC issued in December 1995 the Guidelines on Securities
Borrowing and Lending, and the SIA 1993 was amended to allow
short sales.
 The regulatory changes came into force on March 7, 1996 and
allowed Kuala Lumpur Stock Exchange (as previously known) – to
enact short-selling rules. With that, regulated short selling
commenced on September 30, 1996.
 However, in August 28, 1997, and in the onset of the Asian
financial crises, these activities were suspended as interim
measures to prevent excessive volatility in the markets.
 In February 2001, the SC launched the Capital Market Masterplan
– that recommended the re-introduction of short selling and
securities lending activities.
Indonesia Not allowed. Not allowed.  No guidelines have been provided BAPEPAM.
Philippines Allowed in 1998. Allowed in 1998.  Although the SEC has approved the rules on SBL and short
selling, the rules are not clearly defined in the market.
Singapore Before 1990. Not allowed.  Limited onshore lending. Offshore lending is active.
Thailand Allowed in 1999. Allowed in 1999.  Short selling is very limited after being allowed in 1999.
Note
 Securities lending refers to the ability of an investors to borrow securities from another party.
 Short selling refers to the ability to sell a borrowed security to a third party.
 Data is obtained from the Global Network Management Division at Morgan Stanley, the International Securities Lending at Goldman Sach, market regulators ISSA
handbook and practitioners.
Short Selling in the Region

40
Country When securities
lending allowed
When Short selling
allowed
Comments
Australia Before 1990 Before 1990  Securities can be borrowed from ASX and counter party.
 Cash and non-cash collateral are accepted at 105% - 110% of
the underlying value of the loan securities. Collateral is marked-
to-market daily.
Hong Kong Allowed in 1996 Before 1990  Short selling was prohibited before January 3, 1994. The SEHK
then allowed 17 ut of the 33 constituent stocks of the Hang Seng
Index to be sold short subject to several restrictions.
 These restrictions were lifted on March 25, 1996 at the same
time that 113 of the firms listed on the exchange, including all the
constituent stocks for the index were allowed to be sold short.
 Short selling is allowed for 33 stocks in 1994 and then to a wide
range of stocks in 1996.
Japan Before 1990. Before 1990.  Allowed for stocks listed on the first section of the exchanges.
South Korea Before 1990. Not allowed.  Securities lending and borrowing has not been active.
Taiwan Not allowed. Not allowed.  Foreign investors are prohibited from borrowing securities on
shore and can only lend securities on-shore to brokers to cover
their fails.
UK Before 1990 Before 1990.  Active short selling
USA Before 1990 Before 1990.  Active short selling
Short Selling in Selected Countries
Note
 Securities lending refers to the ability of an investors to borrow securities from another party.
 Short selling refers to the ability to sell a borrowed security to a third party.
 Data is obtained from the Global Network Management Division at Morgan Stanley, the International Securities Lending at Goldman Sach, market regulators ISSA
handbook and practitioners.

41
Conditional Sales
• Khiyar al-Shart or Stipulated Option
– “stipulated option” legitimized in several hadiths.
– An unconstrained right to rescind an otherwise binding contract (for a fixed duration).
• Ba’i Al-Arbun or Down Payment
– Buyer concludes a purchase and makes an advance of a sum less than the purchase price. If he
decides not to take the good, the seller keeps the advance.
– Of all Islamic contracts, this offers the closest analogy to the option.
• Ba’i Al-Salam or Full Payment for Deferred Delivery
– Sale of goods for delivery at a later date but payment in full is made immediately.
– The goods were usually agricultural goods but the principle can be applied to other assets.

42
An Alternative to Short Selling - Salam Sale
• Salam Sale: a seller sells a commodity to a buyer against immediate full payment for delivery of
commodity at a future date.
– Existence of the goods at the contract time is not required.
– An exception to the rule.
– Consensus among the scholars.
• An investor in stocks can hedge part of his exposure to cover downside risk by selling stock as Salam.
E.g. We own 1000 shares of Tenaga, current price $10/share
– Contract to sell at $9.90/share for delivery in six months. We receive $9,900 today. (Placed in a
Murabaha a/c)
– After six months:
• Share price $9.50/share - Profit $400
• Share price $10.30/share - Loss $400

43
Salam Sale vs. Short Sale I
– Short selling actually consists of two distinct transactions: “borrowing” of stock at interest and
selling the stock. In Salam, there is a sale but no borrowing of the stock.
– In a salam sale, the sale price may incorporate the time value of money (financing cost) but early
delivery of good will not reduce the price as the full price is paid upfront.
– For short selling, dividend even during the borrowing period, belongs to the lender. In Salam, it
needs to be estimated and factored into the price.
• Salam sale shares the same economic result with short sale but differ in the nature of
contractual relationship.

44
Salam Sale vs. Short Sale II
Salam sale Short sale Differences
Structure
A contract to sell a security or a basket
of securities against an immediate
payment for a future delivery.
A contract to sell a security which the
seller does not own. The seller delivers
it by borrowing the security which he
returns later by buying back from the
market.
Different in philosophy.
Underlying
Can be a security or a basket of
security.
One stock. Seller has to borrow all the
shares of the basket to replicate a
basket.
More flexibility to Salam sale.
Deal rationale
More oriented towards hedging or
reduction of exposure to volatility or
drop in equity market.
Usually used as an aggressive
implementation of a bear view on a
stock.
Similar but different
philosophy.
Risk/Exposure
Seller is exposed to the unlimited
upside in price of the underlying.
Seller is exposed to the unlimited
upside in price of the underlying.
Similar.

45
Salam Sale vs. Short Sale III
Salam Sale Short sale Difference
Operations
A pure contract between two parties
with a pre-agreed delivery date.
The borrowing and the sale are two
different transactions. The borrower
may call the stock back at anytime.
Different philosophy. Easier
for salam sale.
Credit Exposure and Collateral
The price is paid at inception. The seller
has to deliver the stock in the future.
The buyer may fear the seller will not be
in a position to deliver, thus may ask for
collateral to cover the risk.
The lender wants to ensure the
borrower will be in position to return
the stock at anytime, even when the
stock price is very high. The
lender/agent will therefore require
collateral from the borrower.
Similar
Costs
Consists of structuring cost as well as
brokerage, net financing cost and
estimated dividend. As costs are paid
upfront, early delivery is not
advantageous.
Consist of borrowing fees and
brokerage to sell and buy back the
underlying.
More expensive for salam
sale.

46
Issues of Salam Sale of Stocks
 A line of credit and collateral (of Murabaha and more)
 Higher costs & administrative handling.
 Early delivery does not yield cost reduction.
 Stacking of back to back contracts (due to the above) increases the cost and potential operational
complexity.
 Dividend estimation.

47
 Single Manager Strategy
 Fund of Funds
IMPORTANT NOTICE

48
Islamic Hedge Fund
SEDCO - Permal Hedge fund
• Launched in second half of 2003. Size of fund - USD 250 million.
• Managed by the Permal Group according to Islamic investment guidelines established by a Shariah
Advisory Panel with advice provided by the Saudi Economic & Development Company Ltd (SEDCO).
• Permal Investment Management Services is a US-based group with a total asset under management
of about USD18 billion.
• SEDCO is a private investment firm based in Jeddah, Saudi Arabia.
• The fund is a single manager hedge fund using a Long/Short strategy focussing on mid-to-large growth
US stock.
• The fund utilizes the ‘salam’ concept in providing flexibility in portfolio construction.

49
Islamic Hedge Fund
Shariah Equity Opportunity Fund
• The first fund comprised of conventional long / short equity hedge fund managers that complies with
Shariah.
• The fund allocates its assets to a few hedge fund managers. Each of the Fund’s underlying hedge
fund managers will invest in his historical investment strategy i.e. based upon their strategic focus and
sector concentration.
• To achieve Shariah compliance, the fund has developed a proprietary software to monitor its fund
managers activities and worked with its Shariah scholars to ensure that its methods are in line with
Shariah requirements.

50
IMPORTANT NOTICE

51
Conclusion
 Both industries/niches growing rapidly.
 Both are evolving and innovative.
 Both have to understand each other and look for the crossover bridges.
 A marriage of the two will be “the best of both worlds”.
 However, there can be no compromise on Sharia’h.
 We believe that innovation within Shariah perimeter is the key to growth of Islamic finance.

52
Thank you

53
Contacts
Suryono Darnor
Assistant Director, CIMB Islamic
Commerce International Merchant Bankers Berhad
10th Floor, Bangunan CIMB
Jalan Semantan, Damansara Heights
50490 Kuala Lumpur
Tel: +603-2084 9664
Fax: +603-2093 0685
Email: suryono@cimb.com.my
Azri Zaharuddin
Assistant Manager, CIMB Islamic
Commerce International Merchant Bankers Berhad
10th Floor, Bangunan CIMB
Jalan Semantan, Damansara Heights
50490 Kuala Lumpur
Tel: +603-2084 9714
Fax: +603-2093 0685
Email: azri.zaharuddin@cimb.com.my

54
Important Notice
We have based this document on information obtained from sources we
believe to be reliable, and we do not make any representation or warranty
nor accept any responsibility or liability as to its accuracy, completeness
or correctness.
Expressions of opinion herein are subject to change without notice.
This document should not be construed as an offer or a solicitation of an
offer to purchase or subscribe or sell CIMB investment products.

55
Appendix 1
Factors to be considered in determining the domicile of the fund
• Factors to be considered:
– Familiarity of the jurisdiction with hedge funds;
– Reputation;
– Degree of local regulation;
– Local tax and double tax treaties;
– Anti-money laundering measures;
– Service providers - accountancy firms, legal firms, local banks, custodian and
administrators;
– Convenience for holding board meeting;
– Duration of local incorporation, licensing and approval process;
– Cost;
– Listing;
– Is the jurisdiction within the OECD;
– Political stability; and
– Common language.

56
Appendix 2
Common risk for hedge funds
Market risk Liquidity risk Borrow /counterparty credit risk
Although hedge funds typically
reduce market risk, most d not
eliminate entirely either purposely or
they are unable to identify hedges to
their position.
Hedge funds often take very large
positions relative to market liquidity. In
the event it need to exit a large position
quickly, it may not be able to do so.
Borrow risk is the risk that the
borrowed security used in shorting is
called in by the lender. If replacement
borrow cannot be found, short
position has to be closed or borrower
will be in default.
Security-specific risk “Herd” risk Financing risk
The risk remaining after the effects of
common risk factors have been
removed
The risk where large proportion of fund
managers attempt to exit a common
strategy simultaneously.
Risk from tightening of credit.
Non-market common factor risk “Greek” risk Redemption risk
Risk that arises from factors common
to some but not all, securities. Hedge
funds take on such risk by taking
large positions in certain types of
securities, such as stocks of specific
industries, low-grade debt
instruments or ‘deal stocks’.
Risks arising from the use of options.
Delta, vega, gamma, rho & theta
Hedge funds allow redemption only
infrequently. Massive redemption
may force manager to unwind trades
at wrong time.

57
Appendix 3
Description of various hedge fund strategies
Aggressive Growth
A primarily equity-based strategy whereby the manager invests in companies experiencing or expected to experience strong growth in
earnings per share. The manager may consider a company’s business fundamentals when investing and/or may invest in stocks on the
basis of technical factors, such as stock price momentum. Companies in which the manager invests tend to be micro, small, or mid-
capitalization in size rather than mature large capitalization companies. These companies are often listed on (but are not limited to) the
NASDAQ. Managers employing this strategy generally utilize short selling to some degree, although a substantial long bias is common.
The manager invests in the debt and/or equity of companies having financial difficulty. Such companies are generally in bankruptcy
reorganization or are emerging from bankruptcy or appear likely to declare bankruptcy in the near future. Because of their distressed
situations, the manager can buy such companies’ securities at deeply discounted prices. The manager stands to make money on such a
position should the company successfully reorganize and return to profitability. Also, the manager could realize a profit if the company is
liquidated, provided that the manager had bought senior debt in the company for less than its liquidation value. “Orphan equity” issued by
newly reorganized companies emerging from bankruptcy may be included in the manager’s portfolio. The manager may take short
positions in companies whose situations he deems will worsen, rather than improve, in the short term.
Emerging Markets
The manager invests in securities issued by businesses and/or governments of countries with less developed economies (as measured by
per capita Gross National Product) that have the potential for significant future growth. Examples include Brazil, China, India, and Russia.
Most emerging market countries are located in Latin America, Eastern Europe, Asia, or the Middle East. This strategy is defined purely by
geography; the manager may invest in any asset class (e.g., equities, bonds, currencies) and may construct his portfolio on any basis (e.g.
value, growth, arbitrage).
Fund of Funds
The manager invests in other hedge funds (or managed accounts programs) rather than directly investing in securities such as stocks,
bonds, etc. These underlying hedge funds may follow a variety of investment strategies or may all employ similar approaches. Because
investor capital is diversified among a number of different hedge fund managers, funds of funds generally exhibit lower risk than do single-
manager hedge funds. Funds of funds are also referred to as multi-manager funds

58
Appendix 3
Futures
The manager invests primarily in futures, which are financial contracts for the buying and selling of an index or commodity at some
future date. Futures contracts to buy act as long positions while futures contracts to sell may hedge a portfolio. Trading futures can
entail particularly high levels of leverage and could therefore pose greater risk than other investment strategies
Income
The manager invests primarily in yield-producing securities, such as bonds, with a focus on current income. Other strategies (e.g.
distressed securities, market neutral arbitrage, macro) may heavily involve fixed-income securities trading as well; this category does
not include those managers whose portfolios are best described by one of those other strategies.
Macro
The manager constructs his portfolio based on a top-down view of global economic trends, considering factors such as interest rates,
economic policies, inflation, etc. Rather than considering how individual corporate securities may fare, the manager seeks to profit
from changes in the value of entire asset classes. For example, the manager may hold long positions in the U.S. dollar and Japanese
equity indices while shorting the euro and U.S. treasury bills.
The manager seeks to exploit specific inefficiencies in the market by trading a carefully hedged portfolio of offsetting long and short
positions. By pairing individual long positions with related short positions, market-level risk is greatly reduced, resulting in a portfolio
that bears a low correlation and low beta to the market. The manager may focus on one or several kinds of arbitrage, such as
convertible arbitrage, risk (merger) arbitrage and fixed income arbitrage. The paired long and short securities are related in different
ways in each of these different kinds of arbitrage but, in each case, the manager attempts to take advantage of pricing discrepancies
and/or projected price volatility involving the paired long and short security.

59
Appendix 3
Market Neutral Securities Hedging
The manager invests similar amounts of capital in securities both long and short, maintaining a portfolio with low net market exposure.
Long positions are taken in securities expected to rise in value while short positions are taken in securities expected to fall in value.
These securities may be identified on various bases, such as the underlying company’s fundamental value, its rate of growth, or the
security’s pattern of price movement. Due to the portfolio’s low net market exposure, performance is insulated from market volatility.
Market Timing
The manager attempts to predict the short-term movements of various markets (or market segments) and, based on those predictions,
moves capital from one asset class to another in order to capture market gains and avoid market losses. While a variety of asset
classes may be used, the most typical ones are mutual funds and money market funds. Market timing managers focusing on these
asset classes are sometimes referred to as mutual fund switchers.
Multi-Strategy
The manager typically utilizes two or three specific, pre-determined investment strategies, e.g., Value, Aggressive Growth, and Special
Situations. Although the relative weighting of the chosen strategies may vary over time, each strategy plays a significant role in portfolio
construction. Managers may choose to employ a Multi-Strategy approach in order to better diversify their portfolio and/or to more fully
use their range of portfolio management skills and philosophies. (This strategy was originally referred to as “Several Strategies”.)
Opportunistic
Rather than selecting securities according to a single strategy as defined herein, the manager’s investment approach may change over
time to better take advantage of current market conditions and investment opportunities or may combine aspects of different
approaches at a given time. Characteristics of the portfolio may vary significantly from time to time. Long and short equity positions are
generally the most common types of positions in these managers’ portfolios.

60
Appendix 3
Short Selling
The manager maintains a consistent net short exposure in his portfolio, meaning that significantly more capital supports short
positions than is invested in long positions (if any is invested in long positions at all). Unlike long positions, which one expects to rise
in value, short positions are taken in those securities the manager anticipates will decrease in value. In order to short sell, the
manager borrows securities from a prime broker and immediately sells them on the market. The manager later repurchases these
securities, ideally at a lower price than he sold them for, and returns them to the broker. In this way, the manager is able to profit
from a fall in a security’s value. Short selling managers typically target overvalued stocks, characterized by prices they believe are
too high given the fundamentals of the underlying companies.
Special Situations
The manager invests, both long and short, in stocks and/or bonds which are expected to change in price over a short period of time
due to an unusual event. Such events include corporate restructuring (e.g. spin-off, acquisitions), stock buybacks, bond upgrades,
and earnings surprises. This strategy is also known as event-driven investing.
Value
A primarily equity-based strategy whereby the manager focuses on the price of a security relative to the intrinsic worth of the
underlying business. The manager takes long positions in stocks that he believes are undervalued, i.e. the stock price is low given
company fundamentals such as high earnings per share, good cash flow, strong management, etc. Possible reasons that a stock
may sell at a perceived discount could be that the company is out of favor with investors or that its future prospects are not correctly
judged by Wall Street analysts. The manager takes short positions in stocks he believes are overvalued, i.e. the stock price is too
high given the level of the company’s fundamentals. As the market comes to better understand the true value of these companies,
the manager anticipates, the prices of undervalued stocks in his portfolio will rise while the prices of overvalued stocks will fall. The
manager often selects stocks for which he can identify a potential upcoming event that will result in the stock price changing to more
accurately reflect the company’s intrinsic worth.

61
Appendix 4
Biases that affect performance measurements
Self selection bias Managers decide themselves what they want to include in the database. Those that have funds
with unimpressive track record will not want to have that information exposed.
Instant history bias When a hedge fund enters a database, it has a track record. Because only hedge funds with
good track records enter the database. This creates a positive bias in past performance in the
database.
Survivorship bias Unsuccessful funds and managers tend to disappear over time. Only successful ones present
their track record.
Biases also affect risk measures. Funds that exhibit highly volatile returns in the past tend to
disappear. Only funds that exhibit low volatility survive. Thus, reported volatility will end to be
low.
Smoothed pricing Illiquid assets are frequently used by hedge funds. Because prices used are often not up-to-
date market price, but estimates of fair value, their volatility is reduced.
Option-like investment Traditional risk measures in performance appraisal assumes normal distributions or at least
symmetric distribution. Many investment strategies followed by hedge funds have option-like
features that violate this assumptions. E.g - Small profit if price converge but huge loss if model
fails.
Fee structure and
gaming
Funds charges high fees – base + incentive. Creating an option like compensation structure.
One can argue that they have strong incentive to take huge amount of risk if past performance
have been bad.
One can also argue that because of high water mark provision, hedge fund managers may not
want to take more risk as their performance diminishes.
Past risk measures may be misleading for forecasting future performance and risk for a fund that
as performed badly in the past.

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