The Roles of Islamic Investment Funds as Institutional Investors: The Perceptions of Fund Management Companies' Representatives in Malaysia

Transcription

1 The Roles of Islamic Investment Funds as Institutional Investors: The Perceptions of Fund Management Companies' Representatives in Malaysia Nurul Aini Muhamed* School of Commerce, University of South Australia, Australia nurul Ronald McIver School of Commerce, University of South Australia, Australia

2 The Roles of Islamic Investment Funds as Institutional Investors: The Perceptions of Fund Management Companies' Representatives in Malaysia Abstract The Islamic investment funds established in the 1990s represent a class of institutional investor, along with other intermediaries such as Islamic banks. In addition to consider Islamic investment funds as a financial vehicle, this study views them as institutions responsible both for fulfilling the investment objectives of their shareholders and preserving the rights of other stakeholders. To explore these ideas, this paper surveys the perceptions of registered representatives of Malaysian fund management companies on the roles that should be played by Islamic investment funds. Keywords: Business ethics, ethics, ethical decision making, spirituality. INTRODUCTION Investment based on ethical principles operates in parallel with conventional investment practices. Conventional investment focuses on financial return (Baskin & Miranti 1997) rather than religious, social and environmental issues (McLachlan & Gardner 2004). Muslim investors should be concerned about matters that are prohibited, obligated and recommended under Islam, and thus should aim to embody these principles in their investment practices. Thus, not surprisingly, attention from Islamic investors worldwide has contributed to rapid growth in Islamic finance at 12 to 15 per cent a year (El- Hawary, Grais & Iqbal 2004). Assets under management are estimated at over USD 360 billion as at 2006 (Wilson 2006), with Islamic financial services being offered in 70 countries (Khan & Bhatti 2008). Investment funds, as distinct entities from their trustees or managers, are viewed as 'institutions' or 'institutional investors'. This suggests that they have a responsibility to fulfil their investors' objectives, and should endeavour to execute their investment activities based on Islamic principles (Ahmed 2006). Thus, this study views those Islamic investment funds' as institutional investors, as holding responsibilities towards both beneficiaries of and stakeholders associated with these funds. For Islamic investment funds the contractual investor-investment fund relationship regards investors I A Syariah fund here refers to an Islamic investment fund. `Syariah fund' is a specialised collective investment vehicle that provides investors with an opportunity to invest surplus cash in a diversified securities portfolio operated and managed by professional managers in accordance with Syariah principles (SEC 2001: 27) 1

3 as the capital providers and beneficiaries of the investment fund and the fund as the fiduciary. Fund managers (on behalf of funds) need, potentially, to fulfil the investment objectives of both their investors and stakeholders. Thus, the main question at hand is: In what way are the roles of Islamic investment funds supposedly different to those of conventional investment funds? In light of this question, this paper examines the institutional role of Islamic investment funds from a management perspective. Analysis of this role is based on the consideration of the investment process that should be followed by these funds under Islamic principles. Thus it considers four main aspects: selection of the investment portfolio, societal and environmental contributions, monitoring, and involvement in investee companies. These roles of Islamic investment funds are then explored from a fund representatives' viewpoint in Malaysia. The reminder of this paper is, therefore, divided into the following sections: literature review, background of Malaysian Islamic investment funds, research methods, results and discussion, implications and suggestions, and conclusions. LITERATURE REVIEW The institutional investor role of investment funds as has become a large topic in the literature. This is due to the rapid development of these financial vehicles (Schneider 2000; Chaganti & Damanpour 1991). Studies on the performance of Islamic investment funds show that these investment vehicles can provide good returns, and demonstrate no significant performance difference to that of other types of investments (Elfakhani, Sidani & Fahel 2004; Elfakhani & Hassan 2005). Thus, it is unsurprising that Islamic investment funds have gained the attention of Muslim investors seeking to fulfil their religious duties and, at the same time, earn good returns. However, in their role as institutional investors, Islamic investment funds must not focus purely on profit maximization. Under Islamic investment principles there are both negative and positive elements in relation to investments and the investment process (Figure 1). Negative elements, or prohibitions, exist in relation to investments that: embody riba (interest), gharar (uncertainty), and maysir (gambling); or are in firms that produce certain goods, such as alcohol and pork (Islamic Capital Market Task Force of The International Organization of Securities Commissions 2004). Positive elements derived from Islamic teachings, in 2

4 the form of responsibilities placed on and recommendations for investors include: the obligation to pay zakat (Islamic tax); the encouragement of sadaqah (charity); a concern for environmental aspects (El- Gamal 2006; Asutay 2007); shura (consultation) (Rahman 1994; Parvez & Ahmed 2004); and hisba (supervision) (Hamed 1993; Pomeranze 2004). Islamic teachings argue that Muslim investors must consider these elements, as they are responsible for what they invest in (El-Gamal 2006). Based on the above principles, Muslim investors have a responsibility to make a contribution to society, to monitor and be involved in investee companies. Since fund holders waive their right to control their capital in favour of their investment fund under contractual agreement (Islamic Financial Services Board 2007; Norman 2004), the investment fund is deemed to be responsible for realising these guidelines on behalf of the capital providers and stakeholders. However, except in relation to the main prohibited elements, no specific guidelines have been mandated of these Islamic investment funds (for example, see IFSB 2007). Although Islamic principles are used by institutional authorities such as the Securities Commission Malaysia (SEC) in developing their guidelines, the main focus is on the prohibited elements (Khatkhatay & Nisar 2000). It is argued that the practices of Islamic investment funds do not fully follow Islamic principles, since positive elements are ignored (El-Gamal 2006). Grais and Pallegrini (2006c) also highlight the neglect by the Islamic investment fund industry of positive elements such as contributions through sadaqah. Lewis (2006) raises the need for ethical conduct in business governance in Muslim countries, given that the elements of shura and hisba are stressed under Islamic teachings. A major concern is whether their description as Islam investment funds is used only as camouflage for promoting the funds rather than investment practices that fully follow Islamic principles. Similar issues also appear in relation to ethical investment in the U.S and U.K. Schwartz (2003) and, Cowton and Sparkes (2003), for example, question the appropriateness of the term 'ethical investment' in situations where there are inconsistencies in investment practice by this type of fund. A number of studies have focused on the issue of corporate governance within Islamic financial institutions. These relate to the: internal structure of corporate governance in Islamic financial institutions (Grais & Pellegrini 2006a, 2006b, 2006c); social responsibility of Islamic organizations 3

5 (Beekun 1997; Beekun & Badawi 2005); and monitoring and involvement from the perspective of stakeholders through corporate boards (Chapra & Ahmed 2002). Bar exceptions like Chapra and Ahmed (2002), which is focused on the involvement of shareholders and stakeholders in Islamic financial institutions such as Islamic banks, few studies provide empirical evidence on monitoring and involvement within Islamic-based corporations from an investor's perspective. The importance of this omission in the literature is that such involvement should provide an important point of difference between Islamic and mainstream institutional investment practices. Institutional investors involved in mainstream investments do not have a propensity to be involved in investee companies if there is no financial gain to be earned from this involvement (Downes, Houminor & Hubbard 1999). However, Lewis and McKenzie (2000), in their study on the perception of ethical investors in the U.K on activism, found that there is support for involvement with investee companies through soft engagement, but not directly through corporation board mechanisms. Given the potential parallels that may exist between Islamic and ethical investment, this suggests a gap in the literature in term of the roles that should be played by institutional investors such as Islamic investment funds in the way they preserve investors and stakeholder interests. This paper thus aims to bridge this gap by examining the role of Islamic investment funds from the perspective of the representatives of fund management companies operating under supervision of the Ministry of Finance (MOF) and Malaysia Securities Commission (SEC). Thus several questions are examined in this paper as follows: What are the selection criteria that must. be used in the construction of the investment portfolios of Islamic investment funds? Do Islamic investment funds need to monitor their investee companies, and what are the criteria for such monitoring? Do Islamic investment funds need to be involved in their investee companies, and if so how? The results of this paper illustrate the extent of application of Islamic principles in a more operational way under existing financial structures in order to comply with investors' objectives. 4

6 Islamic Investment Funds As Institutional Investors Investment funds are considered to be intermediaries between investors and third parties such as investee companies (Obaidullah 2004). Based on the structure of the contract under mudaraba (profit sharing contract) or wakala (agency contract) arrangements, Islamic investment funds must fulfil their contractual obligations under Islamic principles. Parallel with agency theory (Jensen & Meckling 1976), fund managers as agents must fulfil the objectives of capital providers based on their contractual relationships2. Monitoring and involvement with investee companies is an obligation that must be undertaken on behalf of the capital providers. Furthermore, it may be appropriate to assume that Islamic investment funds should be responsible for zakat and sadaqah, as their contribution towards society, on behalf of their beneficiaries. Islamic investment funds must not be driven by merely profit maximization, since religious concerns associated with investment are the main objective of these investors (Beekun 1997). In the same way, the investment process of Islamic investment funds must consider all relevant stakeholders. However, although Islamic investment funds can be viewed from the perspective of stakeholder theory, which promotes the ethical elements and benefits of all stakeholders (Freeman 1994; Nordberg 2007), in this context stakeholders are not considered as being on the same level as capital owners (Beekun & Badawi 2005). Treating capital owners on the same level as other stakeholders seems unfair, since the capital owners bear the risk of losing their capital from their investment activities (Gambling & Karim 1991). Islamic investment funds as separate entities from their manager can be viewed as responsible owners of their investment in investee companies, and so need to be responsible for what they invest in. The framework proposed by Beekun (1997), which views firms as responsible owners that consider benefits to all stakeholders, including owners, can be applied to Islamic investment funds. Islamic investors and Islamic investment funds are assumed to have the same responsibilities and objectives in dealing with the benefits of all stakeholders. Given that investment funds have their own beneficiaries that should be considered ex ante and ex post in their investment process, they are expected to exercise 2 Except where contradictions between agency theory and Islamic principles are the case, as has been discussed in Beekun and Badawi (2005). 5

7 monitoring and activism roles on investee companies. This is besides investment screening and their contributions to stakeholders. Although monitoring of the corporation is performed by the corporate board (Hart 1995), outsider shareholders can also monitor investee companies to reduce information asymmetry between the capital owners and their agents. Monitoring by outsider shareholders can thus work as a check and balance on business corporations and on boards to avoid agency conflicts (Sparkes 2003). Monitoring can be undertaken on several aspects such as performance, activities, ethical compliance and corporate governance. Similarly, activism and engagement in investee companies are considered as mechanisms to ensure the investee companies do not diverge from the investment objectives of shareholders, in this case, with the investment fund as intermediary. Activism is not limited to hard activism in the form of traditional governance mechanisms such as takeovers. It also can be practiced in the form of soft approaches such as dialogue and voting (Kreander 2001), and in other forms such as preparing and voting on shareholder proposals (O'Rourke 2003). Background of Malaysian Islamic Investment Funds Islamic investment funds in Malaysia are operated under the authority of different regulatory bodies, each of which is directly or indirectly under the MOF. Fund management companies are regulated by the SEC through the Securities Industries Act 1983, Securities Industry Act (Central Depository) 1993, Companies Act 1965, Securities Commission Act 1993, and Futures Industry Act The Islamic investment funds under the SEC supervision consist of unit trust funds and corporate funds. As well as these funds, there are also specialised Islamic investment funds, such as the Pilgrimage Board (Lembaga Tabung Haji), which facilitates Muslims fulfilling their religious obligations. This is directly located under the MOF. The SEC, through its Shariah Advisory Council (SAC), issues resolutions to guide the operation of the Islamic investment industry and releases a list of Shariah-compliant securities that is used by investors who want to comply with Islamic principles in their investment selection (SEC 2006). This study focuses on the role of Islamic investment funds from the perception of staff and representatives of fund management companies' licensed with the SEC. 6

8 RESEARCH METHOD AND DATA This study uses a survey method in the form of a mail questionnaire as the instrument for data collection, since it can cover large area. Most of the questions in the questionnaire use the Likert measurement scale, except for questions on demographics. In section of the questionnaire dealing with perceptions, the five-point Likert scale was used. The five points range from I 'strongly disagree' to 5 'strongly agree'. In the section of the questionnaire dealing with perceptions, questions were asked about criteria that must be followed by managers of Islamic investment funds. Questions regarding perceptions of fund managers on the role of Islamic investment funds are divided into four parts. These are: (1) criteria that must be used in the selection of investment portfolios, (2) contributions to society and environment (3) monitoring aspects, and (4) involvement with investee companies. Questionnaire validity was enhanced through its evaluation by two experts in the area of Islamic investment. The experts are academics in two public universities in Malaysia, with one of them being a registered Islamic advisor with the SEC, and a former member of the Shariah Board of the Malaysian Central Bank. Based on their recommendations, several questions were adjusted in relation to the screening criteria for investment portfolios. In the question on the screening elements used by the Islamic investment funds, 'life insurance' was combined under the 'conventional insurance' element to avoid ambiguous responses. In addition, 'others' as one option was put in all questions as an alternative to encourage respondents to give more detailed answers on their perceptions. A reliability test on the instruments was made by conducting a pilot test, in the form of sending the questionnaire to 20 licensed representatives of one of the largest fund management companies in Malaysia. Only six questionnaires were returned. No alterations were made to the questionnaire on the basis of the pilot test. Questionnaires were sent to representatives and staff of the investment divisions of fund management companies and institutions that offer Islamic investment funds. Information on Islamic investment funds, fund management companies, and their representatives was gathered from the SEC's website. Information on the investment staff of Islamic investment funds under a direct supervision of MOF 7

9 was gathered directly from their fund management companies. The purposive sampling of fund management companies' representatives as the respondents reflects their direct involvement in the management of Islamic investment funds and thus their presumed knowledge of this area. Data Collection and Analysis Data collection was conducted between July 2007 and November Ethics approval for this research was granted before the data collection process. Questionnaires were sent to 121 representatives and staff from 31 fund management companies and institutions. Two follows-up were undertaken due to low response rates. A total of 46 questionnaires were received by early November 2007, a 38 percent response rate. However, only 44 questionnaires were included in the analysis, as two responses had missing answers. Following Roscoe (1975, cited in Sekaran 2003, p. 295), a sample size of more than 30 and less than 500 is suitable for the study. Data were coded and analysed using SPSS. Based on the data, 70 percent of respondents are at senior management level in the fund management companies and institutions, with positions as chief executive officer, director, chief investment officer or senior manager. The other 30 percent of respondents are at the assistant manager level. 80 percent of respondents have attended a course on Islamic investment. This is believed to be useful to the validity of the study. Since they are familiar with Islamic terms and Islamic investment principles, and have an exposure to the management of Islamic investment funds, these respondents are believed to have an appropriate level of understanding of the concepts included in the questionnaire. Note that, as per Tables 1 to 4, an analysis of responses to individual component questions in the questionnaire is done in terms of mean and standard deviation of Likert scores. RESULTS AND DISCUSSION Selection of the Investment Portfolio Though Islamic investment funds are required to comply with Islamic principles, under the SEC's regulation, the questionnaire included questions on prohibited investment elements. This was to ensure consistency in the reporting of the respondents' perceptions. The results are shown in Table I. Prohibited elements such as non-involvement in interest-based activities, gambling, alcohol, 8

10 companies associated with pork and its products, and the conventional insurance industry must be considered in investment. These elements are considered as important elements, with average Liken scores of between 4.75 and 4.89 on the 1 to 5 scale (5 indicating strong agreement). This is unsurprising since the SEC (2007) has ruled that the investment portfolio of these funds must be derived from securities listed on the SAC's list of Shariah-compliant securities. However, while still important, environmental aspects, with an average score of 4.18, rate as less important to respondents than the five prohibited elements. Contributions to Society and the Environment Contributions towards society are considered as very important under Islamic principles. However, no specific guidelines have been ruled upon by the regulatory bodies regarding the elements of zakat, charity, education sponsorship, societal activities and environmental preservation of Islamic investment funds (IFSB 2007). This section explores how fund representatives perceive the Islamic investment funds' roles on societal and environmental aspects. Results are presented in Table 2. Respondents agree/strongly agree that due to their responsibilities towards society that investment funds should contribute to zakat (Islamic tax) and charity (with average Likert scores of 4.43 and 4.20, respectively). These elements are followed by involvement in education sponsorship (4.08). However, involvement in societal activities and environmental preservation are considered as less important compared to other elements associated with contributions to society. This is reflected in their average scores of 3.89 and 3.82, respectively, indicating an average neutral/agree position by respondents. Monitoring With respect to monitoring, respondents were asked whether the Islamic investment funds must monitor aspects such as the governance, performance and operation of investee companies. These questions were asked since the Islamic investment funds are deemed to be the capital owners of investee companies, on behalf of fund holders. Results are reported in Table 3. Fund representatives agree/strongly agree that all aspects in monitoring investee companies are important. Monitoring of 9

11 investee company operations is rated most highly (4.66), followed by investee company performance (4.57), with investee company governance aspect rating the lowest of these elements (4.32). Activism In recent literature, activism in investee companies has been highlighted as an important role for institutional investors (Massel 2002; Cole 2007; Simpson 2007). A question asked whether investment funds should exercise their roles as shareholders, with this referring to the shareholders' right of voting. Other questions focused on elements such as providing advice on performance, lobbying for improved corporate policy, campaigning publicly for improved policy, debating corporate ethics, and promoting better standards in corporate ethics. Responses are presented in Table 4. Exercising rights as shareholders is rated as the most important of these elements, with the average response indicating that respondents agree/strongly agree on their use (4.59). On the use of offering advice on investee companies' performance, promoting higher standards on corporate ethics, and lobbying investee companies to adopt better policy, soft mechanisms, by respondents provided a neutral/agree rating (3.50, 3.73 and 3.23, respectively). Respondents were neutral regarding the use of public debate on corporate ethics (2.98) and public campaigns for better policy (3.02) by investment funds. IMPLICATIONS AND SUGGESTIONS The results of this study indications several methods that may be used to improve Islamic investment funds as vehicles for their investors' Islamic principles. The first section on respondents' perceptions of investment selection shows the high level of the perceived importance of following Islamic investment principles based on prohibitions. The grey area of environmental-based selection of investments is rated as being less important than the five prohibited elements. This result is consistent with El-Gamal (2006) and The Royal Chartered Surveyors (2005, 2006), which highlight how Islamic investment practices have been characterised as being based on prohibitions. Responses on societal and environmental aspects indicate that the respondents strongly/very strongly support the importance of contributions through zakat, sadaqah, and educational sponsorship. Such a result implies the possibility of such contributions being adopted easily under Islamic investment fund practices. 10

12 However, in reality such practices are not consistently undertaken at present (Grais & Pallegrini 2006). Support for other elements in the societal activities and environmental preservation group is rated as less important (respondents are neutral/agree as to their importance). Perceptions on the role of monitoring and activism (in the form of exercising rights as shareholders) in investee companies can be thought to be encouraging. The survey suggests that respondents strongly/very strongly support the importance of these mechanisms. Monitoring and activism are mechanisms that may be used to preserve the investment objectives of capital providers as well as stakeholders' benefits. This set of responses is encouraging because activism by institutional investors is deemed to be a new stream for Islamic investment in comparison to the situation in the UK and US. Additionally, involvement with investee companies by outsider shareholders in Malaysia is considered a recommendation, rather than obligation (Finance Committee on Corporate Governance 1999). Overall the results on the perceptions on the roles of Islamic investment funds show that funds are consistently rating prohibitions as being more important than other elements in the investment process. This suggests that existing regulations and rules have played an important role in ensuring investment funds follow major Islamic precepts, in particular the Islamic main prohibitions. Giving consideration to other elements besides these prohibitions, suggests that investment practices may be improved by moving beyond negative-based screening process. Although it can be seen that certain elements such as the preservation of the environment, social contributions, and shareholder activism are rated as less important than negative elements, they have potential to be incorporated in Islamic investment funds investment practices due to their perceived importance. It is recommended that regulations be implemented to encourage a greater variety of the elements of Islamic teaching on investment be put into practiceboth negative and positiveespecially in relation to obligatory aspects such as zakat. Additionally, it is suggested regulatory bodies such as the SEC facilitate the inclusion of positive elements in investment selection through the introduction of education and training programmes that emphasise the importance under Islam of these elements to industry practitioners. Such programmes will support the directive-based mechanisms widely practiced by these institutions. 11

13 CONCLUSIONS This study has explored the perceptions of fund management representatives and staff on the roles of Islamic investment funds as institutional investors. This has been done in relation to screening elements, contributions to society and environment, monitoring, and activism. This reflects the increasing importance of Islamic investment funds as vehicles in Islamic finance, and one of the fastest growth areas of the Islamic financial industry. Rather than view these funds just as financial vehicles, as is normal in the finance area, this study has viewed these funds as institutional investors that have a responsibility towards investors who are devotees of Islam, and other stakeholders as outlined under Islamic teachings. This study brings to light elements that should be emphasized by these funds, since they rely on Islamic teachings, rather than their current focus on the four main prohibitions. Based on Islamic teachings, both positive and negative elements must be reflected conjointly in investment practices. For this reason, positive elements must be more strongly emphasized if the spirit of Islamic investment is to be followed properly. It is important to highlight the need for improvement in investment funds' operations. This is so as to comply with Islamic principles to ensure these funds do not diverge from their real objectives, or be used only as advertising plans to attract capital from beneficiaries. The fulfilment of these elements can thus be considered as the responsibility of these investment funds towards their beneficiaries as whole. The survey on perceptions of the representatives of fund management companies offering Islamic investment fundsone of the contribution of the studyis made to get a perspective on the perceived roles of these funds. The results provide insights into the possibility of incorporating additional elements into Islamic funds investment practices. However, to a certain extent, a mixed result emerges from these perceptions. Based on this study, regulations and, education and training programs by the regulatory bodies are believed to be useful to encourage and educate providers of Islamic investment funds to incorporate positive elements into their investment selection processes. 12

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18 Figure 1: Main Guiding Principles in Islamic Investment Principles Guiding Islamic Investment Positive Elements Societal and environmental concern Zakat (Islamic tax) Sadaqa (charity) Preservation of Environment Management elements -Hisba (supervision) Shura (consultation) Negative aspects: Prohibition of riba (interest) Prohibition of gharar (uncertainty) Prohibition of maysir (gambling) Prohibition of certain goods such as alcohol and pork Table 1: Islamic-Based Screening Criteria Aspects n=44 Mean Standard deviation Non-involvement in interest-based activities Non-involvement in gambling industry Non-involvement in alcohol-based industry Non-involvement in pork-based industry Non-involvement in conventional insurance investment Non-involvement in companies that contribute environmental impact Notes: Totals for certain aspects are not equal to 44 due to incomplete answer. 17

19 Table 2: Contributions to Society and Environment Aspects n=44 Mean Standard deviation Zakat contribution Charity contribution Education sponsorship Societal activities Environmental preservation Table 3: Criteria That Are Considered In Monitoring the Investee Companies Aspects n=44 Mean Standard deviation Monitoring governance aspect Monitoring performance Monitoring operation Table 4: Shareholder Activism That Can Be Used In the Relation with the Investee Companies Aspects n=44 Mean Standard deviation Exercising rights as shareholders Offering advice to investee companies on performance Lobbying quietly investee companies to adopt better policy Campaign publicly for companies to adopt better policy Debates about corporate ethics Promoting higher standards on corporate ethics along with other investors