Islamic Mutual Funds: How Islamic Are Their Benchmarks?
Exploring the Discrepancy Between Investment Returns and Outdated Benchmarks
I have been waiting for the other Pakistani hedge fund U Microfinance Bank (UBank) to release their 2Q 2023 financials so that I can do a quick review of the financials as a sequel to my last post Pakistani Hedge Funds #3: Pak Kuwait Investment Company is ‘leverage on steroids.’ We will be into 4Q 2023 in three days yet UBank isn’t releasing the previous quarter’s result. Oh well..let’s do a quick post on the useless benchmarks of Islamic mutual funds instead.
In the world of finance, transparency and accuracy are paramount. Investors rely on benchmarks as the yardstick for measuring the performance of their assets. However, in the realm of Islamic mutual funds, a striking incongruity has emerged—one that not only questions financial transparency but also casts doubt on the adherence to Sharia principles. Moreover, it prompts us to ponder the efficacy of a CFA education and the principles of GIPS if they fail to yield tangible results in the reporting practices of Islamic funds.
Irrelevant and misleading benchmark of Al Meezan Sovereign Fund
There was this tweet a few days ago.
The Meezan Sovereign Fund is yielding a return of 20.40%, significantly outperforming its benchmark of 7.80%. While it's not uncommon for active funds to slightly exceed their benchmarks by a few percentage points, the return in this case is nearly three times higher than the benchmark. There's a nagging sense that something may be amiss.
I visited Al Meezan’s fund fact website.
Until fiscal year 2019, the fund's performance closely tracked the benchmark, but in 2020, a shift occurred that rendered the benchmark irrelevant
I googled what SECP says about the benchmark and stumbled upon their August 2016 notice, which recommends that suitable benchmarks should be determined in collaboration with the Mutual Funds Association of Pakistan (MUFAP)..
The subsequent action was to browse the MUFAP website in order to understand the methodology behind the benchmark calculation. According to the information posted on their website for the month of August 2023, the benchmark for Islamic Income Schemes is derived from an average of the returns offered by selected Islamic banks' savings accounts.
Two noteworthy observations emerge:
Islamic banks appear to be offering returns to their depositors that are significantly lower, by nearly 10 percentage points, than what conventional banks provide. This discrepancy would be more comprehensible if Islamic banks were simultaneously offering loans at a rate approximately ten percentage points lower on the asset side of their balance sheet, or if their Sharia compliance costs were close to 10% of their deposit base. However, it seems that neither of these scenarios applies, leaving one to contemplate the alignment of this practice with Sharia principles.
The benchmark used for Islamic money market funds appears to be fundamentally flawed and has exhibited this flaw at least since 2020.
Observation 1 isn’t the subject of this post so let’s ignore it. For Observation 2, CFA Institute’s Global Investment Performance Standards (GIPS) guidance statement on benchmarks for firms recommends the following characteristics for an appropriate benchmark:
A valid composite or pooled fund benchmark is one that is:
• specified in advance. Although this scenario may not always be the case, firms should select a composite or pooled fund benchmark prior to the evaluation period.
• relevant. The benchmark reflects the investment mandate, objective, or strategy of the composite or pooled fund.
• measurable. The benchmark is quantifiable
• unambiguous. The constituents of the investable universe can be clearly identified and priced.
• representative of current investment options. The firm has current knowledge of the investable universe.
• accountable. The firm selects the benchmark and is accountable for any deviations from the benchmark.
• investable. It is possible to forgo active management and simply hold the benchmark.
• complete. The benchmark provides a broad representation of the segment of the market to which it pertains.
Al Meezan might argue that the rate on Islamic savings accounts is the closest approximation they can find for the benchmark of their fund. However, it raises the question of why UBL's Al Ameen Islamic Sovereign Fund (as shown below) employs a more pertinent benchmark. It's worth noting that both Al Meezan's Sovereign Fund (MSF) and UBL's Al Ameen Fund predominantly invest in GoP securities. (if the below image/font is too small, you can get the report by clicking here, Page 6 of PDF).
For comparison, here is MSF's fund management report. What stands out as peculiar in MSF's report is that although the benchmark (indicated by the red arrow) is stated as the 6M PKSRV rate, similar to the Al Ameen Sovereign Fund mentioned earlier, the benchmark comparison chart and table (highlighted in blue) reference Islamic bank saving account deposit rates. (if the image/font is too small, you can get the report by clicking here, Page 15 of PDF).
We can draw two clear-cut conclusions:
Inappropriate Benchmark Selection: Despite the availability of a more suitable benchmark for an Islamic sovereign fund, specifically the 6M PKSRV used in Al Ameen's report, MSF opts for an irrelevant benchmark, namely the MUFAP-defined Islamic bank savings rate.
Potentially Misleading Investor Reporting: I am inclined to believe that the benchmark indicated in the MSF report (red arrow) might be a typographical error. Otherwise, it could imply that MSF is providing misleading information to investors by stating that the benchmark is 6M PKSRV while, in the chart and return comparisons, it is actually assessing performance against bank deposit rates.
Irrelevant Benchmarks of Islamic Income Funds
Now that I have gone down this route, let’s look at some other Islamic funds.
This is Al Ameen’s Islamic Cash Fund which which primarily invests in Sukuks but utilizes the Islamic bank savings account rate as its benchmark. As a result, the fund's performance surpasses the benchmark by nearly threefold.
Next is the NBP Islamic Mahana Aamadni Fund primarily investing in Sukuk yet utilizing the irrelevant benchmark of saving accounts deposit rate.
Finally, this is Al Meezan’s Islamic Income Fund which also uses the bank deposit rates as the benchmark yet generates returns in multiples of it.
There's no need for me to delve into the reports of every Islamic mutual fund, as I trust you understand the gist. All these funds have produced comparable returns that significantly exceed their respective benchmarks. This pattern highlights that the bank deposit rate benchmark has lost its relevance for income funds when they are invested in Sukuks and money market instruments, consistently generating returns that far outstrip it.
CFA Institute’s GIPS guidance mentions different types of benchmarks including the following:
Peer Groups and Manager Universes: Peer groups and manager universes are often used for comparing like-managed funds within a given industry, country, or sector. For example, the investment objective may be to perform in the top quartile of UK managers over a three-year period. Some common problems with peer group benchmarks include the following:
• self-reporting bias (only some pooled funds choose to report performance data), • survivorship bias (historical returns of closed pooled funds are removed from the peer group benchmark),
• inability to obtain returns for the same periods as the composite or pooled fund, and
• lack of investability (some pooled funds within a peer group benchmark are closed to new investors).
Also, because a peer group is typically a median pooled fund return over a specific time period, risk statistics (e.g., standard deviation), which must be presented in a GIPS Report that includes time-weighted returns, are not necessarily meaningful because the median fund could differ for each time period used in the peer group calculation. Although the use of peer groups as benchmarks is not considered best practice, in certain asset classes (e.g., private equity, real estate, alternatives), peer groups are widely used and generally considered the best option available. When using benchmarks that have limitations, such as peer group benchmarks, the firm should disclose these limitations
Bespoke: Bespoke benchmarks are universes of securities created by either the firm or client that specify a benchmark that better reflects the investment strategy than an index available from an index provider. Many types of custom benchmarks exist, such as those created by narrowing the opportunity set of investments (e.g., excluding specific stocks) or by establishing customized rules for inclusion in the benchmark (e.g., including specific sectors).
There's no denying that no benchmark is flawless. However, the unquestionable fact is that the present benchmark suggested by MUFAP and embraced by Islamic funds is utterly irrelevant and has remained so for a minimum of three years, if not longer. When these investment funds share a comparable investment mandate, invest in Sukuks, and consistently achieve returns significantly surpassing the existing benchmark, it's imperative to establish a customized benchmark or one based on a peer group comparison. If MUFAP is unwilling to take this initiative, it should, at the very least, acknowledge the absence of any pertinent benchmark, a practice permitted by GIPS as well.
No Appropriate Benchmark
In some situations, there may be no appropriate benchmark for a composite or pooled fund— that is, no benchmark exists that reflects the composite’s or pooled fund’s investment mandate, objective, or strategy. If the firm determines that no appropriate benchmark for the composite or pooled fund exists, the firm must disclose why no benchmark is presented.
Sample Disclosure: “Because the composite’s strategy is absolute return and investments are permitted in all asset classes, no benchmark is presented because we believe that there is no benchmark that reflects this strategy.”
چراغ تلے اندھیرا
The leader of Al Meezan, Mohammad Shoaib, not only holds the prestigious position of founding president at CFA Society Pakistan but also sits on the Executive Committee of GIPS, the body responsible for benchmark guidance. Additionally, he chairs the Mutual Funds Association of Pakistan, the organization responsible for these clearly skewed benchmarks. With such an impressive résumé, one would expect Mr. Shoaib to be acutely aware of the pressing need to update these benchmarks. Therefore, it is genuinely startling that Islamic funds in general, and Al Meezan funds in particular, continue to rely on these hopelessly outdated benchmarks without any discernible effort to refresh them over the past three years, rendering them entirely irrelevant.
The glaring mismatch between the investment returns of Islamic mutual funds and their outdated benchmarks, as highlighted by the performance of Al Meezan and other similar funds, raises significant concerns. It is imperative that the Securities and Exchange Commission of Pakistan (SECP) revisits its guidance and directs the Mutual Funds Association of Pakistan (MUFAP) to formulate benchmarks that are relevant and reflective of the current investment landscape. Without a doubt, this is a crucial step to ensure transparency and accuracy in reporting and to better serve the interests of investors in Islamic mutual funds.