Q: Would you tell us about the history of the fund and the assets currently under management?
After managing Shariah-compliant fixed-income fund internally from 2010 to 2013, Azzad had reached a threshold. The product, the Azzad Wise Capital Fund, had reached about $50 million, and Azzad felt they needed outside help to manage it – particularly to manage the credit and interest-rate risk.
In November 2013, Azzad approached several firms, and after a due-diligence process they chose our team at Federated as the fund sub-advisor. That became official in June 2014.
The Azzad Wise Capital Fund currently has almost $100 million in assets under management, which represents significant growth since we at Federated started our relationship with them.
Q: What is the mission of the fund?
The Azzad Wise Capital Fund pursues long-term income and capital preservation by investing primarily in Islamic Bonds (Sukuk) and interest-free bank deposits and notes issued primarily by overseas banks in developing countries. A small portion of the Fund’s assets may be invested in dividend-yielding stocks.
In lay terms, the fund seeks to provide a return from fixed-income-like investment-grade assets while focusing on preservation of capital. So, this is not a fund that has long duration or high sensitivity to interest rates; it’s not a fund that has significant credit exposure or high credit risk. It has practically no high-yield instruments; we’re allowed only about 10% maximum. Our goal is to provide reasonable returns with low volatility in a diversified manner, but the main objective is to be Shariah-compliant, which requires alternative investments like Sukuk bonds. I believe this is the only Shariah-compliant 40-Act Fund in the fixed-income market.
While WISEX may have initially focused on Shariah-sensitive investors, it’s not limited to them. We’re looking at all investors in the alternative investment space, not just in the Islamic world. And although this fund invests in assets that do have some correlation to U.S. interest rates, it tends to be a more diversified, less-correlated type of fund than traditional alternative-investment funds or U.S. fixed-income funds, with much less volatility on a relative basis.
The key aspect of WISEX is that our buy-and-hold strategy offers investors a lower volatility fund. It’s not your typical mutual fund. You are getting global diversification with a focus on capital preservation and a limited downside. The fund has fared relatively well in the U.S. short-duration category in general.
Q: How do the roles of Azzad and Federated differ in managing this fund?
Azzad is the investment advisor to the Azzad Funds, which include the Azzad Wise Capital Fund. As of June 2014, Federated took over the day-to-day portfolio management duties as sub-advisor of the Azzad Wise Capital Fund. What does this mean exactly? Simply put, investments are selected at Federated from a universe of fixed-income products passing ethical, Shariah screens managed in-house by Azzad Asset Management.
Using a thorough due diligence process, our investment team at Federated seeks to identify fixed-income investments that are suitable for more conservative investors and in line with the Azzad investment philosophy. The Azzad philosophy does not condone charging or paying interest from lending, trading debt, money market instruments, futures contracts and currencies, based on the notion that financial transactions should be conducted on a fair and equitable basis for both borrower and financier.
Q: What exactly does Shariah compliance involve?
According to Shariah, or the Islamic legal code, money itself does not have any specific value, it’s just a way to exchange assets from one person to another. According to the rules of Islamic finance, you cannot charge interest—it’s haram, or forbidden. But what you can do is share risk and distribute the profits that are earned from that risk.
That’s why many equities are Shariah-compliant – because you share in the risk and the price you get back is a share of the profit. The Azzad Wise Capital Fund provides a way to extend that into the fixed-income market, in a bond-like format.
The return our investors earn is not based on interest; it’s profit-sharing based on an underlying asset -- that might be land, infrastructure, real estate, etc. -- of which they have an ownership stake. But the point is that ownership generates a profit and you share in that profit, rather than being paid a flat rate of interest.
Q: How does a debt interest-paying instrument fit into that process? If you invest in a bond, are you allowed to collect interest?
No, all interest would run afoul of Islamic investing guidelines; you cannot collect interest. But the Azzad Wise Capital Fund is structured in a way that gives you ownership rights over actual assets, almost like an equity share. When the underlying assets generate a profit, you get paid a return. The scheduled payments are set in a certificate or Islamic bank deposit, depending on the kind of asset classes we’re talking about in the fund. They generate profits that pay an income on a regularly scheduled basis, so it resembles a coupon.
Either way, though, it’s not interest; it’s shared profit.
Q: Do the underlying assets in which you are allowed to invest have to meet all the conditions of Shariah law? Do they have to be non-alcoholic and non-harming too?
Precisely. That’s another condition. We also look at how the assets are being invested and what the purpose of that investment is. Ultimately, the objective is to do no harm in society—the universal socially responsible investing credo.
Q: So with those ground rules, how do you go about looking for opportunities? Are you domestic, international, regional? What kinds of bonds are attractive to you?
Let’s talk about Sukuk bonds. If you look at Islamic financial institutions globally, it’s a very large market. There is probably close to $2 trillion in assets, and that number could easily reach $3 trillion in the next three to five years.
The Shariah Advisory Council (SAC) certificate-based market was almost $300 billion at the end of last year. It’s global and it’s growing fast. Traditionally, it’s been the Gulf Cooperation Council countries and Southeast Asian countries that issue Sukuk certificates, and they still dominate – Malaysia is a big issuer, and so is Saudi Arabia.
Then that is subdivided into the local-currency SAC market and the dollar-denominated SAC market. We deal exclusively in the U.S. dollar-denominated market, even though it’s the smaller asset class. In the Middle East, the big issuers on the sovereign or quasi-sovereign side are the UAE, Qatar, and Saudi Arabia; in Asia, Malaysia is a dominant player, but we are also starting to get invested in smaller countries.
Lately, we also are seeing non-traditional issuers. For example, this year alone Hong Kong issued sukuks, the U.K. issued sukuks, South Africa and even Goldman Sachs issued sukuks. So, a lot of non-traditional issuers are expanding and broadening the market.
In terms of what we do, we at Federated are basically a credit shop; we focus on fundamental, bottom-up credit research. Our process is two-fold – we have to make sure the instruments we are buying are in compliance with Azzad’s guidelines, and then we have to make sure they are good investments.
The first step is to show any potential investment to Azzad, which has its own Shariah scholars and its own Shariah board that review and approve all investments. They will either say, “Yes, this is something we can continue to look at,” or “No, it doesn’t comply.” That’s the first part of the process.
Once the Shariah scholars and board approve of an investment, it becomes like any other fixed-income investment we analyze – we look at its credit-worthiness, balance sheet and the country in which it is based. If it’s a corporate, we look at it as a pure corporate; if it’s a sovereign, we look at it as a pure sovereign.
We only deal in high-quality, dollar-denominated issues, and that kind of paper tends to have high sensitivity to U.S. interest rates. Our analysis has to consider not just the credit risk, but also the interest-rate risk. It’s not a 100% correlation, but if it’s something that trades on a spread of 50 or 100 basis points over Treasuries, it will be affected by U.S. interest rates. One of the main goals of the Azzad Wise Capital Fund is capital preservation, so generally, we are not going to take significant interest-rate risk. When we consider a potential investment, we look at the interest-rate expectation and the interest-rate components related to the U.S.
I can tell you, for example, that the duration of the total fund right now is well under two years – so it has a very short duration and lower sensitivity to U.S. interest rates. To achieve that, we invest in three principal asset classes: 1) Sukuk bonds; 2) Islamic bank deposits; and 3) Shariah-compliant equities, generally large-cap stocks that pay a small dividend, say 5% or less:
1) Sukuk Bonds: The biggest part of the portfolio is the Sukuk bonds; those represent around 50%. They are diversified globally, including many countries and companies in the Middle East, Southeast Asia and Africa. It’s a fixed-income portfolio that is regionally and geographically diversified, as well as industry-diversified.
The portfolio generally has no concentration of more than 2% or 3% per issue, and it tends to be a short-duration portfolio – many of the bonds will mature in 2017 or 2018. A few have longer maturities, but even those tend to be five years or less. Again, they also tend to be high quality. Investment-grade is an important consideration for us.
We are allowed to have some below-investment-grade exposure, but it tends to be minimal, and in shorter-dated assets on the bank deposit side; many of those have maturities of one year or less. Geographically, we are invested in the UAE, Turkey, South Africa, Saudi Arabia, Malaysia, Qatar and Indonesia, to name a few countries. That’s the Sukuk part of the fund.
2) Islamic Bank Deposits and Notes: The second part, which we are expanding and using more and more, is bank deposits. These deposits have to be in an Islamic bank or a unit that is Shariah-compliant. Many banks in the Middle East have such an Islamic sub-bank that operates independently but is owned by the parent, and some Turkish banks are set up that way, as well. We like that sector.
The way these work is that you buy the certificate, and at maturity you get your money back, plus a share of the profits that the bank earns on your behalf by investing that money for you. Bank deposits offer an attractive return; no interest-rate risk; and preservation of capital without too much credit risk, because they tend to be short-dated paper -- high-quality or maybe just below investment-grade. They currently represent about 20%-25% of the portfolio, but I see that growing more and more, especially in an environment where we believe interest rates will rise.
3) Shariah-Compliant Equities: The rest of the portfolio comprises a little exposure, about 5%, in high-quality equities.
Also, we keep some cash on hand for tactical considerations, so we can invest as we see fit.
Q: Are the bank deposits available in local currencies or are they in dollar units?
There are both on the market, but we only invest in dollar deposits. I might look at a bank in Turkey or Saudi Arabia or Kuwait or Malaysia, but only at their dollar deposits; 100% of the Azzad Wise Capital Fund is in dollars.
Q: Can you give us some details about your research component? What steps do you take to evaluate a potential investment?
Once a potential investment is approved by Azzad as Shariah-compliant, we go through our standard credit process. There is no extra credit given because this is an Islamic bank; we look at the balance sheet and go through the same research process we use for any investment. So, if we are looking at a bank, we will consider the balance sheet, the quality of earnings, the quality of loans, whether the non-performing loans are increasing or decreasing, the asset base, the deposit base, how reliant it is on local funding versus external funding and the debt profile.
We’ll look at how much money it needs in the next three months, six months and 12 months, what’s the market and what the profitability is, just as we would with any bank.
Looking at a sovereign is actually much easier for us because at Federated, we run other funds like that, so we leverage the research we already are doing on Indonesia or Malaysia or Saudi Arabia.
The major components of looking at any sovereign in terms of credit research are the monetary policy, the fiscal policy, the political situation, GDP growth, inflation and any kind of expected changes in the assets on which the country relies for growth. For us, the credit of the sovereign is paramount.
We also are very mindful of the embedded interest risk coming from the U.S. It’s not that we don’t care what local rates are doing — looking at the local rates gives us more in-depth knowledge of what’s happening in that economy and its stability; in order for the sovereign to service its debts, you have to know what’s happening domestically. But because these investments are dollar denominated, we are focused more on what U.S. rates are doing.
Q: Let’s talk more about the second largest fund component, bank deposits. What is attractive about bank deposits compared to what other Shariah-compliant securities offer?
We are looking for short duration, low interest-rate risk, and hence the lower volatility aspects of bank deposits. I avoid buying anything over one year – I am looking for minimal interest-rate risk.
In this rising-rate environment, that’s probably the most attractive element of bank deposits right now. That may change; if interest rates were 4% or 5%, and we thought they were headed down, we might use fewer bank deposits. But as of now, that’s what’s attractive.
What do we look for? What you look for in any short-dated fixed-income asset is very different from what you look for in a 10- or 20-year bond. For the latter, you are looking for a long-term balance sheet and a company that is going to grow. That’s a much more complicated analysis.
For three-month or six-month paper from a bank, it really comes down to just two things: the ability and the willingness to pay back my money when it comes due. That’s why we consider slightly below investment-grade quality. In general, with bank deposits, things don’t deteriorate very quickly – a bank doesn’t go from a BB+ rating to defaulting in just a couple of months, especially an Islamic bank, which tends to be well-capitalized and supported by a parent bank.
So, we focus on the ability and willingness to pay, and the support of the parent bank for Islamic investors. In Malaysia, Saudi Arabia, the UAE, and Turkey, for example, there is implicit support from the sovereign for these entities because they are vital to the economy. It’s kind of like JP Morgan or Citibank in the United States, the idea of too big to fail. We tend to stick to those kinds of banks in our portfolio.
Q: What kinds of large-cap equities do you consider and what do you look for? Are dividends acceptable to you?
The equities in the fund are managed by Azzad. We discuss the allocation, but they choose the actual equities. Dividends are not an issue. Dividends are shares of profit. They are not guaranteed; you share the risk. So, we don’t have a Shariah issue when looking at equities. We have the largest blue-chip large-cap types of holdings, namely a Shariah-screened version of the S&P 500 companies with a track record of dividends, and each has a very small allocation, roughly 25 basis points or so.
Q: Who determines the allocation of sukuk, bank deposits and equities?
We decide between equities and fixed-income in collaboration with Azzad; we talk multiple times a week. The allocation tends to be fairly stable. Over the past year, the range has been between 5% and 7%.
Our outlook depends on where the equity market is. We determine the allocation of the fixed-income portfolio internally, team at Federated making the determination. That is driven to a large extent by our expectation of the industry.
If I think the industry is strong, I’m going to have more bank deposits; if I see weakness, I’ll have less. I’m not managing it as a clear-cut asset-allocation decision. Instead, I’m looking at the overall yield of the portfolio and what I’m trying to achieve: the overall duration of the portfolio and interest-rate sensitivity.
