Research Paper: Shariah Review of Hedge Funds

Hedging involves reducing overall risk by taking on an asset position that offsets an existing source of risk. Its strategies encompass a broad range of risk tolerance and investments, such as but not limited to, debt and equity securities, commodities, currencies, derivatives, and real
estate vehicles. The most widely used equity longshort strategy involves simultaneously taking long and short positions in stocks. Such a strategy is not compliant with Shariah as short selling involves Gharar and Riba. Another common strategy is credit funds. Credit funds include distressed debt strategies, fixed income strategies, direct lending and others. Credit funds are non-compliant with Shariah due to the existence of bond trading which also involves Riba.

Other common strategies include market neutral funds, merger arbitrage and convertible arbitrage. The Shariah compliance of such strategies depends on the instruments employed.

The overall objective and concept of a hedge fund is not against Shariah principles. Mitigating one’s risk as much as much as possible and
trying to gain a favourable return is acceptable. However, this must be achieved within the confines and guidelines of Shariah. The problem with conventional hedge funds is the financial instruments used to conduct the hedging. A hedge fund which uses Shariah compliant
financial instruments to hedge positions has the potential to be Shariah compliant. Some Shariah compliant instruments include Bai al Arbun, sale and promise and Wa’dan. The Tahawwut master agreement is a big development to assist in formulating risk management strategies in the Islamic finance sector. Despite this, much more work is required to develop this sector within the Islamic finance space.

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