Asset allocation, as much academic research claims, accounts for more than 90 per cent of the variation of returns. Shariah finance imposes specific demands in this area. BLME, the Islamic bank, explores the issues.

The three key considerations for any investor when determining asset allocation are liquidity, risk profile and desired return. These are clearly all linked, and the starting point should always be the investor liability profile, as this will determine the required balance between fixed income and equity type risk.

The risk tolerance and desired returns of the investor will then govern how much equity risk is kept in listed equities and how much is transferred into less liquid alternative investments. These are common themes to both conventional and Islamic asset allocation models; where the variations occur is in the choice of individual assets. Shariah guidelines preclude investment in interest-bearing assets such as conventional bonds, certain industry sectors, including alcohol, gambling, arms manufacturing and trading, pork-related products and conventional banks and conventional derivative products. Nevertheless, taking these prohibitions into account an Islamic asset allocation model can be developed as follows:

Islamic asset allocation

This is a description of a simple asset allocation model, which is how we suggest investors can choose between the following four different asset classes:

Fixed Income which includes cash, Islamic money market instruments, and sukuk

Equity which includes listed equities, Islamic tracker funds or Islamic exchange-traded funds (often referred to as “passive management”), and professionally managed stock selections (often referred to as “active management”;

Property which includes individual properties or property portfolios funded with cash, not debt, but which excludes equity investments in listed property companies which fall within equity risk (above); and

Alternative Assets which mainly comprise Shariah-compliant private equity funds, but also include some commodities, including agriculture and energy, as well as esoteric asset classes like art.

Investors often refer to fixed income and equities as “core” asset allocations and property and alternative assets as “satellite” asset allocations. This important distinction is discussed further below.

Our starting position is to assume that an investor’s portfolio is equally distributed between all four classes, 25 per cent each, and that these “asset allocations” are subsequently adjusted to reflect three major factors:

·         The liabilities of the investor which naturally change over time; (management of liquidity)

·         The distinction between ‘core’ and ‘satellite’; (risk profile)

·         The investment performance of each of the above asset classes (desired returns).

The three key considerations of liquidity, risk profile and desired returns must continue to be applied as the portfolio matures.

In addition to following the asset allocation model, it is advisable that, at least once a year, investors rebalance their income funds to ensure that they can meet their short term liabilities. They should also review the performance of their “core” investments plus any available “satellite” data to ensure return objectives are being met.  

If the asset allocation model is consistently applied and investments are made and monitored within specific risk and return parameters, investors should benefit from a diversified and balanced portfolio delivering their desired returns.