* Capital-protected products traditionally distrusted
* Some scholars find them controversial
* But equity volatility pushes investors towards them
* Industry gravitates toward wa'ad structure
* This allows exposure to wide range of markets
By Bernardo Vizcaino
SYDNEY, June 14 Islamic capital-protected products are starting to gain ground among retail investors in the Gulf, because of volatility in the equity markets and growing acceptance within the industry of how the products are created.
Traditionally, capital-protected products have been somewhat controversial among Islamic investors; although offering a defined return is acceptable in Islamic finance, investors must take some risk, so that they are not getting money for nothing. In capital-protected products, it can be argued that investors are avoiding downside risk.
The complexity of the products has also alienated some Islamic investors, given Islam's suspicion of pure monetary speculation and financial engineering.
"It's a proprietary solution, a black box," said a senior banker involved in one of the transactions, adding that reading the fine print of the contract was needed to understand some of the risks borne by investors.
But investors' disillusionment with equities is pushing some towards capital-protected products as a relatively safe alternative. After soaring in the first quarter of this year, Gulf stock markets have given up almost all their gains as the global financial climate has worsened. Equities trading volumes have fallen back towards last year's low levels.
Takaful (Islamic insurance) companies in the Gulf and Saudi Arabia have cut their equity exposure by 30 percent over the past five years, according to an April report by Ernst & Young.
"Long-only funds have not met the requirements of sharia-compliant investors" who lack tools to protect themselves against high market volatility, said Ruggiero Lomonaco, executive director for the Middle East and Africa at Royal Bank of Scotland.
A number of Gulf institutions is responding to the market opportunity. Earlier this month, Qatar-based Barwa Bank launched a retail offering linked to a basket of Indonesian and Turkish stocks, guaranteeing all principal with the "potential to earn double-digit returns", the bank said.
Dubai-based Noor Islamic Bank launched two products in May. One is linked to the volatility of stock markets in the six Gulf Cooperation Council countries; if a benchmark for volatility is breached, exposure to equities is trimmed and moved to other investments. The other offers a choice from a basket of asset classes; every six months, clients are given the option to pick the best-performing asset and drop another from their basket.
In March, Dubai-based Takaful Emarat launched an equity fund offering 90 percent of principal protection, structured via Morgan Stanley. The aim was to "come up with innovative products that suit the demands and needs of our customers", chief executive Ghassan Marrouche said.
Industry sources said it was too early to tell the extent to which demand for capital-protected products was rising in the Gulf. Takaful Emarat said it raised 4 million dirhams ($1.1 million) in the first two weeks.
Since the products are sold as certificates, with assets actually held in large issuer companies such as Morgan Stanley, asset size is not reported by the Islamic banks, making it hard to determine the volume of their business.
But in the United Arab Emirates at least, the regulatory environment appears to have become more welcoming for structured products in recent months.
"In the UAE, the approval process for retail distribution was tightened three years ago, but since then it has been somewhat relaxed," said Geert Bossuyt, chief executive of Islamic finance consultants Dar Al Istithmar.
Conventional capital-protected products often comprise a zero-coupon bond, which guarantees a fixed amount at maturity, and an option contract that provides access to a particular market exposure.
Islamic versions tend to use a similar approach. The guaranteed principal is often created using a murabaha, a cost plus mark-up contract, that delivers a return similar to a zero-coupon bond.
Attempts to replicate the option contract have spawned different, competing methods but the market has gradually warmed to a structure known as wa'ad, a "unilateral promise". Effectively the issuing institution promises to deliver a return linked to a reference index.
This flexibility has allowed investors access to commodity baskets, as in the case of a product launched by Abu Dhabi Islamic Bank in September, and hedge fund returns, as in a product available from Dubai Islamic Bank.
The wide range of financial instruments and markets to which Islamic investors can be exposed through a wa'ad has prompted criticism from some sharia scholars, who have questioned whether religiously impermissible industries such as tobacco could become involved indirectly.
Also, Islamic scholars are against the buying and selling of promises; capital-protected products can be seen as based on precisely this activity.
But since the early years of Islamic capital-protected products in 2004-2005, when the objections were strongest, the wa'ad solution has gradually gained acceptance across the industry, including among large international firms such as RBS and HSBC.
Scholars in Saudi Arabia have spoken against wa'ad, but at the same time they have recognised that they have previously approved the structure in mortgage products, said Bossuyt at Dar Al Istithmar.
At one stage another structure called arboun, an Islamic call option, competed with wa'ad. But it appears largely to have lost the battle; Lomonaco at RBS said arboun was "obsolete", while Bossuyt said, "Arboun is not widely accepted."
"Everybody discusses wa'ad and everybody hates wa'ad, but at the end of the day everybody uses wa'ad," he said. (Additional reporting by Anjuli Davies; Editing by Andrew Torchia)