Islamic finance is the major way of banking and financing within Islamic communities. The Shariah-compliant segment is designed according to the Islamic law, which prohibits certain activities such as collection of interests, as well as investments in businesses deemed harmful, including pornography and tobacco.
Islamic finance accounts for around 3% of the global financial markets by valued assets, with key activities in Southeast Asian (SEA) markets such as Indonesia, Malaysia and Brunei, and the Middle Eastern region. Islamic finance consists of Islamic banking, Sukuk (fixed income), Islamic equity funds and Islamic insurance, among other lines of business.
In the Middle East, the Islamic finance market is estimated to be worth $2 trillion in 2024 and is expected to reach $2.57 trillion by 2029, according to reports. Iran and Saudi Arabia are two of the world’s largest markets by Shariah-compliant assets, with over $400 billion in both countries.
The region is also the largest contributor of Islamic banking, with Gulf Cooperation Council (GCC) countries being home to some 70% of the Islamic banking assets in 2023, according to S&P Global Ratings.
In this piece, FinanceAsia spoke to market players to find out where they see the most opportunities.
Sukuk: an alternative funding source
Data from S&P Global Ratings suggested that 37% of the Sukuk issuances in 2023 came from issuers based in GCC countries, revealing a growing Islamic funding need from GCC companies. Saudi Arabia has been the main growth driver, particularly in dollar-denominated Sukuk issuances.
Some proceeds from the Sukuk issuances are channelled to activities related to energy transition and sustainability, on top of general business operations, according to Sue Lee, director and Asia Pacific (Apac) head of index investment strategy at S&P Dow Jones Indices.
This coincides with a push across most GCC governments to diversify away from economies that have been overly reliant on the oil trade. Amid the diversification drive, new sectors such as green technology and clean energy are high on the agenda. For example, Saudi Arabia is aiming to achieve net zero by 2060, and is targeting 50% of renewable energy usage by 2030.
To achieve such goals, extensive fundings are needed to support infrastructure and technology development in the region, which in turn pushed up the issuance volume within fixed income space.
Sukuk, as a Shariah-compliant alternative to conventional bonds, provides issuers with a diversified funding source by tapping into a different investor pool, Lee said. For example, markets in SEA, such as Malaysia, are long-time leaders within the Islamic finance space.
Statistically, Sukuk products performed better than its peers on the secondary market in the first half of 2024.
Lee explained that this is linked to an averaged shorter duration of Sukuks, generally less than five years. In an environment with rising interest rates, short terms have become an advantage for the Islamic fixed income product.
Meanwhile, sustainable Sukuk is growing fast from a low base, supporting the energy transition of GCC countries.
Equity funds: growing investor demand
Munirah Khairuddin, chief executive officer (CEO) Malaysia and managing director, strategic distribution and institutional client relations, Southeast Asia and global Shariah, at Principal Asset Management, said that the teams is seeing growing interest from Middle Eastern investors, especially those based in Saudi.
“As Middle Eastern economies grow and diversify, there will be an increased demand for Shariah-compliant investment products. Investors who are guided by Islamic principles will seek out opportunities that align with their values,” she said.
A premium in Shariah-compliant investments is also applicable to other asset classes at the moment.
For example, the S&P 500 Shariah, an index which covers all Shariah-compliant constituents of S&P 500, offers a 1-year return at 26.77%, slightly higher than that of S&P 500 at 26.15%. Lee said that Shariah-compliant global equity indices generated on average 2.5% excess return per annum versus their conventional counterparts, over the past five years ending June 30, 2024.
The Shariah-compliant indices, filtered with Shariah rules, take out financial stocks and high-leveraged sectors such as utility, which in turn leads to an increased undertake of other sectors such as tech stocks. In times when the information technology (IT) sector outperforms financials, Islamic indices will generally outperform as well.
Steven Larson, portfolio manager, global equities, at Principal Financial Group, echoed these views, expecting sustaining returns generated from IT, logistics, healthcare and biomedical sectors.
“The global Islamic finance industry continues to rapidly grow its assets but only in a few core markets,” he said.
Larson added: “Additionally, we see an increased appetite for private market products, however, the market lacks shariah-compliant structures to cater to the rising demand. Nonetheless, we are seeing more efforts from asset managers to develop more shariah-compliant strategies in real estate, private lending and private equity.”
On top of that, “Shariah rules share a lot of commonalities with environmental, social and governance (ESG) principles. And as more investors look to these principles while investing, returns of ESG or Shariah-compliant companies may be affected,” Lee pointed out.
In terms of Islamic funds, she said that an increase in passive assets should be an upcoming opportunity, as proportion of passive assets under management in Islamic funds are much lower than that of conventional ones.
Meanwhile, Kuala Lumpur-based Khairuddine pointed out how regional initiatives and partnerships can help standardise practices, enhance liquidity and create larger markets. This also includes improvements in trading platforms, settlement systems and regulatory frameworks to make Islamic finance more accessible.
Digitising Islamic finance
Islamic finance also faces a problem of limited products, as well as investment appetites.
Rushdan Nadzir, director of Shariah services at CGS International Securities, pointed out that while generic Islamic banking products are available, more sophisticated ones, such as derivatives and structured products, have room to grow.
“'One product fits all' will not work. Products must be developed and tailored according to the customer’s needs and to do so, market research should be performed," he furthered. Apart from Sukuk, Nadzir anticipated an emergence of environmental, social and governance (ESG) related Islamic products; those targeting high net worth individuals and family offices; as well as exchange-traded funds (ETF) and real estate investment trusts (REITs).
Saif Khan, founder of iFintechpro, a fintech player focussing on Islamic finance, said enhances in technology and digitisation would help.
“Internet penetration is high in the Middle East, with more and more people opting for digital products. The landscape is shifting towards a digital-first approach,” he told FA.
These include digital Islamic banking, digital Sukuk issuances, and tokenisation of real-world assets, on which Khan’s team is working on. He said that the blockchain technology would help lower thresholds and improve risk profiles of investment projects, therefore making Islamic investment more accessible. For example, assets like buildings, solar farms and agricultural projects can be tokenise, enabling retail investors to invest and benefit.
“Technology can reduce the wealth gap by making high-quality investment products available to everyone,” he said.
Despite the practice remains at its infant stage, Khan said some markets in the Middle East have already established a welcoming regulatory framework. In Dubai, the Dubai Financial Services Authority (DFSA) introduced its rules over investment tokens in 2021, as part of its digital asset regime. Saudi Arabia and Qatar have also put in place similar guidance.
Another potential use case would be tokenisation of Waqfs, referring to endowments of property that are donated for religious and charitable purposes, as per Islamic law.
“This can lead to tremendous social impact by providing transparency, traceability and greater trust,” he explained. “With smart contracts on chain, updates could be automated and simplified for stakeholders.”
To press ahead, more communication between regulators and different players is needed, Khan added. For example, legal structuring, investor protection, liquidity and market education are some aspects to carefully consider.
