Incorporating Islamic finance into a sovereign wealth fund

FT Tilt, an emerging markets blog (one I recommend), has a article about the Qatar sovereign wealth fund and the more aggressive posture it has taken compared with the Abu Dhabi Investment Authority. The article compares the track of the Qatar Investment Authority with that of the Dubai World private equity subsidiary Istithmar and quotes another blog:

"They did not want to own 20 million shares of Costco, they wanted to own Barneys. They didn't want to own six dozen holiday inns in the Midwest [US], they wanted to own the W Union Square in New York. They didn't want to own 3% of Federated Investors they wanted to own Perella Weinberg and GLG. For the powers that be in Dubai making levered investments into high profile companies was part of building 'Brand Dubai.'"

As they note, the Qatar Investment Authority has not taken nearly as aggressive an approach as the brand-driven Dubai fund, but if the global economy continues to recover, it may be tempted to take a similar approach (although probably with less leverage than Istithmar given the "New Normal").

An alternative "brand-driven" approach for the sovereign wealth fund would be one based (at least in part) on Islamic finance. While it is relatively small ($60 to $80 billion) compared to Abu Dhabi's sovereign wealth fund, it is still large enough to be selective in its investment decisions to avoid the types of investments that brought Dubai World to the brink of default. In the process, it could use its clout to force the investment banks bringing deals to strip out extra costs normally associated with Islamic financial products.

This would add value not only to the Qatar Investment Authority but also to the industry as a whole. While doing so, it should avoid the pitfalls of capturing "landmarks" but instead creating opportunities for others. For example, instead of subscribing to sukuk on its own, it could focus on taking a 'lead investor' position in sukuk from GCC companies as well as global companies interested in 'jumping the gap' into Islamic finance. More helpful (both to QIA in the long run and other investors), it could adopt the approach of creating liquidity in secondary markets by selling a portion of its allocation in secondary markets in sukuk with significant investor demand.

This would have the advantage of capturing some gains in sukuk that see high investor demand but would also spur secondary market development in sukuk generally (and free up capital to buy in other secondary market issues). More liquid secondary markets benefits sovereign wealth funds not only in assessing market values for sukuk they already hold, but also by providing opportunities to diversify their holdings and move between different sukuk. Most bond fund investors already do this with conventional bonds, but it is currently much more difficult to do with sukuk, particularly where investors are looking for larger volume trading opportunities.

In addition to sukuk, a move into Islamic finance could create an opportunity for the QIA to contribute to broader social goals within and outside of Qatar through Islamic microfinance. Many Istithmar investments (like the W Hotel) were "status" purchases. They may have been viewed as solid investments pre-crisis, but the acquisitions were done with secondary motives in mind (building Brand Dubai). If secondary motives are included in the investment decision, shouldn't they do more to contribute than just through the acquisition of landmarks? Qatar have been working in other areas to increase its global profile in arts, culture, media and diplomacy. Blending a poverty reduction strategy into a sovereign wealth fund that incorporates Islamic finance seems like a good way to build credibility for both Qatar and Islamic finance.