Principles of Islamic banking and finance/PIBF203/Portfolio management/Overview

Portfolio management in finance

According to Investopedia "Portfolio management is the art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance. Portfolio management is all about determining strengths, weaknesses, opportunities and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other trade-offs encountered in the attempt to maximize return at a given appetite for risk."

The Key Elements of Portfolio Management

Asset Allocation

"The key to effective portfolio management is the long-term mix of assets. Asset allocation is based on the understanding that different types of assets do not move in concert, and some are more volatile than others. Asset allocation seeks to optimize the risk/return profile of an investor by investing in a mix of assets that have low correlation to each other. Investors with a more aggressive profile can weight their portfolio toward more volatile investments. Investors with a more conservative profile can weight their portfolio toward more stable investments."

Diversification

"The only certainty in investing is it is impossible to consistently predict the winners and losers, so the prudent approach is to create a basket of investments that provide broad exposure within an asset class. Diversification is the spreading of risk and reward within an asset class. Because it is difficult to know which particular subset of an asset class or sector is likely to outperform another, diversification seeks to capture the returns of all of the sectors over time but with less volatility at any one time. Proper diversification takes place across different classes of securities, sectors of the economy and geographical regions."

Rebalancing

"This is a method used to return a portfolio to its original target allocation at annual intervals. It is important for retaining the asset mix that best reflects an investor’s risk/return profile. Otherwise, the movements of the markets could expose the portfolio to greater risk or reduced return opportunities. For example, a portfolio that starts out with a 70% equity and 30% fixed-income allocation could, through an extended market rally, shift to an 80/20 allocation that exposes the portfolio to more risk than the investor can tolerate. Rebalancing almost always entails the sale of high-priced/low-value securities and the redeployment of the proceeds into low-priced/high-value or out-of-favor securities. The annual iteration of rebalancing enables investors to capture gains and expand the opportunity for growth in high potential sectors while keeping the portfolio aligned with the investor’s risk/return profile."

Portfolio management in Islamic finance

As it could be concluded from above, the basic issue in portfolio management is portfolio management is to allocate the available investment funds in away so as to maximize the returns given a particular level of risk appetite that could be different for different individuals and institutions. In most cases the total funds are allocated to a mix of assets yielding fixed and variable returns. Within these tow types of assets, a further allocation is made based on their risk and return profiles. Finally, to reduce the overall risks of the portfolios, diverse domestic and foreign industries are chosen.

When it comes to Islamic finance, the major problem arises due to prohibition of interest. Of course, there are other issues such as non allocation of any funds to companies producing goods and services prohibited under shari'ah.

"Islamic finance is currently witnessing a huge momentum in the global financial markets triggered by the growing Muslim population and their demand to invest their capital in financial products that do not conflict with the Shariah. The Islamic fund and wealth management industry specifically is growing rapidly in terms of number of funds launched or portfolios managed as well as the value of assets under management. According to Ernst & Young, global Islamic funds reached about 700 funds with assets under management exceeding about US$44 billion. Similar numbers were reported by Booz & Co. who state that the number of Islamic funds is growing annually by about 30% – which of course slowed down during the recent financial crisis. This growth is not only witnessed in Muslim dominated countries such as the GCC countries or Malaysia but even extended to offerings in Western countries such as the US, UK, and Germany. Asset management firms in the West either offer these services to the Muslim communities residing in these countries, or as is most common, to attract and manage GCC wealth."

This section will provide the current practices and procedures in Islamic portfolio management and the possible future trends in this area.