Gains for Shariah-compliant assets

There has been a gradual but important evolution in the methodologies implemented by index providers to create appropriate Shariah-compliant indices. While there are differences in some of the details, all the main indices have broadly similar methodologies regarding business activity screening, financial ratio screening and dividend purification.

Shariah-compliant indices offer investors the ability to gain equity exposure based on a screening and selection process that combines benchmark index design with Islamic principles. As a result, these new indices have allowed investors to follow equity markets in a way that is consistent with their underlying ethical principles and secure in the knowledge that these indices have a rigorous structure and methodology.

The evolution of well-defined indices that are acceptable to a broad constituency of Islamic investors has also led to the development of suitable investment products. Additionally, the availability of these indices has allowed for the widespread introduction of lower cost products such as Exchange Traded Funds (ETFs), with well defined exposures and high levels of transparency, to enter the market.

The first Shariah-compliant ETF was launched in January 2007 based on a narrow large cap global index from Dow Jones. Since then, other ETF providers have entered the market, although these have tended to incorporate some swap-based elements typical of less transparent funds.

Since the first Shariah-compliant fund, iShares, the world's leading provider of ETFs, has also introduced Shariah-compliant ETFs; however these were created on a physical based structure. These ETFs offered a number of 'firsts' – they were the first to be based on broad recognised global benchmark indices and were the first to offer Shariah-compliant exposure to MSCI World (Developed Markets) and MSCI World Emerging Markets. This meant that for the first time, Islamic investors could access broad equity market exposure via ETFs, thereby gaining exposure to key benefits such as exchange liquidity, transparency and low costs.

Transparent structure

The MSCI Islamic indices for equities covering the developed world, the emerging market world and the US are accessible through a physical ETF structure. This configuration is important from a Shariah perspective, as the fund owns the underlying securities, thus making it the most appropriate and transparent structure with respect to ensuring compliance at both an index and a product level.

The benefit of the new indices is that they allow an expansion of the use of ETFs amongst investors where exposure to Shariah-compliant equities is an important consideration. The physical ETFs bring with them the multiple benefits of on-exchange liquidity, an efficient creation and redemption process, a multi-dealer trading platform and the transparency of holdings and structure.

The key feature of all the Shariah indices is the screening process. Companies are screened for compliance with Shariah principles and those involved in non-compliant activities are screened out of the Shariah indices. Companies are then screened again for financial ratios in terms of leverage, cash and the share of revenues derived from non-compliant activities.

Whilst initial index design tended to adopt an absolute form of exclusion from any of the prohibited activities, recent methodology has tended to employ a revenue based cutoff using these categories. The absolute exclusion index selection criteria is currently only used by Dow Jones in its Islamic indices, the revenue-based cutoff for the other index providers is typically five per cent of the total revenue.

The main element of index methodology relates to the screening of stocks based on financial criteria. The aim of this screening is to address the issue of companies having excessive leverage or where a significant portion of income is from interest receipts.

There are a number of different ratios calculated for the purpose of financial screening; however one of the main differences amongst index providers is the use of market capitalisation as opposed to the total assets of a company. Ultimately, using market capitalisation can lead to a more volatile screening process even when a 12-month average is used, whilst total assets bears a greater relationship to the underlying balance sheet criteria being analysed.

Dividend purification

In order to mitigate the impact of the inclusion of income from either interest income or prohibited activities, there is a process of dividend purification. This is designed to allow investors to deduct from their dividend income the appropriate amount that should then be given to charity. As a result, the underlying Shariah-compliant benchmark varies substantially from the base index. If one considers a broad developed market equity exposure, as represented by the MSCI World Index, then the differences due to the screening process are easily highlighted when comparing to the MSCI World Islamic index.

The core element of the screening process is based on business activity and this drives the bulk of the sector differences. Understandably, the most substantial sector change relates to financials, where the weight in the Islamic index falls to 1.17 per cent versus 19.4 per cent in the unscreened MSCI World benchmark. The main beneficiaries of the selection process include energy stocks, healthcare and materials.

The main differences between the indices can be seen with the recent outperformance as a result of the reduced weighting in financials. A comparison of the main Shariah-compliant indices from a performance perspective shows that at a developed world level, they are broadly similar.

The correlation over the past year for the FTSE and Dow Jones indices to the equivalent MSCI World Islamic index has been over 99 per cent. The daily tracking errors range from 3.3 per cent for FTSE to over four per cent for the Dow Jones indices.

Overall, the trends for the first half of 2009 have been encouraging with assets under management growing by over 50 per cent. Whilst the overall market has grown in terms of ETF products, the weak performance of the equity environment has conspired to limit the growth of assets under management. However, as equity markets recover and investors become increasingly aware of the benefits of trading ETFs, we could expect Shariah-compliant assets to grow significantly in the near future.

- The writer is the Vice-President and Regional Business Director, GCC, iShares. The views expressed are his own

Follow Emirates 24|7 on Google News.