Opportunity Knocks for Islamic Index-based Products
Historically the Islamic world has been sparsely served with investment products because many providers have been deterred by the perceived time, trouble and expense required to comply with Shari’ah principles, which restrict Muslims from investment in companies that produce or sell prohibited products and substances, including pornography, alcohol, tobacco and pork.
The principles also prevent investment in banks and other types of financial services companies that infringe Islam’s prohibition of the charging of interest, and they make it difficult to follow certain investment techniques such as short selling, using leverage or buying securities in margin, because Muslims are not allowed to sell something they do not own.
But with Muslims making up more than 20% of the world’s population, and the wealth of many Islamic countries and their people having grown sharply in recent years as a result of the surge in energy prices, their potential as investors is much too big to ignore. For years, some of the brightest financial minds have been examining with Islamic scholars how to design and offer to Muslims a range of financial products that do not contravene the Shari’ah rules.
It was the potential of the Muslim world, from oil-rich Saudi Arabia to developing and populous Indonesia, that prompted the launch in 1999 of the Dow Jones Islamic Market Indexes. Constructing a Shari’ah-compliant portfolio stock by stock would exhaust the patience of the most dedicated institution, but at that time, there was no set of indexes available anywhere offering benchmarks for investment that complied with Muslim beliefs.
Developing rules for the index family required substantial investment of time and resources. The key was assembling an independent Shari’ah advisory board composed of respected members with different backgrounds and national origins, to develop a consensus on what companies could be considered acceptable investments and which could not, and to provide an interpretation of Shari’ah in which Muslims would place their trust.
While there can be differences of interpretation among Islamic scholars about the permissibility of different investments and structures, they are also mindful of Islam’s positive view of free enterprise and markets. The experts work together in a spirit of compromise to develop a formal methodology to determine which stocks are Shari’ah-compliant and which are not, enshrined as a standard to which the scholars give their endorsement.
Even today, a number of misconceptions persist about Shari’ah investment principles – for instance, that only companies with Muslim managers or based in an Islamic country are eligible. On the contrary, the Dow Jones Islamic Market index family includes many of the same components as well-known mainstream indexes, such as the Dow Jones Euro STOXX 50 and the Dow Jones Industrial Average.
The selection universe for the Islamic Market Indexes is the Dow Jones World Index, which accounts for around 95% of the underlying market capitalisation of 44 countries whose stock markets are open to foreign investors, excluding the smallest and most thinly traded stocks. The components approved by the Shari’ah board comprise nearly 2,300 of the 6,400 stocks in the World Index and include many of the world’s largest and best-known companies, including Coca Cola, BP, Glaxo SmithKline, Vodafone and Anglo American.
Companies that are excluded from the Islamic investment universe include producers of alcohol and pork-related products, providers of conventional financial services such as conventional banks and insurers, and providers of entertainment services, such as hotels, casinos and betting firms, films and music. The indexes also rule out some sectors that are not strictly prohibited by Shari’ah, including tobacco companies and defence and weapons manufacturers.
In addition to the industry screens, stocks are also subjected to a series of financial-ratio screens to exclude companies with excessive levels of either debt or interest income. They may be excluded or dropped from the Islamic indexes if any of their debt, cash plus interest-bearing securities, or accounts receivable, represents 33% or more of their average market capitalisation over the previous 12 months.
In addition to changes due to mergers, delistings and bankruptcies, the composition of each index is reviewed four times a year for continuing compliance with Shari’ah principles to ensure that the business and revenue sources of each component stock remain within the limits set out by the advisory board.
Over the past seven years, the Dow Jones Islamic Market Indexes have expanded into a comprehensive range of more than 80 sub-indexes, all using the same screening criteria but divided like other index families according to criteria such as market capitalisation, sector and geographic region or country.
One interesting facet of the Islamic indexes is that whereas investment on moral or ethical lines, such as according to criteria of environmental sustainability, often require the investor to accept a lower return than from a comparable broad market benchmark, Shari’ah principles do not historically impose any performance penalty; indeed, many of the Dow Jones Islamic Market indexes tend to perform better than their conventional counterparts.
Part of the reason for this is the requirement for index component companies to keep debt and other fundamental ratios within prescribed bounds. For example, both Enron and WorldCom were formerly members of the Islamic World indexes, but each company was excluded at least a year before its respective declaration of bankruptcy because some of their fundamental measures, notably debt ratios, no longer complied with the Shari’ah requirements.
Since the two companies remained components of conventional indexes that do not consider fundamentals in determining membership, this suggests that Islamic indexes could sometimes act as an alert system for the financial markets as a whole. By no means all removals of stocks from the Islamic family are down to financial problems – it could, for example, reflect the sale of a subsidiary or division for cash – but the increased indebtedness prohibited by the rules may in some cases point to solvency problems in the future.
In addition, in many instances the rules governing Shari’ah investment, such as the exclusion of stocks related to alcohol, tobacco, pornography and weaponry and restrictions on debt, not only resemble the criteria used by ethical investors in North America, Europe and elsewhere, but provide diversification for conventionally constructed portfolios. It may be that greater understanding of Islamic investment rules will in future prompt their adoption by a much broader range of investors outside the Muslim world.
Since 1999 the development of the Dow Jones Islamic Market Indexes has done much to remove many of the misconceptions surrounding Shari’ah compliance among product providers and major investors. This growing familiarity has prepared the ground for the next stage in the development of the Islamic investment industry, the creation of a wider range of index-linked products including funds as well as certificates and warrants.
Currently more than US$5bn is invested in index-linked investment products, mostly mutual funds, which use the Dow Jones Islamic Market Indexes as a benchmark. However, this illustrates the potential for growth, since this figure accounts for barely 1% of the estimated total market for Islamic investment. By contrast, the proportion of investment linked to market indices is estimated at 35-40% in the US, 20-25% in the UK and 10-12% in continental Europe.
Today, the majority of products that use the indexes as benchmarks are actively-managed funds, but given the patchy record of active funds in beating their benchmark and their higher management charges, there is an opening in the market for products that track the Shari’ah-compliant indexes. This opportunity is about to be seized by a range of providers who are preparing to launch products in the near future.
By the end of the first quarter of 2007, investors are likely to see a much broader offering of products for investors including not only index-tracking funds but certificates and exchange-traded funds (ETFs). As securities that trade on an exchange and are capable of gathering substantial assets, ETFs may well provide the breakthrough for Islamic products in the mainstream markets and bring them onto the radar screen of conventional investors, prompting the development of further products.
A lot of interest is coming from Europe, in part because of the region’s burgeoning Islamic population. Countries such as the UK, France, Germany and Sweden are home to sizeable Muslim communities whose members are increasingly prosperous but are often constrained by the lack of permissible investment opportunities apart from real estate.
Whereas conventional investors in Europe and North America are accustomed to being spoiled for investment choice, with tens of thousands of funds, certificates and other products available on the market, Islamic investors have up to now faced an acute shortage of collective investment vehicles and high charges for actively managed equity products that can severely depress performance. While there is growing enthusiasm about the potential for Islamic bonds, commodity investments, real estate investment trusts and even hedge funds, the first priority is an attractive range of core equity investments.
Europe often serves as a gateway for investment companies into the Gulf Co-operation Council countries, North Africa and South-East Asia. The pent-up demand for broader investment opportunities can be seen in the impressive if volatile performance of Gulf region stock markets such as Dubai, Bahrain and Kuwait. The development of Islamic index products is also opening the door to cross-investment across Muslim regions, such as between South-East Asia and the Gulf – both of which have money looking for investment opportunities and in particular for diversification outside its home market.
The existence of the Dow Jones Islamic Market index family and the assurance provided by approval from the Shari’ah advisory board relieves both retail and institutional investors of the burden of conducting due diligence for Shari’ah compliance company by company as part of a stock-picking process. As an independent provider, Dow Jones Indexes has no view on whether a particular company should or should not be included in an index, simply an interest in ensuring that the rules determined by the Islamic experts are applied accurately and consistently.
As in Europe and North America, the next step beyond equity indexes is likely to involve a range of increasingly complex and sophisticated Islamic indexes. Already sukuks or Islamic bonds have attracted interest from Western financial institutions, with issuers such as German local authorities attracted to the market because of the established demand from institutions in many parts of the world. In spring 2006, Dow Jones Indexes and Citigroup Corporate and Investment Banking, launched the Dow Jones Citigroup Sukuk Index, the first index that measures the performance of global bonds complying with Islamic investment guidelines.
Meanwhile scholars are examining how to construct real estate funds, commodity vehicles and hedge funds in a way that complies with the Shari’ah strictures. These types of product may take longer to find their way into mainstream retail markets, but the important message of Islamic equity market indexes is that whatever their type or complexity, methods can be found to deliver the same investment characteristics in a form that respects Shari’ah principles – good news for investors throughout the Muslim world, and beyond.