Shari'ah Governed Investing
Shari’ah principles are applied to all aspects of living an Islamic life. For our purposes we are interested in their application to the investment world to accommodate individuals and institutions adhering to these principles, which are religious. At the same time, aspects might be shared by a variety of socially responsible investors that abide by certain ethical, social, or cultural requirements. In general, Shari’ah principles are concerned with the distribution of wealth in society, how income is generated, and how profit and loss is shared.
Shari’ah principles are set forth by qualified religious scholars. Global estimates claim there are about 250 clerics and only about two dozen or so that are internationally known and, therefore, coveted to help design and approve investment products. These individuals also provide ongoing support to financial institutions to assure products continue to conform to Shari’ah rules. Portfolio managers must have trades approved by the Shari’ah committee. Where possible, a pre-approved list of securities facilitates this process, avoiding unnecessary delays in communications. The process is both time consuming and expensive for financial firms.
General good practice states that Shari’ah committees consist of three or more individuals. In fact, most clerics serve on multiple committees. Some have called into question whether scholars are serving on too many committees and perhaps overstretching their ability to support firms and products adequately. There is a significant movement underway to develop the Shari’ah cleric pool.
The following list is a high level guide to the principles of Shari’ah. Words in parenthesis note the Islamic word, where applicable:
Shari’ah investing requires trained scholars that combine an understanding of Islamic law with a firm grasp on the financial markets. It’s a unique combination, particularly given the relatively young industry of Shari’ah investments and a still new capital market.
Islamic institutions and governments are now advocating the training of additional scholars to create a broader base of available and qualified individuals and to create a future pipeline of scholars. Several have set up funds to develop more scholars.
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has about 140 members from 30 countries. AAOIFI introduced a Certified Islamic Public Accountant (CIPA) programme, and is developing a certification and fellowship programme for Internal Shari’ah Supervisors. The number of standards set by AAOIFI stands at 68, including 30 Shari’ah standards. However, there is still more to be done, and since Shari’ah is an interpretative law that has variance among countries and people, it will take some time.
The Islamic capital markets are an innovative market whereby financial institutions define product frameworks according to Shari’ah-compliant routines. However, that said, the Islamic industry still uses common terms with the conventional market, for example, the instrument representative of a swap simply becomes an Islamic swap. Generating awareness and understanding in the global markets will be key to the success of a secondary market in Islamic finance. Several organizations in the Middle East and Southeast Asia have been formed to promote Islamic Investments worldwide.
As a result of evolution in Islamic financial markets, the swell of oil money in the Gulf, and a somewhat more guarded interest in US financial and property markets, the region’s financial services industry is coming of age. Further, governments looking to diversify their countries’ economic base from the oil industry are supporting more amenable business regulation, improvements in market infrastructure, and increased consumer opportunities. Financial services is an ideal industry, given the oil rich cash flow of the region.
To date, there are three high profile Islamic financial hubs, including Malaysia in Southeast Asia and in the Middle East, Bahrain, and the United Arab Emirates (UAE). In Europe, London is aggressively advancing its cause to become a global center for Islamic finance and something of a gateway to the Western world’s Islamic population.
There is a wide variety of asset managers operating and investing in the Middle East. They run the gamut of large international banks and independent money managers to local entrepreneurial firms that are gaining assets and attention.
There is more than US$15bn in assets in about 125 Islamic funds worldwide. Asset managers with the most funds include Wellington Management Co., Pictet & Cie, Worms & CIE/SEDCO, Al Rajhi Banking & Investment and Azzad Asset Management.
Some estimates place the number of funds overall, in equities, structured products, and real estate at more than 500, including both open and closed funds.
Prominent local financial institutions in the Middle East and Southeast Asia include Dubai Islamic Bank, Global Finance House (Bahrain), National Commercial Bank (Saudi Arabia), Bank Islam Malaysia Berhad, and Bahrain Islamic Bank, among many others. Additionally, asset management firms active in Shari’ah include international money managers such as Société Générale Asset Management Alternative Investment and numerous entrepreneurial asset managers in the local markets. Although the Islamic asset management market has existed for some time, progress has occurred in this decade, specifically with advancements in the capital markets, coupled with Middle Eastern and Asian governments updating regulation and formalizing greater acceptance of foreign presence. These changes have created a market considered ripe with opportunity attracting multinational foreign firms.
A few foreign, conventional, multinational firms that focus on the capital market side of the business have extended their participation into Shari’ah asset management through their firms’ money management divisions active in the capital markets or asset management. Two notable firms with Shari’ah-compliant asset management products are HSBC, which works through its Amanah Capital division, and UBS, which operates under Noriba Bank. Barclays wealth division launched a presence in Dubai in 2007.
The growing availability and diversity of benchmarking is a sure sign of the growth and staying power of a niche business. Standard, market accepted benchmarks are a metric that is the cornerstone of investment management best practices. The diversity and continual growth of available indices are a testament to the development of Shari’ah governed investments as its own market. The Islamic investment community now has Shari’ah-compliant indices that either alone or in combination can benchmark a wide variety of investment approach.
The Dow Jones started Islamic Indices in 1999 and has expanded to more than 60 types. Other index providers include Global Investment House and Citigroup.
FTSE has five indices: Islamic All World, Islamic Americas, Islamic Europe, Islamic Asia Pacific, and Islamic South Africa. Yassar Limited, based in Dubai, teamed with FTSE to launch the FTSE Asia 100 Shari’ah Index. Yassar provides independent screening of the securities by its Shari’ah Committee.
The FTSE SGX Asia Shari’ah 100 Index is the first index of a planned series. The index includes Shari’ah-compliant companies from Asia-Pacific markets: Japan, Singapore, Taiwan, Korea and Hong Kong. The index is calculated in real-time and published in US dollars. The index is 50% weighted in Japan and contains well-known brands such as Toyota Motor, Samsung Electronics, Matsushita Electric and Nippon Steel. Korea makes up 19% of the index, Taiwan 15%, Hong Kong 14% and Singapore 2%.
As global capital market participants forge ahead with new security issuance and creative product design, a secondary market for Islamic securities grows. In turn, the asset management community will increasingly develop and distribute portfolio management products. However currently, all financial institutions still face several hurdles in reaching full market capacity:
Islamic cleric shortage. In order to comply with Shari’ah law requiring design and oversight by properly trained scholars, a greater number of individuals are needed with the dual training in Shari’ah and financial markets.
Which comes first? Secular law versus Shari’ah law. With exceptions such as Saudi Arabia, Yemen, and Iran where secular law is Shari’ah law, most governments uphold national law, not Shari’ah law, as the final law to be applied in litigation. This can create potential litigation or lack of recourse issues.
Lack of regulation, oversight, and consumer protection in developing countries. Some market participants feel that the regulatory environments in developing countries are severely deficient in oversight and consumer protection, and that Shari’ah products may not always serve the general population well. An example is the potential for an exorbitant mark-up in a profit sharing lending scheme. Generally this would apply to banking products versus long-term investment portfolio. However, the issue is conceivable, and underlying Islamic investments might need to be screened for such activities.
No standard Shari’ah law. Shari’ah law interpretations vary by country, particularly in the Middle East versus Southeast Asia. Although the efforts of organizations, such as IFSB, IIFM, IIR, and IDB, are making strides in opening communications, differences may continue to exist. Therefore, products may not be universally accepted by Muslims.
No standard documentation. Operational aspects of product origination, trading and settlement can be quite complex with fixed income and derivative instruments. This is true of non-Islamic products as well. However, as the industry as a whole grapples with these issues, Islamic securities are included in the progress. The International Swaps and Derivatives Association (ISDA) and Bahrain-based International Islamic Financial Market (IIFM) are active on this front.
Lack of investment education. While the public in Western countries is generally bombarded with investment education, such resources are not always available in other parts of the world.
Lack of savings. Further, with negative savings rates and a state welfare system in Gulf Arab region, broad adoption may be difficult. For many, there is cultural dependence upon extended families for financial resources. According to The World Bank, the savings rates are only relatively better in South Asia.
Foreign firms: present, needed, but welcome? While Islamic countries are dependent upon the global powerhouses to help build a thriving secondary market for securities, their presence is not necessarily welcomed. Some Shari’ah scholars will not recognize an ‘Islamic window’, an instance where a conventional financial institution sets up a product, division, or private company to launch an Islamic product. The feeling is that the firm itself does not comply with Shari’ah, therefore, by association an Islamic Window will not be in compliance. This can apply to domestic firms as well, for example, the Shari’ah bank with a ‘conventional window’.
Islamic finance centers are slowly opening up to global financial institutions, which will further efforts to support strong secondary markets in Islamic debt and equity. Similarly, large, well-resourced and creative institutions are, and will continue to, rapidly develop the capital markets across asset classes. In turn, this will arm money managers with a deeper well to draw from in creating managed portfolios. The securities markets in the Gulf are not as large as western markets, which means there are far fewer security selections for asset managers. Southeast Asia is also still developing, Malaysia, with 1,000 listed companies, is considered a large sector. Countries in the Middle East and Southeast Asia must attract listings and new securities products to promote growth in the financial services industry.
On the investor front, market studies have repeatedly shown that if given the option to invest in Shari’ah products with competitive performance, Muslims prefer to do so. As the Shari’ah sector moves forward, advancing financial education for investors and improving product distribution will stimulate a response from the retail sector. Today, the institutional market and the ultra high net worth in numerous family offices already deploy assets according to Shari’ah, many in the real estate and private placement market.
A break-out opportunity for the Islamic asset management business is possible, particularly after 2007 which is a ‘stage setting’ year for many financial institutions in both the capital markets and asset management businesses. While general market consensus suggests growth rates in the 15-20% range, Celent feels the global market could average 38% over the 2007-2010 period, with greater momentum in 2009. Equity fund assets would jump from US$15.5bn to US$53.8bn by 2010, not including the vast amount that will make its way to private placements in alternative investments by institutions and family offices. More financial firms implementing investment programs, growing awareness of investment options and a cash rich investor are the drivers of this growth.
The Shari’ah-compliant industry is formalizing its infrastructure, amassing assets quickly, and will become a significant and profitable component of the financial services industry globally.