The concept of Islamic finance, banking and economics has gained tremendous popularity of late. It is appreciated and implemented not only in countries where Islam is the dominant religion, but also in non-Islamic nations. The basic premise of Islamic finance, banking and economics is based on ‘hygienic’ ways of doing business as prescribed by the Islamic Law or Shariah.
What is a Shariah Compliant financial product?
A Shariah compliant financial product (mutual funds, ETFs etc) is an investment avenue that is fully compliant with the principles of Shariah Law.
Let’s have a look at some of the concepts and guidelines of this law. Islamic law basically divides actions into three broad categories. These are farz (compulsory), halal (permissible) and haram (prohibited). Shariah rules of doing business, therefore concentrates only on farz and halal but strictly excludes haram. Companies whose business involves interest on debt, gambling, alcohol, pork-related products, pornography or armaments are prohibited. Since interest on debt (Riba) is prohibited, it automatically implies that a conventional commercial bank fails to qualify as permissible business under the Shariah.
So does it mean that Islamic banks and financial institutions are charitable bodies that lend money without any expectation of income?
The answer is that a NO. Profit sharing and fee-based financing is what drives the income streams of these banks. Fee-based financing can be the result of safe deposits, fund transfer, trade financing, property sales and purchases or handling investments. Profit sharing involves partnerships (in businesses funded by the banks) and sharing of profits and losses. This means that in order to comply, the creation of debt is not facilitated through direct lending and borrowing, but through sale or lease of a real asset which is expected to provide a regular cash flow stream for the bank.
Debt financing is indispensable for any company or economy. Even companies that qualify under Shariah and countries governed by the Shariah law, have to resort to debt financing. They do this by the issuance of special types of Islamic bonds. These are sukuks and ijara bonds. These bonds do not consider interest to be the focus of any transaction. However, sukuk and ijara bonds signify ownership of assets which are tied up to a lease contract between the borrower and lender. These bonds (similarly to conventional bonds) are highly flexible and can be traded in the secondary market. Shariah also prevents a person from selling what the individual does not own; therefore Shariah compliant financial institutions abstain from short selling financial securities.
The demand for Shariah-compliant financial products is not limited to a particular community or a group of countries but involves participation of investors all around the world. Investment managers and fund managers worldwide are constantly looking for Shariah-compliant stocks in order to include them in their portfolio.
Mutual funds and exchange traded funds are also fast gaining popularity in this niche segment of the financial world and have constantly witnessed an increase in their assets under management. A recent study by Ernst and Young (Islamic Funds and Investment Report) shows that Islamic funds all across the globe witnessed 7% growth in their AUM as of 2011.
A number of Shariah-compliant mutual funds and exchange traded funds are being launched all around the world. The world’s leading stock market index provider Standard and Poor (S&P) has a wide range of Shariah investable and benchmark indexes to meet an array of investor needs. There are 15 Shariah-compliant Benchmark Indexes and 11 Tradeable Indexes, all of which bear testimony to the fact that Shariah-Compliant financial products have come of age.
The portfolio of Shariah indexes comprises only of stocks of those companies whose businesses are in alignment with that of the Shariah law. Therefore it is prudent to note that the portfolio of the Shariah index would significantly differ from that of the broader market index. Heavyweight sectors such as financials will be ruled out of the portfolio of the Shariah-compliant Index.
So does this mean that investments in Shariah-compliant financial products will act as a perfect hedge against investments in traditional financial products during economic downturn when the market turns south?
Unfortunately, the answer is no. The broad-based S&P 500 Index and the S&P 500 Shariah index shows a correlation of 0.99 for a period of three years. The graph below shows the relative movement of the two indexes.
The S&P 500 Shariah Index includes stocks of companies whose businesses are in alignment with that of the Shariah law as well as fulfilling the following criteria on a 36 month average basis: 1) A Debt/ Market Value of Equity ratio of < 0.33, 2) Accounts receivable/ Market Value of Equity ratio < 0.49 and 3) (Cash +Interest Bearing securities)/ Market Value of Equity ratio <0.33.
The Shariah compliant financial products are flexible instruments which are open to investments across all investor classes, irrespective of their religious beliefs. Therefore, an ETF approach is always a better alternative for a targeted bet on any market index. Unfortunately, domestic investors cannot boast of many choices in this segment as far as exchange traded funds are concerned.
We would like to discuss a particular fund targeting this space which ceases to exist as of today due to lack of popularity. JETS Dow Jones Islamic Market International Index (JVS) intended to match the before-expenses price and yield performance of the Dow Jones Islamic Market International Titans 100 Index. The product intended to provide investors with an option to play the Shariah growth story. it also provided an exposure to Shariah-compliant companies. The ETF debuted in the year 2009 and held 94 securities in all with 31.91% of its assets in the top 10 holdings.
According to Brint Frith, the president and founder of Javelin (The fund managers), they “found it difficult to reach target investors through the marketing channels typically used by ETFs”. This clearly shows that the fund was targeted at a particular section of the community, rather than the public at large. It was probably the reason why the product failed.
The article does not intend to compare the ethical and the unethical. Neither does it intend to identify a better investment avenue. But it does aim to highlight Shariah-compliant investments as an asset, solely from a returns and coverage point of view without any geo-political comment. Nevertheless, given the growth and popularity of Shariah-compliant financial products, we can only infer that Shariah ETFs are to be looked out for.