Setting the benchmark

IFR Islamic Finance Report 2009
17 min read

The sukuk market has been gaining headlines, but Sharia-compliant products for equity investors have been around for years. Matthew Attwood asks if they really can be a substitute for investors’ own due diligence.

Since Dow Jones launched its first Islamic equity index in 1999, a plethora of index products aimed at institutions managing money in accordance with Sharia principles have been launched. Dow Jones and the main index providers, such as the FTSE Group, MSCI Barra and S&P, between them offer hundreds of indices allowing investment institutions to track Sharia-compliant companies according to region, country, industry and market capitalisation. Many other institutions, including investment banks, also run their own indices.

For some Sharia-compliant investment managers, the indices perform an important primary function by identifying appropriate companies to invest in. "If you're an asset manager running a fund, you need a benchmark reflecting Sharia principles," said Christine Chardonnens, product manager for Islamic indices at MSCI Barra. "Some investors use indices to have a pool of securities to choose from to create a fund – they make asset allocation decisions based on them. Also the indices can be replicated for passive funds."

Such use of the indices is only possible if users trust them to include only genuinely Sharia-compliant companies, and there is an exhaustive screening process designed to exclude those that, because of their business interests or financing arrangements, fall outside the limits of acceptability.

The initial screen tends to be the sector one, filtering out stocks benefiting from associations with markets and activities proscribed according to Sharia principles. This would include companies involved with pork, financial services, alcohol, gambling, arms, pornography and some sections of the media and advertising industries compromised from a Sharia perspective by their involvement with those markets. Conventional financials, including investment managers, are not permitted because of their reliance on the payment of interest, with the same applying to speculative investing such as private equity and venture capitalism.

"We use a threshold of 5% of the revenues of a company to determine whether it should be screened out of an Islamic index because of its business activities," said MSCI's Chardonnens. "You could decide to remove from the index every company with even the slightest exposure to non Sharia-compliant activity. This, for example, would extend to airlines, which might serve alcohol on board flights, although that isn't their main business. The revenue from that area of their business could be very marginal, so we would not exclude that company, although some Islamic investors wouldn't want to invest in it at all."

Following the sector screen, companies' financial arrangements are then examined so as to exclude those with significant reliance on interest or leverage. Three screens are used, some – such as Dow Jones’ – based on market capitalisation, others – such as S&P's and MSCI's – on total assets. They look at debt over assets or as a proportion of market capitalisation, the sum of cash and interest-bearing securities over total assets or as a proportion of market capitalisation and the sum of accounts receivables and cash over total assets or as a proportion of market capitalisation.

Typically if the ratio in any of these areas exceeds 33.33%, the company in question is excluded, although S&P requires that accounts receivables as a percentage of debt and the 12-month average of market value of equity must be less than 45%. Liquidity is also considered, to ensure that the most thinly traded stocks do not make the cut.

While these ratios are accepted by most investors, there is no clear guidance from Islamic legal books as to what level they should be pegged at, meaning that contemporary Sharia scholars had to apply some Ijtihad, or legal reasoning. According to one Sharia expert, a saying of the prophet attaches significance to a third of assets as a proportion, which is how the 33% ratio was settled on. Beyond that, he said, there was no clearly appropriate level, and there is some dissent from the more conservative thinkers.

"Some scholars say that you're either compliant or not and don't feel – whether 10%, 33%, or 49% of its income is from interest-bearing investments – that a company can be compliant if it derives income from interest," said Khalid Howladar, an Islamic finance specialist at Moody’s based in Dubai.

"All sorts of numbers float around, and ultimately it comes down to the opinion of the scholar in question," he said. "Within Islam the possibility of compromise exists, and then it becomes very subjective. There are no 10 Commandments of Islamic finance: among other things Sharia just says that the self-generation of money from money is prohibited, but doesn't necessarily go into prescriptive details. The message is there and it's up to you to put it into practice, using your own knowledge and moral judgement in doing so."

The priority within the screening process is ensuring sufficient compliance with Sharia guidelines while giving investors the widest possible universe of companies to choose from. For this reason, the personnel involved in judging stocks is crucial.

"We have a set of standards, which is laid down by our very well respected Sharia board in the Middle East," said Alka Banerjee, vice president of global equities within the index services group at S&P. "It isn't universally accepted because obviously there are differences of opinion within the Sharia world, but it is accepted by the majority of users and prospective clients. We haven't come up against a situation where someone has said 'we can't use you because you're too liberal or too conservative'. We meet a broad need."

MSCI Barra takes a similar view, while recognising that investors in different regions may have very personal views on whether a company can be part of their Sharia portfolio.

"Some are more stringent that others but we believe our indices encompass the best practices within Sharia investment guidelines, while ensuring that they are not too narrow, so they can be used to create funds while remaining a relevant benchmark for performance," says Chardonnens.

A lot of investors, as long as a scholar signs something off as Islamic, consider it compliant without making any further investigation of their own, depending on the level of trust they place in the scholar concerned.

"Sharia approval is not so much about the company issuing the approval but the scholars backing the company," said Khalid Howladar.

Even so, fund managers sometimes do their own due diligence on investors' behalf. Speaking anonymously during the preparation of this article, one market participant mentioned the case of Louis Vuitton, the high-end leather goods and fashion business. That industry is not a proscribed sector, so – subject to the usual accounting screens – Louis Vuitton was widely regarded as compliant. But when one institution took a closer look at the financial information the company provided, it was revealed that a significant proportion of the company's trading activity involved alcohol, more than 5% of its income.

This example aside, the main additional due diligence is done for the opposite purpose. Mainstream index providers, anxious to preserve the integrity of their products from a Sharia perspective, produce a limited universe, of between 5,000 and 15,000 stocks depending on the product. Many fund managers would like to have a bigger universe, so they do their own due diligence on potentially permissible stocks that have been excluded.

"An example might be a company listed under financial services that has been excluded by an index provider," said Humayon Dar, CEO of BMB Islamic, a subsidiary of asset management and advisory firm BMB Group. He is also former CEO of the Deutsche Bank subsidiary Dar al-Istithmar, which acts as an independent Sharia board for MSCI's Islamic indices.

"If someone does more due diligence they could discover that it's an IT service provider offering services to banks and financial institutions, which are interest-based," he said. "But this company’s activity is software provision and some scholars might take the view that it is compliant. But it's only after you've done the digging down that you can come to the conclusion that this company is compliant despite being listed in a prohibited sub-sector."

"Investors would do their own work on companies for their own active strategies," said Alka Banerjee at S&P. "They don't do it for a further Sharia overlay – that's done by us. Suppose an index carries 100 stocks that are Sharia-compliant. They may only use 50 of them because of what their strategy defines, or they may use all 100, but that's based on a conventional strategy. It has nothing to do with Sharia. How they manage their product has to be Sharia-compliant – how they trade, how they manage the cash – but that's not related to the indices, it's a separate issue.”

There is no presumption that companies based in Islamic countries are preferred when Islamic indices are being constructed, although of course there are national and regional funds that focus on Islamic states. Equity capital markets are much deeper and stronger in other regions, and the primary motive for Sharia investors – as it is for any other kind - is investment returns; they simply have to secure them without compromising certain key principles. It is analogous to green investing, where a fund starts out with the entire universe of investments, and strips out entities that do not conform to its standards.

"It's reducing that sphere of investable equities to something that's compliant with you," said Khalid Howladar. "Whether it's Islamic countries or non-Islamic, there are still a lot of non-Sharia compliant stocks in both. The physical location is not the primary concern but the activities of the company are, and the source of the income."

Even so, a perennial truth in the Sharia-compliant market is the differing levels of conservatism across the Muslim world, and this might make a difference, said Howladar, adding: "An index in Indonesia or Malaysia probably wouldn't satisfy a conservative Saudi investor, because he doesn't necessarily agree with the compliance policies of the scholar in question in Malaysia. Different markets with a different investor base will have differing levels of acceptance."

Investors have several options in terms of how they use the indices. Banerjee reports that active fund management is the most popular, with each index providing the required pool of compliant stocks and a benchmark. After funds, structured products are the most popular product line, according to S&P.

There is some debate about index trading. Given Sharia's requirement that investors share in profit and loss, if an index is screened satisfactorily it would be consistent with Sharia principles for an investor to replicate it by buying the underlying equities in the proportion that they are held in the index.

"That is tangible," said Khalid Howladar at Moody's. "Maybe you trade via a fund, certificate or shares, but the index itself is intangible. Trading on the value of the index – for example buying at 1002 and selling at 1010 without ownership of any actual stock – strikes me as intangible. I'm not sure if that would work from a Sharia perspective."

Recently, efforts have been made to make trading in indices more palatable to scholars and a number of exchange-traded funds are being marketed as Sharia-compliant.

"One way of doing it is by way of a total return swap," says BMB Islamic's Humayon Dar. "Someone offering an ETF produces a structure that allows Islamic investors to invest in a basket of Sharia-compliant stocks drawn from an index. Investors enter into a trading relationship with the provider, whereby the stocks would be priced with reference to an index the economic effect of which they are trying to replicate."

This can be done by means of a Wa’d, a promissory arrangement, where the two parties – investors and service provider – agree in advance to buy and sell the basket of stocks at a price determined by movements in an index.

Harris Irfan, head of Islamic products at Barclays Capital, was part of the team that worked on the Wa’d methodology at Deutsche Bank. The intention, he recalls, was to provide Islamic investors with complicated pay-off structures and thus a broader range of products than was available to them previously – it enabled returns from any asset class to be replicated for Sharia investors, but although it was an excellent technique for creating structured products, the market found a way to abuse it.

"We could have used it for good or not-so-good purposes, and more often than not the industry has used the technique to link to non Sharia-compliant underlyings. The technique has been accepted by some of the world's most conservative scholars, but the nature of its use, linking to non-compliant assets, has some of them up in arms. That is understandable, because it has negated the creation of purer structures from first principles, and ended up offering certain types of product that are not in the spirit of the law even though they may be within the letter."

That debate aside, participation in Islamic indices is not simply a question of Sharia-compliance. With interest in Islamic products now extending well beyond the traditional group of investors commonly associated with those products, a broad investor base involving more than those with a specific mandate for compliance with Sharia principles is involved.

Ethical and Islamic investments share a lot of similarities, for example, as Christine Chardonnens at MSCI Barra has found. She says: "We've heard of investment managers using Islamic indices to run ethical funds for non-Islamic ethical investors, such as churches."

Investors buy performance, and even those with no specifically "ethical" mandates will have had their interest piqued by the Sharia indices' performance relative to that of conventional indices during the credit crisis. Given the limits on a company's indebtedness and the level of profit it can derive from interest-based investments and still remain eligible for inclusion in a Sharia index, conventional indices have, in general, suffered more as they included more financial stocks vulnerable to credit tightening.

Of course, the opposite was true in the run-up to the market peak in 2007: Sharia indices underperformed their conventional counterparts because of their underweight position in the financial sector, which was providing good returns before the bubble burst.

As the pool of users of Sharia-compliant equity indices expands to encompass more than just Islamic investors, one observer believes the mainstream index providers should do more than simply create "vanilla" Sharia indices that involve only the removal of stocks that are not Sharia-compliant.

"Investors are looking for solutions that will allow them to capture and reflect specific investment opportunities and strategies through the lens of Sharia-based principles," said Kevin Bourne, global head of e-Equities at HSBC. "This requires a portfolio optimisation approach to index construction."