Is it time for another Shariah ETF? - ETF News And Commentary
28 May 2012 - 5:35PM
Zacks
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.
![](http://www.zacks.com/images/upload_dir/1338141289.jpg)
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.
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