A closer look at Shariah ETFs

Despite thriving and affluent Islamic communities across Europe and North America, Muslims living in these regions have traditionally been underserved when it comes to investment. The reason for this is that managing investments according to Shariah principles (the moral code and religious law of Islam) can be incredibly time consuming since the vast majority of investment decisions need to be pre-approved by Islamic scholars.

Shariah-compliant exchange-traded funds (ETFs), which provide low-cost exposure to conventional equity markets while strictly adhering to Shariah investment principles, provide a much-needed solution to this problem.

Offered by providers such as db X-trackers andiShares, Shariah ETFs are benchmarked to indices that apply a series of trade activity and financial screens to weed out non-compliant companies. The screening process is typically overseen by leading Islamic scholars and results in a portfolio of securities in adherence with Shariah law.

While these products have been gaining some traction lately, many investors may not know that these products exist or may be cautious to get involved as the actual Shariah methodology remains somewhat foreign. For those wary of the methodology, it will come as a welcome surprise to hear that the screening and compliance criteria are actually relatively straightforward.

Underlying almost every ETF, of course, is an index. Most of the major index providers offer Shariah-compliant indices created under the guidance of advisory boards comprised of experts in Islamic Law, often representing multiple countries and various schools of Islamic thought. The screening process varies from index to index, but generally Shariah indices exclude businesses with trade activities in the following industries: alcohol, gambling & entertainment, pork, tobacco, and financials, with the exception of Islamic banks, Islamic financial institutions and Islamic insurance companies.

Perhaps surprisingly, the classification of weapons, arms and defence manufacturing firms is the only aspect of the screening process that is not entirely clear cut (although most index providers lean towards the sector’s exclusion).  For example, FTSE, directed by Yasaar, the index provider’s Shariah consultant, takes the view that the industry is non compliant. By contrast, S&P, guided by its supervisory board of Islamic scholars, takes the view that weapons can be used for both permissible (self-defence) and non-permissible (unprovoked aggression) purposes; the weapons themselves are neutral and hence the manufacturing of weapons is considered permissible.

Certain indices, such as the S&P Shariah Indices, also screen against genetic cloning, gold and silver cash trades, and advertising and media companies. That said, news and sports channels are permitted, as are media and advertising companies generating greater than 65% of revenue from member countries of the Gulf Cooperation Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE).

After screening out companies with non-compliant trade activities, there are typically a number of accounting/financial screens that potential constituents are then subject to. Only those companies that pass certain financial ratios relating leverage (highly indebted companies are excluded) and interest income (interest-bearing investments are banned under Shariah law) will be considered Shariah compliant. As an example, MSCIanalyses total debt over total assets; cash and interest-bearing securities over total assets; and accounts receivables and cash over total assets. If any of these ratios exceed 33.33%, the company is excluded.

How does this all add up for investors? The results of the activity screens have a few potential effects to look for. The removal of alcohol and tobacco companies tends to increase the beta moderately, as these are core consumer staples industries with dependable revenue streams. However, the removal of entertainment, advertising, media and gaming (casino) companies tends to lower the cyclicality of the fund, reducing beta. Broadly speaking, these exclusions net off.

In addition, the removal of tobacco, alcohol and (as is the case with most Shariah indices) defence companies, reduces the political risk, as these industries are often subject to the political whim of politicians.The major difference compared to conventional indices is the application of financial/leverage screens. By excluding companies with high levels of debt, the resultant portfolio has lower financial risk and superior credit fundamentals.

Overall, Shariah ETFs have demonstrated lower volatility than their non-compliant counterparts and have tended to outperform over the past few years (see chart comparing S&P Shariah 500 with S&P 500). This is likely due to the more defensive nature of these funds, a style which has been in favour of the past few years. Of course, Shariah ETFs are not restricted to Muslim investors. Indeed, non-Muslims may see these funds as an attractive, less-volatile alternative to conventional index-tracking ETFs.

Manooj Mistry, Deutsche Bank’s head of exchange-traded products, EMEA, said: “Shariah ETFs are one of the easiest ways for investors to make a Shariah-compliant investment, with all the usual benefits that ETFs provide, such as transparency and low fees. It’s fair to say today that the market hasn’t lived up to the hype of several years back, when some predicted an explosion in demand for Shariah investments in general. If the market does start to pick up again however, then Shariah ETFs will hopefully be one of the first instruments potential investors look to.”

For investors looking to get in on the ground with Shariah-compliant ETFs, a range of options are available. Deutsche Bank’s db-X trackers and BlackRock’s iShares are the leaders in this space, together offering exposure to world, US, European, Japanese and emerging market equities.

For core global exposure, the iShares MSCI World Islamic ETF (ISWD) and db X-trackers DJ Islamic Market Titans 100 UCITS ETF could represent solid portfolio holdings. The iShares MSCI World Islamic ETF is listed on the London Stock Exchange, Deutsche Börse, NYSE Euronext Amsterdam and NYSE Euronext Paris, and tracks the MSCI World Islamic Index via a physical replication process. This fund comprises 561 holdings across 22 countries. The db X-trackers DJ Islamic Market Titans 100 UCITS ETF tracks the DJ Islamic Market Titans 100 Index via a swap-based replication process and is listed on the London Stock Exchange, Deutsche Börse and Stuttgart Stock Exchange. This fund comprises 100 global Shariah-compliant blue-chip stocks across 15 countries. 

(Etf Strategy / 14 Feb 2013)

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Alfalah Consulting - Kuala Lumpur: www.alfalahconsulting.com
Islamic Investment Malaysia: www.islamic-invest-malaysia.com