Lack of Sharia-compliant indices stymie Islamic investing

IFR Asia-------------- Marketplace - Other News ------------- 16 May, 2009 --------------- ---------- Islamic funds have seen significant growth in recent years. However, the industry remains constrained by the lack of reliable Sharia-compliant indices compiled by data providers. To date, companies based in the US and Europe have provided Sharia-compliant indices based on methodologies that are often unacceptable to mainstream investors from the Gulf Cooperation Council (GCC) countries, especially from Saudi Arabia. In-house regional providers have also compiled indices that lack credibility in that they are not independently certified. Over 800 Islamic funds around the world controlling around US$925bn – half of them based in the GCC region – are struggling to find investments which meet strict rules dictated by Islamic beliefs. Traditional suppliers of indices have fallen short in one way or another. Dow Jones, the pioneers of Islamic indices, began this line of business 10 years ago. However, their approach has a major flaw: screening is on a sector level, rather than on the company level. For example, airlines that serve alcohol and pork would pass using this screening method, whereas a food company, which does not sell pork or alcohol, would fail since Dow Jones bans the whole sector to avoid screening companies individually. Dow Jones will even identify Islamic banks as being non-compliant since they fall into the category of banks. S&P and MSCI entered the Islamic index business at a later stage and are much more influential in the GCC region. Their Sharia rules allow for inclusion of companies that generate revenues from non-compliant business activities as long as it does not exceed 5% of their total revenues. However, quality issues persist over the identification of the respective revenue sources of a given company, as well as the identification of non-interest-bearing debt, for instance. These details can only be captured using local know-how and Arabic language capabilities. Fund managers normally subscribe to one of these indices for a couple of reasons: to identify which equities are Sharia-compliant and to benchmark their fund performance to the respective index. However, existing indices compiled by companies from outside the region generally fail to meet the requirements of Islamic funds in the GCC, and especially in Saudi Arabia. Islamic funds are generally governed by their own Sharia board, which may define different Sharia requirements than those imposed by the Sharia board of the index. Some funds may only be willing to invest in companies that do not have any non-permissible revenue, rather than use the 5% allowable threshold followed by S&P and MSCI. On an operational level, it is difficult to ensure that requirements defined by Sharia boards are met due to faulty screening. Based on practitioners’ feedback, a number of constituents that should be included in S&P’s Islamic indices are excluded because of the incorrect classification of some debt as non-compliant. Islamic indices are normally a subset of a conventional parent index. These indices are constructed using a specific methodology, such as minimum market capitalisation requirements. Therefore, the asset universe could be reduced without having a Sharia-specific reason, limiting opportunities for diversification. Finally, if the fund is exposed to Sharia requirements different from those defined by the index, it would be hard to benchmark the fund appropriately. Solution? Saudi Arabia has the most sophisticated investor and portfolio management talent in the region. Its investment community has relied on local Sharia service providers that have local expertise and language capabilities. But local providers are normally focused on a specific regional market and fail to meet the broader or global coverage required by some Islamic funds. Another alternative is to use global data providers or regional providers, such as Mubasher, to extract all the data required and to screen the companies in-house. The drawback is that these data providers do not report financial figures and revenues in a structure supporting Sharia screening. For example, for a specific company in the GCC we would not know how much of its debt is non-interest bearing. One promising alternative is the service of specialised Sharia financial data providers, such as San Francisco-based IdealRatings. They have a research team that mines raw financial data and extracts the relevant figures and revenues required for defining client-specific Sharia requirements. Additionally, they provide Sharia auditing, compliance monitoring, purification calculations as well as benchmarking services by using an advanced web-interface. Another is Jeddah- based Shariyah Review Bureau, which is doing something similar. Dhafer Salih Alqahtani (Alqahtani is managing director of Darahim Capital, a Bahrain-based investment management company.) © Thomson Reuters 1992-2009. All rights reserved. http://www.ifrasia.com/story.asp?storycode=88192 5/30/2009

Global Islamic Index Providers – The Wrong Choice

The Shari’ah compliant fund management industry in the GCC region and the larger MENA region is experiencing explosive growth. The number of Islamic funds world-wide has now exceeded the 800 mark with asset under management touching 50 billion dollar where about 35% are based in the GCC alone. The growth in this industry has enabled the region to recruit the best of breed portfolio managers, allowing a shift away from the necessity to appoint European, US or even Asian-based portfolio management firms to manage these funds. A major limiting factor for the industry’s growth is finding service providers that can empower local portfolio managers with the tools they need to create Alpha. We need to invest in regional companies that understand regional cultures and values to grow the industry to it is maximum potential. A top priority for the industry today is to be able to indentify Shari’ah compliant investments. To date, the region has been unable to produce its own index as most providers are based in the US and Europe. It has taken them many cycles of trial and error to produce improved products i.e. indices, and even then many remain unacceptable for mainstream GCC investors. Some in-house indices are open to the accusation of being expedient tools since they are not being independently qualified. The evolvement of Islamic indices contributed significantly to the growth of the Islamic funds industry witnessed in the last decade. Global players such as Dow Jones, Standard & Poor’s, FTSE, MSCI and others, provide fund managers with a set of Shari’ah compliant equities that are determined using sector and financial screens defined by their respective Shari’ah boards. Dow Jones, the pioneers of Islamic indices, began this line of business 10 years ago and have contributed greatly to the growth of the Islamic funds industry. They screen companies based on the sector they are operating in and additionally use a set of financial screening ratios defined by their Shari’ah board. A large number of industry participants consider Dow Jones as being the most conservative Shari’ah screener since companies operating in non-compliant business activities are excluded, irrespective of the amount of revenue generated from these activities. On an abstract level this conservatism seems to hold, but operationally Shari’ah screening as performed by Dow Jones may result in passing non-compliant companies and failing compliant companies. The reason for this paradox is that compliance is defined on a sector level rather than on a company level. So airline companies that serve alcohol and pork, for instance, would pass using Dow Jones screening methodologies whereas a food company, which does not sell pork or alcohol, will fail since Dow Jones bans the whole sector in order to avoid screening companies individually. Dow Jones will even identify Islamic banks as being non-compliant since they fall into the category of banks. Standard and Poor’s and Morgan Stanley entered the Islamic index business at a later stage and are much more influential in the GCC compared with Dow Jones or other providers. The Shari’ah rules of both providers allow companies to generate revenue from non-compliant business activities as long as it does not exceed 5% of their total revenue. This would overcome the shortcomings of Dow Jones in failing a compliant company or passing a non-compliant company on a sector level. Even then, there are still quality issues regarding the identification of the respective revenue sources of a given company as well as the identification of non-interest-bearing debt, for instance. With respect to the GCC, such details can only be identified using local know-how and Arabic language capabilities. Fund managers normally subscribe to one of these indexes for two reasons: to identify which equities are Shari’ah-compliant and to benchmark their fund performance to the respective index. Generally, for funds in the GCC and especially in Saudi Arabia, these two requirements cannot be met adequately by using Islamic indices offered by Global Index providers such as Dow Jones, Morgan Stanley or Standard and Poor’s because of: - Forced Shari’ah mandate. Islamic funds are generally governed by a Shari’ah board, which may define different Shari’ah requirements than those imposed by the Shari’ah board of the index. So, for instance, some funds would only be willing to invest in companies which do not have any non-permissible revenue rather than using the 5% allowable threshold followed by Standard and Poor’s and Morgan Stanley. This rule might be adequate for global companies in the West but should be defined differently for companies operating in Islamic countries where the difference between halal and haram is well known. - Quality of Screening. On an operational level it is difficult to ensure that the requirements defined by the Shari’ah boards supervising the indices are truly being met. As highlighted earlier, Dow Jones index calculations and processes would result in the inclusion of non-compliant companies and vice versa, for instance. Based on practitioners’ feedback, a number of constituents should be included in the Standard and Poor’s Islamic indexes but are excluded. One example for this would be the fact that a significant amount of debt that is Shari’ah-compliant debt is not identified which would have resulted in passing rather than failing such companies. - Limited Index constituents. Islamic indices are normally a subset of a conventional parent index. These indices are constructed using a specific methodology such as only including companies that meet a minimum market capitalization value, for instance. This has two main drawbacks. First, the asset universe is further reduced without having a Shari’ah-specific reason, making fund managers’ stock selection decisions more difficult in meeting diversification requirements and asset allocation parameters. Second, if a particular equity is excluded from the parent index, it is automatically excluded from the Islamic index. This confuses the investor regarding the current and future compliance of this equity, which is held in the portfolio but is no longer monitored by the index provider. - Benchmarking. If the fund is exposed to Shari’ah requirements different from those defined by the index used, it will be hard to benchmark the fund appropriately due to the fact that funds in the GCC normally have much stricter Shari’ah requirements than the ones defined for Global Islamic indexes. Is there a solution for these problems? Saudi Arabia has the most sophisticated investors and portfolio management talent. Their investment community has realized a solution by relying on local Shari’ah service providers across the GCC that have both the local expertise and the required language capabilities to screen companies adequately. A problem remains with using local providers because they are normally focused on a specific regional market and would therefore not be able to meet the regional or global coverage requirements defined by the Islamic funds. Another alternative is to use global data providers such as Thomson Reuters or regional providers such as Mubasher to extract all the data required and to screen the companies in-house. Again, this alternative is not feasible due to the fact that these data providers do not report financial figures and revenues in a structure supporting Shari’ah screening. For example, for a restaurant we would not know how much alcohol they sell in a specific period of time and for any specific company in the GCC we would not know how much of its debt is not interest bearing. A promising alternative is the service of specialized Shari’ah financial data providers such as IdealRatings. They have a local research team that mines raw financial data and extracts the relevant figures and revenues required for defining the client-specific Shari’ah requirements. Additionally, they provide Shari’ah auditing, compliance monitoring, purification calculations as well as benchmarking functionalities by using an advanced web-interface. Although IdealRatings does not have a Shari’ah board to provide them with specific Shari’ah mandates, this might actually be advantageous for most fund managers in the region as it enables them to invest and benchmark according to requirements defined by their own Shari’ah boards. Finally, the growing demand for Islamic products and funds must be satisfied with advanced Shari’ah services, increasing both the credibility and the quality of the investment products branded as Shari’ah-compliant. To grow the industry to its maximum potential, we must develop local service providers that understand Islamic investor needs rather than relying on western brand names that have in many cases been tainted by the credit crisis. Only then can we provide sustainable delivery of the depth and quality required for the firm foundations of Islamic funds. Dhafer Salih Alqahtani ظافر صالح القحطاني