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