Islamic Finance: Emergence of Sharia-compliant securities indices

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What is a stock index?

A stock index represents the aggregate current market value of the publicly traded shares of a varied mix of defined companies. It tracks the changes in the value of a hypothetical portfolio of shares of these companies on a day-to-day basis.

The weight of an individual stock in the overall portfolio is equal to the proportion of the portfolio invested in that stock. The percentage increase in the value of an index is usually equal to the increase in the total value of the stocks comprising the portfolio at that time.

An investor’s dilemma

Investors worldwide have been reaping rewards of such increases for decades and have also suffered with the stock market downturns. However, a large number of Muslim investors had refrained from investing in shares in view of the confusion whether the activity to invest in the shares of public joint stock companies (PJSCs) from the Western world is Sharia compliant or not.

Major event

A most striking and innovative development to address this dilemma took place in the world of Islamic finance during the late 1990s when Dow Jones, the world’s leading stock market index provider, constituted the first Islamic Securities Index in the world with the valid approval and support from a panel of renowned Sharia scholars. The idea, pioneered by Dow Jones, was based upon the Sharia principle of investing Muslim money only in the Islamically permitted trading activities.

Hitherto, Islamic investors were confined to place their funds on traditional and non-exciting products, such as savings and investment accounts with Islamic financial institutions in order to avoid interest. However, the endorsement of the idea of an Islamic index by renowned Sharia scholars provided a much needed fillip in this direction.

Emergence of others

The large-scale acceptability and success of the Dow Jones Islamic Index was followed by the emergence of a series of such other indices and funds, prominent one being FTSE. Today there are more than 100 Islamic indices and funds spread all over the world with an estimated aggregate market capitalisation running into hundreds of billions of dollars. These include high-cap, mid-cap and small-cap indexes, which are further spread into various economic segments and regions.

Synergy with the rest

Islamic indexes have generated great deal of interest amongst non-Muslim investors too due to their synergy with social indexes on ethical grounds. The concept of social index was developed in the U.S. during early 90s. It emphasises upon the slogan ‘invest with values’.

The argument put forward by the supporters of a social index is that the personal values and personal finance should go hand in hand. They say that it is possible that one can achieve financial goals and at the same time help make this world a better place to live by encouraging investment in the ethically appropriate companies.

The avoidance screening in a social index is comprised of the activities including liquor, violation of animal rights, environment pollution, toxic products, gambling, causes for global warming, nuclear field, tobacco and weapons.

Perhaps the cause of social indices is gaining popularity since a 10-year comparison carried out in 2000 revealed that one of the leading social index in the U.S. had outperformed the prestigious S&P 500 index. Today the total size of the social indexes and funds has exceeded $2 trillion.

Difference

An Islamic index does not contain securities of the companies producing or trading in alcohol and pork-related products, providing interest-based financial services (banking, insurance, etc.) and are engaged in the entertainment business such as hotels, casinos/gambling, cinema, music, and the other such activities considered unethical in Sharia.

The manufacturers of tobacco and weapons/ammunition, although not clearly forbidden for investment under Sharia, are also excluded from the index under the advice from scholars due to the known harmful impact of these industries on a society.

Other parameters

Following are the other essential parameters, which make a company eligible for an Islamic index:

a) Total interest bearing debt of the company at any point in time should remain below one third of its average market capitalisation during last 12 months.

b) Sum of a company’s cash and interest bearing securities must not be greater than 33 per cent of its trailing 12-month average market capitalisation.

c) The company’s account receivables should remain below 45 per cent of its total assets.

Purpose of screening

It is to ensure that a company’s business practices are not exploitative, unethical or inefficient while dealing with suppliers, customers, creditors and debtors.

The purpose of the first screening is to discourage the company from amassing interest bearing debt beyond a reasonable level. Of course, in a Western environment, it will be naïve to expect that a company will not borrow on interest. However, scholars feel that there should be some cogent controlling measure for it.

Aim of the second covenant is to encourage the company to invest in its trading activities in order to earn real profits rather than to become complacent by relying on effortless interest income.

Furthermore, this measure also ensures that the element of interest earning is kept to the minimum in a company’s net profit, out of which the dividend is declared. Scholars strongly recommend Muslim investors to keep track of the interest earnings in a company’s net income and purge an amount from the dividend in the same ratio.

The third condition clearly tackles the quality of a company’s debtors. On the other hand, by deploying efficient recovery means, a company will be able to rely less on borrowed funds and hence will incur lower interest expense, thereby improving the overall Sharia acceptability for an Islamic investor.

Monitors

These well thought after measures approved by the panels of high-repute Sharia scholars are religiously monitored on an on going basis by index managers.

A company is removed from the index if it fails to meet any of the above litmus tests. The integrity of an Islamic index is gauged by the frequency of periodic reviews conducted by its Sharia board.

Initially, it was not considered an issue by blue-chip companies who formed part of an Islamic index. However, as the activity in the Islamic market picked up and with the emergence of more Islamic indexes and funds, there is growing urge by these companies to lure the Islamic investor. As such, of late, there has been some thought being given by them towards meeting the said Islamic criteria.

Another factor which is quietly working in favour of Islamic indexes is the recent promulgation of various regulations by the world’s financial regulatory authorities aimed at curbing excessive borrowings by the corporates.

Liquidity

Though not a Sharia requirement, promoters of Islamic indexes and funds have so far tried to play it safe by selecting actively traded stocks from the developed world. Their purpose seems to have an easy access and exit in order to provide greater flexibility to an Islamic investor in this relatively new investment field.
 

By Sohail Zubairi
The author is the head of risk management at Dubai Islamic Bank

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