The Dubai stock exchange: interest in Islamic finance has gone global

Major global index providers rushed to satisfy a burgeoning interest in sharia-compliant investing. Now the challenge is to expand coverage and develop new products if the market is to reach its true potential. Writer James Gavin

Eleven years ago, market indices were the exclusive province of the conventional investor. Dow Jones' decision to launch the first sharia-compliant index in 1999, the Dow Jones Islamic Finance World Index, opened the way for those seeking a benchmark to invest according to sharia principles.

Islamic investors now have a dizzying array of Islamic indices to measure against, from sector to country and region-specific varieties, taking in both equities and fixed-income instruments. All four of the main global index providers offer indices refashioned for Islamic finance, in the aim of providing new tools to stimulate domestic investment and attract global capital flows.

These indices are driving the process of standardisation in the industry, helping investors gauge performance of funds in relation to the market in which they invest. They support the decision-making process and are starting to play a critical role in the functioning of Islamic capital markets. They also provide the basis for the development of new products, as exchange-traded funds (ETFs) attempt to gain traction in the sharia-compliant fund sector. The Dow Jones index family is the first to be licensed as underlying for an Islamic ETF.

New phase of growth

The Dow Jones Islamic Market index now benchmarks more than 150 companies with more than $7bn in assets.

The decision to launch an Islamic index came in response to a tide of interest from clients searching for sharia-compliant benchmarks. "The initial interest mainly came from family offices in the Middle East, which really wanted to be able to invest according to their culture and religion. And while that interest is still there, it has now gone global," says Debora Ciervo, senior director of international markets and products at Dow Jones Indexes.

As global equity markets revive, providers believe Islamic indices are primed for a new phase of growth. Index providers are looking to win business in a market that is still operating well below its potential. The global Islamic finance industry boasts 560 funds with $37bn under management as of March 2010.

"Where we are in the Islamic investment space is about 1983," says Rushdi Siddiqui, head of ThomsonReuters Financial Gateway and former head of the Dow Jones Islamic index. "About 94% of Islamic funds today are actively managed and licensed from one of four index providers. From the point of view of revenues, this is an upside as this particular space grows."

Asset management is emerging as one of the key drivers in the Islamic finance industry, says Mr Siddiqui, and the role of index providers will grow in tandem. Providers want to offer the full spectrum of offerings and speciality Islamic indices are being crafted to address the needs of the market.

"Beyond plain equity indices, they will be looking at alternative asset classes, and there's talk of an Islamic commodity index. Dow Jones already has the DJ-Citigroup sukuk index. It may be ahead of its time but, post-financial crisis, we are seeing a lot more sukuk issuance in the pipeline and more sovereigns coming to market," says Mr Siddiqui.

Dow Jones has been joined in an increasingly crowded market by its main rivals, MSCI, Standard & Poor's, FTSE and, last year, Russell Investments, in a joint venture with Saudi Arab's Jadwa Investment. These providers have migrated their conventional index offerings to the sharia investment universe, building on strong brand appeal.

Filling the void

The MSCI Global Islamic Indices are constructed from the underlying MSCI country indices and cover 69 of the MSCI developed, emerging and frontier markets countries. The reputation MSCI has built in the Islamic finance world is a result of the quality of its data, client service and internationally recognised brand name, says Christine Chardonnens, vice-president and product manager for MSCI Global Islamic Indices. "We are a natural choice when it comes to choosing an index as asset managers largely use MSCI conventional indices. As a result, MSCI has a vast pool of clients and market participants to gather knowledge and views from to ensure its indices and methodology respond to clients' needs," she says.

The MSCI Islamic indices are targeted at asset managers based in the Middle East or Asia, but also at global equity managers who run global equity mandates for investors wishing to respect sharia investment principles. "These would typically use MSCI already and see it as natural to come to us when they have additional index needs, such as Islamic," says Ms Chardonnens.

In 2006, Standard & Poor's introduced the S&P Shariah Indices, which have evolved into a line-up of 30 benchmark and investable sharia indices. FTSE Group has developed a range of sharia-compliant indices based on large and mid-cap stocks in the FTSE Global Equity Index. Last year, a new sharia-compliant offering, the Russell-Jadwa Shariah Index was launched. The family of indices screens about 10,000 securities in the Russell Global Index universe, covering more than 60 countries.

For a Saudi fund manager such as Jadwa, the appeal of launching its own index was obvious. As Fadi Tabbara, Jadwa's head of asset management explained at its June 2009 launch: "As managers of sharia-compliant funds and discretionary accounts, we have often struggled to find benchmarks that would provide an appropriate comparison with peers and an accurate measurement of our performance. The Russell-Jadwa Shariah Index fills that void."

Confidence is key

As the market has become a lot more competitive, differentiation is the key to success for index providers. As with all things Islamic, the need to win the confidence of investors over the indices' compliance criteria is paramount. While the brand name helps, it is the screening methodology and the quality of the sharia board that really helps capture investor interest.

The main providers follow similar procedures, starting with an initial screening of companies based on their business activity. They then sift through the stocks from their conventional global equity indices to screen for prohibited elements such as interest, pornography and gambling.

This is followed by an assessment of their financial ratios, which is where the providers tend to differ in their methodologies. Broadly, they either opt for a market capitalisation-based screening approach or a total assets-based model to gauge the eligibility of the financial ratio.

The primary business screen is the same for all index providers, namely the elimination of companies in the sin sector, says Mr Siddiqui. "However it is the financial ratios where variances occur. Some index providers use debt/asset and others use debt/market cap, some have a cut-off of 5% for non-permissible? income and others purify all impermissible income."

Dow Jones uses the market capitalisation rather than total assets to calculate debt ratios. To start with, its independent sharia supervisory board counsels with Dow Jones over the compliance of index-eligible companies. Stocks are screened based on industry type and financial ratios. Companies engaged in alcohol, tobacco, pork-related products, financial services, defence/weapons and entertainment are excluded.

"We start with the automated process for the initial screening but use manual research to break down industry groups. If we simply filter certain sectors we might miss key facts. Take the publishing sector, which might sound as though it is sharia-compliant but there could be a pornography company. Nothing is black and white," says Ms Ciervo.

Also excluded are companies for which financial ratios are 33% or more: debt divided by trailing 24-month average market capitalisation; cash plus interest-bearing securities divided by trailing 24-month average market capitalisation; and accounts receivables divided by trailing 24-month average market capitalisation.

MSCI uses the total assets approach, assessing the suitability of companies based on the percentage of total assets that debt, cash and receivables account for.

The use of total assets in the calculation of the financial ratios is a major point of difference with the competition, says MSCI. "Our research has shown this does not lead to more securities being screened out as some opponents have suggested," says Ms Chardonnens. "However, it does have the benefit of reducing turnover when markets and equity prices [and therefore market cap] are volatile."

MSCI will now start to differentiate between sharia-compliant debt and conventional when calculating its debt/total assets ratio. Likewise, any sharia-compliant instrument will be excluded from the numerator when calculating the ratio of cash and interest-bearing securities over total assets. "These recent developments are unique to MSCI and are explicitly detailed in the methodology books that are publicly available. This will also coincide with the introduction of buffer rules in the MSCI Islamic Index methodology," says Ms Chardonnens.

Index providers know that a legitimate screening process is fundamental to their appeal to investors. The index eligibility criteria are important considerations, and this means having a credible sharia board. Here, too, approaches differ. While Dow Jones has its own in-house board of sharia scholars, FTSE sharia screening is undertaken by Yasaar, a global sharia consultancy.

Those indices that appear most stringent may have the greatest appeal to Islamic investors. Some investors are more conservative than others and in the Middle East, they do not want to have to question what they are investing in.

"When we compare our indices to others, almost 30% of the companies we would not consider as being compliant. There are stark differences when you look at the detail," says Ms Ciervo.

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Christine Chardonnens, vice-president and product manager for MSCI Global Islamic Indices

Product innovation

Islamic indices could prove to be a font of product innovation, in particular with the development of sharia-compliant ETFs. The Javelin Dow Jones Islamic Market International Index Fund was launched last year on the NYSE. The fund tracks a Dow Jones index of 100 firms in 23 non-US countries with exposure to 18 different currencies.

Indices can lay the foundation for innovative products. ETFs have been around since 1993 but it is a recent phenomenon in this space so much still depends on the credibility of the index provider.

There are more than 15 Islamic ETFs worldwide, but the liquidity has not met expectations. Much work remains to be done before they appear on Islamic investors' radar screens.

This is not unexpected, and few predicted the success of ETFs in the US and Europe to be replicated overnight in the Islamic finance space as the learning cycle is so long. For example, says Mr Siddiqui, the first ETF was launched in the US in 1993 and has now become a common phenomenon, but in Islamic finance the first ETF was launched in Turkey several years ago and is still small in terms of assets under management. "What is interesting is that there is no Islamic ETF in the Gulf Co-operation Council states, the heartland of Islamic finance, but two conventional ETFs, in Saudi Arabia and Abu Dhabi," says Mr Siddiqui.

US-based Saturna Capital, which offers a range of Islamic funds under the Amana brand, looked at creating a Dow Jones index fund when it launched, but encountered early obstacles. "We saw we needed something like $75m in assets before we were even close to breaking even. At that time the Amana funds only had $30m in assets. There's a certain critical mass you have to have and unless you have big backing from large institutions, it can be difficult," says Monem Salem, director of Islamic investing at Saturna.

Index providers have to navigate a market that has developed quickly but often lacks the depth that maturity brings. "The index is the DNA for an ETF so the index providers probably have the right index but much more is needed in terms of educating investors," says Mr Siddiqui.

There can be a disparity between a product on offer and the investor mindset. "Institutional money is dividend-oriented so they invest in companies that throw out dividends and sometimes there is a mismatch between an ETF that may want to project to a liquid underlying index but which may not have dividend paying stocks. There has to be a deeper understanding that the offering has to be aligned to the needs of the marketplace," says Mr Siddiqui.

The wider truth is that Islamic funds and their index benchmark must reflect the same opportunity set, otherwise there will be a benchmark misfit to the fund.

Expansion plan

For the big index providers, the challenge now is to expand coverage and develop a more compelling offering for an investor base that still tends towards the conservative in both investment style and moral perspective.

MSCI plans to expand its country coverage. For example, when new frontier market indices are created, such as Bangladesh, these are screened for sharia investment principles according to the MSCI Islamic Index methodology. "Our range of thematic and strategy indices are also available in an Islamic version. MSCI will soon start calculating and distributing environmental, social and governance indices, which is an exciting development. These will also be available as Islamic indices," says Ms Chardonnens.

As liquidity returns to the fixed-income market, sukuk indices may grow in popularity. The Dow Jones Citigroup Sukuk Index only has about 15 securities listed. Created as a benchmark for investors seeking exposure to sharia-compliant fixed-income investments, it has proved a slow burner.

"There's a lot out there in the sukuk universe, but when you start narrowing it down to what is liquid, there's no secondary market for most of it," says Ms Ciervo.

However, the asset class's strong appeal to both Islamic and non-Muslim investors suggests sukuk indices will mimic the growth trajectory of Islamic equity indices. Though it is a niche industry, it is one with huge upside growth potential to reach non-Muslim investors who espouse certain inherent social and ethical values.

As the Islamic market matures, index providers need to think outside the box of traditional equity indices, yet ensure they are adapted to a particular country. "Most Islamic countries have five or six economic sectors at best - these are the constraints that you as an index provider have to operate in. Local money is invested locally, so you have to be aligned to that," says Mr Siddiqui.

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