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Country reportsNovember 1 2013

Spreading the sharia success story

With sharia-compliant investments outperforming their 'conventional' counterparts, appetite for these products can only be expected to grow. But the industry is still too fragmented, according to Ian Lancaster of Cogent Asset Management, with a lack of cross-border connectivity preventing it from achieving critical mass.
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Spreading the sharia success story

After the economic roller-coaster ride experienced since 2008, investors are finally being rewarded with what equity markets are meant to provide. That is a reasonable rate of return that fairly reflects the risk of being a partial owner of a commercial enterprise.

In theory, the developed equity markets should not offer the 15%-plus returns that many demand, nor should they demonstrate a level of volatility that does not fairly reflect changes in fundamentals. However, large drops in equity value followed by abnormal 'recovery returns' have become increasingly commonplace since the 1999 technology bubble.

Undoubtedly, one of the causes of financial market volatility has been the lack of leverage control in the laissez-faire capitalist model. Given that markets and economies have now stabilised, market authorities need to focus on reducing the causes of the volatility that have deterred many from making equity investments altogether, and created a spin-off industry providing expensive capital protected funds.

Economic enterprise

In recent years, the financial screens of sharia-compliant equity investing have provided a valuable protection for Islamic investors. High leverage undoubtedly magnifies the effects of the economic cycle on equity valuations, and ultra-high leverage has been shown to be catastrophic.

In a study published by Islamic finance expert commentators M Shabri Abd Majid and Rosylin Mohd Yousof in 2007, it was demonstrated that during the period running from January 1992 to December 2000, the interest rate was a significant determinant for movements in Malaysia’s conventional equity market, while insignificant for the Islamic counterpart. This is a useful reassurance that the returns from Islamic investing are linked to the benefits of true economic enterprise, rather than interest-based financial engineering.

However, many clients question whether the protection that sharia-compliant investing offers means that they will suffer poorer market returns. This is not the case. Recent equity market returns have demonstrated the benefits of Islamic investing. Over the three-year period that began June 30, 2010, the S&P Developed BMI Shariah index provided an annualised return of 12.1% with a standard deviation of 14.9%, whereas the S&P Developed BMI index provided an annualised return of 11.6% with a standard deviation of 15.9%. The greater return for lower volatility of the sharia-indices also holds true over five years and 10 years.

A greater return for a lower level of risk is the optimisation goal for any investment process, so sharia-compliant equity investing over these periods would be deemed superior to conventional investing. Combined with the positive ethical screens, one wonders why the 'conventional' investment community has not exercised fiduciary duty and allocated more capital into sharia-compliant investment products. Then again, the Islamic countries themselves still have a long way to go in encouraging their own populations to invest in local equity market funds.

Building a base

Assets under management within the Islamic finance industry have certainly grown rapidly, albeit from a very small base. While the headline of a $1100bn industry is striking, it is sobering to consider that a conventional bank with $1100bn of assets would only be ranked 25th worldwide by size; about the size of Credit Suisse.

Assets under management for mutual funds are equally disappointing with only about $50bn of the global fund industries total of $75,000bn being invested in sharia-compliant funds. In addition, takaful represents only 1% of the global insurance market, whereas Muslims account for 20% of the world’s population. There is undoubtedly much to be done.

Islamic finance trailblazers such as Malaysia have worked hard to build the current Islamic infrastructure. Core components such as clear sharia-compliant asset regulation, reliable well-regulated financial exchanges and dependable Islamic asset management service providers have been put in place to provide a strong platform. With the infrastructure in place, the next step is to encourage the development of wealth management services to allocate capital efficiently, which will in turn support the sustainable development of the Islamic asset management industry.

It would be reasonable to conclude that to develop the industry further, the vast majority of assets in Islamic countries, whether public or private, need to be allocated to the Islamic asset management providers. For example, the sovereign wealth funds of the Gulf Co-operation Council (GCC) manage funds of more than $1400bn that are largely invested conventionally. One has to ask why this is the case when there are many well-managed Islamic funds to invest in, and easily accessible indices from S&P, Dow Jones, MSCI, etc... that clearly show which equities the scholars deem sharia compliant.

Compatibility issues

Even though starting from a small base, I am optimistic regarding the future for Islamic equity products. The young populations of the GCC and Islamic Asia are a good indicator of high future demand. The majority of the GCC and Indonesian populations, and 47% of the Malaysian population, are under the age of 25. We know from the experience of the developed countries that this age group will start to raise families, stimulating the requirement for sharia-compliant mortgages, long-term savings products, retirement schemes and life assurance.

On the flip side of equity supply, as demand for sharia-compliant equity increases, there will be a good opportunity for owners of sharia-compliant enterprises to list their businesses. It is interesting to note that countries such as Malaysia are developing junior equity markets such as the ACE market. At an even earlier stage, many GCC governments have put in place schemes to stimulate start-up activity.

Evidence of the growing importance of Islamic finance can be seen in the increased degree of cross-border connectivity between the Islamic finance industries of the GCC and Asia. Notably, several GCC Islamic banks such as Al Rajhi and KFH have operations in Malaysia, and Abu Dhabi’s sovereign wealth fund Mudabala has made significant investments in Iskandar Malaysia, one of the largest development projects in south-east Asia, over the past few years.

However, there is not so much evidence of GCC-Asian cross-border investment at the equity market level. Gulf-based investors still need reassurance and education that sharia-compliant investing institutions and sharia-compliant investments in Asia are compatible with their own sharia standards. Institutions such as the Malaysia International Islamic Financial Centre are doing a good job and are key to developing cross-border trust and understanding.

In fact, at the institutional level, Malaysia has provided very firm foundations such as the establishment of the Shariah Advisory Council as the highest sharia authority. This regulatory-based system compares favourably to the system of self regulation and minimal governance as practiced in the GCC. It is one of the cornerstones of Malaysia’s position as the pre-eminent Islamic financial centre.

Superior returns

With demand for Islamic equity expected to rise, it is interesting to compare the recent returns from investing in the various regions where Islamic countries are located. The S&P Pan Asia BMI Shariah returns for one and three years to the end of June 2013 stood at 5.2% and 3.6% annualised, respectively, whereas the returns for the S&P GCC Composite Shariah were 10.3% and 6.1% annualised, respectively, over the same periods.

Over the one-year period, the S&P Developed BMI Shariah index returned a healthy 12.7%. Variations in return have been due to both differences in the economic cycle and sector exposure, with the developed markets having now recovered most of their losses post the global financial crisis. Strikingly, the S&P GCC Composite Shariah index comprises 31.6% financial stocks and 32.1% materials stocks. This reflects the sharia-compliant banks that hold the GCC countries’ private wealth and the high level of local construction activity.

The S&P Pan Asia Shariah index exposes investors to just 3.7% financial stocks and 7.2% materials stocks, whereas the IT sector for this region represents a huge 45.2% of the index. Clearly, there are some diversification benefits to be achieved for sharia-compliant investors in both regions if they invest in the other markets.

Islamic equity markets have demonstrated superior returns to conventional equity markets during the global financial crisis and over longer periods. As the youthful populations of the Islamic countries age, the demand for long-term equity-linked savings products will increase, stimulating the availability of increasingly more sophisticated sharia-compliant products, providing the scale required to further develop the industry.

The time is right for financial institutions in Islamic countries to support the sharia-compliant equity markets by investing in line with the beliefs of their populations. To claim a lack of diversifiable assets or an undeveloped sharia-compliant infrastructure is no longer a defendable excuse.

Ian Lancaster is founder and chief executive of Cogent Asset Management, which serves as an advisor to the World Shariah Funds’ global equity fund.

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