Obeying the limits

Access to Shariah investments is becoming more widespread, but where does it sit in the institutional marketplace? Christopher Andrews reports

According to EUMAP, a programme of the Open Society Institute, around 20 million people of the Muslim faith reside in the European Union – about 4% of the population. To cater to the financial needs of European Muslims, the last few years have seen the growth of Islamic banking, and an increase in insurance and finance products on the market.

Based on the tenancies of Shariah law, drawn from the Qur'an and the teachings of the prophet Muhammad, these financial products carry strict guidelines on how money is managed and invested, as well as guidelines for the types of companies suitable for investing in.

For Shariah investment funds, there are several tenets which must be met for a fund to be compliant. Shariah prohibits the receipt of interest, which is considered usury, so investment in companies involved in lending or borrowing is prohibited. This eliminates most banking institutions.

Likewise, debt is equally frowned upon, making highly geared companies unacceptable investments. Also, funds offering fixed or guaranteed returns on capital are prohibited, as profit must be linked to actual earnings generated from the underlying assets.

In addition, organisations are considered either Halal (lawful) or Haraam (unlawful) investment opportunities depending on their activities. So companies involved with alcohol, pornography, pork products or gambling are excluded.

Many of the basic characteristics applying to conventional investment funds also apply to Shariah funds, but it is this screening that really sets them apart.

Market perspective
In light of increasing demand for these products, primarily driven by Asia and the Middle East, most of the major index providers, including Dow Jones, MSCI Barra and FTSE, now offer their own Islamic indices.

Dow Jones Indexes launched its first Islamic index in 1999 and now has a series of over 70 indices covering various markets and sectors. "As a first step we involved an independent Shariah board, which advised on what is permissible and what is not, and we applied our methodology and created the index," says Sumeet Nihalani, senior director sales, Asia Pacific & Middle East, of Dow Jones Indexes.

The indices take account of Haraam activities, including interest income, excessive debt, or over -dependence on accounts receivable. "Essentially it is about the negative screens which are not permissible under the Shariah tenants," says Nihalani.

The MSCI launched its indices in July 2007, which broadly follow the Dow Jones methodology of screening. "You could compare this to socially responsible or ethical indices in a way," says Christine Chardonnens, product manager for the MSCI Islamic Indices. "The first part of the screen is very similar to ethical in that it screens out prohibited activities such as pork, alcohol, and gambling, and some of these are the usual suspects in SRI."

The index also uses financial ratios to identify companies with excessive leverage or debt. "So one of the ratios is total debt over total assets, and if that exceeds 33%, the company is screened out."
The FTSE group recently re-launched its index series to cover the entire FTSE developed markets universe, and now has some 96 Shariah compliant indices. These take a "global approach" to screening, rather than on a country by country basis, says Imogen Dillon Hatcher, MD EMEA at FTSE Group. "And the advantage of doing that is that you can compare market with market and sector with sector."

Shariah in Europe
While demand is still centred on the Middle East and Asia, several Shariah investment funds operate in Europe. These include HSBC's Amanah Global Equity Index fund, the UBS Islamic fund and Scottish Widows' Islamic Global Equity fund.

However, while these, and other, funds are available, "it's not exactly a crowded marketplace at the moment," says Ian Vose, head of global developed markets at Scottish Widows Investment Partnership (SWIP) which manages the SWIP Islamic Global Equity fund.

Vose sees this as a growing area, particularly in economies with large immigrant populations, including France and Germany. "I can imagine that there are fairly sizeable pools of underlying investors with equivalent interests. So I do think this is something that has broadly European scope."

FTSE's Hatcher agrees: "We've seen interest coming out of Germany, France and the UK too. I’d say that we have been pleased with the interest generated and the discussions now under way."

And MSCI's Chardonnens also sees the European market expanding, as fund managers become familiar with what Islamic investment entails. "Some institutional asset managers in Europe are new to Islamic asset management, so they are in the process of picking up the skills and finding out what it's all about. A lot of our clients are new to this, but have been talking to us because they want to attract clients."

Worth considering?
So, with indices in place and products being developed, should European pension funds consider Shariah investments?

"I think particularly if a pension fund is defined contribution, and you have a reasonable percentage of the workforce who are Islamic, then it probably is something in the broader product offering that would be definitely worth considering," says SWIP's Vose.

FTSE's Hatcher says that discussions are under way to inform pension funds of the existence of Shariah compliant options. "Clearly some of them are looking at potentially putting together Shariah funds, so they know the approach we're taking and the feedback to that approach has been positive."

"It is important to recognize that whether and to what extent a Muslim investor chooses Shariah compliant products is subject to his discretion and the options available to him," says the CFA Institute's director, Islamic finance and ESG, Usman Hyat. "The Shariah compliant pension funds use the same business screening and financial filtering processes being used by other Islamic funds."

Hyat says that there could be challenges specific to marketing and portfolio management of Islamic pension funds. To provide life-cycle investing, they may have relatively limited options of instruments that could offer fixed-income like returns due to the emphasis on profit-loss sharing in Islamic investments.

So, should schemes that do not represent a large Islamic workforce be considering this type of investment? "I wouldn't see there is a burning need to," says SWIP's Vose. "I think this is a niche market in the way SRI is a niche market."

According to Chris Oulton, CEO of Prime Rate Capital Management: "In the same way you might decide to go for nut free ingredients in your cooking in case someone has an allergy, you may decide that, while you're not anticipating a large Islamic section of your workforce, you might want to offer this option.

"So do you need to do it? No. But if it's not beating up your investment returns and it's not doing you any harm, why not have something that gives some of those special issue features a tick, rather than not?"

The performance story
In fact, evidence suggests that, far from beating up returns, Islamic indices have actually delivered a performance story in recent times.

"In current market conditions there are probably no indexes that are year to date or month to date positive, but we have noticed that over the last year Islamic indexes outperformed their conventional counterparts," says Nihalani.

Both Hatcher and Chardonnens confirm that both their indices have witnessed out-performance as well. For example, in October the MSCI World Islamic Index was down by 32.1% year-to-date, while its conventional counterpart, the MSCI World Index, was down by 37.5%.

"If you take the MSCI world index, the weight of financials is about 21%," says Chardonnens. "Now if you compare the weight of financials in the [Islamic index], that is only 1%. So the indices have demonstrated very little exposure to the financial industries."

And this, says SWIP's Vose, is the reason for that perceived out-performance, although one should be cautious in drawing the conclusion that Shariah investment is superior to conventional.

"What compensates for that significant missing part of the pie [financials] is a commensurate up-weighting of the commodity complex. So oil gas, related industries, and the broader materials complex." Vose says that, until recently, there was a bull market in commodities, and an ongoing bear market in financials. While this ostensibly looks like out-performance, "that's not really what's at play here. It's different sectoral tilts in the underlying index which is driving the deviation."

Of course, for those investing in Shariah funds through belief, comparison with non-Shariah funds is irrelevant. But even with the perceived out-performance of the last year, for most European pension schemes Shariah funds are unlikely to feature highly in their investment policy. But it probably wouldn't hurt to have a fund option or two for employees who otherwise might not join the scheme. If markets carry on as they have, those with Shariah funds could be the only ones actually able to retire.

Written by Christopher Andrews, a freelance writer