Shariah-compliant indices offer investors the ability to gain equity exposure based on a screening and selection process that combines benchmark index design with Islamic principles. As a result, these new indices have allowed investors to follow equity markets in a way that is consistent with their underlying ethical principles and rigorous in its structure and methodology.

The evolution of well-defined indices that are acceptable to a broad constituency of Islamic investors has also led to the development of suitable investment products. The availability of these indices has also allowed for the widespread introduction to the market of lower-cost products such as Exchange Traded Funds, known as ETFs, with well-defined exposures and high levels of transparency.

The first Shariah-compliant ETF, launched in January 2007, was based on a narrow large-cap global index from Dow Jones. Since then, other ETF providers have entered the market, though these have tended to incorporate some swap-based elements typical of less transparent funds.

Among Shar’iah-compliant funds, those offered by iShares were the first to be based on broad, recognized global benchmark indices and were the first to offer Shariah-compliant exposure to MSCI World (Developed Markets) and MSCI World Emerging Markets. This meant that for the first time, Islamic investors could access broad equity market exposure via ETFs, thereby gaining exposure to key benefits such as exchange liquidity, transparency and low costs.

The MSCI Islamic indices for equities covering the developed world, the emerging market world and the US are accessible through a physical ETF structure. This configuration is important from a Shariah perspective, as the fund owns the underlying securities, thus making it the most appropriate and transparent structure for ensuring compliance at both index and product levels.

The benefit of the new indices is that they allow an expansion of the use of ETFs among investors where exposure to Shariah-compliant equities is an important consideration. The physical ETFs bring with them the multiple benefits of on-exchange liquidity, an efficient creation and redemption process, a multi-dealer trading platform and the transparency of holdings and structure.

Shariah-compliant ETFs have significant advantages for investors compared to traditional means of gaining Shariah exposures. These traditional products have tended to lack transparency about methodology and be both less diversified and 
more expensive.

The key feature of all the Shariah indices is the screening process. Companies are screened for compliance with Shariah principles, and those involved in non-compliant activities are excluded from the Shariah indices. Companies are then screened again for financial ratios in terms of leverage, cash and the share of revenues derived from non-compliant activities. While initial index design tended to adopt an absolute form of exclusion from any of the prohibited activities, recent methodology has tended to employ a revenue-based cut-off using these categories. The absolute exclusion index selection criteria is currently only used by Dow Jones in its Islamic indices. The revenue-based cut-off for the other index providers is typically 5 per cent of total revenue.

The main element of index methodology relates to the screening of stocks based on financial criteria. The aim of this screening is to address the issue of companies having excessive leverage or where a significant portion of income is from interest receipts. A number of different ratios are calculated for the purpose of financial screening; however, one of the main differences among the index providers is their choice between considering a company’s market capitalisation on the one hand and total assets on the other. Ultimately, the use of market capitalisation can lead to a more volatile screening process, even when a twelve-month average is applied, while the use of total assets bears a closer relationship to the underlying balance sheet criteria 
being analysed.

A process of dividend purification aims to mitigate the effects of including income from either interest income or prohibited activities. This is designed to allow investors to deduct from their dividend income the appropriate amount that should then be given to charity.

As a result of these various screening processes, the underlying Shariah-compliant benchmark varies substantially from the base index. If one considers a broad developed market equity exposure, as represented by the MSCI World Index, then the differences due to the screening process are easily highlighted when comparing to the MSCI World Islamic index.

The core element of the screening process is based on business activity, and this drives the bulk of the sector differences. Understandably, the most substantial sector change relates to Financials, where the weight in the Islamic index falls to 1.2 per cent versus 19.4 per cent in the unscreened MSCI World benchmark. The main beneficiaries of the selection process include Energy stocks, Healthcare and Materials.

Changes with respect to country weights are less pronounced and generally moderate.

The main differences between the indices can be seen with the recent outperformance as a result of the reduced weighting in Financials. This has been the main factor since June 2007, resulting in a substantial difference in performance.

A comparison of the main Shariah-compliant indices from a performance perspective shows that at a developed world level, they are broadly similar. The correlation over the past year for the FTSE and Dow Jones indices to the equivalent MSCI World Islamic index has been over 99 per cent. The daily tracking errors range from 3.3 per cent for FTSE to over 4 per cent for the Dow Jones indices.

Overall, the trends for the first half of 2009 were encouraging, with assets under management growing by over 50 per cent. While the overall market has grown in terms of ETF products, the weak performance of the equity environment has conspired to limit the growth of assets under management. However, as equity markets recover and investors become increasingly aware of the benefits of trading ETFs, we could expect Shariah-compliant assets to grow significantly in the near future.

Nizam Hamid is MD and Head of Sales for iShares in Europe at Barclays Global Investors, a product leader in exchange traded funds. Hamid is responsible for  thought leadership on investment solutions for the sales and marketing teams.