There are a multitude of Islamic equity indexes — a testament to the demand for and interest in them. CAMILLE KLASS takes a look at the various Islamic index providers and what sets their products apart especially in terms of compliance criteria.

Islamic investments and investment strategies are likely to come under greater scrutiny to see if they comply fully with Shariah law, as the number of Muslim faithful who seek to invest according to Islam grows and become more familiar with the concept of Islamic finance.

As part of this closer inspection, Islamic, or Shariah, indexes are expected to come under the spotlight, particularly as they represent a means to spur domestic investment and invite global capital flow, and given they offer up a universe of stocks which have been identified, researched and approved as being Shariah compliant.

For the Islamic index market, it means index providers need to remain vigilant to ensure that constituents of their indexes remain eligible for inclusion and their criteria for stock inclusion or exclusion are constantly reviewed to ensure they hold true to the tenets of Shariah law. However, leading index providers aren’t perturbed.
Like conventional indexes, Islamic indexes are also used by investors and fund managers to benchmark their investment performance and also as underlying constituents of passive and increasingly popular exchange traded funds (ETFs). “We actually welcome scrutiny — we like the fact that people question us,” said Alka Banerjee, New York based vice president of global equities with index services at Standard & Poor’s. “It helps us to show we’re objective and keeps us on track.”

“Malaysia’s interpretation of the Shariah is generally viewed as more liberal, compared to the stricter approach taken by scholars in Saudi Arabia”

Standard and Poor’s (S&P), together with Dow Jones Indexes, MSCI Barra and FTSE, are among the world’s leading equity index providers. These providers say they have not had any issues with compliance for their Islamic indexes. Maintaining strict compliance, given the nature of the products they offer, is crucial, in order to instill customer confidence and trust. “We work with an established group to meet the requirements of international investors because it’s important for the products we’re creating to be compliant, and for (investors) not to have concerns about using them as benchmarks or tradable indexes,” said Paul Hoff, managing director of FTSE Asia Pacific.

Index providers concur that Shariah compliant products such as theirs need to be carefully checked, monitored and reviewed in order to be in accordance with the Shariah. The process and criteria used by providers to arrive at a list of companies that is Shariah compliant and; therefore, eligible to be included in an index, are largely similar, index providers noted.

“Criteria for compliance — that’s standard,” said Tariq Al-Rifai, director of the Islamic Market Index Group at Dow Jones Indexes.

“They have by and large merged, but some differences remain,” said S&P’s Banerjee. “In general, our rules are well accepted.”

Indeed, a look at the methodology of the four leading index providers shows that they all share a similar compliance process comprising an initial screening of existing and potential companies based on their business activity, followed by a screening based on their financial ratios.Index providers derive the base of stock constituents for their Islamic indexes from the universe of stocks from their respective conventional global equity indexes which are then screened for prohibited elements such as excessive uncertainty (gharar), gambling (maysir), interest (riba) and forbidden products (haram).

Companies directly involved with conventional finance and insurance, alcohol, pork-related products and pornography are, as a result, unacceptable for inclusion in any Islamic index. Tobacco companies and weapons or items associated with the defence industry aren’t universally regarded by Shariah scholars as prohibited areas of business, but as Shariah boards advise against their inclusion in indexes, they are left out across the board.

While there is general consensus on the types of businesses and industries that are prohibited, where index providers diverge is on financial ratios. The second level of screening involves an examination of a company’s financial ratios to ensure its debt, cash and interest-bearing items and accounts receivables are of a permissible level before they can be included in an index. In addition, a company cannot qualify for inclusion if 5% or more of its income is derived from interest or prohibited activities.

“When you’re looking at whether a particular company’s operations and finances are Shariah compliant, you have standard restrictions on various industries such as those that are related to financial services, alcohol, pork, gambling, weapons — that’s straightforward,” said FTSE’s Hoff. “But, it’s the financial ratios screening that is one of the most important areas.”

Dow Jones Indexes’ Al-Rifai agreed, saying: “As you interpret it further, if you look at the sub-segments of the screening, you’ll find some differences among the indexes and index providers.”

The differences relate to the methods used to arrive at the financial ratios for each company to determine their eligibility for index inclusion. “No one will argue with a debt ratio of 33%, or about prohibited industries, but on debt to market cap, that’s where the questions come,” Al-Rifai said.

Index providers use either a market capitalization based or total assets based approach to conduct the financial ratio screening of stocks for eligibility. They assess the suitability of companies based on the percentage of either market capitalization of a company’s stock; or total assets that debt, cash and account receivables account for.
FTSE and MSCI adopt a total assets approach to calculating financial ratios while Dow Jones Indexes and S&P employ a market capitalization method.

Market capitalization is the value of a company calculated by multiplying a company’s current stock price by the number of shares that are outstanding. If the market capitalization is based on a free float, the stock price is multiplied by the number of the company’s readily available shares in the market. Total assets, on the other hand, refer to the sum of a company’s long-term and permanent assets, both tangible and intangible. S&P’s Shariah board said there are “pros and cons for both” methods, but decided on market capitalization because using “total assets can give a flawed picture.” FTSE, meanwhile, believes book value or total assets shuns the volatility that using a market capitalization can bring.

“FTSE takes the more conservative approach to Shariah compliance financial screening by rating debt ratio limits measured as a percentage of total assets, rather than more volatile measures that use 12-month trailing market capitalization,” said Hoff. “This ensures that companies do not pass the screening criteria due to market price fluctuation, allowing the methodology to be less speculative and more in keeping with Shariah principles.”

For MSCI, the decision to use the total assets method “came from initial client consultations and advice from our Shariah board and scholars because total assets is a more stable element and market cap is very volatile,” said Christine Chardonnens, vice president and product manager of MSCI Global Islamic Indices at MSCI Barra.

She said total assets bring elements of stability and consistency by providing lower index volatility and turnover in terms of index composition.

Explaining Dow Jones Indexes’ use of market capitalization instead of total assets to calculate such items as debt, Al-Rifai said: “When we posed the question to our Shariah board, they said debt is based on a company’s value and a company’s value is based on the market.”

Dow Jones Indexes uses a free float 24-month trailing market capitalization method, which the firm’s Shariah board feels provides a more stable gauge of a company’s value, he added.

S&P uses a three year moving market capitalization method also to ensure greater stability in the calculation of a company’s financial ratios. Banerjee said the use of the method came about last year during a compliance review when the firm’s Shariah board deemed that the volatility in stock markets in 2008 and 2009 was “exceptional”. This changed the moving average for market capitalization to three years from 12 months. While stock market volatility has eased somewhat, Banerjee said the three-year rule will remain.

“If the rules are valid, there’s no reason to change unless we get a request,” she added.

The screen for accounts receivables ratio is another area where the index providers diverge. S&P is more lenient in this area as it screens out companies with an accounts receivables ratio that is equal to or greater than 49%, compared to the 33% figure used by the other providers.

“The board felt that it is unclear that accounts receivable will earn interest,” said S&P’s Banerjee. “Hence, to lump it in the same category as other interest-bearing securities would not be inappropriate. In Islam interest is forbidden, not the activity of lending itself.”

All four providers, however, screen out companies whose ratios for debt, cash and interest-bearing items are above 33%.

While differences exist among the indexes, do these differences in methods make some indexes more compliant and others less so?

As far as the indexes are concerned, their methodology is approved by a Shariah board and they are all issued with a fatwa — which gives them a Shariah compliant stamp of approval — before they are put on the market. However, the question strikes at the heart of current discussions in the market over the need for standardization in terms of Shariah interpretations, given the prevailing differences between jurisdictions.

While standardization may be beneficial, if it can be achieved, index providers believe that differences in methods or approaches are acceptable.

“In any industry it’s very difficult to get 100% standardization and there are many different rules, approaches and philosophies,” said FTSE’s Hoff.

“The index providers’ job is to ensure the index methodology is fully up-to-date with the latest practices and reflect the investment needs of investors,” he said. “Whether there is truly standardization or there continues to be different interpretations of the Shariah law, FTSE will continue to maintain, evolve or customize indexes that meet these needs.”

“Different markets develop in different ways, and as such I don’t see a problem with a Malaysian solution being different from a Hong Kong one,” said Rudi Prenzlin, chief financial officer of the Hong Kong Islamic Index. “Investors can thus pick and choose which one they prefer.”

Malaysia’s interpretation of the Shariah is generally viewed as more liberal, compared to the stricter approach taken by scholars in Saudi Arabia. A case in point — in Malaysia, the Shariah Advisory Council of the Securities Commission Malaysia carries out screening of Shariah compliant stocks at a central level for the Malaysian market and issues a list of eligible stocks half-yearly.

Unlike index providers and the Shariah boards of other countries such as Saudi Arabia — which adopt a stricter approach towards screening by using debt and liquidity screens — Malaysia only screens companies based on their business activity and income.

“Securities Commission Malaysia’s Shariah advisory board doesn’t do any screening for international markets,” said Hoff of FTSE. “It doesn’t take into account the financial ratios and international investors want a strict interpretation of financial conditions of companies.

That means analyzing all the ratios of assets versus dividends versus cash and balance sheet versus whatever asset or liability relates to receiving interest.”

In the case of Islamic indexes, industry providers say there is already a great deal of standardization where it matters. Al-Rifai of Dow Jones Indexes said the company, in trying to ensure balanced compliance rules and acceptance from international investors, selected a five-member Shariah board from different jurisdictions — Bahrain, Malaysia, Saudi Arabia, Syria and the US. While no one is holding their breath waiting for a harmonization of standards and interpretations, their hope is that if it does happen it will help add clarity on issues that are unclear and ambiguous.