Keypoints:

• Islamic funds are for everyone
• According to Ernst & Young’s Islamic Fund and Investment Report 2010, Malaysia is the second largest global Islamic financial hub with total estimated Islamic AUM of USD5.1 billion and 184 Islamic funds
• Shariah-compliant assets are identified using sector-based and accounting-based screening
• The Dow Jones Islamic Market World Index only allocates a marginal 0.25% of its market capitalisation into the financial sector, while the MSCI World Index has 20.5% in this sector
• Dow Jones Islamic Market World Index has consistently outperformed the MSCI World Index since 2007 even though the index does not have much allocation in the financial sector
• During the 2008 financial crisis, the Dow Jones Islamic Market World Index dropped 38.9% compared to 43.5% drop in MSCI World Index

ISLAMIC FUNDS FOR EVERYONE - MUSLIMS AND NON-MUSLIMS

Many investors think that an Islamic fund is only suitable for Muslims as its investment strategy and criteria adheres to the Shariah (Islamic law). This is incorrect. Islamic funds are actually for everyone. The offering of Islamic fund in the asset management industry is meant to provide investors who wish to invest according to Shariah principles with a wide range of investment instruments which are Shariah-compliant. This also offers investors an alternative choice to conventional funds.

AUM (ASSETS UNDER MANAGEMENT) OF ISLAMIC FUNDS ARE GROWING

The growth in the global Islamic asset management industry (even during the 2008 financial crisis) over the past few years indicates that there is an increasing demand for Islamic funds. According to Ernst & Young’s Islamic Fund and Investment Report 2010, the Islamic fund industry is concentrated in the Gulf countries and Malaysia. Saudi Arabia is the largest Global Islamic Financial Hub in the world with total estimated Islamic AUM of USD22.7 billion and 174 Islamic funds, while Malaysia is the second largest with total estimated Islamic AUM of USD5.1 billion and 184 Islamic funds. With Islamic funds getting more and more popular in the global asset management industry, investors should not overlook them when making their investment decisions.

In this article, we drill deeper by looking into the stock screening process that identifies Shariah-compliant securities as well as comparisons between Islamic funds and conventional non-Islamic funds.

HOW ARE SHARIAH-COMPLIANT ASSETS IDENTIFIED?

A security is deemed as a Shariah-compliant security when it fulfills several Shariah criteria developed by the Shariah Supervisory Board for the stock screening process. In this part, we will discuss the stock screening process adopted by the Standard & Poor (S&P) Shariah Indices, Dow Jones Islamic Market (DJIM) Indices and the Securities Commission of Malaysia.

S&P SHARIAH INDICES AND DOW JONES ISLAMIC MARKET INDICES

There are two levels of screening for S&P Shariah Indices and DJIM Indices to remove securities that are not suitable for Islamic investment. The first is the sector-based screen to select companies with acceptable business activities. Companies with business activities related to Table 1 are screened out. According to DJIM Shariah Supervisory Board, a company classified “Financial” according to Industries Classification Benchmark (ICB) is considered eligible if the company is incorporated as an Islamic Financial Institution, i.e. Islamic Bank and Takaful Insurance Company. Real Estate companies are considered eligible if the company’s operations and properties are conducted in accordance with Shariah principles. After removing companies with unacceptable primary business activities, the companies are evaluated according to several financial ratios to remove companies with unacceptable levels of debts or impure interest income (refer to Table 2). This second accounting-based screen focuses on three factors – leverage, cash, and the share of revenue derived from unacceptable business activities.

SECURITIES COMMISSION OF MALAYSIA[1]

In Bursa Malaysia, securities listed as Shariah compliant are evaluated by the Shariah Advisory Council (SAC) of the Securities Commission Malaysia in three areas.

1. The core business activities of the company
2. The level of contribution of interest income received by the company from conventional fixed deposits or other interest bearing financial instruments as well as dividend received from investment in Shariah non-compliant securities
3. The level of mixed contributions from permissible and non-permissible business activities. Table 3 compiles the criteria for each factor. For companies involved in both permissible and non permissible business activities, the SAC considers two additional criteria:
• The public perception or image of the company must be good
• The core business activities of the company are important and considered maslahah (benefit in general) to the Muslim nation and the country

MSCI WORLD INDEX AND DOW JONES ISLAMIC MARKET WORLD INDEX

In order to have a clearer comparison of how Islamic funds stack up against conventional non-Islamic funds, we compare the MSCI World Index and Dow Jones Islamic Market World Index. Unlike the MSCI World Index, the Dow Jones Islamic Market World Index only allocates a marginal 0.25% of its market capitalisation into the financial sector, while MSCI World Index has 20.5% in this sector.

The Dow Jones Islamic Market World Index also has lower allocation on consumer goods, telecommunication and utilities sectors as compared to the MSCI World Index. Nonetheless, the Dow Jones Islamic Market World Index has much higher allocation in the energy, technology, health care, as well as basic materials and industrial sectors (refer to Chart 1). A common question is whether an Islamic equity fund will lag conventional equity funds because of their restrictions on Shariah noncompliant assets. However, this may not be the case. Chart 2 and Table 4 show that the Dow Jones Islamic Market World Index has consistently outperformed MSCI World Index since 2007 even though the index does not have much allocation in the financial sector.

During the 2008 financial crisis, the Dow Jones Islamic Market World Index was more resilient than the MSCI World Index, dropping by 38.9% compared to a 43.5% drop in MSCI World Index. While it declined less than the MSCI World Index, the Dow Jones Islamic Market World Index also performed better than the MSCI World Index during the recovery from 2009 to 2010. As of 29 April 2011, the Dow Jones Islamic Market World Index returned an 8.4% gain, which was higher than the 7.9% gain in the MSCI World Index.

CONCLUSION

During the 2008 financial crisis, Islamic equity funds were able to draw attention from investors as they proved more resilient than conventional equity funds. Incidentally, the global financial crisis in 2008 was partly the result of excessive leverage in the financial system and investment into exotic financial derivatives such as credit default swaps and collaterised debt obligations — all prohibited under Shariah principle.

Besides, Islamic equity funds usually have lower risk as compared to conventional equity funds. This is because Shariah-compliant securities have less leverage than Shariah non-compliant securities (based on the screening criteria of S&P and Dow Jones). In addition, Shariah principle prohibits Gharar, which means speculation is prohibited.

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