Although ETFs are one of the fastest growing investment vehicles in the conventional market, the same cannot be said in the Islamic space. SAEID HAMEDANCHI looks at the possible reasons.
In today’s world of global finance there are few growth trends to speak about, yet Islamic finance and the growth of the global Muslim population remain on a strong trajectory.
Global financial institutions are rapidly expanding their services both into Islamic countries and Muslim communities in non-Islamic countries. According to
Maybank, assets under management (AUM) in Islamic funds should reach US$110 billion by the end of 2012 and could be as high as US$170 billion by 2013. Impressively, the Islamic funds management industry has enjoyed a rapid growth rate of 25% per year in the past 10 years, according to various sources.
However,
Shariah compliant investors have yet to embrace one of the fastest growing investment vehicles – the exchange traded fund (ETF). ETFs have accumulated over US$1.5 trillion in global assets, and investment firm Black Rock predicts that there will be well over US$2 trillion invested in ETFs globally by the end of 2012.
By comparison, in 2000 the AUM of ETFs were less than US$70 billion worldwide. This translates to an annual growth rate of 31% per year. Currently there are over 2,500 ETFs listed on 43 separate stock exchanges worldwide.
The US and Europe are the more developed ETF markets but there is high demand for the product structure coming out of Asia as well.
Yet there are only 13
Shariah compliant ETFs listed globally: eight in Europe, two in the
GCC and three in Asia, with assets under management of less than US$1 billion.
The
Shariah compliant ETF market is extremely under-served and this evidence supports our conclusion that
Shariah compliant ETFs have the potential for rapid growth.
What keeps
Shariah investors from embracing ETFs? Education is a major factor, as explained by
Deutsche Bank‘s Manooj Mistry in a previous article for slamic Finance news (Vol 8 Issue 22).
However, more action is needed. We agree with Mr Mistry that education is lacking, and suggest that one reason for that is the lack of attention by the current ETF providers. After extensive research and analysis of the
Shariah compliant ETF market, we were surprised to discover that no one has satisfied the demand.
Deutsche Bank,
iShares and other ETF sponsors have a few of the listed
Shariah-based ETFs but their assets under management are trivial compared to other ETF strategies.
Most ETF firms have hundreds of ETFs listed, but it is clear their
Shariah product sales effort has either been lacking or ineffective, at least in comparison to the current most popular ETFs such as emerging markets and gold ETFs. This has left the Islamic investing community mostly untended.
One lesson learned from the growth of the US and European ETF markets is that education was the catalyst for AUM growth and it took a consistent message, delivered over a lengthy period of time, in order to succeed.
ETF sales forces would go from financial advisor office to financial advisor office promoting not just the performance of their products but the concepts and value the ETF structure could bring. This process needs to be repeated for the Islamic finance community.
Now let’s take a quick look at the advantages of ETFs versus traditional funds. There are several major points to be made when explaining ETFs.
1. Lower total expense ratio: The
Shariah compliant ETF total expense ratios are targeted to be substantially lower than that of competing mutual fund products – which according to our research is in a range of 1-2% per annum.
Total expense ratios for
Shariah compliant ETFs are also very competitive with other socially responsible ETFs.
iShares and
Deutsche Bank ETF offerings are generally charging less than 60 basis points for total expense ratio per year. One should also note ETFs do not have upfront or backend loads associated with them.
2. Speedy execution:
Shariah compliant ETFs are purchased just like stocks. This can be done with a broker for an individual or by the trading desk of an asset manager at any time during trading hours. However, mutual fund investors can only invest/redeem at market close.
3. Greater transparency: ETFs reveal their holdings on a daily basis whereas mutual funds do it only twice per year on a significantly delayed basis. Investors clearly prefer real-time transparency in this environment.
4. Greater tax efficiency:
Shariah compliant ETFs are more tax efficient than mutual funds because of their structure. Mutual fund investors get penalized during periods of heavy redemption where one pays for capital gains of others. In an ETF structure, the ETF investors pay capital gains tax only upon sale of their ETF shares.
5. Lower trading costs for institutional investors: With ETFs, institutional investors trade with authorized participants who create and redeem the underlying baskets. Institutions can trade creation and redemption baskets which typically hold between 25,000-100,000 shares, lowering their transaction costs even further.
6. Trading close to the net asset value: ETFs, unlike closed-end funds, trade very close to the net asset value (NAV) of the fund, not at a discount or premium. With an ETF, there are market makers performing constant arbitrage in both the ETF and the underlying securities, thus causing the ETF to trade at very little discount or premium to the NAV of the portfolio.
ETF applications for institutional investment managers
Cash overlay strategies: This is very useful for an active manager who has redemption or cash inflows. It enables the active manager to minimize the cash drag and equitize the cash return. This enables the manager to gain market exposure instantly to a
Shariah compliant index whilst accumulating assets and lowering cash drag.
Institutional investment managers can purchase ETFs to manage their cash flows during periods of inflows and outflows. A portfolio manager can establish a position that corresponds with the manager’s benchmark or investment strategy, investing inflows into the ETF and liquidating the position as needed to meet redemptions.
Portfolio diversification: By purchasing a broad-based
Shariah ETF, a manager can gain instant portfolio diversification in a single trade.
Transition management: Institutional investors (pension plans, endowments) can use ETFs to invest assets in a low cost manner whilst in transition between active managers.
Asset allocation:
Shariah compliant ETFs can help asset managers with their asset allocation decisions in choosing between different asset classes.
What makes an ETF Shariah compliant?
Shariah compliant ETFs are prohibited from investing in the following industries:
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Manufacture and distribution of alcohol, tobacco and pork-related products;
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Conventional financial services;
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Weapons and defense contractors;
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Entertainment (i.e. gambling).
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In addition, there are financial ratio criteria which must be maintained for inclusion in the
Dow Jones Islamic Market Indices:
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Total debt divided by 24-month trailing average market capitalization must be 33% or more;
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Cash plus interest-bearing securities divided by trailing 24-month average market capitalization must be 33% or more;
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Accounts receivable divided by 24-month trailing average market capitalization must be 33% or more.
Shariah compliant ETFs must have a
fatwa issued by a prominent
Shariah board verifying that they are indeed in compliance with the
Shariah rules and that the manager is in full compliance with the rules and procedures established by the index provider.
There are five major
Shariah compliant index providers globally (
Dow Jones, S&P,
MSCI, Russell
Jadwa &
FTSE), all of whom use a slightly different methodology in their screening criteria.
Once Islamic investors take a hard look at their portfolios and see where efficiencies can be made and weigh the benefits of the ETF structure, we believe there will be a new growth vehicle for both ETFs and
Shariah-seeking investors.
The projected strong growth rates of ETFs and Islamic finance remain two of the biggest opportunities in global finance today. Imagine if the two were combined and provided fuel for each other’s growth.
This is the opportunity facing the ETF industry, through reaching into specific distribution/investor channels such as the Islamic fund management industry and promoting the use of ETFs.
Saeid Hamedanchi, CFA, is the president and chief executive officer of ShariahShares, which he founded in Irvine, California, USA. He an be reached at
[email protected].