ETFs are regulated, open-ended investment funds that trade on stock exchanges just like any other listed, tradable security. They combine in a single, easy-to-use product the key intra-day trading and liquidity elements of stocks, which means they can be bought and sold via a broker, with the attractive elements of index funds — a regulated structure and diversification.
Both professional and retail investors use ETFs, and as the products let investors maintain buy-and-hold positions in market indices over the long term in a cost effective manner, they are becoming increasingly popular as asset allocation tools.
Investors can use ETFs to build custom made portfolios consistent with their investment goals and risk and return requirements. Meanwhile, ETFs have proven effective when it comes to implementing well known asset management strategies, such as the core/satellite strategy. Very broad-based ETFs can serve as the diversified, core holdings of the portfolio, while the outer satellite parts are linked to more specific sectors, regions, stocks or styles that the investor wishes to overweight.
ETFs are also effective completion strategy tools, in that they can help fill in sector or regional exposure gaps in a portfolio.
ETFs can also be used by investors to put idle cash to work, a process known as cash equitization. Because ETFs can be traded quickly, easily and at low cost, they can be a useful tool for maintaining market risk exposures during periods of portfolio transition.
The first ETFs tracked major benchmarks such as the S&P 500 equity index, but as the market has expanded a vast range of underlying exposures have become available in ETF format, from equity and fixed income investments in emerging markets, to ETFs that track the performance of specific sectors, to ETFs that provide investors with exposure to alternative investments such as commodity price indices. It was only a matter of time before ETFs linked to Shariah compliant indices emerged.
In creating a Shariah compliant ETF, an ETF provider must source an appropriate Shariah compliant index to reference, and must also ensure that the method the ETF uses to track that index complies with the religious law. In the case of some ETFs, the vast majority of products track their underlying indexes synthetically using derivatives. This involves a bank as a swap counterparty being obliged to provide the ETF with the returns of the index.
Some ETFs track established Shariah compliant indices, such as the S&P 500 Shariah, which is based on the parent S&P 500 but adopts explicit investment criteria defined by Shariah law. It therefore only includes those companies from the parent index that are deemed to be Shariah compliant — the Shariah version currently has 276 constituents. To achieve this, Standard & Poor’s Ratings Services (S&P), uses a specialist screening company that utilises the expertise of a qualified Shariah supervisory board. The board consists of Islamic scholars that serve to interpret business issues.
For a Shariah compliant ETF to achieve tracking, rather than utilize a swap agreement, the ETF instead enters a Shariah compliant non-debt and non-derivative agreement with a bank to provide the returns of the index. As in other areas of Islamic finance, the economic outcome is the same as that provided by a non-Shariah investment, but the method used to achieve the outcome involves agreements designed to comply with Shariah law.
Despite such innovations, the Shariah ETF market has, as yet, failed to take off in any significant way. There are currently 13 Shariah compliant ETFs listed globally. In Europe there are eight products with combined assets of around US$300 million, which is a relatively small amount for ETF products.
In Asia, there are three products with combined assets of around US$220 million and there are also a couple of products in the Middle East with minimal assets.
The slow uptake can be put down to a number of reasons. ETF providers in Europe still have some way to go towards educating retail and institutional investors about the benefits of ETFs in general, and it could simply be the case that not enough investors know about the products.
For the moment then, the Shariah ETF market is not set for significant product expansion. For that to happen, more assets will have to flow into the products already established.
But as the ETF market itself expands, the Shariah ETF component should come up with it. Providers have to work hard to educate and inform investors about Shariah ETFs, but the longer term prospects for the market remain positive.
Manooj Mistry is the UK head of db X-trackers, the ETF platform of Deutsche Bank. He can be contacted at manooj.
[email protected]
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