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Islamic Review


Shariah compliant ETFs: Time to go local?

Religiously inspired ETFs hardly setting the heather on fire

By Imran Ahmed*

ince the launch of the Standard and Poors 500 Index Exchange Traded Fund (ETF)1 in 1993, the ETF industry has enlarged its scope to include many different facets of tradable assets. Sectors, countries, regions, commodities and long or short active strategies are amongst the many types of ETFs available to investors. The variety is such that an investor with an internet connection and a discount brokerage account can practically run a hedge fund from his or her living room. Recently, socially responsible investment (SRI) strategies have participated in the ETF boom. Socially responsible investing is an investing strategy that attempts to combine financial return with social responsibility. Ethical strategies tend to focus on three key areas: the environment, social justice and corporate governance (ESG). Typically, a socially responsible investor favours corporations which are sensitive to the environment, consumer rights, human rights and even employee diversity.

Domini 400 Social Index which is a market capitalisation weighted stock index of 400 publicly traded companies that meet certain social and environmental

Like their Christian counterparts, Shariah compliant ETFs have also found the market to be far from receptive
Currently, SRI investors have several ETF investing options available. The iShares MSCI USA ESG Select Index (KLD) has assets of US$171 million and tracks the FTSE KLD Select Social Index. The FTSE KLD Select Social Index is designed to identify companies with positive environmental, social, and governance factors while exhibiting risk and return characteristics similar to those of the FTSE US 500 Index. There is also the iShares KLD 400 Social Index Fund (DSI) with assets of $157 million. DSI tracks the 20 ETFI ASIA 2011 AUGUST standards. Interestingly, both the KLD and DSI track the broader US market very closely, having a beta of 0.98 and 0.99 respectively.2 However, faith based socially responsible ETFs have not had an easy time. In December 2009, Faith Shares launched several ETFs which invested in companies based on Baptist, Catholic, Lutheran, Methodist and broad Christian principles. Due to lack of interest from investors, all but the FaithShares Christian Values Fund (FOC) were closed on July

15, 2011. As at May 31, 2011 the broad FOC had assets of only $3.2 million. Shariah compliant ETFs form another subset of faith-based socially responsible ETFs. Shariah compliant investing focusses on companies which adhere to Islamic ethical principles pertaining principally to a companys debt ratio and scope of business. In general, businesses which have a high debt to equity ratio or operate in un-Islamic areas such as alcohol, tobacco, armaments and pork must be excluded from the investment universe.

Tough nut to crack

Like their Christian counterparts, Shariah compliant ETFs have also found the market to be far from receptive. The Dow Jones Islamic Market International Index Fund (JVS) which was launched in July 2009 by Javelin Investment Management survived just over one year. The JVS was liquidated on October 19, 2010. For a vibrant Shariah compliant ETF sector to emerge at least two ingredients are required: products and investors. Manufacturing ETF product is
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Islamic Review
daily trading valued at $2.2 billion, already has 12 ETFs listed. However, as at end 2010 ETF assets were a modest $154 million.4 Turkey may not be a BRIC nation but it is giving the four nations a run for their money. Turkey has a population of approximately 79 million with a GDP per capita income of $12,300 (purchasing power parity).5 As testament to Turkeys recent success in wealth creation, Forbes magazine ranks Istanbul as the city with the fifth most resident billionaires (36) with a combined wealth of $61 billion. Malaysia, already positioning itself to be an international hub for Islamic finance, is another logical location January 2008. Currently, the ETF has net assets of approximately $193 million.9 Given the assets available to international ETF manufacturers through listing on US markets, it is not surprising that many domestic markets feel somewhat neglected. When master ETFs tracking mainstream indices such as the Standard and Poors 500 Index (SPY) and the Dow Jones Industrial Average (DIA) raise assets measured in billions of US dollars there is little reason to look to overseas domestic markets. Even popular sector ETFs such as the Financial Sector Select SPDR (XLF) or the SPDR Standard and Poors Retail Sector Fund (XRT) have assets which put most international domestic ETFs to shame. Surely, global ETF manufacturers commonly use internationally listed feeder funds to tap savings from smaller domestic capital markets. However, for niche products such as Islamic ETFs, being accessible by the right population demographic is critical to achieving a reasonable fund size. There may be approximately seven million Muslims in the US and countless more Christians but, as both the Christian and Islamic ETFs demonstrate, Americans rarely make investment decisions along confessional lines. Islamic ETF providers will do well to devise creative strategies which nurture large domestic markets in predominantly Muslim countries such as Egypt, Indonesia, Malaysia, Pakistan and Turkey. Malaysias emerging experience with an Islamic ETF is encouraging. Undoubtedly, ETFs in these domestic markets may not hit billions of dollars in assets anytime soon but recent experiences by religiously inspired ETFs in the US have set low benchmarks for success.
* Imran Ahmed is a principal at Deodar Advisors LLP. He can be reached at Imran@deodaradvisors.com

not a challenge. The ETF industry is well established and operating procedures are well entrenched. In 2010, the global ETF industry had over 2,400 ETFs with 5,554 listings versus 1,943 ETFs with 3,827 listings at year end 2009, i.e. almost 500 new ETFs were launched during calendar year 2010.3 ETFs normally require transparent and replicable indices to track. Both Standard and Poors and Dow Jones have Shariah compliant versions of several major indices, including the Standard and Poors 500 Shariah Index and the Dow Jones Islamic Market World Shares Index. In reality, the list of global and local Shariah compliant indices is long. Lack of

For niche products such as Islamic ETFs, being accessible by the right population demographic is critical to achieving a reasonable fund size
Shariah compliant indices is not the issue holding back ETF manufacturers. Clearly, the first part of the Islamic ETF equation, i.e. products, is not the impediment. ETF manufacturers will go where the demand takes them. Obviously, at least to date, the demand for Shariah compliant ETFs has not been sufficient to entice more ETF manufacturers into the sector. Perhaps that is because the historic focus on the US and other large centres by global ETF providers is shading their view of second tier savings markets, especially in predominantly Muslim countries. for marketing Islamic ETFs. The Kuala Lumpur Stock Exchange (KLSE) is one of Southeast Asias largest exchanges, with a market capitalisation of approximately US$435 billion. The KLSEs recent average daily traded value is almost $500 million.6 Malaysias 29 million residents, of which 60% are Muslims, have a GDP per capita of $14,700 (purchasing power parity).7 At last count, the KLSE had five listed ETFs of which one is a Shariah compliant ETF.8 The KLSE main board listed MyETF Dow Jones Islamic Market Malaysia Titans 25, managed by i-VCAP Management, tracks the Dow Jones Islamic Market Malaysia Titans 25 Index. Importantly, based on the Islamic ETFs assets, Shariah compliant ETFs have some appeal with Malaysian investors. MyETF has been in operation for over three years, since

Turkey and Malaysia are two potentially attractive markets for Shariah compliant ETFs. Turkeys Istanbul Stock Exchange (ISE), with a market capitalisation of approximately $295 billion and average
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For the purposes of this article, the term ETF includes all forms of exchange traded portfolios or ETPs, including exchange traded notes (ETNs). ETF data, including beta, obtained from Yahoo Finance on June 14, 2011. 3 Source: BlackRock 4 Istanbul Stock Exchange data sourced from the Federation of Euro-Asian Stock Exchanges. ISE ETF data as reported by BlackRock. 5 CIA Factbook. 6 Source: Bursa Malaysia website accessed June 14, 2011. 7 CIA Factbook. 8 Source: Bursa Malaysia website accessed June 14, 2011. 9 Source: June 14 data obtained from MyETF website.
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