Exchanges around the world are listing Shariah-compliant ETFs and creating indexes to meet the needs of Islamic investors.

Shariah investing is growing rapidly worldwide as Muslims seek to earn profits without violating the tenets of their religion. While the infrastructure is still emerging, mutual funds and exchange traded funds (ETFs) are being developed to meet the needs of this important customer segment. Exchanges are capitalizing on this trend by creating and listing these and other new products.

While estimates vary, a recent Ernst & Young study of Islamic funds shows assets held by investors in Muslim countries at more than US$1.6 trillion, which is expected to rise to US$2.7 trillion by 2010. At the same time, the Sukuk (Islamic bond equivalent) market, currently worth about US$70 billion, is increasing at an average annual rate of 40 percent and is estimated to reach US$200 billion by 2010.

Shariah investing is the fastest growing sector within this investment market. Shariah investment criteria screen out banks and other financial companies. On the debt side, Shariah does not allow ‘house of cards’ scenarios in which investors are entitled to no more than a stream of revenues. Instead, Sukuk transfer ownership of performing assets.

“Islamic finance is prudent business,” explains Yusuf Talal DeLorenzo, Chief Shariah Officer at Shariah Capital. “Shariah has nothing against sophisticated investing or trading strategies, as long as the underlying investments are real and fundamentally sound.”

Originally focused on real estate, Islamic finance is beginning to diversify into infrastructure finance, leasing, private equity, structured products, Sukuk and alternative asset classes. While many derivatives are not permissible under Shariah, there is now a wide spectrum of investments available for the diversification of investment portfolios.

Non-Islamic countries are looking to capitalize on this potentially high-growth market. Hong Kong and Singapore are planning to challenge Malaysia’s dominance in the Asia-Pacific region. Meanwhile, London bankers are predicting that Sukuk origination and issuance by European corporates and governments is coming soon. Still, there are relatively few Shariah-compliant opportunities for investors outside the Middle East.

“In many parts of the world, people are not familiar with investing,” says John Jacobs, NASDAQ OMX Executive Vice President, Global Financial Products and Global Marketing. “That challenge is compounded in many Muslim societies due to Shariah rules. These societies typically have traditional banking products, but there is a shortage of other investment vehicles.”

It is also difficult for investors to do the rigorous analysis required to determine whether a company is Shariah compliant, which involves more than just a simple test to ensure the company is not involved in the sale of products such as alcohol, tobacco or pork. Too much cash on a company’s books might imply that the company is earning interest income and, therefore, must be screened out.

Several companies are now filling that gap. Securities firms are becoming established in local markets to offer Shariah-compliant products such as mutual funds, ETFs and structured products, and people are learning about the financial markets.

Shariah Capital, for example, is developing unique investment solutions for asset management in compliance with Shariah. Recently, the firm developed refined criteria for screening stocks by means of proprietary software and a shortsale alternative that complies with Shariah law.

“Our refined Shariah screening solution uses the latest technology to provide managers with accurate data on more than forty thousand publicly traded companies worldwide,” says DeLorenzo. “Likewise, we rely heavily on technology for our ongoing Shariah supervision of the hedge fund managers on the Al Safi Trust platform.”

The firm acts as advisors to the Al Safi Trust, an offshore alternative investment platform for hedge funds, which bridges Western investment management and Shariah. The firm allows hedge funds to manage in a manner consistent with their existing strategies while still addressing the religious requirements of Muslim clients.

A trading mentality is beginning to emerge in the Islamic finance industry. Exchanges have an opportunity to facilitate growth in the market and help determine how Islamic capital markets will function. “While the going may be hard at the outset, the opportunity is a real one. But for those with an eye toward the future, the rewards can be remarkable,” says DeLorenzo.

In late 2007, a Shariah index was launched on the Tokyo Stock Exchange. The index includes 79 Japan-traded stocks selected with respect to each company’s compliance with Islamic canonical law. The index excludes businesses that offer products and services that are considered unacceptable or noncompliant according to Shariah law. All constituents are monitored daily to ensure the indexes maintain strict Shariah compliance.

In May 2008 Daiwa Asset Management launched Singapore’s first Shariah-compliant ETF on SGX. The Daiwa FTSE Shariah Japan 100 (DaiwaETF) offers Islamic investors instant access to the top 100 Shariah-compliant companies in Japan by market capitalization. While the DaiwaETF was created to cater to the expanding needs of Islamic investors for greater investment alternatives, Daiwa Asset Management expects it will also appeal to non-Islamic investors internationally. Besides offering exposure to top tier companies in Japan, the ETF’s sector diversification is an attractive proposition for professional and retail investors seeking to participate in Japan’s stock market.

NASDAQ OMX is also leveraging its large index business to tap into this opportunity. The exchange plans to roll out a screened version of the NASDAQ 100 and the NASDAQ Biotechnology Index by the end of 2008, which will open up tremendous opportunities for investment firms to create new products based on the indexes.

“Companies included in these indexes are now being introduced to a whole new group of investors,” says Jacobs. “They’re getting the visibility of being in a world-class index, they’re receiving the direct and indirect investment of these new investors, and hopefully that leads to improved valuations over the long haul.”

It is likely that more Shariah-compliant products will appear on the scene in the coming years. Exchanges have an opportunity to play a key role in the building of the infrastructure to support this market. Those that want to break into it must include in their offering a fast, efficient way to trade these products. Also they need to ensure they have the capabilities to market indexes and capture the fees that go with them.
 

BY SHERREE DECOVNY   PHOTOS LAM MENG YEIN, ONASIA IMAGES  ILLUSTRATION ANNA SVANFELDT

MarketView 2008:2