Why is there still so much inconsistency over what should constitute Shariah compliant investing, despite standardization of rules issued by AAOIFI?
It turns out that part of the confusion is due to bits of unwritten practical rationale, tangential to what would be classified as Halal or Haram, explained Sherif Salem, Lunate Capital’s Head of Public Markets.
Citing the example of how funds are created with units suitable for investors, Sherif said the fund’s constituents will dictate – from a commercial perspective – whether they would work better as a conventional or a Shariah compliant offering.
“Take Japan, where a lot of the major stocks are of carmakers, which are mostly heavily indebted. With such high levels of debts, those companies would not have passed the Shariah filter.”
Faced with this issue, Lunate Capital eventually decided it was better to craft its Chimera S&P Japan UCITS ETF as a conventional exchange-traded fund (ETF) “as the names within that are much more recognizable for investors”.
Sherif said another company that would have dropped out is Nintendo and as such, the ETF won’t be a good representation of the Japanese market – even though it is designed to track the top 30 most liquid stocks listed on the Tokyo Stock Exchange.
ShariaPortfolio Global Wealth and Chief Compliance Officer Irfan Chaudhry noted what trips up many would be the quantitative ratios like debt-to-market capitalization and cash compared to total assets – as these ratios are prescribed to be below 33%.
An especially tricky aspect would be delineating income from non-Halal sources to be below 5%, often accomplished by ringfencing the non-compliant revenues to avoid the timing issue – as the ratios can vary widely from day to day, potentially breaching the threshold.
“However, even in cash-rich companies, the cash-to-market capitalization ratio will very rarely cross the 33% mark. For example at Google, it is just 5.41%. For Apple, it is 3.95% and for Amazon, it is 0.64%.”
So, whichever Shariah audit is conducted on such stocks – despite it being conducted annually or half-yearly – chances of that company failing to meet this ratio is very low. “That imbues a good corporate governance control. Management is not able to use cash in wasteful projects.”
BlueBox Asset Management Co-founder and Lead Portfolio Manager William de Gale highlighted another aspect that makes it difficult to offer a Shariah compliant fund.
“Large and successful investment firms did not see the need to create Islamic products, as the size of the market was small before. This was exacerbated by the perceived administrative burden of maintaining Shariah compliance. The Shariah market was therefore left to second-tier firms and underperforming fund managers.”
Due to this poor public perception of players in the Islamic investment landscape – especially in new and emerging markets where conventional investment opportunities were entrenched – there had to be an extra incentive to draw in potential investors, going beyond relying purely on the ethical draw.
William said BlueBox conducted a test by applying a Shariah screen to its well-run conventional equity portfolio – by first excluding non-compliant stocks and proceeding to scale up the remaining portfolio valuation back to 100% to produce the new Islamic fund.
“When we back-tested, by applying our Shariah screen retrospectively to the first four years’ track record of our conventional fund, it added roughly 1% a year to performance.”
This analysis persuaded the firm to pursue the Shariah route with its BlueBox Islamic Global Technology Fund, concluded William.
Lion Global Investors Islamic Business Director Zefri Delaney Mohd Dennis echoed that potential customer demand must be quantified first before any product can be offered for assessment by market acceptance.
Only then will the focus shift to possibly achieving consistent top quartile performance. “If the fund doesn’t sell or perform well, it is unlikely to succeed over the long term.”
The main challenge for conventional fund issuers is whether to either tweak in-house expertise to achieve Shariah compliance or take the more difficult route of implementing new processes, to substitute existing ones deemed impermissible.
“It is a delicate balance and the final decision is understandably skewed to results from a cost-benefit analysis.”
Even though the Shariah investment landscape is growing rapidly, Zefri said that it would take significant market demand and some degree of commercial certainty for a conventional fund house to exclude conventional investments completely from their operations.
