Some criticism on Islamic indices and the responses
Have the Islamic indices been effective and competitive when it comes to providing the desired return to investors, either by investing through Islamic funds or investing individually, vis-a-vis the conventional indices?
There is an argument that the Shariah screening process does not leave much to select from a long list of stocks as a majority of the companies fail to qualify to enter into an Islamic index. Furthermore, the companies listed in an Islamic index can be pushed out at any time if their interim or annual results fail to impress the Shariah screening manager.
This leads to another argument that in addition to market forces, the movement in an Islamic index could also be independent of the market. This is because at any time a stock considered good by the market and wished for by investors may be dropped out of the index due to its failure to survive the periodic Shariah screening process.
This can cause a sudden drop in the Islamic index if the exiting stock held a sizable weightage in the index. It is important to note that this may happen despite market sentiments being bullish and that particular stock gaining lots of attention as I explained in the case of Worldcom, Tyco, Enron, Parmalat, etc. Therefore, the critics opine that perhaps there is a need to relax the Shariah screening parameters in order to broaden the base of Islamic indices and provide them with a certain degree of stability and consistency.
Another reason brought against the Islamic indices is that these were tilted toward the technology stocks due to their relatively low indebtedness and higher Shariah compliance nature. As such, just when the Dow Jones Islamic Index had started to emerge, the market saw the burst of the technology bubble. Although the impact was felt by indices globally, the drop in the Islamic indices was larger since these were loaded with technology stocks.
Coming back to the first point, it is true that out of a given basket of stocks, the ratio of stocks not making it to an Islamic index may sometimes be over two-thirds or even higher. However, one should not forget that until the start of this century, an Islamic investor did not have an opportunity to enter into the world’s leading stock markets with the complete satisfaction to its consciousness.
Managers of Islamic indices have taken it upon themselves to provide a clean bill of Shariah health to the stocks listed in their portfolio. Now, any investor can pick the stocks from an Islamic index knowing fully well that by investing in them, he is not violating any Shariah principle. This in itself is a great stride when we look back at the past when the stock market was devoid of any such facility for investors.
As far as relaxing the Shariah screening process is concerned, this seems unlikely, especially after these parameters have proved their effectiveness and are regarded highly successful in protecting investors’ interest.
To the contrary, the base of Islamic indices is gradually broadening with the stricter regulatory environment and self-containment of debt by the publicly traded companies.
The argument that the Islamic indices are sensitive toward fluctuations in the technology stocks may have been outdated. With constant review and research, the Islamic indices have since achieved a well-diversified base, and except for the sudden exit due to a stock’s failure in Shariah screening, as per my own observation the fluctuations are more or less in line with market sentiments.
In addition, now there are various sector-wise Islamic indices also available to investors to choose from. These are mainly comprised of real estate, technology, energy, telecommunications, financial, healthcare, material, utilities, cyclical and non-cyclical. As such, an investor can decide if he or she would like to take a stake in a multi-segmented or an industry-specific index.
One must remember that the most vital criterion for good performance by an index is the sustained bull run. Islamic indices are not alien to this phenomenon since all the stocks appearing in an Islamic index are also part of the wider and unconstrained conventional indices.
Hence, if the fluctuation in a particular common group of stocks moves a conventional index either way, it is bound to swing an Islamic index too in a similar fashion. It will be alright for both types of indices if the swing goes up; however, investors in an Islamic index are better guarded in bearish market conditions due to the stricter Shariah regulatory environment.
There is also a complaint that Islamic indices fetch lower returns compared to conventional indices due to their restricted nature and rigid policies. This is to be noted that a stock index is a hypothetical portfolio deriving notional returns whereas a fund, which invests in the stocks, contains the physical portfolio and actual returns.
In-depth analyses of the performances of different Islamic indices over a period of time portray that despite Shariah constraints, more often than not these indices have proved to have recorded superior performances compared to their conventional counterparts.
With this, I conclude my explanation of the Islamic indices and the Shariah screening of listed stocks. However, just before I go away for this week, I would like to reiterate that the same screening parameters can also be applied when dealing with a private equity investment.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at sazubairi1979@gmail.com.
Next week: Discussion on Islamic REITs.
