De-linking from conventional benchmarks

By Rushdi Siddiqui, Available at: http://www.btimes.com.my/Current_News/BTIMES/articles/isfin3/Article/index_html

UNTIL Islamic finance can have its own set of syariah-compliant benchmarks for investing and financing, the criticism of dependence to conventional finance will continue. But, if Islamic finance is eventually deemed “conventionally efficient”, then Islamic benchmarks should have same returns/value, but the means to the ends would be different.

The cross sell of Islamic finance to non-Islamic investors, investing or financing, is, at minimum, about market performance. However, to many Islamic investors, it must not only outperform Islamic indexes, but also conventional benchmarks.

Continuing the format of a “self-interview”, I want to reply to challenging questions on benchmarks with deeper dive answers.

Q:Why are Islamic benchmarks important?

A: A benchmark, be it Islamic equity or Sukuk index, serves multiple functions:

* Provides a pulse of the markets and also acts as a news barometer;

* Allows for relative comparison to funds and stocks;

* Serves as basis for investment products such index funds, Exchange Traded Funds, etc;

* For high profile indexes, like Dow Jones Islamic Market Index or S&P syariah 500, company inclusion may become part of its marketing and PR materials, hence, badge of honour; and

* Has encouraged a number of comparative academic studies on Islamic vs. conventional equity investing.

Its interesting to note that banks often place financial ratio covenants on corporate customers, hence, ratios like debt/market capitalisation of 30 per cent or debt/asset of 30 per cent , commonly found in syariah screening, shows the benefits of imposing discipline on corporations balance sheets, especially important in slow/no growth or high interest rate environment.

Q: What do syariah-compliant equity indexes measure?

A: At face value, they capture syariah compliant companies according a rule book of an Islamic index provider, Malaysia’s Securities Commission or Accounting and Auditing Organization for Islamic Financial Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI’s) screening. The screening results in a style of investing called ‘low debt, non-financial, social-ethical’ investing.

The screening also results in bias towards G20 countries (85 per cent), towards three economic sectors (technology, healthcare, and energy) and with companies like ExxonMobil, Pfizer, IBM, and so on.

The question I have is this, ‘what is the link to the pulse or health of Islamic finance of a (Muslim) country and today’s syariah-compliant indexes? In Muslim countries with stock exchanges, the syariah repugnant conventional financial is the largest economic sector, and technology, healthcare and energy is extremely small, if it exists at all.

Thus, the syariah-compliant indexes, even for Muslim countries, do not give a good pulse of Islamic finance in the said country.

In fact, such indexes, with the Islamic equity funds off of them, shows fund flows from where sourced, to where invested.

Thus, the industry needs to look at two important areas on syariah (equity) screening:

First, separate screening for countries, as present rules book do not work well where largest sector is financial sector and a non-equity culture of financing exists. To ‘equitise’ the balance sheet by refinancing conventional debt with sukuk, hence, increasing supply of not only compliant firms, but also sukuk for secondary market trading and sukuk funds.

Enlightened firms in Malaysia, like toll-operator Plus, have undertaken sukuk refinance to be in an Islamic index.

Second, we need to develop syariah based indexes, as such dedicated Islamic financial institutions have exposure to retail (deposits and financing), international trade (LCs), treasury, corporate, real estate, stock brokering, etc. Will this cause confusion with syariah-complaint indexes? What will happen to syariah-compliant indexes?

Q: From the universe of Islamic funds, is it possible to create Islamic indexes?

A: With financial engineering everything is possible, but it may not beneficial, as US mortgage industry was a model case example of ‘innovation’ run amuck. The Islamic fund industry presents an interesting story of an embryonic industry getting ready for wealth/asset management take-off trajectory.

According to Lipper data (Q2, 2010), there are 560 Islamic funds, and 96 per cent are actively managed with 98 per cent of the assets under management (AUM). Put differently, Islamic fund managers believe they can capture Alpha, excessive performance of the corresponding benchmark.

It should be noted that 42 Islamic funds were liquidated during the period of January 2009 to August 2010. Some were capital protected funds maturing, and others were under-performing corresponding Islamic benchmarks, hence, redemptions.

In putting together an Islamic fund index, the objective is to capture the fund manager’s Alpha.

The chart shows Lipper Islamic Fund Index outperforming the Dow Jones Islamic Market index, from December 2003 to June 2010.

The Islamic finance industry has come a long way on performance benchmarks in a short period of time, with equity and Sukuk indexes, and, now, we need to look at Islamic fixing, i.e., delinking from the London Interbank Offered Rate (LIBOR).

This will be a pricing indicator, calculated of various tenors on daily pricing through bank contributions with pricing checked and balanced by established governance scrutiny.

Best Regards
Zulkifli Hasan

Grindelwald, Switzerland