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MARKET REPORT
Genetics of a Shariah Compliant Equity Index
By Saeid Hamedanchi and James Altenbach
In 1896, the Dow Jones Industrial Average (DJIA), a price weighted
index, was one of the rst stock market indexes in the US that was
used to measure the performance of the stock market and as a
benchmark for investors. The capitalization weighted S&P 500
debuted in 1957.
traded funds (ETFs) and separately managed accounts. They can also
be used to benchmark actively managed Shariah portfolios. Most of
the indexes are designed to represent the performance of the largest
and most liquid Shariah compliant companies based on the publisher’s
universe of large, mid and small cap companies.
Until around the mid-1960s, most US equity portfolios were actively
managed, with their benchmark usually being the S&P 500 that
manages over- or under-weighted stocks in the index universe in order
to try to outperform it and achieve a higher return for their clients. The
average holding period in the index itself as published by the provider
was usually over ve years, but active managers usually traded far
more often, even several times a year, adding to transaction costs.
Most publishers use a weighting format similar to FTSE’s which is to
“… weigh its constituents by its adjusted market capitalization, such as
after the implementation of the investability weight …” Most publishers
make available their most popular indexes every 15 seconds at least
in US dollar, so they can accommodate their ETF clients, which is a
growing market.
In the 1960s, the Efcient Market Hypothesis grew in popularity,
at least in part due to growing evidence that most active portfolio
strategies did not add any value, often even before fees were removed.
Almost all were lacking in evidence that they outperformed after fees
and transaction costs were taken out. This was said to be because all
information is discounted into the prices of stocks, and no amount of
fundamental analysis could add value after fees. As such, stock prices
were said to follow a “Random Walk”.
“Most of the indexes are
designed to represent the
performance of the largest and
most liquid Shariah compliant
companies”
All publishers have an index management function that is responsible
for reviewing the rm’s Shariah index series and for approving
changes of constituent stocks. They will maintain the records of the
market capitalization of all constituents and will make changes to the
constituents and their weightings in line with pre-established rules.
The providers carry out reviews of their indexes and implement the
resulting constituent changes as required by their policies. For Shariah
indexes, these policies will always include the screening by a team of
world-renowned Shariah scholars.
Indexing started becoming popular in the 1970s. It would be almost
30 years before Dow Jones and later other providers would construct
and publish their sets of Shariah compliant indexes.
The rst Shariah compliant equity products we know of were separately
managed accounts and mutual funds. Some may have been used as
a benchmark for a relevant Shariah compliant index, but even this
may not have been possible over 20 years ago, as there was a lack of
Shariah compliant indexes around to benchmark to. As such, the old
benchmarks were likely just the conventional indexes, which over a
long period of time correlate highly with a Shariah index.
Construction of Shariah indexes
The ve major providers of Shariah equity indexes are FTSE, Dow Jones,
MSCI, Russell and S&P. Dow Jones is the oldest Shariah compliant
Index provider. Most of the published Shariah indexes are categorized
by region, country and sector or according to developed/emerging/
frontier markets status. Similar to conventional indexes, there is an
assortment of options available.
Shariah equity index suites as provided by the major publishers are
all designed to provide a family of Shariah compliant indexes suitable
for the creation of nancial products, such as index funds, exchange-
©
Indexes that are not quite so popular can be used for mutual funds,
benchmarking and separately managed accounts, and are published
at the end of each day. Capital and total return indexes are usually
available.
The Shariah Board usually comprises ve Islamic nance scholars,
who are responsible for ascertaining the Shariah compliance of
constituents of the publisher’s conventional universe, as well as
additions or deletions of stocks based on the permissibility of sector
and company. The scholars base their compliance determinations
upon data supplied by the publisher that is ltered by its proprietary
software screens, reviewed and approved by the Shariah scholars.
What makes an index Shariah compliant?
As indicated, the index publisher, whether it is FTSE, MSCI, S&P,
Russell or Dow Jones, starts with its broadest conventional index for
the relevant global and regional indexes and then screens out certain
stocks that are not Shariah compliant.
Eligible securities
Most indexes are based on large and mid-cap companies. Publishers
screen quarterly although there is some push to do this monthly as
market volatility is up and may change the market caps of companies
sooner than later, as well as debt coverage ratios, especially where
market value calculations are used.
Shariah compliant investments are required not to invest in the
following industries:
• Manufacture and distribution of alcohol, tobacco and pork
related products.
• Financial services industry with the exception of Islamic
banks.
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• Weapons and defense contractors.
• Entertainment that involves adult
gambling.
entertainment
and
After the index is screened for eligible securities, nancial screens
are applied. For example, companies whose nancial ratios are
above these metrics are excluded from the Dow Jones Islamic Market
Indexes:
• Total debt divided by a trailing 12-month average market
capitalization is 33% or more.
• Cash plus interest-bearing securities divided by trailing 12month average market capitalization is 33% or more.
• Accounts receivables divided by 12-month average market
capitalization is 33% or more.
FTSE’s nancial screen allows companies with debt less than 33% of
total assets; cash and interest bearing items which are less than 33%
of total assets; accounts receivable and cash which are less than 50%
of total assets; and total interest and non compliant activities income
not exceeding 5% of the total.
“Sometimes a permitted
company is merged with a
prohibited one, and thus the
new company can no longer be
included in a Shariah index”
MARKET REPORT
index at the same time as it is removed from the corresponding
conventional index.
Mergers, restructuring and takeovers change the conventional and
Shariah indexes. Sometimes a permitted company is merged with a
prohibited one, and thus the new company can no longer be included
in a Shariah index. The scholars make this determination usually at
the next screening date which usually is quarterly, as with FTSE, but
can be as often as monthly. According to S&P, over the longer term
(ve- to 10-year period) there is a 94% to 97% correlation of the S&P
500 Shariah index with the S&P 500 index. In developed markets, the
correlation between the developed market Shariah and conventional
indexes remains very high. However, in emerging and frontier markets,
the correlation drops between Shariah Index and conventional
indexes.
Summary
Indexing started to become popular in the 1970s after academics
and investors gured out that the most active managers do not add
value in return for the fees they charge. The Shariah compliant indexes
end up overweighted in energy and technology, which in general are
compliant and have no exposure to conventional nancial services.
Commodity related companies will usually be overweighted compared
to conventional indexes.
Most of these indexes would not benet from a rebound in the nancial
sector, as would conventional indexes. However, as the Shariah indexes
are overweighted in energy and commodities and not heavily exposed
to heavily indebted companies, they should do well in an inationary
environment, which we expect in the coming years.
S&P and Dow Jones Indexes also use slightly different processes; some
use book value as opposed to market capitalization in calculations,
but the spirit of the process is very similar. It is possible for some
companies to have non-compliant activities, in which case some of
the dividends need to be “puried”. This means that the scholars
recommend to the faithful to donate to charity some portion of their
dividend that was derived from non-Shariah means. This amount is
usually not more than 5% of the dividends, or else the whole security
will just be non-compliant.
Shariah compliant indexes have a Fatwa (declaration certicate) issued
by a distinguished Shariah board that they are indeed in compliance
with the Shariah rules and procedures. All the index providers use a
slightly different methodology in their screening criteria.
When a company is added or removed, it is often a function of whether
the cause of action is due to market cap issues or other screening
criteria. A market cap-removed stock is usually removed from a Shariah
The indexes are used as benchmarks for Shariah compliant portfolios,
as well as for index strategies used for separate account, mutual
funds and now the ever more popular ETFs. The index strategy simply
reproduces the index and does not provide active management. The
Shariah index strategy provides a low cost means for Shariah seeking
investors to get Shariah compliant exposure to the equity markets.
Saeid Hamedanchi, CFA
President and CEO
Florentez Investment Management (ShariahShares ETF)
Irvine, California
The US
E-mail: [email protected]
James Altenbach, CFA
Principal
Florentez Investment Management (ShariahShares)
Irvine, California
Next Forum Question
As recent defaults have marred the Islamic nance industry, and question marks loom over other past issuances,
transparency remains a great concern. How reliable are credit ratings within the Islamic nance industry? Are the
current methodologies adopted adequate and what could and should be introduced to improve this?
If you would like to air your views on the next Islamic Finance Forum Question, please email your response of between 50 and 300
words to Christina Morgan, Forum Editor, at: [email protected] before Wednesday, 16th September 2009.
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