ETFs have revolutionised the global fund management industry, spawning into a US$1trn business. Yet Islamic ETFs in the Middle East are much slower to take off. John Foster finds out why.
Islamic exchange-traded funds (ETFs) are not a new concept. The first Sharia-compliant ETF was launched in January 2007 by Liechtensteinische Landesbank and the now disappeared ABN Amro on the SWX Swiss Exchange.
The market began to gain traction when Daiwa, Japan’s second largest securities house and Barclays Global Investors’ iShares (now owned by BlackRock) also rushed out their own versions of Islamic ETFs covering various equity markets before the close of 2007.
The humble Sharia-compliant ETF seemed to have got the official nod a year after it first came to light when Malaysia, the world’s leading Islamic finance hub, launched its own state-sponsored Islamic ETF in January 2008. This was followed by the creation of a suite of Sharia-compliant ETCs – or exchange-traded commodity products – by London-based ETF Securities.
Then the market went quiet, except for a few ETFs that popped up in the next few years, most notably Javelin Investment Management’s US-focused Islamic ETF, and the launch of Benchmark Asset Management’s India-focused ETF last year. But on the whole there was more action at a librarian’s convention than in the Islamic ETF market.
Why?
ETFs have taken the conventional world by storm, and are now as much a part of the investor’s compendium as the balanced fund. However, in the world of Islamic finance they are a fringe product.
According to research by IFIS, there is only US$8.53bn (€6.65m) invested in Sharia-compliant ETFs out of an estimated total assets for the Islamic finance industry of $1trn (according to Standard & Poor’s). When ETF assets are broken down, $8.2bn of these assets are in ETCs, based on precious metals, and therefore equally attractive to non-Islamic investors.
Until quite recently there were no Middle East-based Sharia-compliant ETFs. In March, Falcom Financial Services, a Sharia-compliant bank in Saudi Arabia, launched a Saudi-domiciled ETF based on the Saudi bourse, Tadawul.
At around the same time, the National Bank of Abu Dhabi launched a UAE product, and most recently, in July, Falcom launched its second ETF that invests mainly in Sharia-compliant equities of Saudi petro-chemical firms.
No reason why not
According to Majid Dawood, chief executive officer of Yasaar, an Islamic finance consultancy based in the UAE, there is no legal or theological impediment to the creation of Islamic ETFs. “We originally worked with iShares setting up Barclays Capital’s suite of MSCI-based Sharia-compliant ETFs and ETFs as a product are very cost effective for investors, allowing them to get in and out of markets simply and efficiently,” he says, adding: “However, they are passive products that don’t generate a lot of alpha, and just haven’t caught the imagination of fund manufacturers or investors in the Middle East region. We have not had a single approach from fund managers wanting to design Sharia-compliant ETFs in the Middle East.”
Ali Shervani, director of Islamic finance at Miftah Advisory India, and behind the launch of the Shariah Benchmark Exchange Traded Scheme, Shariah BeEs ETF, in India, in February 2009, was another strong advocate of Islamic ETFs. He says: “ETFs make you believe in the market. In Islamic finance there is no such concept as a ‘fixed return’ and as ETFs are based on trading there is no Gharar, or uncertainty, and if the underlying index or securities of the ETF are screened for Sharia-compliance, they are a perfect Islamic financial product.” The fund size of Shariah BeEs was approximately $250,000 as at end of July.
Shervani stresses the lack of participation in the ETF sector by Islamic finance companies. “In India Islamic finance is in its infancy and there are only a handful of Sharia-compliant funds. The market is growing at a very slow pace,” he says.
Financial disincentive
The lack of market interest – so far – in Sharia-compliant ETF products can be explained by the relative immaturity of the Islamic fund management industry as a whole. But there are other reasons.
One senior Islamic banker, who preferred to remain anonymous, said: “The big problem with ETFs in the Middle East is the fees that managers can earn from them. Office rents and costs of living in the financial centres such as the DIFC [Dubai International Financial Centre] and Doha are still very high and the fund manufacturers are just not interested in earning the measly 20 basis points in management fees that you can get off ETFs. I guess the fund manufacturers are too greedy to want to go through the trouble of setting up products that will earn them little in the long run.”
But Rushdi Siddiqi, head of Islamic finance for Thompson Reuters and former global director for Dow Jones Islamic Market Indices, also believes that an unsophisticated investment infrastructure and lack of investor education were other reasons why Islamic ETFs had not taken off in the Middle East. He says: “In the Middle East, if you take the majority of financial services companies out of the index for Sharia-compliance reasons, you are left with a handful of large liquid companies and lots of medium-sized illiquid companies. The indices are not as structurally attractive from an ETF perspective.”
Compared to the stock markets of the UK or the US that are diverse and liquid, or the depth and maturity of the capital markets in developing nations such as India or Malaysia, Gulf stock markets do not have the same profile. Many of the companies listed on the regional exchanges do not have a large free float of shares, as they are still tightly controlled by their owners and family offices.
Alternatively, the local exchanges are also dominated by ‘national champions’, for example Emaar on the Dubai Financial Market, which has such a large value that it completely overshadows and dictates the daily movement of the market. Local investors are so used to riding these stocks up and down, frequently trading in and out of them, that the passive index-tracking concept of an ETF becomes redundant.
Regional investor attitudes are also very different amongst retail investors in the Gulf with a short-term trading approach, as opposed a long-term investing approach to stock market participation prevailing. And it is also this lack of investor sophistication that has muted the response to ETFs – Islamic or conventional – in the Middle East.
“When NBAD and Falcom launched their ETFs earlier this year, many investors thought that they were participating in an IPO, as opposed to investing in a passive investment product. When the investor community realised the nature of the product, optimism and liquidity swiftly drained away,” says Siddiqi.
The biggest Sharia-compliant ETF in the world, the New Gold ETC from South African bank Absa, has a net asset value (NAV) of $1.97bn. This is peanuts compared to the largest conventional ETF, the so-called ‘Spider’, based on the S&P500, with a NAV of $80bn and a daily average trading volume of $15bn and is a fair reflection of where Islamic ETFs stand in comparison to conventional ETFs.
There have been moves in the world’s most sophisticated Islamic finance market, Malaysia, to try and bring ETFs in from the cold. Zainal Izlan, CEO of i-VCAP creator of Malaysia’s first Sharia-compliant ETF, explains that the South East Asian bourses were trying to increase investor education and participation in Islamic ETFs. “Bursa Malaysia has come up with a few initiatives to encourage the liquidity of ETFs, one of them being the reduction of the tick size of ETFs in August 2009,” he says.
Better balance
Previously, the tick size – or price change – was set at one cent, and NAV prices were quoted to four decimal points. To strike a better trading balance between buyers and sellers, Bursa Malaysia changed the tick size to three decimal points. Moreover, the Malaysian Securities Commission and Hong Kong Financial Services Centre recently signed a Memorandum of Understanding to enable the listing of more Islamic products, including ETFs. However, industry players do not expect to see this being emulated too swiftly by the Middle Eastern bourses due to their infancy.
Siddiqi believes that if Islamic ETFs are going to take hold globally and specifically in the Middle East there has to be government, or quasi-government support, through sovereign wealth fund participation in the market. “What is needed is the creation of a family of Sharia-compliant ETFs. If you have just sectoral or country-focused ETFs, when that sector or country is doing badly you will have a lot of money sat on the sidelines,” he says.
“State pension funds or sovereign wealth needs to support this. Having a basket of ETFs with $100-200m behind it will make the global markets sit up and take notice.”
Niche market
However, the acceptance of Sharia-compliant ETFs in the local and global market has to be there. John Sandwick, a Switzerland-based specialist in Islamic finance and Islamic wealth management, says: “Mature, disciplined wealth managers do indeed buy them for their managed client accounts. ETFs have a role to play. But let’s be honest. They are a niche product and will always be a niche product. No professional allocation would have more than 10% of all funds into equity ETFs. Any more than that and the client is getting fooled and the manager is an idiot.
“So, they are not a gimmick, but at the same time ETFs are not the brave new world of investing, either, as some of the wags want you to believe.”
It took 17 years for the conventional ETF phenomenon to morph into a $1trn industry. If 1993 was the start of the conventional ETF market, the Sharia-compliant market is by comparison in 1995. The existing funds have to prove that they can perform; investors have to be educated about the value of long-term, low-cost, liquid, passive investment, and there needs to be a significant coordinated effort to put assets into the sector before Sharia-compliant ETFs can truly become a substantial part of the global Islamic finance industry.
©2010 funds global