Islamic law, or Shariah, is a comprehensive body of principles and precepts developed over 1,400 years. Variously spelled Sharia, Shari’ah, Shar’iya, or Shariahh, in the context of investing it is a complete body of law applicable to finance. In the past, observant Muslims were wary of being involved in financial investment vehicles for fear that they weren’t compliant with Shariah. But now Muslims are increasingly demanding Shariah-compliant investments. Britain’s Financial Services Authority estimates that assets held in Shariah-compliant accounts worldwide total between USD 100 billion and USD 500 billion, and that they’re growing at 10%-15% per annum. Even a conservative figure of USD 250 billion represents a fairly substantial number.

During the selection process, each company’s audited annual report is reviewed to ensure that the company isn’t involved in any non-Shariah-compliant activities. Those found to be noncompliant are screened out.

Standard & Poor’s is responding to the needs of Muslim investors with the launch of several equity indexes that track the stocks of Shariah-compliant companies. These indexes are designed to provide Shariah-compliant alternatives to various headline indices from Standard and Poor’s, like the benchmark Standard & Poor’s 500 index, the Standard & Poor’s Europe 350, and the Standard & Poor’s Japan 500, the S&P BRIC 40, and the S&P GCC series. The S&P 500 is the leading index for measuring the performance of the U.S. markets, and both the S&P Europe 350 and the S&P Japan 500 are well known barometers of their respective regions. The S&P BRIC 40 measures the performance of the four BRIC countries, namely Brazil, Russia, India, and China, while the GCC series are designed to measure the six gulf nations of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE. All have been designed to capture the largest and most liquid stocks from their coverage areas and provide investors with an easy and transparent tool for performance measurement.

The need for these Shariah-compliant indexes is clear. Over the last few years, the concept of Islamic finance has received a broader acceptance worldwide. Banks, insurance companies, finance companies, and asset management firms have all been actively seeking ways, and more importantly, instruments to increase their involvement in Islamic finance. The reasons for this aren’t hard to find. They include a large and growing pool of petrodollars, increasing financial sophistication among Muslim investors, and a greater desire to invest in compliance with religious norms. Added to that is a recognition by large financial institutions that a hitherto untapped market exists for these kind of products. The players now range from large banks, insurance companies, and finance companies to smaller asset managers, and they are creating more and more Shariah-compliant products. Also, the client base has expanded globally from Southeast Asia and the Middle East to the U.S. and Europe.

Shariah-compliant investment vehicles have been growing in range, complexity, and variety over the last few years at an astonishing speed. Starting with murabahas (trade finance) and growing to sukuks (Islamic bonds), real estate products, equity indexes, and even to hedge funds, the basket of products offered has proliferated.

However, despite this growth, there’s still a dearth of Shariah-compliant products. A pronounced shortage of short-term instruments and the absence of a secondary market for Islamic financial instruments have both hindered the creation of true liquidity in the world of Islamic finance. Additionally, since Shariah law is mostly oral, multiple scholars have issued numerous interpretations, with differences arising from their leanings – more conservative vs. liberal. The complex nature of today’s accounting and financial transactions, and the growing interest in interpreting these as Shariah-compliant or not, has led to some confusion among scholars on what the gold standard ought to be.

Construction of Shariah-Compliant Indexes
Standard & Poor’s new Shariah equity indexes are derived from two major fatwas (legal opinions handed down by Islamic religious leaders), one issued in the late 1990s and the other in 2003. As in all other Islamic financial products, a Shariah supervisory board oversees construction and maintenance of a compliant index. The board oversees the structure and documentation of the index and other related products. The requirements of the index or the investors aren’t the board’s primary concern, but rather adherence to the principles of Shariah in regard to creating the index. The board provides the fundamental principles upon which the index constituents’ eligibility is determined, how the ongoing rebalancing is done, and how often the index is reviewed. The actual index construction, the selection of constituents, and any business decisions related to the index are within the purview of the index provider, in this case Standard & Poor’s, as long as they adhere to the Shariah principles defined by the board.

Generally Accepted Principles of Shariah Compliance
The screening of companies for compliance is based on both a sectoral basis and an accounting ratio basis. Sector-based screens filter out stocks in the following business activities that are not considered acceptable under Shariah and would not be appropriate for investment for observant Muslims:

• Pork
• Alcohol
• Gambling
• Financials
• Advertising and media (newspapers are allowed,
  sub-industries are analyzed individually)
• Pornography
• Investment management
• Venture capital

During the selection process, each company’s audited annual report is reviewed to ensure that the company isn’t involved in any non-Shariah-compliant activities. Those found to be noncompliant are screened out.

Accounting-Based Screens
After removing companies with noncompliant business activities, the remaining companies are examined for compliance in financial ratios, as certain ratios, as determined by the Shariah board, may violate compliance measurements. Three areas of focus are leverage, cash, and the share of revenues derived from noncompliant activities. All of these are subject to evaluation on an ongoing basis.

Historical analysis reviewing the past five years shows that the Shariah-compliant indexes in the three regions had a high correlation to the underlying indexes.

Leverage compliance
This compliance is measured as:
Debt minus cash as a percentage of debt plus the 12-month average market value of equity must be less than 33%.

Cash compliance
For cash holdings to be compliant, they must conform to the following:

• Accounts receivables as a percentage of debt and the
  12-month average of market value of equity must be less than 49%.
  
  
• Cash as a percentage of the 12-month average market value of equity must be less than 33%.

Revenue share from
noncompliant activities
In certain cases revenues from noncompliant activities are permissible, if they comply with the following threshold:

Nonpermissible income as a percentage of total revenue must be less than 5%.

Building a Shariah-Compliant Equity Index
By applying Shariah principles to our headline indexes, we’ve created Shariah-compliant versions: the S&P 500 Shariah, S&P Europe 350 Shariah, S&P Japan 500 Shariah, S&P BRIC Shariah, S&P GCC Shariah series.
Stock selection for the new Shariah indexes is done on a two-tier basis. First, equities are selected for the underlying index, and only these are eligible for the Shariah-compliant version. Then the underlying indexes’ existing constituents are screened using the filters mentioned earlier. The stocks that pass the screen remain in the index. Compliant stocks are deleted from the Shariah index if they’re deleted from the underlying index. Stocks that are added to the underlying index are reviewed for compliance before being added to the Shariah version. Monitoring is done for all stocks in the underlying indexes to ensure ongoing compliance. Annual reports are being constantly reviewed to measure any changes in business activity or accounting ratios.

Returns from the Shariah Indexes
Historical analysis reviewing the past five years shows that the Shariah-compliant indexes in the three regions had a high correlation to the underlying indexes. In the U.S., the S&P 500 Shariah correlated over 98% with the regular S&P 500, the Europe 350 saw 97% correlation, and in Japan it was slightly less, at 88% over the last 5 years. Though total-return performance overall was slightly lower for the Shariah versions, the differences were minor over time. The key is that investors can get the top-tier proxies for market investment and yet comply with Shariah norms.
Sector weightings are also well distributed, as seen in charts (from sector wt. tab). Besides the sectors that are deliberately filtered out, the rest are fairly well distributed.

Commercial applications of Shariah Equity Indexes
Currently, Shariah investment offerings are most popular for creating structured products, which are relatively narrow, liquid baskets and focused on specific sectors and regions. These are primarily sold as structured deposits or mutual funds. However, they can be relatively more expensive to create, and retail customers have little access to them.

A few Shariah-compliant exchange-traded funds (ETFs) have also been launched, but they’re still on a relatively small scale. The Singapore stock exchange and the Dubai International Financial Exchange have been fairly aggressive in promoting the launch of some region-specific ETFs based on Shariah indexes. Islamic certificates have also been listed for trading on exchanges.
The recent increase in acceptance of Islamic finance has led to a spurt in the number of players entering the market. The industry, however, is witnessing a phenomenon somewhat similar to the initial days of the dot-com boom: the existence and exuberance of too many players. That will necessarily be followed by a period of consolidation and standardization. Still, despite any cyclical ups and downs, Islamic finance and Shariah-compliant equity indexes are here for the long haul.

Editor’s Note: The author of this article, Alka Banerjee, is Vice President at S&P’s Index Analysis and Management Group. The opinions expressed are the independent opinions of S&P Index Analysis and Management Group and do not reflect the opinions of other areas of S&P. S&P Index Analysis and Management activities are performed as an entirely separate activity from other Standard & Poor’s analytic services in order to preserve the independence and objectivity of each analytic process.