How to Benchmark the Performance of Islamic Funds: Islamic Indexes - dummies

How to Benchmark the Performance of Islamic Funds: Islamic Indexes

By Consumer Dummies

To manage any investment fund effectively, you need to understand your fund’s performance. The best way to do this is to compare it to industry benchmarks and performance indicators. When Islamic investment funds were first being developed, the funds were benchmarked against the well-known conventional indexes. But that yardstick was flawed because Islamic funds can’t invest in so many of the industries represented by those indexes.

As a result, Islamic indexes were created and now serve as more-appropriate benchmarks for examining an Islamic investment fund’s performance. The Dow Jones Islamic Market (DJIM) indexes, created in 1999, were the first successful Islamic indexes developed, and they have been joined by many others, such as

  • The FTSE Shariah Global Equity indexes

  • Global GCC Islamic Index (by Global Investment House Kuwait)

  • Global Islamic Index (by MSCI Indices Company)

  • The Kuala Lumpur Sharia Index (KLSI)

  • MSCI Global Islamic Indices

  • The S&P Shariah indexes

Most of these indexes use a similar set of criteria to screen companies for inclusion.

Islamic indexes provide invaluable services to investment fund managers. The process of selecting companies for inclusion in a sharia-compliant equity fund is technical and time-consuming. Because Islamic indexes conduct their own initial compliance screening research under the guidance of a sharia board or committee, Islamic fund managers can trust that any stock included in such an index is fair game for investment. Thus, Islamic indexes reduce the costs associated with an Islamic fund’s screening process and help funds tap into a wider diversity of stocks.

Just as individual funds must strive to maintain sharia compliance by conducting ongoing screening and purifying when necessary, indexes must do the same.

The following sections profile four Islamic indexes to point out the benchmarks and screening processes they use.

Dow Jones Islamic Market (DJIM) indexes

The Dow Jones Islamic Market (DJIM) is a whole family of broad-market, blue-chip, fixed income, and other indexes. According to its website, the DJIM screens companies to remove those that engage in the prohibited industries (alcohol, pork-related products, conventional financial services, and tobacco). The website also lists the broad terms “entertainment” and “weapons and defense” as industry screens. The DJIM conducts financial tests to ensure that each of the following financial ratios is less than 33 percent:

  • A company’s total debt divided by its “trailing 24-month average market capitalization”

  • “The sum of a company’s cash and interest-bearing securities divided by [its] trailing 24-month average market capitalization”

  • The company’s “Accounts receivables divided by [its] trailing 24-month average market capitalization”

A supervisory board of five sharia scholars guides the DJIM. This board currently has members from Bahrain, Malaysia, Saudi Arabia, Syria, and the United States. Per the Dow Jones Indexes website, “The geographic diversity of the scholars helps to ensure that diverse interpretations of Shari’ah law are represented.”

S&P Shariah indexes

Standard & Poor’s introduced its first sharia indexes in 2006. Initially, three indexes were screened for sharia compliance, creating the S&P 500 Shariah, the S&P Europe 350 Shariah, and the S&P Japan 500 Shariah. Since that time, S&P has developed significantly in this market. It now has three index series — the S&P Global Benchmark Shariah Index Series, the S&P Global Investable Shariah Index Series, and the S&P Global Strategy Shariah Index Series — with a total of 27 indexes as of Winter, 2014.

In conducting its industry screening, the S&P excludes companies in the traditional list of prohibited industries: alcohol, gambling, pornography, tobacco, pork products, conventional finance, and cloning. It also excludes advertising and media companies, with some exceptions: Newspapers, news channels, and sports channels, as well as advertising and media companies that derive more than 65 percent of their total income from Gulf Cooperation Council (GCC) countries, are accepted. The S&P also screens out any companies that deal in the “Trading of gold and silver as cash on [a] deferred basis” (according to the Standard & Poor’s website).

FTSE Bursa Malaysia Hijrah Shariah Index

The website for the FTSE Bursa Malaysia Hijrah Shariah Index (click on Global Equity Indices → FTSE Shariah Global Equity Index Series) indicates that the index operates with direction from the Malaysia Securities Commission’s Shariah Advisory Council. Launched in 2007, the index screens to exclude companies whose core business activities relate to conventional banking and other interest-related activities, life insurance, alcohol, tobacco, arms manufacturing, gaming, and pork and other prohibited food products.

The index also excludes the following:

  • Companies carrying a level of debt that indicates “an inappropriate use of leverage relative to their assets”

  • “Companies that have income from cash or near cash equivalents or inappropriate levels of receivables to assets”

  • Companies with an unacceptably high percentage of “liquid assets to illiquid assets”

  • “Companies whose cash and cash equivalent to total assets exceeds the percentage permitted under Shariah principles and commonly accepted philosophies”

MSCI Global Islamic Indices

Per MSCI‘s website (click on Indices → Faith-Based), this family of indexes excludes businesses that derive more than 5 percent of their revenue (cumulatively) from alcohol, tobacco, pork-related products, conventional financial services, defense and weapons, gambling, music, hotels, cinema, and adult entertainment.

The MSCI indexes publicly provide more detail than most other indexes regarding what, exactly, they look for during the industry screening process. Visit the website for details on each prohibited industry.

As well, the MSCI indexes examine three financial ratios for each company when determining sharia compliance:

  • Total debt divided by total assets

  • The sum of the company’s cash and interest-bearing securities divided by its total assets

  • The sum of the company’s accounts receivable and cash divided by its total assets

Each of these ratios should be less than 33.33 percent.