Islamic Exchange-Traded Funds, Bonds, and the Islamic Derivative Market - dummies

Islamic Exchange-Traded Funds, Bonds, and the Islamic Derivative Market

By Consumer Dummies

If you’re interested in diversifying your investments and the Islamic market intrigues you, don’t forget about Islamic exchange-traded funds, sukuk (Islamic bonds), and the Islamic derivative market. Many non-Muslim investors are interested in the Islamic capital market for two basic reasons: Islamic investments are ethical and invested with social responsibility, and compared to the conventional market during financial crises, the Islamic market is stable.

The Islamic capital market is open to any investor who wants to achieve the objectives involved in the capital market.

Investing in Islamic exchange-traded funds (IETFs)

Exchange-traded funds are open-ended fund pools that may be composed of stocks, bonds, and/or commodities. Initially, only institutional or authorized investors bought and sold ETFs; these days, individual investors have easy access to these funds and make up a good chunk of the market.

Islamic ETFs (or IETFs) bear all the features of conventional ETFs but are sharia-compliant. IETFs are very attractive investment instruments because they offer instant diversity (much like mutual funds). Because they’re based on indexes, they also boast a great deal of transparency; at any given moment, an investor knows which companies the IETF has invested his money in.

IETFs are still very young but are poised for great growth. They serve a purpose not only for the Muslim investor, whose primary objective is sharia-compliant investment, but also for non-Muslim investors who want to support socially responsible investing and tap into low-debt securities. Though the Middle East region has enormous wealth that should support a thriving IETF market, the relative lack of stock exchanges makes this product (which trades much like shares of stock) less accessible than Islamic mutual funds and unit trusts.

Diversifying with the sukuk (Islamic bond) market

Sukuk are one of the major sectors in the Islamic capital market and are an alternative to conventional, debt-based bonds. Sukuk are asset-based and thus the preferred mode of investment for many high-net-worth investors and governments. Sukuk are issued by governments (Japan, South Korea, Germany, and the United Kingdom, for example), by international financial bodies (such as the International Financial Corporation), and by global corporations (such as GE Capital).

International, conventional bond-rating agencies such as Standard & Poor’s (S&P) and Fitch have recently started to issue ratings for sukuk. The ratings system used for conventional and Islamic bonds is the same, and the ratings offer an assessment of the issuers’ ability to make repayments.

Developing the Islamic derivative market

A derivative is any financial asset based on the value of one or more underlying financial assets. Derivatives are used to hedge the risk of the assets. Many derivatives are available on the market, but the most commonly used are swaps, options, futures, and forward contracts. (Note that many financial regulators have blamed derivatives for the global financial crises that emerged starting in late 2007.) Here’s what these terms mean:

  • Swap market: This instrument is used to transfer risk. The Islamic swap market has two components:

    • Profit rate swap: This option is based on exchanging fixed-rate for floating-rate profits.

    • Cross-currency swap: Investors use this swap to transfer currency fluctuation risk among themselves.

  • Options: In this financial contract, the option writer offers a second party the right to buy or sell a financial asset at a fixed price on or before a certain date — without obligation to do so.

  • Futures: This type of financial contract solidifies an agreement to buy or sell financial assets or commodities on a future date. In a futures contract, both the buyer and seller are obliged to perform the contract.

  • Forward contracts: These contracts, which are used to hedge risk, let two partners agree today on the price of a future asset sale/purchase. Forward contracts and futures have some things in common but are different in certain ways; for instance, forward contracts aren’t traded on the exchanges.

The Islamic investment industry is divided regarding its outlook on Islamic derivatives because of varying sharia interpretations. Many scholars don’t agree with Islamic derivatives, arguing that such products inherently involve speculation. The relationship between recent financial crises and derivatives for hedging risk supports this argument. On the other hand, some Islamic bankers point out that in the midst of recent financial turmoil, conventional banks have options that help them manage their risks, while Islamic banks don’t. As a result, the Islamic finance industry is looking for solutions to manage the risk — which could include derivatives.

Standard Chartered Saadiq Malaysia is already offering some Islamic derivative products, such as the Islamic Profit Rate Swap, Islamic Cross Currency Swap, and Islamic Forward Rate Agreement. If you want to find out more about Islamic derivative products, check out Standard Chartered Bank.