SPECIAL COMMENT: Shariah Equity Compliance in the West

By Rushdi Siddiqui, Global Head of Islamic Finance at Thomson Reuters

The time has arrived to take a deeper dive on better understanding of Shariah compliant companies in an Islamic (or Shariah compliant) equity indexes. To many informed and uninformed observers of Islamic equity investing, it seems to imply investing in publicly listed companies in Muslim countries.

The end results contradict the assumptions. This also rebuts the often heard allegations by many from the anti-Shariah movement that Islamic investing is about investing in companies linked to terrorism or financing terrorism. The largest companies in the S&P Global BMI Shariah include ExxonMobil, IBM, Chevron, Nestle, Microsoft, etc.

Today, there is a large stock count and market capitalization weighting bias towards the non-Muslim G20 countries in all global Islamic equity indexes. In part one we will look at country exposure of compliant companies, and part two economic sector exposure, and part three examine selected Muslim country Islamic indexes and how to increase number of Shariah compliant companies.

Conventional Bias

The stock exchanges in Muslim countries have a bias towards the conventional financial sector (banks, financing companies, etc), and, therefore, also over-reliance on debt culture for corporate financing. Thus, many publicly listed non-financial companies in Muslim countries fail the debt financial ratio for Islamic screening.

The question becomes, where are the Shariah compliant companies are listed? If not in Muslim countries, then are we exporting (Shariah compliant) capital and importing returns, and how does this contribute to local/regional economic and capital market development?

Today, we have Islamic equity indexes from all the six index providers from Dow Jones Indexes to S&P to Thomson Reuters-IdealRatings. The Islamic indexes are about ‘doing good by avoiding the bad.’ Put differently, its about negative screening, much like Islamic finance, which is prohibitive oriented way of funding and financing.

Shariah Compliant Universe

Table A shows the Shariah compliant companies, stock count and market capitalization weighting, of S&P Global BMI Shariah and S&P Global BMI as of October 31, 2011.

Some of the observations on the S&P Global BMI Shariah index includes:

1. There is an obvious bias towards the developed countries, where five countries, US, UK, Japan, Switzerland and Canada, accounts for 1,749 companies (50% of stock count) and 74.34% market capitalization weighting. Is it because these developed countries have a robust equity culture, hence, companies not relying exclusively on banking (debt) financing, but also raising equity capital?

Does an equity capital market promote knowledge based economies, as banks do not provide entrepreneurial capital? Its well known and accepted that Islamic banks finance (exclusively) ‘old economy’ companies.

2. Shariah compliant listed companies from Muslim countries include Turkey, Morocco, Malaysia, Indonesia and Egypt, accounting for 132 companies (3% of stock count) and less than 1% (.86%) market capitalization weighting. Although, there are 57 Muslim countries with 42 stock exchanges, the small representation is due to prohibitions against direct investing by all international investing (Saudi Arabia), small free float (meaning small shares of company available for trading), illiquidity (stock does not trade the minimum amount according to the index provider’s rule book), and so on.

3. Interesting to note that there is larger market capitalization weighting (.44% and 1.36%) and total market capitalization representation (of $60B and $187B) in the index of Shariah compliant companies from Israel and India, respectively, than any of the five Muslim countries. Thus, Islamic investing is not confined to Muslim countries.

Performance Correlation

Islamic equity indexes, especially at global, with a bias toward developed country compliant companies, should then have a high correlation to conventional counter-part indexes. Graph A shows the performance of the S&P Global BMI Shariah to S&P Global BMI, since 2007, and we observe (1) tracking market movement and (2) outperformance by the Shariah index.
Graph A.

Thus, notwithstanding a smaller universe of Shariah compliant companies, 32% of total stock count (3,460) and 42% of total market capitalization ($13.813 Trillion), Shariah compliant indexes has consistently outperformed in Graph A. The underperformance of the S&P Global BMI is attributed to large exposure to the conventional financial sector, nearly 20% of the index, and its impact by the credit crisis (sub-prime mortgages in US) and European sovereign debt situation.

There is nothing ‘Islamic’ here, its basically a style of investing and others have called it an ‘alpha strategy:’ low debt, non-financial, social-ethical investing. This may indeed be the need of the hour in these turbulent times.

The second part of the article will look into a global Islamic equity index’s economic sector exposure of Shariah compliant companies. An early hint, the largest three sectors in today’s global Islamic index are generally not present in Muslim countries.