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• Cognizant 20-20 InsightsSharia Stock Screening:A Fund Manager’s Conundrum   Executive Summary                           ...
Challenges to Islamic Stock Screening                    LVMH at a GlanceAutomated vs. In-depth Researched ScreeningMost f...
Another major issue with automated screening             with a legal government or state defense body)and relying on the ...
irrelevant to take into account where the funds               and HSBC Amanah. This was attributed toare originating from;...
Some confusion also arises in determining              leading to such status change (e.g., discontinua-whether purificati...
the acceptable threshold of 5%. If that stock is a                                                    the fund manager mis...
Here’s how it works:                                   There are a host of parameters that a fund                         ...
needs while choosing a provider with sound                     The fund manager’s responsibilities once he has     impleme...
third-party screeners or resort to the index list as                                                       Conclusionwell....
spect about the credibility of the process these                                   for the fund manager, while adhering to...
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Sharia Stock Screening: A Fund Manager's Conundrum


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Islamic investing, based on Sharia compliance, is a huge and growing field, but automated screening is problematic, with gray areas involving lines of business and computing relative debt ratios. This paper examines how third-part Sharia compliance assessment could compensate for shortfalls in the Islamic indices.

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  1. 1. • Cognizant 20-20 InsightsSharia Stock Screening:A Fund Manager’s Conundrum Executive Summary screening. Lastly he has the option of numerous third-party screening providers (e.g., IdealRat- A Sharia-compliant Islamic equity fund is an ings) and off-loading the entire screening process. integral part of the Islamic wealth management bouquet. Unlike a conventional equity mutual This white paper identifies key issues surround- fund, managers must focus on investing ethically ing Sharia stock screening and how these issues in businesses which comply with the Islamic could be resolved by adopting a more prudent law, or Sharia. For example, Sharia prohibits screening framework. Riba (interest), Maysir (gambling) and Gharar (uncertainty). Sharia Screening: A Snapshot Sharia stipulates that any fund manager man- A fund manager has to abide by a set of business aging an Islamic fund needs to get the approval and financial parameters before selecting and from a Sharia supervisory board set up by a finan- including a particular stock in an Islamic fund cial institution, which would be comprised of at portfolio. There are various Islamic screening least three Sharia scholars who are champions of methods followed by stock indices and banks, Islamic banking. They are responsible for laying namely Dow Jones Islamic Market Index (DJIMI), down guidelines (Fatwas) for the fund manager FTSE Global Islamic Index Series, S&P 500, and monitoring his investment practices. MSCI (Morgan Stanley Capital International) and Accounting and Auditing Organization for A fund manager selects a set of Sharia-compliant Islamic Financial Institutions (AAOIFI). Sharia stocks by screening and selecting from an overall stock screening is based on the business activity universe of stocks that meet his fund’s investment performed by the companies; their financial objectives. The resultant set is reviewed by the ratios are generally perceived as an easy and Sharia scholars and on compliance they sign off on direct function because they rely on data feeds the investment. The screening conducted by the from the various data providers (e.g., Bloomberg). fund management is two-fold: business activity/ But in real life, it is far from simple; there are industry screening and financial screening. various issues that plague the Sharia screening Business activities that are considered to be non- of a stock and its subsequent selection/omission compliant with Sharia include alcohol, tobacco, from a fund portfolio. gambling, cinema, adult entertainment, advertis- ing and media, conventional financial services and A fund manager could follow the current prevalent defense. The various financial ratios used for the system of picking stocks from the Sharia- Sharia screening of securities primarily consider compliant indices from various index providers interest, cash and receivables with the company (e.g., DJIMI). He could also use an in-house and debt availed by the company.1 developed proprietary tool that performs the cognizant 20-20 insights | january 2012
  2. 2. Challenges to Islamic Stock Screening LVMH at a GlanceAutomated vs. In-depth Researched ScreeningMost fund managers use the Global Industry Revenue by Business GroupClassification Benchmark (GICS) or the Industry (Euro millions) 2010 2009 2008Classification Benchmark (ICB) to filter stocks onthe basis of their lines of business (LOBs). GICS Wine & Spirits 3,261 2,740 3,126is an industry classification taxonomy developedby MSCI and the S&P. It comprises 10 sectors, Fashion & 7,581 6,302 6,01024 industry groups, 68 industries and 154 sub- Leather Goodsindustries into which all major public companies Perfumes & 3,076 2,741 2,868are categorized. ICB is a taxonomy, developed by CosmeticsDow Jones and FTSE, which is used to segregatemarkets into sectors within the macroeconomic. Watches & 985 764 879It uses a system of 10 industries, divided into 20 Jewelrysuper-sectors further segregated into 41 sectors,which then contain 114 subsectors. Selective 5,378 4,533 4,376 RetailingThe issue with both GICS and ICB is that their Other Activities 39 (27) (66)categorizations for a company classification & Eliminationsis one dimensional and based only on the corebusiness activity in which an individual enterprise Total 20,320 17,053 17,193is engaged. It does not take into account theother non-core businesses that the company Source: www.lvmh.commight have. Let us consider the example of Louis Figure 1Vuitton (LVMH), the renowned French fashionhouse. Louis Vuitton, per the ICB, is classified as on the different industries or businesses ina “clothing and accessories” company. Businesses which it operates. But since very few organiza-belonging to this subsector are described as tions actually use SIC classifications and report“manufacturers and distributors of clothing, revenue generated through the SIC classificationjewelry, watches or textiles.” Hence, a fund system, the problem largely persists. Sometimesmanager on the basis of the ICB classification a business description keyword filter is alsowould consider LVMH as Sharia compliant. built into the screening system. For instance,However, a close examination of LVMH’s financial the keyword “roulette” might signify that thestatement for fiscal 2010 (see Figure 1), reveals selected company is involved in gambling or thethat revenues from wines and spirits (Sharia casino business.prohibited) represents more than 16% of thecompany’s total revenue, and hence much above Automated screening may result in classifyingthe Sharia allowed benchmark of 5%. compliant companies as non-compliant and vice versa. For instance, if a fund manager exercises anAs a result, if a fund manager uses an automated automated screening on a global asset universe,screening he could treat LMVH as a compliant the tool would classify about 8.38% (4.36% +company whereas in reality it is non-compli- 4.02%) of companies wrongly as compliant orant. The fund manager could largely solve this non-compliant (see Figure 2), which means thatproblem if he employs the Standard Industry if a fund manager invests in 50 equities for hisClassification (SIC) system, where any company fund’s portfolio, six may actually end up beingis typically assigned multiple SIC codes based non-compliant.2Automated vs. Researched Screening Global Asset Universe Researched Screening Fail Pass Fail 66.64% 4.36% Automated Screening Pass 4.02% 24.98%Source: www.islamicfinancenews.comFigure 2 cognizant 20-20 insights 2
  3. 3. Another major issue with automated screening with a legal government or state defense body)and relying on the list of Sharia-compliant stocks would be treated as Sharia provided by indices such as DJ and FTSE Again, all intelligent weapons that require high-is that these global indices have assessed too precision targeting mechanisms to launch —few companies in their portfolio. Hence, when a thereby minimizing unintended casualties (e.g.,fund manager uses these lists to pick up stock civilians) — could be deemed compliant. On thefor investing, he realistically misses out on a other hand, weapons that can be used withoutnumber of potentially winning stocks, as they are such targeting functionality are deemed as non-not listed in a DJIMI, FTSE or any other Sharia- compliant. Finally, all weapons manufactured forcompliant stock index. mass destruction (e.g., chemical/nuclear weapons) are treated as non-compliant even if they areInconsistently Published Financial Statements manufactured for the consumption of the legalMany organizations report erroneous and/or defense body or other similar organizations.3incomplete financial disclosures on a quarterlyand annual basis. There are a large number of Mistakes in Computing Interestcompanies that do not report interest income Bearing Financing Ratioas a part of their quarterly/annual financial Debt capital becomes a key element whenstatements. In this scenario, the data which a computing the ratios for the financial screeningfund manager uses can be erroneous and results of a company’s stock. However, many practitio-in an improper selection of a Sharia-compliant ners do not consider the fact that nowadays therestock. Many companies in their financial reports are many companies in the Islamic world thatdo not differentiate between cash and cash issue debt capital not through conventional waysequivalents (e.g., money market instruments, but through issuance of Sukuk, which is similar toTreasury bills that can be readily converted into a bond in conventional terms that complies withliquid cash). It has also been noticed that many Sharia. Since Sharia does not permit the issuancecompanies use old financial data to calculate the of a bond which pays out interest to the beneficia-various financial ratios, resulting in misleading ry holder, the issuer of the Sukuk sells an investorinformation. In other cases, data providers may group a certificate, which then rents it back to themiss out on important corporate announcements issuer for a predetermined fee.such as stock splits, bonus declarations, dividendpayouts, etc. declared by companies. When a practitioner performs the financial screening, he frequently includes debt capitalGray/Ambiguous Aspects in raised through Sukuk as well, though it shouldBusiness Activity Categorization be omitted from the conventional debt amount.There are certain industries or LOBs which are Let’s assume a company has a debt capital ofgenerally regarded as Sharia non-compliant. But $50 million on its books, of which $15 million ison closer inspection, there exist certain gray areas. raised through Sukuk while the rest is conven-As a result, various eminent Sharia boards cannot tional debt. The total assets of the companybe unanimous in the treatment of such companies. are $125 million. If the practitioner erroneouslyLet us take the example of the defense industry. does not segregate between non-interest andGenerally this industry is deemed to be Sharia interest-bearing debt, the interest bearing rationon-compliant by most practitioners. But since to total assets is calculated as 40% (i.e., 50/125).per Sharia, defense is necessary to guarantee the Since this ratio needs to be 33% or less to besafety of the citizens and the functioning of the compliant, in this case the company is treated asstate, many Sharia scholars, instead of rejecting non-compliant. But if the actual interest-bearingall defense and weapon manufacturing organiza- ratio is computed, by deducting Sukuk, this ratiotions as non-compliant, have instituted certain becomes 28% (i.e., 35/125), thereby making it aclauses and segregated the industry based on the Sharia-compliant stock. A few prominent indices,nature of the weapons produced, mechanisms like DJIMI, compute this ratio by applying “totalused, the target audience, etc. debt” instead of “total interest bearing debt” and hence fund managers who use data from DJIMIAll weapons sold to legal military institutions (e.g., fail to get the correct picture.United States Marine Corps) could be deemed ascompliant, whereas the ones which are specifical- The Securities Commission Malaysia does notly sold to non-military establishments (e.g., sold in employ the interest-bearing ratio for the purposethe retail market or to institutions not affiliated of stock screening. According to this body, it is cognizant 20-20 insights 3
  4. 4. irrelevant to take into account where the funds and HSBC Amanah. This was attributed toare originating from; it believes the sole deter- Amanah’s use of more conservative financialmining criteria should be the end use of such ratios.4funds. This contradicts Sharia principles whichforbid Riba. Issues with “Purification” of Non-compliant EarningsLack of Uniformity in Rules, In the case of prohibited company earningsFatwas Across Geography which is less than 5% of the total revenues,The screening techniques as followed by various Sharia stipulates that such earnings need to beplayers across the globe vary widely. The reasons cleansed or purified. Once the fund manager iscan be attributed to culture, government regu- certain of the amount of total income that is tolations and different Islamic schools of thought. be considered as Haram, he can proceed with theHence, the rules applicable in places like Malaysia purification process. He can either resort to themight not be applicable in Europe or Gulf Coop- dividend method of computing purification oreration Council (GCC) countries. The Sharia- the Haram income method.5 After computing thecompliant investments are considered taking purification value, he directly deducts the propor-into consideration the localized requirements. tional amount of non-Sharia income of the totalProfessor Ulrich Derigs and Dr. Shehab Marzban, earnings (the direct method), and subsequentlyboth of the University of Cologne, Germany, are passes on the net earnings to the investors.two prominent exponents of Sharia compliancewho conducted a study to learn how different Alternatively, he can inform the investors aboutSharia compliance strategies applied to the same the proportion of the earnings that the investorasset universe could deliver differences among needs to subtract from the total income (thethe sets of assets classified as compliant. They indirect method), sometimes subject to Zakahchose the asset universe of S&P and the following (a form of religious charity as per Sharia law). Inwere the key findings: order to cleanse the Riba-contaminated earnings, it is quite difficult to compute the interest part• Differences between S&P and DJIMI were of the earnings for an equity investment fund as negligible (1.3%). This was attributed to the “interest earned” may not be a separate heading fact that both these indices use average in the income account or may be disguised by market capitalization as the denominator in offsetting interest against certain types of expen- calculating the financial screening ratios. diture. It is practically impossible to obtain all• Differences between S&P/DJIMI and MSCI/ the detailed information required to determine FTSE/HSBC Amanah were quite high (21-26%). the amount of Haram earnings that may arise The reason for this was that the latter set uses within an investment pool that could include 100 total assets as the denominator. different stocks and in most cases the effort spent in performing the analysis will totally outweigh• Though identical in the use of the same denom- the benefit in having the precise figures. inator in the financial ratio calculation, there is a difference of 6% to 8% between MSCI/FTSEAssets and Variation Among Classification Compliance Strategies Compliant Asset HSBC S&P DJ MSCI FTSE Universe Size Amanah S&P 271 1.30% 24.40% 24.90% 21.60% DJ 266 25.70% 26.20% 22.90% MSCI 247 1.60% 8% FTSE 241 6.50% HSBC 232 AmanahSource: Islamic Banking & FinanceFigure 3 cognizant 20-20 insights 4
  5. 5. Some confusion also arises in determining leading to such status change (e.g., discontinua-whether purification is necessary, particularly tion of a Sharia business; an airline stops sellingin the case of capital gains arising from the sale alcohol/cigarettes to its passengers; or an autoproceeds of a fund. One school of thought says company closes down its financing arm), such asthat there ideally would be an interest component a rise or decline in market capitalization due toin the capital gains as the asset value of the certain internal/external factors or merger andcompany in context would reflect some interest; acquisition activity, which as a result rendersthe other school of thought ignores this interest the stock non-compliant. For instance, an LOBcomponent, arguing that it is too miniscule to (such as alcohol) is shut down or new initiativesconsider. Though the latter is easier, the former are launched. It’s the prerogative of the assetoption is more ideal especially in a scenario when management company’s internal compliancea dividend is declared for a particular fund. If department to keep a close eye on these activitiesthe fund manager does not calculate and subse- so that they could inform the fund manager, soquently deduct the purification amount on the that he could make necessary adjustments in hisappreciation, and the unit holder redeems his portfolio and plan for any future adjustments asunits when he has not received any dividend, he and when required to align to Sharia needs as wellwould receive a higher price as the price of the as fund objectives. The internal Sharia scholarunit would ideally result from the appreciation in board also needs to be apprised so that thethe share price held by the fund. Conversely, when scholars could study the new changes, analyzethe units are redeemed post-dividend payout and the same and pass a new Fatwa if required. Apartthe amount of purification has been deducted from that, the compliance monitoring system isby the fund manager before the dividend is dis- vital for historical performance analysis, whichtributed, reducing the net asset value (NAV) per newly launched funds calculate to observe howunit, he will get a lower price compared with the compliant holdings would have performed.former case. Lack of Eminent Sharia ScholarsSmaller Asset Universe and Limited Currently there are too few Sharia scholarsSector Exposure available compared with the number of IslamicAll of the Islamic indices have a limited universe financial institutions. As a result, many Shariaof stocks. There are many companies that are not scholars occupy board positions on at leastincluded in these indices. A leading third-party 20 to 25 institutions. There are scholars whoIslamic stock screening provider recently stated regularly sit on the board of 70 to 80 institu-that it has used its proprietary screening tools tions, which could easily be burdensome andto screen out almost 4,500 companies that are impact their quality of judgment and subsequentpresently trading on various U.S. exchanges (e.g., Fatwas. Proponents of Sharia finance see this asNYSE) as Sharia compliant, whereas the current a problem and growth inhibitor.Islamic market indices have a much smaller Funds@Work, a financial services strategySharia-compliant company universe of around consulting firm, has compiled Sharia-advisory2000. Hence, fund managers find it difficult to statistics over the past two years. It states thatselect a particular stock, however appropriate it there are 1,141 board positions in 28 countries,might be for his portfolio construction, if the same of which the top 10 scholars hold 450 positionsdoes not feature in the index the fund manager (~40%). Apart from that, as the boards of twois following. Also there are certain sectors which different financial institutions might be comprisedform an integral part of any traditional fund, of almost identical scholars, there is always a fearbut are absent because of Sharia regulations. A of conflict of interest as both institutions mightperfect example in this is the traditional banking be in the same industry and geography, offeringand financial services sector; almost all the an identical product bouquet and catering to thecompanies (barring some strictly Islamic financial same target audience.institutions) are deemed Sharia non-compliant. Degree a Company is DeemedLack of Consistent Monitoring on Stock’s Compliant/Non-compliantCompliance Status Change Current screening methods do not normallyMany stocks that form a part of the fund reveal to the fund manager by what margin amanager’s Sharia-compliant fund portfolio in particular stock is deemed as Sharia complianta particular year might become non-compliant or non-compliant. There might be companiesthe next year. There can be various reasons whose portion of Haram income just surpassed cognizant 20-20 insights 5
  6. 6. the acceptable threshold of 5%. If that stock is a the fund manager misses out on many oppor-potential stock for the fund manager’s portfolio, tunities for choosing an appropriate stock forthere could be some communication between the his fund, simply because it is not included infund management and the company in question, the Sharia-compliant list of DJIMI, thoughso that in the future the proportion of Haram it appears in the compliant list of a third-income can be slightly reduced in order to classify party provider. These providers have theirthe same as Sharia compliant. On the other hand, own Sharia board chaired by eminent Shariathere may be companies whose proportion of scholars, and their screening techniques andHaram income is just below the 5% limit. Those proprietary software are endorsed by Fatwacompanies could be kept under tighter supervi- issued by the board.sion as they are at the borderline of becomingnon-compliant, and, if not monitored carefully, • Last but not least, the fund manager faces a lot of issues in the course of his purifica-might soon become so. tion process in the absence of a standardized structure, and ultimately ends up in purifyingSolutions to Make Sharia Screening more/less that the optimal purificationMore Effective amount and wasting a lot of time as a result.Use of Third-party Sharia Stock Screening Third-party providers have a structured, wellProviders defined and logical purification model inFund managers are now gradually moving towards place, which mitigates this problem. Figurethird-party Islamic equity screening providers 4 depicts a prototype model of Sharia stockfor screening purposes. The reason behind it is screening that is somewhat similar to thethreefold. screening procedure followed by many third-• First, the results are much more accurate party providers. In this model, an in-depth and detailed as compared to straight vanilla analysis is undertaken at the business logic automated screening. screener layer, which is currently quite non- uniform and ambiguous and is a prime area of• Second, from the fund performance perspec- concern in the Sharia stock-screening process. tive, the Sharia-compliant asset universe as A two-layer screening approach is adopted furnished by third-party screening providers in which both the automated and the manual is much larger than the normal universe mode of screening is used at different stages. published by the FTSE, DJIMI and S&P. Hence,Third- party Islamic Equity Screening Provider:Business Logic Process Flow Procurement Receives Data Feeds on Stocks from Market Data Providers (e.g. Bloomberg) Team Data Stored Data in Stock Database Receives Data from External Sources (Company Website, Analyst Report, Balance Sheet, Company News & Corporate Actions) Screens Out Universally Accepted Stock Treated as Stock Added to Sharia Conducts Level 1 HALAL Items e.g. Healthcare Sharia Compliant Compliant List Receives Data from Automated Internal Research Data Procurement Team Screening Through Screens Out Universally Accepted Stock Treated as Algorithm & HARAM Items e.g. Alcohol Sharia Non-Compliant Team Proprietary Software Screens Non-Universal HARAM Items Screens Out Ambiguous HARAM Screens Out Indirect Secondary Items e.g. Arms Manufacturing HARAM Items e.g. Hotels with Casino Stock Treated as Income Treated as HARAM Receives Data on Ambiguous HARAM Sharia Non-Compliant Items & Secondary HARAM Items Internal Manual Review Team Income Treated Is Income Conducts 5% Eligible Conducts Level 2 Manual Review as HALAL Eventually HARAM Income Test of These HARAM Items HARAM Stock Treated as Sharia Compliant Stock Added to Sharia Compliant ListFigure 4 cognizant 20-20 insights 6
  7. 7. Here’s how it works: There are a host of parameters that a fund manager should consider before selecting a• At the outset, the data procurement team particular third-party screening provider: collects stock data from global market data providers (e.g., Bloomberg, Thomson Reuters, • Quality of screening output: The fund IDC, Six Telekurs, etc.) and other secondary manager needs to minutely analyze the quality sources (e.g., company balance sheets, analyst of screening that is performed by third-party reports, corporate actions, etc.), and stores providers. It needs to be seen that the resul- the same in the internal equity database. tant Sharia-compliant set of companies are signed off by reputed scholars who form the• The internal research team picks up a stock screening provider’s advisory Sharia board. and the level 1 automated screening through complex algorithms and its proprietary • Type of product suite: A fund manager could software. If the stock belongs to a company select a product suite based on his needs. like Diageo, which is an alcoholic beverages There are screening providers who provide company (i.e., its primary activity being customized packages on stocks belonging to alcohol), it would be straightaway catego- various regions. For example, Amanie offers rized as a company engaged in a universally 15 different packages, of which the “Global accepted Haram business (i.e., alcohol) and Package” covers all regions and is the most rejected. If the stock belongs to a company like expensive one, while there are packages Nike, which is a footwear and clothing company, focusing on particular areas as well. There are and is not engaged in any Haram or ambiguous other providers that offer different packages secondary businesses, it would qualify as based on different requirements. For example, universal Sharia-compliant stock. The rest of Amiri S3 offers four different packages the selections can either be companies whose (Platinum, Gold, Silver and Bronze). activity is ambiguous like an arms manufac- turer such as Alliant Techsystems, which is • Cost: The fund manager needs to do a detailed cost-benefit analysis especially in the long a large aerospace and defense company, or term (typically a three- to five-year view) companies whose secondary business activity before purchasing any particular product. If it’s is Haram (its primary business being Halal) like too expensive and economies of scale cannot Marriott, a hotel chain which, while its primary be obtained, then the fund manager needs to business is compliant, sells alcohol/pork items opt out of it. The fund manager also needs to and operates nightclubs. see whether there is any hidden cost involved• These ambiguous set of stocks are then in the deal. manually reviewed (level 2) by the in-house • Ease of integration and customization: review team, who analyze whether these The fund manager needs to see whether stocks are to be deemed as non-compliant or the program has a comprehensive set of not. For example, if the revenue generated by APIs (application programming interfaces), Marriott from all non-compliant activities like supports different integration technologies alcohol/pork sales, etc. exceeds the stipulated and can be plugged into another product if relaxation limit of 5%, it would be deemed as required. Apart from that, he needs to see non-compliant. The ambiguous stocks on the whether the software/product can lend itself other hand need to be screened more subjec- to customization and configuration. tively and it is qualitative in nature as in the case of defense companies, where the nature • Product version upgrades: The fund manager needs to see how the third party upgrades its of weapons produced, the technology and products, and whether he has to pay for each their buyer category are carefully analyzed. new version of the product or the companyIt has been frequently argued by some Islamic has adopted an evergreen policy where thebanking pundits, that the fund manager should asset management company does not have toconcentrate in maximizing the alpha on his pay for each upgrade. He also needs to checkportfolio rather than involving himself in the whether it is possible to skip versions (e.g., thenuances of stock screening. This should be company is currently using version 2.0 andentrusted to a third party in exchange for a pre- wishes to use the latest version 4.0, withoutdetermined fee. Currently, there are quite a few upgrading to version 3.0 first).professional third-party screening providers in • Implementation support and training: Thethe global market. fund manager should consider implementation cognizant 20-20 insights 7
  8. 8. needs while choosing a provider with sound The fund manager’s responsibilities once he has implementation knowledge. Some providers outsourced the screening and purification task may charge the asset management company a to a third-party screening partner should remain separate fee for implementation, but most will more or less identical. Though he would no include the implementation cost in the overall longer be involved with these tasks, it is the fund training costs. Regarding training needs, fund manager who remains responsible for his fund’s house resources need to be trained to work on performance, compliance, etc. All the leading third-party software/product suites and the advisories have their own Sharia board chaired advisory firm should provide for that. by eminent scholars, so it’s unlikely that their screened list of Sharia-compliant stocks would be• Industry recognition and depth of existing clientele: Various awards and recognition questioned by Islamic institutions and regulators. that a particular product suite has received These advisories also have proprietary tools to should be viewed as another valid indicator of calculate non-compliant income purification. the quality and acceptability of that particular Hence the fund manager has to make a call as product. The existing list of clients and the to whether he should outsource the purification various client segments should also assist part to these providers or keep it to himself. If he the asset management company in making does outsource, it is unlikely that he would opt a choice. For example, IdealRatings (per its for a shadow purification computing in which he Website) caters to asset managers, index would conduct an in-house computation of purifi- providers and brokers/dealers, and does cation (parallel to the third-party purification), as business with numerous prominent clients. it would involve much additional effort and time.• After-sales support: After-sales support is a Though theoretically possible, it is also unlikely key criterion that needs to be considered while that the fund manager would opt for a shadow selecting a third-party screening advisory. This screening of stocks when he has outsourced the helps in building a long-term relationship with screening piece, though the asset management the vendor. The fund manager needs to see company might retain its own screening whether that provider has a toll-free helpline, mechanism — maybe not for current use but for Web or e-mail support. future needs.Figure 5 compares the key attributes of four A fund manager who has not used the serviceprominent third-party Sharia finance advisory of third-party screeners usually picks stockscompanies — IdealRatings, Amiri Capital (Amiri of companies that are present in the Sharia-S3), Amanie Advisors and Sharia Capital Inc. — compliant list published by index providers suchusing information gathered purely from their as DJIMI. But even after outsourcing, he mayrespective Websites. still continue to use this list. It is at his discretion whether he would solely use the list provided byThird-party Islamic Equity Screening Providers and Their Key Attributes Ideal Ratings Amiri S3 Amanie Advisors Shariah Capital, Inc. Covers 42,000+ stocks and Only system to issue Fatwa Can deliver Sharia Screening tests approved by 100+ nations. Data securely in its own right. 40,000 approved data set for all five scholars within the delivered to end-consumer companies covered, strong 5 methodologies (4 DJMI Sharia Board. Over has an iPhone app for coverage in GCC. 29 tests indices and AAOIFI). 4,500 companies covered. instant screening. Periodic to validate screening. Covers 33,000 stocks in Claims to have one of the (even daily) and ad hoc Customized financial ratios 70 nations. Data request largest Sharia-compliant audit reports for Sharia for clients. Direct access to template can extract data stock universes. Thomson board. Data updated on key static screening results from multiple sources. Reuters as per contract daily basis enabling fund on Bloomberg terminals. Uses “Business Descrip- collects publicly reported manager to take prompt No software installa- tion Keyword Filter” for corporate financial informa- investment calls. Back tion required. Different business screening. Offers tion from 242 countries testing tools for suitability packages as client needs. various geography-based prior to stock screening. of conventional funds being Has a Blackberry app for packages. Subscription Sharia compliant. instant screening. can add up to 20 stocks to portfolio.Source: Respective WebsitesFigure 5 cognizant 20-20 insights 8
  9. 9. third-party screeners or resort to the index list as Conclusionwell. Whatever he does, there is usually an annual The Asian Development Bank estimates thatcompliance audit executed by an external agency, Islamic assets, currently estimated at U.S. $1which checks whether the Sharia-compliant trillion, will increase 10% to 15% per year overstocks forming a part of the fund’s portfolio abide the next two to three years. The Islamic fundsto all the stipulated Sharia principles. industry grew to U.S. $58 billion in 2010, a 7.6%Inclusion of Fresh Scholars in Sharia Board increase. The addressable universe for IslamicThe industry needs to induct more Sharia scholars fund managers is more than U.S. $500 billion,to various Sharia boards. Specific schools need which will add more than U.S. $70 billion to theto be set up to nurture the young talent with GCC pool by 2013. Plenty of Islamic funds haverequisite knowledge. The Centre for Islamic been launched over the last four to five years,Finance at the Bahrain Institute of Banking and though the number of funds liquidated is alsoFinance (BIBF) is preparing to launch a program quite alarming. There needs to be a standardizedfor young scholars along these lines.6 Another legal, accounting, regulatory and Sharia supervi-critical need is that a ceiling should be created to sory framework, which would provide an essentiallimit the number of memberships that a particular foundation for future growth, as well as a levelSharia scholar may simultaneously hold. With the playing field for Sharia-compliant funds in theaging of scholars, financial institutions need to global marketplace.hire fresh talent. Otherwise, nearly all institutions Though Sharia-compliant funds are issuedmight suddenly experience a serious paucity of primarily by the Islamic banks, global privatequality scholars. banking players like Bank of America MerrillUniformity in Financial Ratio Screening Lynch, Morgan Stanley, UBS, etc. are about toTechniques and Treatment of Sukuk Across hop on the bandwagon with their own set ofGeographies products. In such a scenario, especially whenAs noted earlier, different indices and other there is a dearth of quality Sharia-compliant fundfinancial institutions calculate the financial ratios products (vis-à-vis traditional fund products), ain different ways. S&P and DJIMI use average proper Sharia screening mechanism assumes amarket capitalization as a divisor for their role of utmost importance. The efficiency in stockfinancial ratios; others, such as FTSE and MSCI, screening would precisely determine the futureuse total assets as a denominator. Apart from success of an asset management company in thethat, the treatment of debt raised through Sukuk largely untapped Islamic wealth managementshould also be treated similarly across the board, segment. The asset management company couldas many institutions do not exclude debt availed build an in-house screening system or alterna-through Sukuk from interest-bearing conven- tively outsource it to a third party, apart fromtional debt. Uniformity is needed so the financial the prevalent practice of following the Sharia-ratios for a particular company cannot be inter- compliant list provided by an index provider.preted in various ways, which might mislead thefund manager. The concept of third-party screening is relatively new and some fund managers are still circum-Growth of the Islamic Fund Management Industry Number of islamic Funds 70 200 Estimated AUN(US$ B) 58 173 60 51.40 53.90 48.7 150 50 39.50 40 34.10 100 78 30 23.29 20 16.78 15.84 46 50 29 27 10 7.61 11 19 23 5.54 4.86 0 0 2005 2006 2007 2008 2009 2010 2007 2008 2009 2010 Year Year Estimated AUM(US$ B) Number of Islamic Funds Launched YOY Growth (%) Number of Islamic Funds LiquidatedSource: The Islamic Funds & Investment Report 2011 (E&Y, Eurecahedge and Zawya)Figure 6 cognizant 20-20 insights 9
  10. 10. spect about the credibility of the process these for the fund manager, while adhering to Shariacompanies follow as well as the resultant cost- principles, to be more competitive by gainingbenefit. But in the future, with the growth of greater bandwidth and flexibility in terms of stockthe Islamic fund industry and increased global selection from a much larger stock universe —competition, these advisories might well be the thereby improving investor returns.preferred way of screening. It would be convenientFootnotes1 Interest bearing financing ratio (i.e., total interest bearing debt/total assets < 33%) Interest generating — assets ratio (i.e., total interest generating assets/total assets < 33%) Tradability ratio (i.e., cash plus — accounts receivables and pre-payments / total assets < 70%). —2 January, 2011.3 November, 2010.4 Prof. Ulrich Derigs & Shehab Marzban, ‘Inequalities of screening’, Islamic Banking & Finance Volume 6, Issue 2, p. 12.5 Dividend approach of purification: (prohibited or Sharia non compliant income / total income) * dividend received Haram income purification: (total prohibited income including interest) / no of shares issued * no of shares held.6 Asa Fitch, ‘Islamic Finance Industry needs for experts’,, April 11, 2011.ReferencesIslamic Banking & Finance I Islamic Finance News I Eurecahedge I Euromoney plc I Islamic Research& Training Institute (IRTI) I The Islamic Funds & Investment Report 2011 I Failaka Advisors I Journal ofBanking & Finance I E&Y I Bank Sarasin I Institute of Islamic Banking & Insurance I Islamic FinancialServices Board I QFinance I Zawya I Funds @ Work AGAbout the AuthorBiswadeep Sengupta is a Senior Consultant within Cognizant Business Consulting’s Banking andFinancial Services business unit. He has for the last five years functioned as a lead business analyst andconsultant for various bank implementation projects across various geographies. Biswadeep’s areas ofexpertise include asset and wealth management, retail banking and consumer lending. He holds an MBAin finance and strategy and can be reached at CognizantCognizant (NASDAQ: CTSH) is a leading provider of information technology, consulting, and business process out-sourcing services, dedicated to helping the world’s leading companies build stronger businesses. Headquartered inTeaneck, New Jersey (U.S.), Cognizant combines a passion for client satisfaction, technology innovation, deep industryand business process expertise, and a global, collaborative workforce that embodies the future of work. With over 50delivery centers worldwide and approximately 130,000 employees as of September 30, 2011, Cognizant is a member ofthe NASDAQ-100, the S&P 500, the Forbes Global 2000, and the Fortune 500 and is ranked among the top performingand fastest growing companies in the world. Visit us online at or follow us on Twitter: Cognizant. World Headquarters European Headquarters India Operations Headquarters 500 Frank W. Burr Blvd. 1 Kingdom Street #5/535, Old Mahabalipuram Road Teaneck, NJ 07666 USA Paddington Central Okkiyam Pettai, Thoraipakkam Phone: +1 201 801 0233 London W2 6BD Chennai, 600 096 India Fax: +1 201 801 0243 Phone: +44 (0) 20 7297 7600 Phone: +91 (0) 44 4209 6000 Toll Free: +1 888 937 3277 Fax: +44 (0) 20 7121 0102 Fax: +91 (0) 44 4209 6060 Email: Email: Email:© Copyright 2012, Cognizant. All rights reserved. No part of this document may be reproduced, stored in a retrieval system, transmitted in any form or by anymeans, electronic, mechanical, photocopying, recording, or otherwise, without the express written permission from Cognizant. The information contained herein issubject to change without notice. All other trademarks mentioned herein are the property of their respective owners.