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Exploring the Complexities Surrounding Islamic Exchange Traded Funds

Industry Insights | June 04, 2018

Exploring the Complexities Surrounding  Islamic Exchange Traded Funds

Jamal Arif Jamaludin

 

Introduction

The world of finance is moving at an exponential pace. There is a growing concern regarding the increasingly frequent rapid shifts of yields induced by market events such as the recent prospects of ‘Quitaly’- Italy’s exit from the European Union. In turn, such events are expected to spike the Chicago Board Options Exchange’s (Cboe) VIX index, the barometer of volatility (Gaudiano. A, 2018). In hindsight, the need for dynamic investment strategies has never been more vital.

Furthermore, Islamic investors can no longer sit idle during such complex scenarios as the world becomes increasingly intertwined. It is paramount for Islamic investment strategies to adapt towards the high velocity market to remain competitive. Concurrently, the nascent Exchange Traded Funds (ETF) market has been gathering momentum as investors sought leverage off this highly innovative segment. Evidently, the same could not be said about the Islamic Finance Industry in recent years, which is facing lackluster growth of Islamic ETFs (iETFs). The scope of this piece does not posit a specific solution but rather attempts to raise an awareness and spark a discussion towards harnessing the benefits of iETFs. Firstly, it aims to shed light by peeling back the perplexity surrounding the ETF product. Concurrently, outlining a vis-à-vis comparison of the underlying characteristics and developments between conventional ETFs and iETFs. Finally, it will suggest potential areas where iETFs can be applied in order to unlock its inherent value in Islamic Finance.

 

Understanding Exchange Traded Funds

ETFs are one of the most exotic investment vehicles available on the market, to date. It is essentially a marketable security that tracks an index, bonds, commodities, or a basket of assets like an index fund. Its creation was spurred by the desire of market participants to purchase financial products that provided broad exposures in accordance with their investment strategies, which was originally achieved via mutual funds. Both products offered a diversified exposure at a lower cost, as opposed to buying each individual stock via individual transactions.

However, the added advantage of holding an ETF was that it can be traded throughout the day like a stock. Conversely, a mutual fund can only be traded at the end of the day based on its Net Asset Value (NAV). Intuitively, an ETFs superior daily liquidity would allow investors to rapidly respond during market events through buying or selling the ETF on the stock exchange, whilst mutual fund investors would have to place a buy or sell order during the day and ride the price of the fund till the closing bell, whereby the opportunity to capitalise on a market event might have faded.

The first ever ETF debuted on the Toronto Stock Exchange 28 years ago, spurred by the 1988 SEC Black Monday postmortem to address the shortcomings of closed ended mutual funds. It sent ripples through the investment landscape. ETFs have since grown by leaps and bounds, as of December 2017 the total global ETF industry’s assets reached the $4.6 trillion mark and is anticipated to reach $7.6 trillion in the year 2020. (EY, 2017; Wigglesworth. R, 2017). The 2017 financial year saw a notable annual asset increase of 53.4% year-on-year, the highest since 2009. In a span of 12 months, 272 ETFs were introduced in 2017 to a total of 5,500 funds in the ETF universe (IFN, 2018)1.

In the realm of Islamic Finance, iETFs have yet to garner the same momentum from market participants. Despite the proliferation of faith based ETFs coming at a time when there was a high net inflow of investment into the ETF universe, iETFs struggled to gain traction (IFN, 2018)1. The existing data paints a picture that is skewed towards conventional ETFs. Currently, iETFs make up 1% (less than 20 funds) of the ETF universe which consists of approximately 5,500 funds (IFN, 2018)1. The first Shariah compliant ETF debuted in February 2006 when the Dow Jones Islamic Market (DJIM) Turkey ETF was listed on the Istanbul Stock Exchange. Since then, countries such as Malaysia and United Kingdom took center stage as an influential player within the iETF market. Despite numerous issuances, a majority of investors in the realm of Islamic finance have yet to grasp the concept behind iETFs (Yun. T, 2018).

One of the main hurdles facing iETFs is the complexity of its structure. The lack of demand for iETFs lies in the lack of investor’s understanding its underlying process. Figure. 1 and Figure. 2 depict simplistic representations of the underlying processes in both ETFs and iETFs.

 Figure 1.The General Structure of an Exchange Traded Fund

 

Figure 2. The General Structure of an Islamic Exchange Traded Fund (Securities Commission, 2014)

 

A vis-à-vis comparison of the two structures (Figure. 1 and Figure. 2) suggests the underlying structure of iETFs incur greater cost in order to adhere to Shariah prerequisites. Essentially, Islamic ETF’s can only track Shariah compliant benchmark indexes, which are comprised of Shariah compliant securities. This entails negative screening of companies that are involved in impermissible industries in accordance with Shariah principles. It is also overseen by an appointed Shariah committee to ensure its structure, investments, and fund activities comply with Shariah law. Thus, iETFs margins are squeezed by the negative screening process and the high cost of launching and maintainingthe ETFs. This is due to the low-cost product offering, which essentially translates into thinner margins for the issuer.

Thus, an emphasis on volume is essential towards the survival of an ETF. Currently, in most Islamic markets including Malaysia, product take up is too slow to create substantial value for issuers to offset the high cost (IFN, 2018)1.The stymied growth inevitably has deterred the supply of iETFs by issuers, creating a market gap for lucrative and interesting ETF’s to attract investors.A potential method of circumnavigating the issue is to reposition ETFs from a standalone financial product to a financial enabler, tapping into its strengths to offset its shortcomings.

 

Empowerment through Islamic Exchange Traded Funds

Thus, it is evident the benefits of ETFs are its liquidity and versatility. Conversely, its potential growth is stymied by its complex structure and cost of issuance.Unfortunately, there is limited literature available that explores the potential uses of ETFs which could possibly elevate the industry and further ensure continuous growth. Regardless, this article suggests ETFs should be viewed as enabling tools that could enhance the performance of the other Islamic products. The liquidity enhancing capabilities of ETFs can potentially improve the viability and catalyse the Islamic finance industry’s overall growth.

An example of a promising area ETFs could contribute is within the waqf segment of the industry. Waqfs often require initial capital prior to being self-perpetual, which can be expensive. Since a waqf does not return profit, the challenge of amassing enough wealth to fund large waqf projects is often through donations. This entails that benefactors would need to have enough wealth to spare into the waqf, thus limiting the potential pool of contributors. A waqf ETF could potentially provide the means of funding a portfolio of waqf projects preserving the capital of the benefactor. Hence, it negates the requirement of setting aside wealth for the purpose of waqf since the ETF could tap into the benefactors existing pool of idle funds such as savings. Moreover, it encourages efficient funding of the waqf initiatives and improved liquidity as it is no longer borne by a single or limited number of entities. A waqf ETF would unlock untapped sources of liquidity that could be used for the betterment of the wider community. The potential value that iETFs could bring goes well beyond financial profitability.

 

Conclusion

Despite its relatively small market size of just 20 funds, the iETF segment is one of the most innovative and novel additions to Islamic finance. It is a nascent segment that is anticipated to fuel growth once fully developed. This is evident in its versatility, which allows for the exploitation of synergistic relationships with existing Islamic finance products. Moreover, there is a dire need for industry players to be educated and enlightened about iETFs. Conferences and exhibitions centering on the role of iETFs would encourage its integration into the status quo. It is worth noting that there has been a push to put iETF center stage by regulators such as the Malaysian Securities Commission. The most predominant was the task force aimed at encouraging investors and market makers into the ETF realm through incentives and subsidies in 2017 (IFN, 2017)2. Moving forward, a suggested area of research is to study the postulated effectiveness of the nascent ETF frameworks and subsidies at encouraging the use of iETFs.

 

 

Reference:

  1. W (2008) The Fortunes and Foibles of Exchange Traded Funds: A Positive Market Response to The Problems of Mutual Funds, Delaware Journal of Corporate Law, Vol. 33
  2. EY (2017) Reshaping Around the Investor- Global ETF Survey, London: EY
  3. A (2018) Stock Market Volatility Gauge Hits 2-Month High as Italy Sparks Global Equity Selloff, Marketwatch,May 29th
  4. IFN (2018)1 Religious ETF: Should We Have Faith In Them, Islamic Finance News, January 2nd
  5. IFN (2017)2 Malaysia’s ETF Efforts bearing Fruit as Country Prepares to Welcome First Islamic Gold ETF, Islamic Finance News, November 28th
  6. Securities Commission (2014) Islamic ETF, Kuala Lumpur: Securities Commission
  7. R (2017), Global ETF assets reach 4$tn, Financial Times, May 11th
  8. T (2018) Cover Story: New Push for ETF, The Edge Malaysia Weekly,

 

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