Funds offer investors the opportunity to pool their money with other investors in an investment that’s managed by professional investment managers. Funds generally invest in stocks, bonds or other securities according to each fund’s objective. This research paper focuses on a particular type of fund known as index funds.

Index funds are, in essence, mutual funds or exchange-traded funds (ETFs) that invest in such a way that the performance of the fund closely tracks that of the target benchmark index, such as the S&P 500. The paper describes how an index fund is an investment fund that attempts to replicate the performance of a given index of stocks or some other investment type. An index measures the value of a specific section of the stock market. An index takes a number of different companies’ stocks and groups them together, so they can be traded as one financial instrument. An index therefore captures the performance of these stocks as ONE number.

The paper dissects the different compositions of indices and how they are developed, with the common formations based on the following:

Company size and capitalization. Index funds that track small, medium-sized or large companies (also known as small-, mid- or large-cap indexes).

Geography. These funds focus on stocks that trade on foreign exchanges or a combination of international exchanges.

Business sector or industry.  Funds that focus on consumer goods, technology, health-related businesses, for example.

Asset type. Funds that track domestic and foreign bonds, commodities, cash.

Market opportunities. Emerging markets or other nascent but growing sectors for investment.

Benefits of Investing in a Fund

The paper enumerates the various benefits of investing in index and tracker funds, and finds the following to be the common incentives and benefits:

Passive Management: Mutual funds can either be actively-managed or passively-managed. The manager of an actively-managed stock mutual fund, for example, is actively buying and selling stocks with the goal of “beating the market,” which is measured by a particular benchmark, such as the S&P 500.

Low Expenses: Keeping costs low are a large advantage for index funds and the cost savings translate to higher returns for the investor. The low costs of index funds are a function of their passive management.

Broad Diversification: An investor can capture the returns of a large segment of the market in one index fund. Index funds often invest in hundreds or even thousands of holdings; whereas actively-managed funds sometimes invest in less than 50 holdings.

The paper highlights how index funds differ in terms of their operations. The common types presented are as follows[1]:

• Full replication – invests in all securities in an index.
• Partial replication – holds a representative sample of securities in an index.
• Exchange Traded Funds – managed funds traded on the stock exchange like shares.
• Enhanced index funds – index funds offering enhanced performance.

Shariah Analysis

The paper ends with a Shariah analysis on conventional indices and trackers and highlights the Shariah concerns with such investments. Conventional indices are usually tracked by conventional financial instruments, conventional exchange-traded funds (ETFs) or derivatives. An investor cannot benefit from such indices without investing in such instruments and products. These tracking devices and vehicles are non-Shariah compliant. Conventional ETFs are composed of underlying assets and equities which are not Shariah compliant. Unscreened equity constituents in an ETF portfolio could well fail at the business screening phase. Others may be prone to excessive leverage and interest-bearing debt, making them non-Shariah compliant in the financials screening.

The paper finds that until 1999, there was no official Islamic index to benchmark the returns of Islamic equity funds against. Dow Jones and FTSE were the first who in 1999 launched the Dow Jones Islamic Market Index (DJIMI) and the FTSE Global Islamic Index Series (GIIS) respectively. The Dow Jones Islamic Market Index series includes thousands of broad-market, blue-chip, fixed-income and strategy and thematic indices that have passed rules-based screens for Shariah compliance. Launched in 1999, DJIM World was the world’s first global Shariah-compliant benchmark.

The paper ends with reviewing the Shariah compliant index funds and their Shariah screening process. The Dow Jones begins with an initial step that involves eliminating stocks of all companies involved in a particular list of activities. These are industries related to alcohol, liquor, pork, conventional financial service (banking, insurance, merchant banking, etc.), hotels, entertainment (including cinema, music), tobacco, defence, weapons manufacturing etc. This first step is qualitative in nature, whilst the second step involves the quantitative analysis of the firm’s financial ratios. This numerical analysis is really aimed at two things: (1) identifying firms with “exercise” leverage in the capital structure, and (2) identifying firms with unacceptable levels of interest income.

Besides the DJIM, the paper identifies the FTSE and S&P Shariah Indices as Shariah compliant. indices. The FTSE have a number of Shariah compliant indices. The FTSE Shariah Global Equity Index Series is based on the large and mid-cap stocks in the FTSE Global Equity Index Series universe. The FTSE Shariah Global Equity Index Series covers all regions across both developed and emerging markets, to create a comprehensive Shariah indexing solution. Unlike other competitor methodologies, a more conservative approach to Shariah compliance is ensured by rating debt ratio limits that are measured as a percentage of total assets, rather than more volatile measures that use 12-month trailing market capitalisation. This ensures companies do not pass the screening criteria due to market price fluctuation, allowing the methodology to be less speculative and more in keeping with Shariah principles.

Index Funds and Trackers are common invest funds, but the conventional funds clearly have Shariah non-compliant elements, as such, a Muslim investor must seek to invest in Shariah compliant instruments which track Shariah compliant indices.

[1] Vanguard, Introduction to indexing. Retrieved from: https://www.vanguardinvestments.com.au/retail/au/jsp/investor-resources/education/index-funds.jsp