INSIGHTS

Index Funds and Tackers: Back to basics

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 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.

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