Solving the Dynamics
of Shariah in ETFs & ETNs

At their core ETFs are hybrid investment products, with many of the investment features of mutual funds married to the trading features of common stocks. Like a mutual fund, an investor buys shares in an ETF to own a proportional interest in the pooled assets. Like mutual funds, ETFs are generally managed by an investment adviser for a fee and are regulated. But unlike mutual funds, ETF shares are traded in continuous markets on global stock exchanges, can be bought and sold through brokerage accounts, and have continuous pricing and liquidity throughout the trading day. Thus, they can be margined, lent, shorted, or subjected to any other strategy used by sophisticated equity investors. ETFs are a listed index-tracking fund whose primary objective is to achieve the returns that correspond to the performance of a particular index.

The aim of an ETF is to track the performance of an index, such as the S&P 500. An ETF’s performance is reflected in the fund’s NAV and in the price of its shares. To replicate an index, an ETF can be structured as either a physically replicating ETF or a derivative replicating ETF.

Physically replicating ETFs buy the same assets as the index being tracked, providing the investor with the reassurance of actually having an ownership interest in the assets through the creation units. As such, in full replication, all the assets in the index are held and the weighting of each asset is equal to its weighting in the index. This process buys all components of an index. For example, a FTSE 100 tracker fund will buy shares in all 100 companies in the index, in proportion to size of the companies within the index. In sampling replication (optimisation) or partial replication, all the assets of a large index are not held, as full replication could be less efficient and costly.

Derivative replicating ETFs are constructed to deliver the performance of an index through the use of derivative contracts (total return index swaps) with counterparties such as investment banks. Under the swap agreement, the counterparty promises to pay the return on the index to the ETF provider in exchange for the return on a basket of securities which the ETF provider owns (normally prescribed by the swap counterparty).

Most ETFs that track market indices are called passive ETFs. Managers who are in charge of overseeing passive ETFs will take a hands-off approach, simply ensuring that their ETFs replicate their designated indices. A manager will not intervene if an index takes a turn for the worse. In other words, the manager is being passive.

 What are ETNs?

In describing Exchange Traded Notes (ETNs), the paper finds that ETNs are senior, unsubordinated, unsecured debt issued by an institution. ETNs are linked to a variety of assets, including commodities and currencies. ETNs are designed to have “no tracking error” between the product and its underlying index. ETNs are not investment funds. They are debt obligations issued by banks for a fixed term in order to raise money. Investors are promised a payment at maturity linked to the performance of a corresponding index, minus fees. Investors can sell their holdings on the stock market before maturity. The issuing bank may offer redemptions (buying back the holdings) at regular intervals. ETNs expose investors to two types of risk: The credit risk of the issuing bank and the market risk of the selected index. ETNs may not have the usual protections of ETFs, such as the independent custody of assets, segregation of liability, diversified exposure and independent oversight.

What are ETCs?

The paper refers to another exchange traded vehicle known as ETCs (exchange-traded commodities). ETCs are debt securities rather than investment funds. They can be either physically backed or derivative-based. Physical ETCs will track the daily movement of the spot price of the relevant commodity by actually buying the asset.

Non-Compliance Issues

In exploring the non-compliant nature of ETFs and ETNs, the paper notes that there are several areas of concern and non-compliance in conventional ETFs, ETNs. Conventional ETFs are composed of underlying assets 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. Bond ETFs are non-Shariah compliant assets as the debt security is essentially a loan with interest. A bond is a debt obligation for which the issuer pays a pre-determined rate of return to the bond holder. There is no investment in any underlying asset; rather, the issuer has a personal right and a liability on his legal personality. A repayment of debt with interest is due to the bond holder. The payment for the bond is effectively a loan (Qard) from a Shariah perspective.

Strictly and legally speaking, tracking a non-Shariah compliant index is not unlawful and neither does it make the investment non-Shariah compliant, however, it is counter-productive for the Islamic finance industry.  For the Islamic finance industry to grow, it needs to develop a holistic, complete and independent system which has its own indices. Tracking a non-Shariah compliant index is an extrinsic issue to the Shariah compliant ETF. Extrinsic in this context means that the contracts involved in the ETF, the assets in the ETF are compliant. The ETF in and of itself – intrinsically –  is compliant. Tracking is an external matter and hence cannot render the ETF as non-compliant. However, a number of Shariah boards have considered the tracking of non-Shariah compliant indices as non-compliant. This will assist the Islamic finance industry grow and disengage with any non-compliant element as a whole.

Many conventional ETFs fail either the business screening or financial screening for Shariah compliance. ETFs are invested in non-Shariah compliant financial instruments such as swaps, financial and unlawful beverage producing companies.

The constituents in commodity ETFs are composed of future and swap agreements. Such derivatives are non-Shariah compliant. In futures transactions, because neither counter-value, i.e., money or goods, is present at the time of contract, the sale is irregular (fasid).

Another prominent issue in conventional ETFs is securities lending. Securities lending is a well-established activity where ETFs make short-term loans of the underlying stocks or bonds in the portfolio; this can incrementally increase the returns for shareholders.

ETNs are generally structured on swap agreements. A swap is a contractual agreement in which two parties agree to exchange payments over a period of time, based on a notional amount of the underlying asset. Swaps are not permitted in the forms in which they are practised in commodity exchanges. The basis for the impermissibility of swaps is that no actual exchange of counter-values takes place thereby. Such swaps, as well, usually constitutes interest payment, ’Inah (sale and buy-back agreement), and deferment of one of the counter-values.