Shariah-Compliant Fund Management

IdealRatings ®
Shariah-Compliant Fund Management
Dr. Shehab Marzban

Head of Research and Product Development
Durham Islamic Finance Autumn School
September 20th 2011, Istanbul

Agenda
• About IdealRatings
• Industry Overview
• Establishing a Successful Islamic Fund
• Shariah Screening Impact on Alpha Generation
• Purification Impact on Alpha Generation
©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

strictly prohibited. IdealRatings®
IdealRatings Overview
• Service: Shariah Compliant Fund Management Service
• Locations:
o San Francisco - HQ
o Egypt – Research & Support
• Team:
o Multidisciplinary and multilingual research team
• Service
o Fund Management Service
o Index Feed / Deliveries
o Brokerage Feed

Backed-up by Research and Practice
• IdealRatings recent Research activities at / with

o Harvard University
• Shariah-compliant Alpha Generation
o Durham University
• Vulnerability of Shariah Investments
o Thomson Reuters
• Shariah Screening Trends and Impact on GCC Performance
• Halal Food Industry
o University of Cologne
• Shariah Screening Methodologies and Purification
o Internal Research Lab

• New strategies
• Correlation analysis

Industry Overview
Shariah Compliant Funds Shariah Compliant Funds AUM’s

Growing Trends By Managers Location (Region)
40000 800 2.70% 2.50% 0.30%
35000 586 700 8.70%

30000 471 600 GCC
25000 414 500 Asia
20000 307 400
North America
236
15000 300
Africa Ex. MENA
10000 200 30.20% 55.70%
5000 100 Europe
0 0 MENA Ex. GCC

2006 2007 2008 2009 2010
AUM (Mn, US$) N° Funds
Source: Lipper, Sep 2010

Industry Overview
Shariah Compliant Funds AUM’s

By Managers Location (Country) 586 Islamic funds
domiciled in 31 countries
11.20%
8.70% Saudi Arabia $37bn of assets

Malaysia
52.10% USA Saudi Arabia – Largest market

28.00%
Others
25% market Share # of funds
52% market Share AUMs
Malaysia - 2nd largest market

34% market share # of funds
28% market share AUMs

Agenda

General Shariah Requirements
• Characteristics of an investment permissible
to Islamic investors include
o being socially responsible
o avoiding interest
o avoiding gharar and maysir (high uncertainty,
speculative activities)
o avoiding prohibited industries and business
èLimitation in asset classes (no conventional

derivatives or interest-based products such as
bonds)
è Is alpha generation possible compared
to conventional funds?
Islamic Portfolio Management
Investment Policy Analysis
Conventional
§ Requirement analysis
§ Investment Strategy selection
§ Benchmark selection
Islamic Considerations Portfolio Construction

§ Defining Shariah Ruling Source
§ Defining Screening Provider Performance Analysis
Conventional And Portfolio Revision
§ Defining Islamic Benchmark
§ Portfolio Optimization / Strategy
§Return / Risk Conventional
§Constraints § Performance measurement
§ Portfolio Implementation § Feasibility compliance
Financial Analysis Islamic Considerations Islamic Considerations

§ Shariah-compliance checking § Purification reporting
§ Considering Purification losses § Zakah Reporting
Conventional § Compliance reporting
§ Asset universe definition § Consider Compliance Trend
§ Violation reporting
§ Quantitative measures for risk
and return
Islamic Considerations
§ Shariah-compliance procedures
§ Quantification of Purification
§ Compliance Trend
9
Planning Implementation Controlling
Best Practices in Islamic Funds
Islamic Fund Management

Fund Setup
- Define Shariah Guidelines
- Define Purification Requirements
- Select appropriate screening provider
Ongoing Operations
Shariah - Ad-hoc compliance checks
- Time violation checks
Governance
Periodic Monitoring / Review

- Compliance Reporting
- Purification Reporting
- Zakah Calculation
- Adjusting Shariah mandates over time

Best Practices in Islamic Funds
Islamic Fund Management

Fund Setup
- Analyze Shariah Guidelines and Impact
on Performance
- Sector and Regional Coverage
Ongoing Operations
- Quantify Purification before Investment
Fund Manager - Compliance Trend Analysis
Periodic Monitoring / Review

- Discussing Shariah Mandate
- Benchmark analysis to other funds

Simple Fund Form
Fund
Shariah Board Investors
Manager
Mudaraba / Supervision Redeemable

Wakala Shares
Limited Liability
Company
Assets
(Investment PorVolio)

Complex Fund Form

INVESTORS

Fund of Funds Setup
Shariah Compliance
Shariah Board
Reporting

Shariah Compliance Fund Fund of Fund, Ac3vely
Management Managed Fund, White Label

External Fund Managers Shariah Compliance Lists
(Global, US Small Cap, Emerging Market…
and Monitors

Fund Administrators

Universe Management Guideline Monitor Custodian Purification Calculation


Establish a Successful Islamic Fund
• Choices of Fund Managers
o Shariah Board Appointment and Mandate

o Use of Index
o Fund Exposure
o Information & Tools

Establish a Successful Islamic Fund
• Success Levels in Shariah-compliant Funds

o Funds with tremendous AUM growth
o Funds that lost AUM or stayed at seed capital
• Priorities for a Shariah-compliant Investor

o Returns compared to conventional funds
o Tight compliance
o Purification and Zakah
• Products Definition
o Shariah Mandate
o Shariah-compliant Asset Allocation

Choices of Fund Managers
• Shariah Board Appointment and Mandate

o Joint innovation in maximizing asset universe
• Use of Index
o Limited Asset Universe
o Different than Funds Shariah Mandate
• Fund Exposure
o Regional versus Global (Region and Sector exposure)
o Small versus Large Market Capitalization
• Information & Tools

o Compliance Trend Analysis
o Benchmarking against indexes and other products
o Timely purification calculation
o Supporting Zakah calculation
Shariah Mandate
Business To Avoid:

Interest Income -‐ Non-‐Opera\ng -‐ Conv., Adult Entertainment, Alcohol, Cinema,
Conven\onal interest based banking, Defense, Gambling, Hotels, Insurance, Music,
Pork, Tobacco) / Revenue -‐ Total ) less than 5%

Screening:
Cash and Short Term Inv. / 12 Months Market Cap less than 30%
Debt -‐ Conv. / 12 Months Market Cap less than 30%
Cash, Cash Equivalents and Receivables / Total Assets less than 67%

Purifica3on Name: Dividend only Purifica\on
Black List: Company Y
Liquida3on Window: X Days


Purification Requirements
-‐ Type of Purifica3on
-‐ Dividend Purifica3on of Non-‐permissible Income
-‐ Dividend Purifica3on of Non-‐permissible Income and Capital Structure
-‐ Investment Purifica3on

• Huge Impact on returns based on purification rule used!
• Complexity to calculate due to dynamics of compliance

Zakah Requirements
-‐ Factors affec3ng Zakah
-‐ Inten3on of investment (Neyah)
-‐ Issuing company paying Zakah or not
-‐ Zakatable assets of the issuing company
-‐ Different approaches

Shariah Screening
• Shariah Screening Overview

• Sector Screens
• Financial Screens
• Norms in the Industry
• Problems with Shariah Screening
• Performance

Shariah Screening Overview
• Lack of standard for Shariah compliance rules

o No governing authority for world wide Muslims similar to the
Catholic Church
o Complexity to derive quantifiable rules from the Shariah

sources
o Existence of different Islamic schools of thought
o Complexity of modern capital markets and investment

instruments
o Shariah research has been industry-driven rather than

from academia and research
Shariah Screening Overview
• Shariah compliance is defined through using a set

of
o Sector / Qualitative Screens

o Financial / Quantitative Screens

Sector Screens
• Non-Shariah-compliant investments include

activities related for instance to
o Conventional banking
o Alcohol
o Pork
o Casinos
o Pornography
o And others
• Since these activities are clearly stated in Shariah,

just minor differences are found in practice
o Music, Cinema, Stem Cells, Defense…

Sector Screens
• Two different approaches with respect to sector

screens are used
o Companies in doubtful sectors and companies with

any involvement in non-compliant activities are
excluded
è Using Industry Classification Codes (ICB, GICS…)
o Companies with revenue from non-permissible

activities larger than a specific percentage are
excluded (5% for instance)
Any comments?

Sector Screens
• What are the advantages of automated

screening?
• What is the impact of automated sector

screening on
o the size of the asset universe,
o the portfolio performance,
o and the compliance credibility?

Financial Screens - Types
• Liquidity Level
• In Islam liquid assets can only be traded at par
• Value of company only negotiable if it has illiquid
assets
• Any return should be based on the assets of the
company and not on cash and account receivables
è Assets should be “productive”
• Example of a screen:
The sum of accounts receivables, cash and short-term
investments may not represent more than 50% of the
total assets of a company

• Leverage Level
• Since not only receiving interest is forbidden but also
its payment, the level of interest payment for debt is
also measured
• Examples of a screen:
The proportion of total debt to total assets of a company
may not exceed 33%
or
The proportion of total debt to 12 month trailing market
cap of a company may not exceed 33%

• Non-Permissible Revenue Level

• Shariah scholars defined thresholds to which extent
income from non-permissible activities is acceptable
• This is similar to the sector screens that limit the non-
permissible revenue element
• Example of a screen:
Revenue from any Shariah non-compliant activity has
to be less than 5% of the total revenue generated by
a company
• Is there any other non-compliant element?

Norms in the Industry
Dow Jones Islamic

Accounts Receivables / 24M Avg. Market Cap < 33.00%
(Cash and Interest Bearing Securities) / 24M Avg. Market Cap < 33.00%
Total Debt / 24M Avg. Market Cap < 33.00%
List of ICB codes which are non-compliant
MSCI Islamic
Accounts Receivables / Total Assets < 33.00%
(Cash and Interest Bearing Securities) / Total Assets < 33.33%
Total Debt / Total Assets < 33.33%
Non-Permissible Revenue / Gross Profit < 5.00%

S&P Shariah
Accounts Receivables / 36M Avg. Market Cap < 49.00%
(Cash and Interest Bearing Securities) / 36M Avg. Market Cap < 33.00%
Total Debt / 36M Avg. Market Cap < 33.00%
Non-Permissible Income / Total Revenue < 5.00%
Al Rajhi
Non-Permissible Income / Total Income < 5.00%
Conv. Debt / MAX (Assets, 12M Avg. Market Cap) < 30.00%

HSBC Amanah
(Accounts Receivables, Cash and Interest Bearing Securities) / < 50.00%
Total Assets
Total Debt / Total Assets < 30.00%
Interest Income / Total Revenue < 5.00%
Malaysian SEC
Clearly prohibited activities < 5.00%
Unavoidable activities (bank accounts, short-term < 10.00%
investments)
Companies with public interest / economy < 25.00%

Norms in the Industry - Empirical
• Based on top 5000 global companies using the AAOIFI

mandate with different divisor:

Norms in the Industry - Empirical
• Based on top 5000 global companies using the AAOIFI

mandate with different divisor:
Example SABIC:
Using total assets the company’s debt ratio is at 28% a clear pass based on
the 30% debt ratio threshold. Whereas the same company if 12 month
average market capitalization is used would have a debt ratio of 31%
which slightly exceeds the threshold and Fails.

Saudi Basic Industries Corporation
• SABIC Compliance Over Time

Analysis of Shariah Mandates - US
• Total assets might be a more stable figure but

market cap provides larger exposure and
opportunities
Debt Ra3o of AT&T in 2008-‐2009
60%
50%
Debt Ra3o
40%
12-‐month
30%
Total Assets
20% 36-‐month
Threshold
10%
0%

Problems with Shariah Screening
• Screening is mostly done wrong
• Shariah Mandate Documentation
• Purification Requirements not clearly defined
Therefore our methodology is:
Islamic Equity Rating is about identifying detailed and

relevant information which would enable us to screen
and purify companies accurately according to the
actual and intended requirements defined by the
governing Shariah boards.
Agenda

Purification – Definition & Reasoning
• After the selection of a final Shariah-compliant asset

universe, there are still Shariah-specific issues to be
considered
èPermissibility of interest or non-permissible income
was relaxed by Shariah scholars but the return is not
completely Shariah-compliant
• Purification is applied to impure returns from any non-

permissible elements
• Amounts to be purified are to be donated without achieving

any gains in terms of tax relieves
• Either donation is done through the Islamic trust fund or

investors are notified about amounts they have to donate
IdealRatings ®
Thank You
IdealRatings
425 Market Street, Suite 2200
San Francisco, CA 94105
Tel: +1 (415) 955 2737
Fax: +1 (415) 397 6309
http://www.idealratings.com
Email:
smarzban@idealratings.com

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IdealRatings ®

Shariah-Compliant Fund Management

Dr. Shehab Marzban

Durham Islamic Finance Autumn School

September 20th 2011, Istanbul

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

• Service: Shariah Compliant Fund Management Service

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

• IdealRatings recent Research activities at / with

o Internal Research Lab

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

Shariah Compliant Funds Shariah Compliant Funds AUM’s

40000 800 2.70% 2.50% 0.30%

35000 586 700 8.70%

0 0 MENA Ex. GCC

AUM (Mn, US$) N° Funds

Source: Lipper, Sep 2010

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

Shariah Compliant Funds AUM’s

8.70% Saudi Arabia $37bn of assets

52.10% USA Saudi Arabia – Largest market

Malaysia - 2nd largest market

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

èLimitation in asset classes (no conventional

Islamic Considerations Portfolio Construction

Financial Analysis Islamic Considerations Islamic Considerations

Islamic Fund Management

Periodic Monitoring / Review

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

Islamic Fund Management

Periodic Monitoring / Review

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

Mudaraba / Supervision Redeemable

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

Fund of Funds Setup

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

• Choices of Fund Managers

o Shariah Board Appointment and Mandate

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

• Success Levels in Shariah-compliant Funds

• Priorities for a Shariah-compliant Investor

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

• Shariah Board Appointment and Mandate

• Information & Tools

Business To Avoid:

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

• Huge Impact on returns based on purification rule used!

• Complexity to calculate due to dynamics of compliance

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

• Shariah Screening Overview

©2011 IdealRatings, Any unauthorized copying, disclosure, or distribution is

• Lack of standard for Shariah compliance rules

o Complexity to derive quantifiable rules from the Shariah

o Existence of different Islamic schools of thought

o Complexity of modern capital markets and investment

o Shariah research has been industry-driven rather than