New frontiers for Islamic finance

Exchange-traded fund volumes have grown dramatically in Asia in the past couple of years as investors have used them to access new markets and underlyings. Now Islamic ETFs are being readied to hit the market, including Ucits III-compliant funds.

EasyETFs make inroads into Malaysia

Total assets invested in Asia ex-Japan exchange-traded funds (ETFs) hit $55.1 billion in October 2010, with the number of ETFs totalling 188 with 293 listings, according to iShares. To date, this growth momentum has yet to benefit the Islamic sector, with just three Islamic ETFs listed on Asian bourses. These three Islamic ETFs - listed in Malaysia, Singapore and India - have attracted $217 million in assets, or just 0.4% of the total market.

However, this may be about to change. Islamic ETF providers have reappraised their position and are seeking to add important new features to future issues. Notably, Bursa Malaysia plans to become the first exchange in Asia to list an Islamic ETF conforming with the European Union's latest Undertakings for Collective Investment in Transferable Securities directive, more popularly known as Ucits III. The move, expected to take place by March 2011, is part of an ongoing effort by Kuala Lumpur to develop Malaysia into an international Islamic financial centre.

Some market participants have high hopes for this new Ucits-compliant ‘EasyETF' series, which will track the DJIM China/ Hong Kong Titans 30 index. The ETF's Ucits III status will enable it to be marketed freely within the European Union. Besides its Ucits wrapping, the open-ended fund also has a China growth theme linked with index tracking. Bursa Malaysia hopes the structure will prove attractive to foreign investors seeking participation in Asia's fledging ETF market.

A different Dow Jones Titan index already forms the basis for the world's largest existing Islamic ETF, called MyETF, which was first listed on the Bursa in January 2008 and now has $199.2 million in assets under management, according to iShares. MyETF tracks 25 Malaysia stocks and has an average daily turnover of $250,000. However, MyETF's assets under management are still very small when compared with the world's largest ETF, the $80.6 billion SPDR S&P 500, which tracks the S&P 500 and has average daily trading activity of $20.5 billion in the US, iShares data shows.

Kevin Chan, Kuala Lumpur-based vice-president of Sigma, a structured product and indexed fund arm of BNP Investment Partners, which seeded and domiciled the new EasyETFs out of Paris, says the listing on Bursa Malaysia could prove an important test case for more Europe-domiciled funds to get listings on Asian exchanges. After a primary listing on the Bursa, industry participants say the plan is to seek a secondary listing in Hong Kong via a mutual recognition agreement signed last year between the Securities Commission in Malaysia and the Securities and Futures Commission in Hong Kong. This agreement is expected to facilitate the cross-listing of Islamic ETFs across the two exchanges.

Dow Jones Indexes' DJIM China/Hong Kong Titans 30 index tracks the 30 largest companies that operate in China and Hong Kong, which are also listed on the Hong Kong bourse. As a result, Chan says BNP Investment Partners has made a special arrangement with its Hong Kong branch to take care of the time zone differences and operational difficulties related to the calculation of intra-day portfolio value - the estimated intrinsic value of the fund during the trading day - and other issues, such as validation of prices between Paris and Hong Kong. As the official net asset value is calculated in Paris, the manager will need to sort out the time-delay issue between Hong Kong and Paris.

The process is costly. "Issuing an ETF - especially an Islamic ETF - is very expensive," says Chan. "Aside from the cost of appointing a listing agent, the costs related to coming up with an index and having a manager to manage the fund, with an Islamic ETF a manager must apply a pure replication method instead of a synthetic method, [as] the use of derivatives to synthetically replicate the constituents of the index is not encouraged," says Chan.

Conventional ETFs can use derivatives such as total return swaps or performance notes to synthetically replicate exposure to the underlying stock constituents that comprise the referenced index. This means the constituents that account for smaller weightings of the benchmark can be replicated synthetically without buying the physical stocks.

However, for Islamic ETFs, the use of standard derivatives is considered in breach of sharia principles - there are still active debates over whether the use of derivatives involves excessive uncertainty (gharar), which is prohibited. Meanwhile, the nature of derivatives, which can be used for speculative purposes and bear similarities to gambling (maysir) - an activity viewed as unlawful (haram) - is a key argument cited by many scholars for not permitting standard financial derivatives in Islamic finance.

This means Islamic ETF asset managers and their bank dealers/market-makers must use pure replication through purchasing the exact number of shares to create a perfect basket to mirror the referenced index. The number of shares is determined by each constituent's weighting.

In the primary market, investors in ETFs can buy or sell one creation unit from participating dealers. In the case of Islamic ETFs, the ban on the use of derivatives means dealers have to buy the entire broad lot of a constituent's shares - which come in 100-share lot sizes in Malaysia - ultimately generating a small degree of mismatch with the respective weighting in the referenced index. The pure replication required results in Islamic ETFs tending to have a slightly higher tracking error than their conventional counterparts, says Chan. For the listing of the proposed EasyETFs in Malaysia, Chan says each creation unit will represent 200,000 ETF units.

"For example, in any referenced index there are the lower weighted constituent stocks of say, 6.75% or 4.26%. Especially when the creation size is small and the constituent stocks are of lower weightings, a manager simply cannot buy 675 or 426 stocks, as they are outside the round-numbered broad lots or their multiples," says Chan. "[But] since the ETF tracks these stocks with odd fractions, rounding up or down is necessary in the purchasing of these stocks for the creation process, hence the tracking error."

However, Zainal Izlan Zainal Abidin, chief executive of asset manager i-VCap, manager of MyETF, does not believe Islamic ETFs suffer from a higher tracking error compared with their conventional counterparts. He says MyETF has a tracking error of 1.2% against the price return version of the index and 0.6% against the total return version of the index. The MyETF prospectus says the manager must attempt to achieve a tracking error of less than 3% between the NAV of the fund and the benchmark index.

The sharia screening at the index level is done by Dow Jones Indexes and is classified into two levels. Ariff Sultan, Singapore-based business development director for Asia at Dow Jones Indexes, says the business screening first aims at removing companies whose business activities are not sharia-compliant because their business involves financial services (as a result of interest or riba being prohibited by Islamic law), pork, gambling or alcohol. "As for the financial screen ratios of the companies selected, these ratios are debt over market capitalisation, cash plus interest-bearing securities over market capitalisation and accounts receivables over market capitalisation," says Sultan. "They have to be less than 33%."

Another layer of screening is also done at the fund level, which also has a sharia adviser that comes up with internal investment polices and guidelines. These rules also incorporate guidelines that are in compliance with the Securities Commission's sharia advisory council criteria, Izlan says.

As ETF units are traded freely on-exchange, similar to stocks, these index funds are increasingly being used in the conventional world as one way to hedge an investor's underlying portfolio. For example, ETFs can be sold short to cover an investor's long futures or long cash equity positions.

In Malaysia, the Bursa now allows market-makers of ETFs to conduct ‘permitted short-selling' on ETF units or to achieve the same shorting effect through shorting the underlying constituent securities. However, market-makers say due to the limited trading volume of Islamic ETFs listed on the Bursa, shorting of ETF units has yet to take place.

There are diverse views in the market regarding whether or not short-selling can be sharia-compliant, but Izlan says MyETF has taken the view that its participating dealers, CIMB Investment Bank and OSK Investment Bank - both of which are also the market-makers appointed by the asset manager - should not be engaged in short-selling, given that MyETF is a sharia ETF.

Raja Teh Maimunah, global head of Islamic markets at Bursa Malaysia, says the Bursa imposes the same set of rules governing market-makers regardless whether they are providing liquidity for conventional or Islamic ETFs. "We require them to make bid-offers just like any other. On short-selling for Islamic ETFs, there is no pronouncement by the sharia advisory council permitting such acts at present," says Raja Teh.

However, a senior executive at an investment bank's securities borrowing and lending division in Kuala Lumpur says as a market-maker his team is answerable to and governed only by the Bursa's rules on market-making.

While CIMB and OSK Investment Bank also act as i-VCap's participating dealers for MyETF, the agreement they have with i-VCap only concerns their role in the primary market in terms of helping investors with the creation and redemption of fund units. Since the listing of MyETF, the source says his team has been hedging its positions through futures contracts on the Bursa's benchmark index, FTSE Bursa Malaysia KLCI - a free-float index that tracks a basket of 30 stocks, a much lower number than its predecessor, the Kuala Lumpur Stock Exchange Composite Index (KLCI), which tracked 100 stocks until it was changed to its current form in July 2009.

Hedging headaches

The banking source says the change in index competition had caused a headache for managing MyETF exposures as the correlation between KLCI futures with the fund's benchmark Dow Jones Islamic Market Malaysia Titans 25 index (DJIM25) has dropped to 58% from 98% before the 2009 change. This has led his team to decrease its hedge ratio to minimise losses. "When MyETF was launched in 2008, it was easier to hedge using KLCI index futures because at that time, the major component stocks of the KLCI index were plantation stocks such as Sime Darby, Kuala Lumpur Kepong or IOI Corporation, which were also tracked by the DJIM25," he says.

The switch to using a free-float index, which requires each company to have a minimum free float of 15% for its stock to be eligible for inclusion, has also moved many banking stocks up the new FTSE Bursa Malaysia KLCI index. The likes of CIMB, Maybank and Public Bank are now key components of the Bursa's benchmark, meaning that the DJIM25, which is devoid of banking stocks, now has more of a divergent performance.

While a number of influential market participants are moving to promote the Islamic ETFs, there are still many barriers to overcome. However, the launch of Ucits III-compliant funds may be an important step in the right direction.