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1- BANK OF KHYBER'S INITIAL PUBLIC OFFERING
2-
PTCL: A STEP AHEAD IN TECHNOLOGY
3- ISLAMIC EQUITY FUNDS
4- GWADAR: NEW STRATEGY
5- NEW DFI MODEL FOR INFRASTRUCTURE FINANCE

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ISLAMIC EQUITY FUNDS

 

 

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By IMTIAZ GADAR
Assistant Manager, 
Product Development Central Depository 
Company of Pakistan Ltd. Karachi

Aug 30 - Sep 05, 2004
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The past 2-3 years of our financial system have been marked by two major trends, depressed interest rate scenario and emphasis on Shariah Compliant investment products. The depressed interest rate scenario meant that people started to channel their funds out of fixed income securities and into avenues that provided higher returns. The boom in the stock market witnessed during the period is reflective of the trend.

In addition, an added inclination towards Shariah Compliant Products was also observed among the investing public of Pakistan. The fact that nearly all leading banks started adding Shariah compliant products in their product offerings is a good indicator of the potential demand in the sector. But these products offered by the bank usually offered a rate of return close to the returns on their other non-compliant products which meant that a product fulfilling both factors i.e. attractive returns with Shariah compliance was still missing.

One product that has hit the Pakistani financial markets in recent times has the potential to fulfill this unmet demand to a certain extent. The product we are referring to is "Islamic Equity Funds" or Shariah- Compliant Equity funds".

ISLAMIC EQUITY FUNDS

An Islamic equity fund is a joint pool wherein the investors contribute their surplus money for the purpose of its investment in joint stock companies to earn Halal profits in strict conformity with the percepts of Islamic Shariah.

The profits are mainly achieved through capital gains by purchasing shares and selling them when their prices appreciate or through dividends distributed by the relevant companies.

The two basic conditions that have to be met for all equity funds are as under:

* Instead of a fixed return tied up with their face value, they must carry a pro rata profit actually earned by the fund. Therefore neither the principal nor a rate of profit tied up with the principal can be guaranteed.

* The amounts pooled together must be invested in a business acceptable to Shariah.

It is obvious that if the main business of the company is not lawful in terms of Shariah, it is not allowed for an Islamic fund to purchase, hold or sell its shares because it will entail the direct involvement of the share holder in that prohibited business.

Similarly, nearly all Shariah experts are agreed that if a company conducts all of its transactions in full conformity with the Shariah including that the company neither borrows money on interest nor keeps its funds in interest bearing accounts then it is permissible to purchase, hold or sell its shares. However, such companies are rare.

Keeping in view this fact, modern day scholars around the world have come up with different criteria for determining acceptable debt-to-asset structure of companies and the amount of interest income the company can earn as a percentage of total income. These criteria are applied to different companies to determine the Shariah compatibility and to adjudge whether the companies are permissible investments from a Shariah point of view.

Naturally some of the income thus derived from such investments is "impure" and has to be quantified and purified. The procedure normally followed for this purpose is that the Asset Management Company (AMC) donates the amount of impure income thus earned to charity.

 

 

ADVANTAGES OF INVESTING IN ISLAMIC EQUITY FUNDS

The advantages available to investors due to investment in Islamic Equity funds are summarized in the following. Some of the below mentioned are advantages that are generally associated with mutual fund investing but some are specific to Islamic Equity Funds and can not be witnessed in conventional equity funds.

HALAL INCOME

The biggest attraction of Islamic funds remains the Halal profits generated by such funds. Although there is still some disagreement as to whether the profits earned by such funds are 100% Halal, as these companies do allow interest bearing debt and interest income to a certain extent. However, as most of these funds are backed by the approval of prominent scholars from around the world, they are generally considered to be generating Halal and Shariah-Compliant profits.

DIVERSIFICATION

Like any other mutual fund, an Islamic equity fund provides its investors with diversification. An individual investor has limited amount of funds available for investment and as a result he can invest in only a limited number of stocks.

The limited investment capital of an individual investor has dual implications. Not only is he unable to benefit from some of the profitable Shariah-compliant opportunities available in the market, his risk is also concentrated to a limited number of stocks.

This problem can be reduced to a certain extent by investing in Islamic equity funds as the joint pool of funds can be used to invest in a larger number of stocks thereby enabling the investors to benefit from a larger number of profitable opportunities and also reduce their risk through diversification into different sectors and stocks.

PROFESSIONAL MANAGEMENT

The fund managers at the helm of affairs in an Islamic Equity fund or any other mutual fund are better equipped than an average investor to recognize profitable opportunities in the market and in determining the Shariah compatibility of an individual stock or sector.

By investing in an Islamic Equity Fund, the investors are able to invest in better avenues providing higher risk-adjusted returns using the expertise and acumen of the professional fund managers.

SCREENING CRITERIA

As stated above, these mutual funds are required to comply with a set of criteria laid out by scholars and Shariah experts. Complying with a set of criteria may seem to be a constraining factor at first thought but in actuality it has, in the past helped some Islamic funds perform better than conventional funds. The criteria have been so effective in some cases that even conventional fund managers are starting to follow the criteria.

The effectiveness of the Funds' Islamic criteria became more evident after the Enron and WorldCom scandals as Islamic investors were "out" of these companies when these companies were still "viable" entities. This was because of the debt screening criteria that Islamic funds use which led to exclusion of these companies from their universe as these were highly leveraged.

ECONOMIES OF SCALE

Like all funds, an Islamic equity fund enjoys economies of scale. These economies are visible in transaction costs as the fund managers due to their larger volumes are able to obtain lower rates than an individual investor. This lower cost entails higher returns and is ultimately passed on the investors.

DISADVANTAGES/ RISKS

Advocating only the advantages and positive points an investment avenue would be an improper analysis of the avenue. In the following, we discuss some of the disadvantages/risks that can be faced by prospective investors of an Islamic equity fund:

INABILITY TO CAPITALIZE ON PROFITABLE OPPORTUNITIES

Shariah Compliant funds are restricted to a certain extent as far as investment opportunities are concerned which means that at times the funds have to forego attractive investment opportunities which in turn has a direct impact on their returns.

Although this may not be a major cause of concern for some investors who are completely Shariah minded. In fact, this acts as major incentive for them. On the other hand, there are investors who are more inclined towards the monetary benefits and for them, this acts as a disadvantage that by investing in Equity based Islamic funds, they miss out on some Non-Shariah Compliant but profitable investment opportunities.

NON-SHARIAH COMPLIANT ACTIVITIES

The fund managers of a Shariah Compliant fund continuously stumble upon investment opportunities that can enhance the returns of the funds but are deficient in terms of their Shariah compliance. The investors in an Islamic equity fund cannot ensure that the fund managers have resisted this temptation and the returns earned by the fund are 'pure' and are free of any Haram income.

Although Shariah Audits are conducted periodically in some funds but the risk is not completely mitigated and the chances of non-Shariah Compliant practices in order to enhance returns always remains.

LIMITED DIVERSIFICATION

One of the disadvantages of any equity based fund is that its investments are concentrated in the stock market. These funds are restricted by their policies to only invest in the stock market and therefore are not able to reap the true benefits of diversification that are experienced by a fund that is diversified into different asset classes other than stocks.

FEES

As mentioned in an earlier section that the investors in an Islamic equity fund benefit from the expertise of professional fund managers but this benefit comes at a cost. The returns to the investors in an Islamic Equity fund or for that matter in any other fund are reduced due to the fund managers' fee that is deducted along with the administrative expenses from the gross returns earned by the funds.

In addition to the fund managers' fee a Shariah based equity fund may have to bear an additional fee burden as some of the funds where Shariah Advisory has been outsourced, a certain amount as a percentage of the Net Assets has to be paid to the Shariah Advisor as fee for his services.

STOCK MARKET A RISKY INVESTMENT AVENUE

The excess returns that can be earned by investing in the stock market are not entirely risk-free. In order to maintain a no-arbitrage situation in any market, it is only natural that any excess returns that are being earned also carry a higher amount of risk. If that was not the case, then all rational investors would opt for the stock market and earn a higher return than other fixed income instruments with the same level of risk.

Therefore a risk in opting for equity based Islamic funds is that the investor is exposed to the risk of adverse movements in the stock market which can lead to loss of principal as well.

GLOBAL SCENARIO

Despite the disadvantages and risks mentioned above, Islamic equity funds have received a good response internationally. This is evident from the fact that currently there are more than 100 Islamic equity funds worldwide. These funds are not limited to Islamic countries but are found all around the world including United States of America, United Kingdom and other major European and Asian countries. The total assets managed through these funds currently exceed US$3 billion. With the continuous interest in the Islamic financial system, there are positive signs that more funds will be launched. Some major Western companies have already joined the fray and some of the others are thinking of launching similar Islamic equity products.

These funds all over the world observe the criteria as laid out by the Shariah advisors of the respective funds. As a result, we see that these funds have been more inclined towards the technology, health care and energy stocks as these stocks generally fulfill the pre- requisite conditions for investment.

Regarding the market for such funds, the major market for such funds has been the Middle East and the estimated size of that market is around US$ 800 billion. This figure is only an estimate as derived by calculating the assets of high net worth individuals of the Middle East regardless of their investment preferences. The exact size is obviously very difficult to estimate but potential for such funds is huge if we also include the retail investors. Fund managers around the world have begun to recognize this and have designed funds that are specifically targeted to this segment of the market.

LOCAL SCENARIO

As mentioned above Pakistan being one of the major Islamic countries of the world and with its current interest rates scenario and additional emphasis on Shariah holds great potential for Islamic financial products. This increased attention towards the equity market coupled with the above mentioned consumer awareness and the apparent benefits of investing through a mutual fund points to a bright future for Islamic equity funds.

This demand for such product has largely been unmet in the past but recently the increased potential has led to the introduction of two Islamic Funds being launched in the market, i.e. Unit Trust of Pakistan Islamic Fund (commonly known as UTP Islamic Fund) sponsored by Abamco and Meezan Islamic Fund (MIF) sponsored by Meezan Bank Limited through its subsidiary Al Meezan Investment Management Limited.

The response to these funds has been highly encouraging and both these funds have been able to attract the attention and the funds of the investors. The response to these funds can be judged by taking a look at the amount of funds that they have been able to attract in a short period of time.

Fund

Launch Date

Fund Size as of
30th June' 04*

UTP Islamic Fund

26th December 2002

Rs.642 million

Meezan Islamic Fund

8th August 2003

Rs.1, 311 million

Total

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Rs.1, 953 million

*Figures rounded off

 

 

Encouraging welcome of these funds by the investing public of Pakistan has led to increased attention towards this sector by the Asset Management Companies and as a result a few projects are already in the pipeline and are expected to hit the market in the near future. Such funds are expected to come in with diverse trading strategies such as income funds, growth funds etc.

The launch of such funds will no doubt add to the investment options available to the investors specially the retail investors who are more conscious of Shariah compatibility when selecting their investment avenues. In addition such finds might just prove to be one of the initial stepping stones in Islamization of our financial system as such funds channel the retail funds towards Shariah compliant avenues.