As the scale of the disaster in the global financial industry has become increasingly apparent, so the perceived attractions of the Sharia financial industry, which is worth more than $700 billion globally, has come into focus. The theory is that it has been less affected than the conventional sector because it has not been exposed to losses from investment in toxic assets and has not operated business models which are dependent on wholesale funds – not least because it is prohibited from gaining exposure here by Islamic, or Sharia, law.
There is unquestionably some truth behind this contention, although unfortunately UK investors have few credible ways to play the story. Both the listed companies in this space, Islamic Bank of Britain (IBB:AIM) and European Islamic Investment Bank (EIIB:AIM) have proved poor investments so far. In addition the government has, at least for the time being, abandoned mooted plans to launch a sovereign Sukuk – the Sharia equivalent of a bond. This leaves the potential option of buying a Sharia-compliant Exchange Traded Fund (ETF).
Strict rules
While Sharia law prohibits the use of interest it is important to understand Islamic banks are not entirely immune from the underlying economic environment, falling interest rates or declines in property and real estate prices.
Sharia also prevents investment in businesses that provide goods or services considered contrary to its principles. These are known as Haraam or ‘forbidden,’ and include mainstream banking, gambling, alcohol and pork-related products. This has led some to flag Sharia finance’s appeal to non-Muslim ethical investors but there is currently no measure of how big this market potentially is, or how successfully it is being tapped.
Islamic law also stipulates transactions must be backed by real assets though increasingly Islamic finance uses a number of different instruments to facilitate a system of banking closer to that of the West. These have attracted varying degrees of controversy, with some debate over whether or not they are in accordance with the spirit if not the letter of Islamic law. They include the Sukuk, mentioned above, and Wa’d promise agreements. All Islamic financial institutions have a Sharia Supervisory Committee which in theory ensures its products are in line with Sharia law.
Mortgage alternatives
In addition to the Sukuk and Wa’d, Sharia offers alternatives to traditional mortgage transactions, the most widely used are known as Murahaba and Ijara. The former is a type of credit which enables customers to make a purchase without having to take out an interest bearing loan. The bank buys an item and then sells it on to the customer on a deferred basis. Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back over a specific period. There is also a Sharia-compliant form of insurance known as Takaful although this is still in the very early stages of development. Principle Insurance became the first FSA-approved independent Takaful company in the UK last year.
Britain is the leading market in the West for Sharia finance, with £18 billion worth of assets, but it is still fair to say the industry as a whole is still in an embryonic state. There are five fully compliant banks in the UK that are FSA-approved, 18 Sukuks, raising $10 billion, listed on the stock market and seven Sharia-compliant ETFs.
In addition around 17 conventional banks in the UK have set up windows in the UK to provide Islamic financial services. This includes the HSBC (HSBC) Amanah. Its assets under management account for 87% of the UK’s identified assets.
As noted earlier, neither of the UK’s quoted companies in this space, European Islamic Investment Bank and the Islamic Bank of Britain, have been a particularly good performer since floating. IBB, which has around 70,000 customers, came to the market in 2004 and at 7.85p the shares stand 76% below the issue price. They have performed better in the last few months, up 45% since February, but it again produced a multi-million pound loss last year. Recently released results revealed a pre-tax deficit of £5.91 million, and the group says the date at which it will break even will be delayed by low interest rates.
Not immune to downturn
While this may seem perverse in a Sharia-compliant bank – which by its very nature has no direct exposure to rates – the group’s investment in commodity markets is affected by the level at which interest is charged. It is also, as the group’s head of marketing Steven Amos concedes, affected by the downturn in the UK economy. He says the group’s failure to record a profit should not come as a surprise given the significant fixed costs involved in starting up a banking franchise. ‘We’re very positive about the future. We are attracting plenty of new customers – some of which are non-Muslims – and are benefiting from being seen as an ethical bank’
EIIB, the first licensed Sharia-compliant investment bank in the UK, has an even worse record than IBB since coming to the market in 2006.
At 3.18p the shares are off 87% with the group struggling to establish itself and the numbers for 2008, released in February, revealed a one-off £15 million write down on property losses .
Baron Junaid Bhatti, chairman of Islamic Finance Week, acknowledges the performance of these listed entities has been disappointing: ‘IBB and EIIB have definitely performed well below their potential. There are numerous reasons for the poor performance by the UK’s two listed Islamic banks. A simplified explanation would be that they have simply failed to provide their target customers with an attractive alternative to the conventional banks.’
Junaid still believes Islamic banks are at an advantage because of their relative stability and the fact they do not trade in debt, futures or options. He notes that by contrast with EIIB and IBB: ‘...the currently-unlisted UK Islamic banks are faring far better and have leveraged their connection to the Persian Gulf very efficiently in order to secure funding and investment.’
The three unquoted operators are the Bank of London and Middle East, which offers Sharia compliant investment and corporate banking to businesses and high net worth individuals across the globe; European Finance House, a unit of Qatar Islamic bank; and Gatehouse Bank, a wholesale investment bank operating in capital markets, institutional wealth management, Treasury business and advisory services.
Junaid also thinks the government, which has been enthusiastic about encouraging the growth of Islamic finance in the UK, will eventually reconsider its recent decision not to launch a sovereign Sukuk in the wholesale sterling markets.
‘The decision not to launch Sukuk has a lot to do with the current political and economic situation, and I believe that it is only a matter of time before sovereign Sukuk becomes a reality in this country. The government simply cannot afford to ignore the lure of billions of dollars of Mid-East liquidity finding a home in the UK.’
ETF angle
Another potential way to play the Sharia compliant story is through ETFs. db-x trackers offer four products that fit this niche: DJ Islamic Market Titans 100 (XIMT), S&P 500 Sharia (XSHU), S&P Europe 350 Sharia (XSHE) and the S&P Japan 500 Sharia (XSHJ).
Although the value of these funds has fallen they have still outperformed their non-Sharia equivalents. The S&P 500 Sharia Index fund is down 26.4% over the last six months while the straight S&P 500 Index fund is down 31.7%. Over the last year the former is down 30.3% and the latter 37.5%. Much of this outperformance can be attributed to the fact the Sharia-compliant products do not include financials.
Manooj Mistry, the head of db x-trackers UK, explains how they work: "The way the products are constructed is on two levels. The first level relates to the index itself – there are S&P and Dow Jones indices which comply with Sharia investment principles. They exclude companies which are involved in things like alcohol, gambling and pork related products. A second filter looks at the financial health of a company.
‘The second level is reflected in the way we have constructed the ETF to meet Sharia requirements - making sure it doesn’t fall foul of any of
the restrictions.’
Mistry explains this is achieved through the use of a Wa’d promise agreement. He admits the products have not been hugely popular thus far: ‘To be honest the products haven’t seen a great take up due to a combination of factors. They were launched in August last year, which was a difficult time for financial markets and people aren’t investing as much as they were. Also there is still a lack of awareness about ETFs in general and in particular with Sharia compliant ETFs which are a niche area. It will take some time to address this.
‘If you look at the Sharia market in general it is still quite small. In the short-term we will continue to raise awareness and build interest in products, but in the future we will look to develop this area.’
His comments reflect the fact Sharia finance has yet to fully develop the potential offered by the two million Muslims who live in the UK. Yet with such a large addressable market Sharia could still establish itself and provide investors with a valuable
alternative investment.
