Monday, July 30, 2012

Where is the Islamic ETF growth?

One of the puzzles of Islamic finance is why Islamic ETFs have not seen a corresponding growth to the rest of the Islamic finance universe.  A Reuters article tackles the subject and suggests that it is the incentive structure in how financial products are distributed in the GCC, the largest market for Islamic finance.  Reuters describes:
In the Gulf, institutional investors are usually catered to by placement agents and fund marketers, not financial planners. These agents, who charge commissions on their sales, prefer to sell private equity, hedge funds and real estate, where margins are higher for them - a hedge fund can charge a 2 percent management fee and a 20 percent performance fee.
That is, the distribution of financial products are run much more along a brokerage model, which is how financial products were overwhelmingly distributed in the the US, and still are to some degree.  However, the rise of investment advisors, who are not reliant on commissions for determining investments, and a general growth in discount brokerages (which has made many investors more cost conscious) has made the relatively cheap, passively managed ETFs more popular.  The investment advisor model is not as prevalent in the Gulf, but Tariq Al Rifai of Dow Jones Indexes says "At some point it will take off...Give it another three years."

However, one of the areas that Reuters only mentions in passing is:
"One attraction of ETFs is that they can provide investors with access to themes that have a low correlation with equities markets. But Islamic ETFs focused on asset classes other than equities have yet to appear, even though major index providers offer large families of sharia-compliant indexes."
Many of the ETFs that provide investors with alternative investors, whether those are hedge funds, individual commodities, and a number of other asset classes (e.g. the VIX index) do not hold the underlying assets themselves, but instead use swaps and other derivatives to gain exposure, either as ETFs or Exchange-Traded Notes which expose the holders to the credit of the issuer and provides return based on the performance of an underlying index. 

The asset classes beyond equities represented by ETFs and ETNs have attracted controversy (ETFs, ETNs) because they are not doing what a normal fund would do--hold a diversified portfolio of investments directly in the fund.   They would also be more difficult to create Islamic versions of, so it is neither clear whether there would be a demand for these products or if they would provide a valuable product for Islamic finance to endeavor. 

In particular, many are leveraged products, and all are designed to be trading vehicles, since they tend to decay in their underlying values regardless of the performance of the underlying indices.  Encouraging extra leverage and frequent trading is likely to not be something that will get favor from Shari'ah scholars approving these products. 

As for plain-vanilla equity ETFs that actually own a portfolio of equities, they may have their day, but it is clearly not upon us yet. 

5 comments:

Yvette Mann said...

They are not doing what a normal fund would do. That's the problem. They are just making everything complicated. The goal is too simple actually.

Blake Goud said...

I think so far the Islamic ETFs available are simple and it hasn't gotten into the realm of complexity of some of the conventional ETFs. The distribution model that makes ETFs appealing is the biggest thing holding back ETF growth and that will come with time, just as it did in the US/EU.

Khaled Sultan said...

Unfortunately, Shariah compliant ETFs are not as widely available as they ought to be (at least in Canada). The process of building ETFs that adhere to pre-defined restrictions on fixed income as well as cash and debt levels is very straight forward. It's likely a question of demand, or its lack-thereof. I think it's in the best interest of investors (and hence their advisors) to have access to compliant ETFs.

Blake Goud said...

Khaled,

I think you are right--the screening process is easy (although it is much more difficult to create a fixed income ETF due to the lack of available, liquid sukuk). The challenge is finding enough size to get the expenses down low enough to differentiate the product from mutual funds (and to have a way to distribute the product to build to that scale). That was the challenge that the Javelin ETF never was able to do, grow large enough, fast enough. Someone will, but it might take a change in the process of distributing products in a big market in the GCC.

Khaled Sultan said...

We need more Shariah compliant investment advisors I guess :)