Chapter 11

Introducing the Islamic Capital Market

In This Chapter

Getting some historical perspective

Following specific investment criteria

Fulfilling investor objectives

Locating the Islamic capital market

Putting money into equities, bonds, ETFs, and more

Examining some major Islamic capital markets

In conventional finance, investments are generally monetary assets that an investor purchases to earn income or to achieve a capital gain by selling them for a higher price in the future. Monetary assets include cash as well as pledges to receive income in the future. An investment can be as simple as a savings account at your local bank or as complex as a foreign exchange derivative or a deep-in-the-money naked call (which isn’t nearly as naughty as it sounds).

Islamic investments function the same way as conventional investments, but the investment activities must follow Islamic law (see Chapter 1). Islamic investment involves putting money or assets into appropriate vehicles to acquire income or capital gain in a sharia-compliant manner.

Investment activity benefits everyone by making capital available to entrepreneurs, businesses, and governments to undertake economic activities. Without this activity, the wheels of an economy would stop turning. Investments allow economic systems to transfer surplus funds from individuals and businesses to projects that need capital resources, and both sides — the entities that have surplus funds and the entities that need them — benefit. Islam not only recognizes the importance of such economic activity but also prohibits the hoarding of money. After all, surplus funds can benefit society only if they’re put into circulation.

Islamic investing is one form of socially responsible investing, which is a broad term that refers to making investment choices in support of companies whose activities mesh with your values (and avoiding supporting companies whose activities clash with your values). In this chapter, I point out the criteria an investment must meet to be sharia-compliant, the objectives of investors, and the growth and potential future of the Islamic capital market. (If you want to find out more about socially responsible investing in general, you may want to pick up Socially Responsible Investing For Dummies by Ann. C. Logue, MBA [Wiley].)

The term capital market refers to any financial market where debt and equity are demanded and supplied. A capital market helps investors find a platform for making their investments and helps both borrowers and investors by channeling funds from those with excess funds to those in need of such funds. Businesses and governments raise funds in the capital market.

Simply put, the Islamic capital market is where sharia-compliant financial assets are transacted. It works parallel to the conventional market and helps investors find sharia-compliant investment opportunities.

Eyeing the Origins of the Islamic Capital Market

When the oil industry boomed during the 1970s, quite a few people in the Middle East accumulated a lot of wealth. Starting in the early 1980s, these high net worth individuals began to look for sharia-compliant investments to leverage and grow their wealth. They created a demand for investment opportunities, and Islamic banks and the Islamic windows of Western banks slowly began to develop the products and infrastructure to serve these individuals.

In Chapter 3, I explain that you can trace the history of modern Islamic financial institutions back to the 1970s. However, the literature on the history of the Islamic capital market isn’t crystal clear. Some researchers propose that the capital market emerged in the 1990s with the introduction of Islamic bonds and Islamic funds. But Islamic funds actually started before that time — and surprisingly enough, not in a Muslim country but in the United States.

Pioneering Islamic investment funds

The first Islamic fund, the Amana Income Fund (AMANX), was established by the North American Islamic Trust (NAIT) in June 1986. NAIT is an Indiana-based nonprofit organization that was established in 1973 to oversee the funding of Islamic centers in America. (That’s right; the first documented Islamic fund in the world came from the state of Indiana!)

The Washington state–based Saturna Capital Corp. now manages AMANX and two other Amana funds that are sharia-compliant. This pioneering product is still on the market and performing well after celebrating its 25th anniversary in 2011. AMANX has received the highest Lipper Ratings (see www.lipperweb.com) for its total return and tax efficiency. For much more information about AMANX and the other two Amana funds, visit www.amanafunds.com.

A second Islamic fund was created in 1991: the Mendaki Growth Fund, which was initiated in Singapore. The growth was fast and furious after that. In 1992, 8 Islamic funds were in operation, and by 2000, that number was 92. Today, approximately 350 Islamic mutual funds and unit trusts are operating (for more on these products, see “Understanding the Islamic unit trust and mutual funds market” later in the chapter).

Opening the door for Islamic bonds (sukuk)

Another important component of the Islamic capital market is Islamic bonds, or sukuk, which I explain thoroughly in Chapter 13. Structured and well-defined Islamic bonds such as those you find on the market today were introduced after 1990, but the first Islamic bond (called a muqarada bond) was introduced in Jordan by the Jordan Islamic Bank in 1978. The Pakistani government then introduced a law favoring Islamic bonds. But these early efforts to jump-start the Islamic bond investment industry were fruitless because they lacked infrastructure and transparency.

The first government-issued Islamic bond came from Malaysia in 1983. Called the Government Investment Issue (GII), this bond was based on the Islamic contract qard hasan (which I explain in Chapter 10). But per sharia, GII couldn’t be traded in the secondary market because it represented an outstanding debt.

Malaysia started the first true Islamic bond market by issuing approximately U.S. $30 million of sharia-compliant bonds from a non-Islamic company, Shell MDS, in 1990. The industry saw only a few Islamic bond issuances after that until the government of Bahrain issued the first international sovereign sukuk in 2001. This event opened the door for additional international issuance of sukuk, which you can read about in Chapter 13.

Meeting demand for additional market instruments

The Islamic capital market has very recently developed more instruments to meet the demand for sharia-compliant products as alternatives to conventional investment products. For example, you can now find Islamic exchange-traded funds, Islamic real estate investment trusts, and an Islamic derivatives market (including a swap market). Later in this chapter, I tell you more about these product niches.

Adhering to Criteria for Islamic Investments

To qualify as a sharia-compliant investment, an activity or a financial asset must be allowed per Islamic law. Islamic scholars determine which investment activities are prohibited and which are permitted. As I note throughout this book, not all scholars agree on all points. However, the information I provide in this section is broad enough that I’m comfortable saying that most Islamic scholars agree with it. In Chapter 12, I offer much more detail about how scholars screen potential investments for sharia compliance.

Conventional financial institutions — and the investments they offer — involve three key activities that are prohibited in Islam: interest, gambling, and speculation. (If you doubt that conventional financial institutions partake in gambling and speculation, think about how stable your 401[k] was in 2008 and 2009.) The key reason that Islamic financial institutions and investments exist is to help Muslims adhere to their religion’s principles and to avoid financial transactions that involve these prohibited elements.

As I explain in Chapter 1, Islamic law prohibits participating in certain industries or supporting certain activities. The following sections explain how the prohibitions play out when it comes to investing.

Fleeing from forbidden industries

Most of the industry investments that Islam prohibits seem pretty obvious; you probably aren’t shocked to find that prostitution isn’t sharia-compliant. Here’s an overview of the industries Islamic investments must steer clear of:

Gambling: Muslims can’t invest in companies or activities that support gambling. In addition to prohibiting investments that would themselves involve too much risk, this criterion also means that an investor can’t support the construction of a casino; the operation of a lottery; or the promotion of horse and dog racing, Internet gambling, and so on. Leasing an investment property to a company that conducts a gambling-related business is also banned.

Pornography, prostitution, and the adult-entertainment industry: Islam considers the pornography, prostitution, and adult-entertainment industries to be harmful to society. Therefore, an investor can’t put money into a venture that involves products or businesses in these fields.

Specific food and beverage products: Some products in the food and beverage industry are prohibited because Islam prohibits their consumption. Foods and beverages that Muslims can consume are called halal. Forbidden items include

• Pork: The Quran (the holy scripture of Islam) prohibits consuming pork and pork-based products (as well as any other meat that isn’t slaughtered according to Islamic principles), so investing in companies dealing with pork-based products isn’t acceptable.

• Alcoholic beverages: Investing in companies involved in alcoholic products is also banned because the Quran specifically bans “intoxicants” (see Chapter 2).

• Tobacco: Islamic scholars hold the opinion that tobacco isn’t good for personal health and therefore believe that Islamic standards prohibit investments in tobacco-related business.

Illegal drugs: Investing in any company or activity that supports the sale, distribution, or use of illegal drugs is also prohibited. (In fact, investing in a way that promotes any illegal activity goes against Islamic law.)

Forgetting about financial market trading

Some types of financial market activity, such as margin trading, day trading, options, and futures, are considered gray areas in Islamic law. The majority of Islamic scholars believe that sharia law prohibits these transactions because the activities involve interest, speculation, and excessive risk without market knowledge. The later section “Discovering the Islamic derivative market” can help you better understand these prohibitions. Here’s a quick refresher about each type of activity and how it fails to follow sharia law:

Margin trading: In margin trading, you buy stocks by getting a loan from your broker. (The broker charges you interest on the loan.) In addition to the interest itself being problematic, the risk involved with this type of activity is extremely high. If you invest the loaned money in a stock that loses value, you may find yourself unable to pay back the money you’ve borrowed and the interest you owe your broker for providing the loan.

Day trading: From the Islamic perspective, day trading in the stock market isn’t actually an investment activity because the person doing it isn’t concerned about the underlying product or economic activity being supported. Instead, day trading is just a transaction based on observing the market price fluctuations on a given day. Of course, it involves a substantial amount of risk because the day trader is essentially gambling that the price of a certain stock is going to rise or fall on a given day. This makes day trading a no-no from a sharia perspective.

Options: A financial contract is sold by the option writer to another party, giving the second party the right to buy or sell a specific financial asset at a fixed price on or before a certain date. In other words, the second party is given the chance to buy or sell without an obligation to buy or sell.

In theory, options are used to reduce investment risk. However, they themselves are highly risky and speculative in nature. The majority of Islamic scholars agree that options have features of speculation and gambling. In addition, the investor (second party) doesn’t intend to hold the asset (which is generally considered crucial for an investment to be sharia-compliant). Based on these characteristics, most Islamic scholars believe that options are prohibited investments.

Futures: A financial contract to buy or sell financial assets or commodities on a future date is traded on future exchanges. The basic difference between futures and options is this: In a futures contract, both the buyer and seller are obliged to perform the contract; an options contract is optional and can be allowed to simply expire, unused.

Respecting Investors’ Objectives

All investors, conventional and Islamic, share some fundamental objectives when making decisions about where to place their money. Obviously, a primary objective for the Islamic investor is to support activities that are sharia-compliant. But in addition, investors likely want to fulfill one or more of the objectives I discuss in this section.

Searching for safety

In reality, very few investments come with a 100-percent guarantee of capital preservation. Outside of a savings account, which may be backed by government insurance (such as the Federal Deposit Insurance Corporation [FDIC] coverage in the United States), you’re taking some risk any time you invest.

With that said, your specific investment choices are based on the amount of risk that you’re willing to take in order to achieve a desired return. Conventional investors are generally encouraged to craft investment portfolios that feature a range of investments that boast varying levels of capital risk. The idea behind such a portfolio is that when one type of investment (such as a high-risk international stock fund) isn’t performing well, another type of investment (such as a lower risk domestic corporate bond fund) may shine. The investor essentially tries to reduce his overall risk by spreading his money across a spectrum of risk/return scenarios.

Because sharia compliance requires that Islamic investors avoid interest, gambling, and speculation, you may assume that Islamic investments provide a guarantee of safety that’s greater than that of conventional investments. In addition to trying to dilute risk within their own portfolios by mixing and matching types of investments, Islamic investors do find a degree of safety in the nature of the investment products themselves. That’s because Islamic financial institutions try to offer products that mitigate risk and spread risk across a wide spectrum of investors. However, Islamic investors — like conventional investors — assume risk every time they invest. They don’t get any guarantees.

Hoping for worthwhile returns

Very rarely does anyone invest money without expecting a return. Even in Islamic and other types of socially responsible investing, the people fronting the money want and expect to get some reward for the financial risks they take. That reward may be a set return (such as a fixed amount of interest for a conventional investment) or an unknown yield (such as a share of the profit from investing in a certain project or activity).

Seeking capital gains

Aside from returns, many investors seek to profit from capital gains on the value of the investment assets themselves over time. Capital gains are achieved by selling the assets at a higher price than the purchase price. Common stocks are generally preferred financial assets for the investor who wants to achieve capital gains.

Islamic equity funds are based on sharia-compliant stocks. Because day trading is generally not allowed for stocks (see the earlier section “Forgetting about financial market trading”), the term capital gains in an Islamic fund refers to long-term gains. Islamic fund management companies that create equity funds focus on long-term gains more than their conventional counterparts, which may use day trading to try to achieve short-term capital gains. Capital gains in both Islamic and conventional funds are distributed among the fund’s investors.

Maintaining liquidity

Investors also consider the liquidity of financial assets when making investment decisions. The more liquid an investment asset is, the more easily it can be turned into cash and used for emergency needs or invested in something profitable. Assets in the form of common stock are highly liquid, for example, but assets as fixed-term deposits are very illiquid.

Like all investors, people investing in Islamic assets need to manage liquidity so they can feel confident about meeting their current and future financial obligations. However, investors in the Islamic capital market face two issues that investors in conventional assets don’t face:

Islamic product development is slow compared to conventional product development. As a result, Islamic investors don’t have as many highly liquid investment options as conventional investors do. This delay exists for two reasons:

• The market share for Islamic investments is still small compared to the conventional capital markets. The Islamic investment field is so young that many people don’t know about it yet. As knowledge increases, demand will increase as well, which will spur faster product development.

• Islamic investments must comply with sharia, which requires screening processes (outlined in Chapter 12) and debate among scholars that can be quite time-consuming.

Investors sometimes lack access to the Islamic capital market. For example, because of a lack of financial infrastructure, a customer in Canada may not be able to access the U.S. Islamic asset market as easily as she can access the conventional market. If she lacks market access, she lacks the ability to turn her investments into cash as quickly as she can in the conventional markets.

Shopping at the Islamic Capital Market

Just as conventional financial assets are sold in the conventional market, Islamic assets are sold in the Islamic capital market. And because of increasing global awareness about sharia-compliant investing, more and more investors are turning to the Islamic capital market. This point is crucial: The Islamic capital market is open to any investor who wants to achieve the objectives involved in the capital market. Non-Muslim customers are active participants in the Islamic capital market. Participants include high net worth investors, corporations, and governments.

The increase of wealth among Muslim investors (especially from nations that are part of the Gulf Cooperation Council — Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates) is also spurring growth in the Islamic capital market. The market’s current growth is between 12 and 15 percent annually. In total, Islamic assets are worth an estimated $1 trillion at the time of this writing, and about 25 percent of that amount is tied to the Islamic capital market.

Where, exactly, is the Islamic capital market located? In many of the same places you’d find the conventional capital market. Islamic capital market instruments are traded on many of the world’s leading exchanges (where conventional market instruments are traded as well). Following is a sampling of just six of the many exchanges that currently trade Islamic capital market instruments: NASDAQ Dubai, Bursa Malaysia, the London Stock Exchange, the Labuan International Financial Exchange, the Luxembourg Stock Exchange, and Tadawul (the Saudi Arabian stock exchange). Right now, no Islamic-only exchanges exist.

NASDAQ Dubai

NASDAQ Dubai is an international capital market exchange serving the West, Middle East, Europe, and East Asia. It’s not exclusively an Islamic capital exchange but does transact Islamic investment products. NASDAQ Dubai is used as an exchange for Islamic securities both regionally and internationally. NASDAQ Dubai is considered to be the largest exchange for sukuk in the Middle East (based on their listed values); I discuss sukuk in Chapter 13.

The following securities are traded on this exchange:

Sharia-compliant equities (stocks), which provide capital to companies.

Islamic funds (mutual funds and unit trusts), which pool funds from investors for the purchase of various investment products. I discuss Islamic funds later in this chapter.

Islamic exchange-traded funds (IETFs), which are pools of equities, bonds, or commodities that trade similarly to stocks. I discuss IETFs later in this chapter.

Islamic real estate investment trusts (IREITs), which are sharia-compliant property trust funds. These funds invest in physical real estate via stocks of companies whose primary business is real estate.

Bursa Malaysia

Bursa Malaysia (MYX) is an exchange holding company that offers capital market products, including sukuk, sharia-compliant equities, IETFs, and IREITs. In addition to the Islamic offerings, this exchange also offers conventional capital market products such as equities, derivatives, and bonds. Almost 1,000 companies are listed on Bursa Malaysia.

In 2006, Bursa Malaysia and FTSE Group jointly introduced the FTSE Bursa Malaysia Index: a series of indexes that measure how the major segments of the Malaysian market (including sharia-compliant equities) are performing. In 2009, Bursa Malaysia introduced Bursa Suq Al-Sila, a sharia-compliant commodity trading platform that is dedicated to facilitating Islamic liquidity management.

London Stock Exchange

The London Stock Exchange (LSE), one of the largest stock exchanges in the world, transacts Islamic assets including sukuk, equity funds, and IETFs. To date, the LSE has supported 31 sukuk (Islamic bond) issues worth U.S. $19.5 billion.

Also, LSE owns a submarket — the Alternative Investment Market (AIM) — that was created to help small companies stay afloat in a more flexible regulatory environment. The AIM has listed four sharia-compliant companies so far: the Islamic Bank of Britain, European Islamic Investment Bank, The Family Shari’ah Fund, and Shariah Capital, Inc.

Labuan International Financial Exchange

The Labuan International Financial Exchange (LFX) is a Malaysian-based offshore exchange operating in Labuan IBFC. (The IBFC stands for International Business and Financial Centre, and it’s located on an island called Labuan off the coast of East Malaysia.) This Internet-based exchange launched in 2000 and operates 24/7. Currently, LFX is attracting a substantial number of Islamic capital investors. U.S. $100 million worth of corporate bonds have been issued from LFX so far. Islamic investment instruments comprise 38 percent of the exchange’s total market capitalization.

Luxembourg Stock Exchange

In 2002, the Luxembourg Stock Exchange became the first European exchange to issue sukuk (the Islamic version of bonds). So far, 16 sukuk have been traded on this exchange. As of September 2010, 37 sharia-compliant funds had also been established on this exchange.

Tadawul (the Saudi Arabian stock exchange)

The Saudi Arabian stock exchange, referred to as Tadawul, transacts Islamic capital market products such as equities, IETFs, sukuk, and mutual funds. Tadawul is the only stock exchange in Saudi Arabia and is supervised by the Capital Market Authority. At the end of 2011, 150 companies were listed on this exchange; these companies operate in various industries, including oil and gas, agriculture, food, technology, banking, and other financial sectors.

Tapping into the Islamic Equity Market

Equity markets (where stocks are traded) are crucial to any economy because they provide capital to companies. The Islamic equity market is where sharia-compliant stocks are traded. (In Chapter 12, I explain how to check the sharia compliance of a particular stock.)

Although some investors may opt to purchase stocks from individual companies via the exchanges I discuss in the preceding section (or via equity brokers), the majority of Islamic investors (especially those with modest portfolios) make equity purchases by using Islamic funds, such as unit trusts, mutual funds, or ETFs. Here are the key reasons:

Islamic equity funds are pre-screened for sharia compliance, so the investor has assurance that his money is being invested according to Islamic law.

Investing in funds is easier than accessing the exchanges directly in order to make stock purchases.

Fund investment is less risky than investment in individual stocks because funds offer instant diversification.

For all these reasons, my focus here is on equity funds rather than individual stock purchases.

In this section, I briefly explain how Islamic equity funds are managed, the benefits and drawbacks of investing in Islamic equities versus conventional equities, and the Islamic indexes that have given this equity market greater international exposure. I also introduce some types of Islamic equity funds worth knowing about: unit trusts, mutual funds, and exchange-traded funds.

Managing Islamic equity funds

Fund management companies form Islamic equity funds by pooling investors’ money and investing it in sharia-compliant stocks. These funds have access to both regional and international markets.

Generally, fund management occurs in one of two ways:

The fund management company works as the representative or agent of the investors. The fee the company charges can be a set fee agreed upon in advance, or it can be based on a percentage of the net asset value.

The fund management company enters into a partnership agreement with the investors based on a mudaraba contract (see Chapter 10). Here, the managers are the working partners of the partnership. The profits (or losses) from the fund are shared by both parties based on the partnership agreement.

Weighing pros and cons of investing in Islamic equities

Obviously, for a Muslim, the primary benefit of investing in Islamic equities is assurance that the funds are purchasing only sharia-compliant assets. But non-Muslim investors are also attracted to Islamic equities, so the benefits go beyond the religious. Here are some other advantages of investing in Islamic equity funds:

Transparency: Investors in Islamic equity funds expect a high level of transparency. After all, if one of a fund’s key objectives is to comply with sharia, the fund managers must be quite open about which industries and companies they invest in. The same isn’t always true with conventional mutual funds, whose investors sometimes aren’t even aware of which industries (let alone which specific companies) their money is supporting at any given time.

Financial screening: I explain in Chapter 12 that part of the screening process for determining whether an equity asset is sharia-compliant involves considering a company’s financials, including how much debt the company carries. Islamic equity funds avoid investing in firms that carry very high levels of debt. Therefore, Islamic funds may be considered more conservative and slightly less risky than some conventional equity funds.

Diversification: Investing in any fund (Islamic or conventional) that purchases assets from multiple companies reduces the risk of losing capital when disaster strikes and a company declares bankruptcy or closes its doors. In other words, a fund provides portfolio diversity that investing in a handful of individual equities can’t offer.

Liquidity: For the Islamic investor, a benefit of investing in a fund versus putting money into a fixed-term investment (such as a mudaraba or musharaka contract, which I explain in Chapter 10) is liquidity. When situations change and the investor wants or needs to cash out, doing so is much easier when the investment is in a fund.

The main drawback to investing in Islamic equities is the limited options. Whereas investors in conventional equities have so many choices that they can tailor a portfolio to meet any investment objective, investors in Islamic funds have significantly fewer funds to choose from.

As I point out earlier in this chapter (and in Chapter 3), the Islamic finance industry in general and the capital market in particular are very new compared with their conventional counterparts. In part, the reason the Islamic equity market is still in its infancy is that Muslims had to create from scratch a screening process that would assure sharia compliance. Not too long ago, many sharia scholars considered all stocks to be prohibited investments because no one had undertaken analyzing stocks for sharia compliance. Only in the 1990s did a screening process finally emerge. So truly, the Islamic equity market has just been born, and it has a long way to go before it can offer a diversity of investment options rivaling conventional equity markets.

Going international with Islamic indexes

The emergence of Islamic stock screening processes facilitated the development of Islamic indexes. (I cover the importance of indexes in Chapter 4.) The first-ever Islamic index was launched by RHB Unit Trust Management of Malaysia in May 1996.

The year 1999 saw the birth of several such indexes as the Islamic equity market really started to come into its own. That February, Dow Jones Indexes introduced the Dow Jones Islamic Market Index (DJIMI), which instantly boosted international recognition of the entire Islamic finance industry. Later that year, Bursa Malaysia introduced its Islamic index, the Kuala Lumpur Shariah Index (KLSI); and the FTSE Group launched the FTSE Global Islamic Index Series (GIIS). Not long afterward, Standard & Poor’s came out with the S&P Shariah Index Series.

Understanding the Islamic unit trust and mutual funds market

An Islamic unit trust or a mutual fund is a type of equity fund that collects funds from investors and pools them for investment in stocks, bonds, or other investment products. The return from the investment is paid back to the investors proportionately after deducting the cost related with the fund and the administration fee, or the fund’s portion of the profit (depending on the contract used). These funds are similar to their conventional counterparts but differ in their mode of financing and in the nature of their investments (which must, of course, be sharia-compliant).

In reality, many Islamic fund management companies use the terms unit trust and mutual fund interchangeably (or use just one term to refer to all fund products). For example, in Malaysia, all Islamic funds are called unit trusts. In the United States, they’re all called mutual funds. However, I want to point out that in theory, a difference exists between the two terms:

Unit trusts generally have a fixed term of one, two, or three years. Also, they generally manage a fixed portfolio of stocks, bonds, and other investments, which means that the trust doesn’t buy and sell assets in the market.

Mutual fund investments include stocks, bonds, and money market instruments. Mutual funds do not hold a portfolio in fixed instruments; instead, the mutual fund managers take an active role in diversifying investments and trading assets on the exchanges. Also, mutual funds don’t tend to have a fixed term.

Islamic unit trusts and mutual funds are managed per one of the following three Islamic contracts (which I discuss in detail in Chapter 12):

Mudaraba: Most of the funds work on a partnership basis. The fund manager is the working partner, and the investor is the silent partner. The fund profits are distributed among the partners, but only the investor loses the initial capital if the venture is unsuccessful. (The working partner loses any time and effort it’s invested.)

Ijara: The fund management company purchases assets (such as real estate and vehicles) and leases them out to users. The company collects rent for each asset, pools it, and distributes it among the investors.

Murabaha: The fund management company uses investments to purchase assets. It then sells the assets on a cost-plus-profit basis, and the profits that it collects are pooled and distributed among the fund investors.

As I explain in the earlier section “Pioneering Islamic investment funds,” the world’s first Islamic mutual fund (Amana Income Fund) was established in the United States in 1986. The number of Islamic funds grew exponentially in the 1990s, from 8 funds in 1992 to 95 funds in operation in 2000.

The first Islamic unit trust was formed by AmBank Group of Malaysia in 1993. Approximately 55 Islamic unit funds now exist, and they’re particularly strong investment products in Malaysia.

Currently, estimates indicate that more than 350 sharia-compliant investment funds — both unit trusts and mutual funds — are established globally.

Investing in Islamic exchange- traded funds (IETFs)

Exchange-traded funds are open-ended fund pools that may be composed of stocks, bonds, and/or commodities. Initially, only institutional or authorized investors bought and sold ETFs; these days, individual investors have easy access to these funds and make up a good chunk of the market. ETFs are listed on the traditional stock exchanges, and investors buy and sell them in units (just as they buy and sell stocks). Many ETFs are designed to track traditional stock indexes, such as NASDAQ or the S&P 500; others track indexes created by fund issuers.

Islamic ETFs (or IETFs) bear all the features of conventional ETFs but are sharia-compliant. IETFs depend heavily on the sharia screening process (which I explain in Chapter 12). IETFs are very attractive investment instruments because they offer instant diversity (much like mutual funds). Because they’re based on indexes, they also boast a great deal of transparency; at any given moment, an investor knows which companies the IETF has invested his money in.

Some IETF milestones include the following:

In 2007, Liechtensteinische Landesbank (try saying that three times fast!) launched the first IETF, and Barclays Capital issued three iShares Islamic ETFs.

In 2008, Daiwa Asset Management of Singapore launched its Islamic ETF as Daiwa FTSE Shariah Japan 100 (DFSJ:SP). That same year, BNP launched its Paribas’ EasyETF, and Malaysia introduced its first Islamic ETF — MyETF-DJIM25 — which was benchmarked against the Dow Jones Islamic Market Malaysia Titans 25 Index.

Princeton-based Javelin Investment Management company launched the first U.S.-based Islamic ETF in 2009. This now-defunct ETF was called the JETS Dow Jones Islamic Market International Index Fund.

In 2009, Absa Capital of South Africa announced the launch of sharia-compliant, equity-linked exchange-traded funds (ETFs).

In the Middle East, the Islamic ETF’s presence isn’t strong. That region’s first Islamic ETF, launched in 2010, was the FALCOM Saudi Equity ETF.

IETFs are still very young but are poised for great growth. They serve a purpose not only for the Muslim investor, whose primary objective is sharia-compliant investment, but also for non-Muslim investors who want to support socially responsible investing and tap into low-debt securities. Though the Middle East region has enormous wealth that should support a thriving IETF market, the relative lack of stock exchanges makes this product (which trades much like shares of stock) less accessible than Islamic mutual funds and unit trusts.

Diversifying with the Sukuk (Islamic Bond) Market

As I explain in Chapter 4, sukuk are one of the major sectors in the Islamic capital market and are an alternative to conventional, debt-based bonds. Sukuk are asset-based and thus the preferred mode of investment for many high net worth investors and governments. Many governments issue sukuk to raise funds for specific projects.

Sukuk are issued by regions, by sovereign states (such as the Saxony-Anhalt German State), by international financial bodies (such as the International Financial Corporation), and by global corporations (such as GE Capital). Even though the market for Islamic bonds originated with demand from governments, the market’s recent development shows that the corporate sector is now taking a big share: 50 to 60 percent.

International conventional bond rating agencies such as Standard & Poor’s (S&P) and Fitch have recently started to issue ratings for sukuk. The ratings system used for conventional and Islamic bonds is the same, and the ratings offer an assessment of the issuers’ ability to make repayments. (Note that sharia compliance doesn’t negatively impact the issuer’s ability to repay bonds and may, in fact, boost confidence in the issuer’s stability.)

The Islamic bond market started with four sukuk in 2001 valued at $500 million. (Those four bonds were issued in Malaysia and Bahrain.) Presently, an estimated $182 billion in Islamic bonds are outstanding in the market. The global financial crises that struck in 2008 set Islamic bond issuances back, but as I write these words, the market is again booming with new issues. Many countries now issue sukuk to raise capital, including Japan, South Korea, Germany, and the United Kingdom.

I hope I’ve whetted your appetite with this short description of the Islamic bond market. Chapter 13 gives you the complete rundown, including descriptions of specific sukuk products and current trends in the Islamic bonds market.

Developing the Islamic Derivative Market

A derivative is any financial asset based on the value of one or more underlying financial assets. Derivatives are used to hedge the risk of the assets. Many derivatives are available on the market, but the most commonly used are swaps, options, futures, and forward contracts. (Note that many financial regulators have blamed derivatives for the global financial crises that emerged starting in late 2007.) Here’s what these terms mean:

Swap market: This instrument is used to transfer risk. The Islamic swap market has two components:

• Profit rate swap: This option is based on exchanging fixed for floating rate profits.

• Cross-currency swap: Investors use this swap to transfer currency fluctuation risk among themselves.

Options: In this financial contract, the option writer offers a second party the right to buy or sell a financial asset at a fixed price on or before a certain date — without obligation to do so.

Futures: This type of financial contract solidifies an agreement to buy or sell financial assets or commodities on a future date. In a futures contract, both the buyer and seller are obliged to perform the contract.

Forward contracts: These contracts, which are used to hedge risk, let two partners agree today on the price of a future asset sale/purchase. Forward contracts and futures have some things in common but are different in certain ways; for instance, forward contracts aren’t traded on the exchanges.

The Islamic investment industry is divided regarding its outlook on Islamic derivatives because of varying sharia interpretations. Many scholars don’t agree with Islamic derivatives, arguing that such products inherently involve speculation. The relationship between recent financial crises and derivatives for hedging risk supports this argument. On the other hand, some Islamic bankers point out that in the midst of recent financial turmoil, conventional banks have options that help them manage their risks, while Islamic banks don’t. As a result, the Islamic finance industry is looking for solutions to manage the risk — which could include derivatives.

The Islamic derivative market is in its infancy, and its size isn’t yet known. Not all conventional derivative products have Islamic alternatives, but murabaha (cost plus) contracts, which I explain in Chapter 10, are being used to develop Islamic derivative instruments. For example, the International Swaps and Derivatives Association (ISDA) in association with the Bahrain-based International Islamic Finance Market (IIFM), in March 2012 launched the ISDA/IIFM Mubadalatul Arbaah (Profit Rate Swap) product standard for the Islamic derivative market.

Standard Chartered Saadiq Malaysia is already offering some Islamic derivative products, such as the Islamic Profit Rate Swap, Islamic Cross Currency Swap, and Islamic Forward Rate Agreement. If you want to find out more about Islamic derivative products, check out www.standardchartered.com.my/islamic-banking/wholesale-banking/treasury-products/en/.

Tracking Industry Trends for Islamic Funds

Worldwide, in 2009, Islamic fund assets under management totaled $53.9 billion. That number grew to $58 billion in 2010, which is a one-year increase of 7.6 percent (from Ernst and Young Islamic Funds & Investments Report, 2011). That’s pretty decent growth. However, compare that statistic to the growth of conventional funds, which increased by 35 percent in the same period.

Why did Islamic funds lag behind their conventional counterparts? One key reason offered by industry experts is that in the West, pensions and 401(k) plans tend to offer only conventional assets, and those plans are the source of a steady flow of new money into the fund markets.

Right now, in the United States, total assets under management in Islamic funds represent less than 6 percent of total assets invested in the Islamic finance industry as a whole. A lot of Islamic investors have their money in sharia-compliant bank products rather than investment funds. If the Islamic investment fund industry wants to entice customers to move their money into mutual funds, unit trusts, exchange-traded funds, and other investment products, it clearly has some work to do to make the transition convenient, painless, and worthwhile.

In the United States, the Muslim customer base for investment funds is still an untapped market, whereas in Europe, much more substantial efforts are already underway to reach that customer base with appealing, sharia-compliant investment products. If U.S. fund managers get serious about marketing to Muslims, they’ll soon start offering sharia-compliant products in standard 401(k) plans, and market growth is almost certain to follow.

Here are a few other statistics about the current Islamic fund market to consider:

An estimated 800 Islamic funds are in operation, 70 percent of them with total assets under $100 million (meaning they’re fairly small funds). This number includes all funds — mutual funds, unit trusts, exchange-traded funds, bond funds, and so on — and is certain to grow.

As I note earlier in the chapter, Malaysia was an early leader in the development of Islamic investment funds. It still leads the Islamic fund industry by having a stake in 27 percent of the world’s Islamic funds. Saudi Arabia is in second place with 22 percent.

According to Eurekahedge (www.eurekahedge.com), the Middle East and North Africa regions boast 52 percent of the total Islamic assets under management.

Promoting International Islamic Capital Markets

In recent years, some organizations have stepped forward to take the lead in further developing the Islamic capital market and introducing investors all over the world to what it offers. In this section, I describe the efforts of two such organizations.

International Islamic Financial Market

The International Islamic Financial Market (IIFM) is a Bahrain-based institution that develops the infrastructure for the Islamic capital and money markets and promotes those markets. The IIFM is focused on the unification and advancement of documents, structures, and contracts.

IIFM has a lot of global buy-in and a long, impressive list of supporters, all of whom want to see the Islamic capital market grow and thrive. These supporters include

ABC Islamic Bank

Autoriti Monetari Brunei Darussalam

Bank Indonesia

Bank Islam Malaysia Berhad

Central Bank of Bahrain

Central Bank of Sudan

Crédit Agricole CIB

Dubai Financial Services Authority

European Islamic Investment Bank

The governmental regulatory authorities of Bahrain, Brunei, Malaysia, Indonesia, Dubai, Sudan, and Pakistan

Islamic Development Bank of Saudi Arabia

Kuwait Finance House

Labuan Financial Services Authority of Malaysia

National Bank of Kuwait

Standard Chartered Bank Saadiq

State Bank of Pakistan

IIFM’s efforts will help develop standardized Islamic capital market operations and enable countries that aren’t currently participating in these operations (including countries in the West) to develop an Islamic capital market infrastructure. By harmonizing processes among industry participants, IIFM strives to create a common platform that will ease Islamic product development, standardize required or recommended documentation, and facilitate transactions.

Malaysia International Islamic Financial Center

The Malaysia International Islamic Financial Center (MIFC) was started in 2006 to promote Malaysia as a hub for international Islamic finance. The MIFC consists of government regulatory bodies, ministries, and professional development bodies in Islamic finance. The products offered by the center include Islamic fund and wealth management, international Islamic banking, and international takaful and sukuk.

The MIFC has developed three new centers: the International Islamic Bank, International Takaful Operators, and International Currency Unit. The MIFC helps foreign investors to establish full-fledged fund management operations.

Because Malaysia has Islamic finance experience that goes back more than three decades, it can offer rich expertise that benefits other countries that are newer to the field. The MIFC concentrates that expertise to make it easy for other nations to tap into the benefits of Malaysia’s experience.