Dividends for Islamic finance

At its peak in early 2000, WorldCom, the giant US telecom company, was valued at $185 billion. If WorldCom were a country, its national economy would have ranked in the global top 25 - more than the economies of Saudi Arabia and the UAE combined.

So when the company collapsed in June 2002, due to a combination of outright fraud and bad accounting practices, the shock was tremendous. Thousands of WorldCom's own employees, who owned shares, saw their life savings disappear into thin air. And millions of investors around the world suffered a similar fate. So why did no one see this coming?

The world's largest fund managers, for instance, watched helplessly as $185 billion in WorldCom stock turned into a mountain of virtually worthless paper. Many mutual funds that had invested in WorldCom were forced to write off their investments, leading to losses of billions of dollars for investors worldwide.

But not everyone was a loser. A small, though rapidly growing group of investors came out unscathed. They escaped because nearly a year before WorldCom's collapse, the Dow Jones Islamic Market index (DJIM) - the leading Islamic benchmark, which guides Islamic investments around the world - decided to remove WorldCom from its indices.

WorldCom was removed because its debt-to-market capitalization ratio broke the limit of 33 percent that Dow Jones imposed in order to be sharia compliant. As WorldCom's debts mounted and share price came off the peaks of 2000, its debt-to- capitalization ratio soared, forcing Dow Jones to remove it from their various Islamic indices.

By deleting WorldCom in June 2001, six months before the scandal broke, Dow Jones enabled fund managers around the world to save their investors hundreds of millions of dollars. Since most mutual funds are attached to indices, if there is any change in the composition, the funds follow suit. As soon as WorldCom was removed, the Islamic fund managers sold off WorldCom shares, at a time when the share price was a respectable $14. Barely six months later, the share was trading at a symbolic penny.

WorldCom was not the only example. On numerous occasions, the Dow Jones Islamic index managed to detect signs of corporate trouble before Wall Street woke up to it. The DJIM ejected Tyco, another deeply troubled American company, well before that scandal became public. And despite the complex accounting that shrouded Enron, the Dow Jones Islamic index tossed out the company before it declared bankruptcy in December 2001.

"Most people were surprised that we had decided to remove these corporate landmarks from our indices. But that was an automatic decision since their debts had gone beyond the limit and were no longer in accordance with the sharia. So we just had to get rid of them," says Rushdi Siddiqui, managing director of Dow Jones Islamic Indices (DJII), a division of the Dow Jones family of financial information products.

There are 95 Islamic funds that follow the DJIM and have over $1.2 billion invested in various stock markets around the world. By selling off WorldCom, Tyco and other dubious shares, the fund managers were able to save several million dollars for their investors - exactly when other fund managers were seeing their investors' wealth evaporating rapidly.

"The dynamics of the global financial sector are creating a new opportunity for accelerated growth in Islamic finance and recommended industry-wide initiatives to encourage this,'' says Mohammed Khalfan bin Kharbash, the UAE minister of state for finance.

"Aversion to interest and speculation are essentially prudential regulations that encourage greater collateralization, marking to market and risk sharing." he says.

For Islamic finance, this was its first major victory on the global scene. Though it has long been cast as a form of ethical investing, it wasn't until WorldCom, Enron and Tyco that Islamic financial fund managers could boast that they could clearly identify potential signs of trouble before the competition. Over the past couple years, especially compared to most Wall Street analysts, many Islamic fund managers look like financial geniuses.

For Siddiqui, these events were an extremely significant moment in the acceptance of Islamic finance by the global financial community. He says that, over the last few years, an increasing number of global banks and funds have been looking to launch Islamic products. This shift has taken place for a number of reasons. First and most importantly, the traditional banking system is now overcrowded and competition has slimmed margins for most players. The shift to Islamic finance is a natural move into virgin territory.

"So these players are looking for newer areas where the market may not be so full up," says Siddiqui. "The entry barrier is very low and the potential is high. After all, there are 1.5 billion Muslims in the world and even if the banks count just two or three percent of them as clients, that is a targeted, large figure. The international banks have their names, brands and distribution channels. They just have to structure some products according to the faith."

As big banks like Citibank and HSBC became interested in Islamic products, Dow Jones saw an opportunity. The company hired Siddiqui and set him the challenge of creating the Dow Jones Islamic Indices. Siddiqui began by first forming a board of advisers, comprising the most respected names in the Muslim world. The board's main task was to formulate and constantly monitor the rules that would allow for including or excluding any particular company, or entire segments of business, from the Islamic index. Siddiqui says this was one of the most important steps in the launch of the DJIM.

"It was very important to have credibility," he insists. "We needed to be certain that only those companies that fulfill the sharia entirely are included in our indices. Even those companies that are doubtful need to be kept out. We had to be extremely credible in our selection process."
The screening of companies for inclusion in the indices is a two-fold process.

First, the company's businesses are examined to see if they are involved in any activities that violate sharia. For instance, companies that produce products containing liquor or pork cannot be included. Neither can those companies that make their money from interest.

The second part of the process is an examination of the company's performance and balance sheet. Only those companies with relatively low levels of debt - and which don't have interests in speculative activities - are included in the index.

"If we structure a product in an Islamically acceptable manner, not only are we conducting our business in accordance with Islam," says Atif Abdulmalik, chief executive officer of Bahrain's First Islamic Investment Bank. "From a business point of view, we are also differentiating ourselves and carving out a niche in the wider, extremely competitive financial services industry."

In February 1999, Siddiqui rolled out his first index. The Dow Jones Islamic Market Index, which mirrors the principal Dow Jones index, was immediately seized upon by banks and fund managers who had been waiting for a tool to use for launching their own Islamic products. The success of the first index led DJII to launch a series of other products. Today, DJII has over 50 indices, tracking practically all the sharia-compliant industries in the world.

Siddiqui says one of the main factors behind the success of DJII is that while fund managers and bankers can devise their own indices for their sharia products, they gain credibility by using outsourced indices like DJII.

The entry of several large corporations in the Islamic finance world led to hugely exaggerated claims about the industry. Some experts quickly claimed that there was already $150 billion invested in global Islamic finance, growing at 50 percent per year. Not only are these claims far from the truth, but they could also hurt the Islamic financial sector by putting a question mark on the credibility of the players in the industry.

In fact, even in Saudi Arabia, the proportion of Islamic finance compared to the total financial industry is less than five percent. Though most Saudi banks, like National Commercial Bank and Riyadh Bank, do offer a bouquet of Islamic financial products, this still forms a very small portion of their overall business. There is, then, clearly greater scope for growth of Islamic finance within the Islamic world itself.

The adoption rates for Islamic finance within the Islamic world itself are not uniform. Malaysia got a headstart in the industry when the government drew up the legal framework to govern Islamic finance, and then let the players come up with their own innovative products. As a result, even ethnic Chinese Malays, who are not Muslims, have started employing some Islamic finance products, such as mortgages, because they are cheaper than traditional home loans.

Siddiqui is encouraged by the Malaysian model, but criticizes the routes adopted by Pakistan and Sudan. "They are trying to compress the time frame and have set a deadline for adoption of Islamic finance, instead of leaving it to the society and the players to find the right pace of adoption of Islamic finance," he says. "What they are trying in Pakistan and Sudan is artificial, and hence it is not going to work. You can not popularize Islamic finance through decree."

But the adoption of Islamic financial products by non-Muslims in Malaysia points to a future when Islamic products will be adopted in ever-greater number, by Muslims and non-Muslims alike. Indeed, this is already happening. Last year, HSBC launched its Islamic mortgage and refinancing products in the United States and Europe.

In 2002, Freddie Mac, a large mortgage refinancing entity in the United States, financed sharia-compliant home loans for the first time. Freddie Mac, which has refinanced loans totaling over $5 trillion, did begin with a rather modest investment of $1 million. But it soon increased its investment and is believed to have now refinanced Islamic mortgages worth over $200 million. The US giant hopes to dramatically increase its Islamic finance portfolio in the coming few years.

These shifts, although small on a global scale, are clear indicators of the spread of Islamic finance in the West. Not only will banks try to introduce Islamic financial products for Muslims living in the West and other non-Muslim areas, but they could also try to market these products to non-Muslims, especially those looking for ethical investments. And as the examples of WorldCom and Tyco show, Islamic finance is a safe bet for risk-averse investors.

However, by excluding significant chunks of business from their purview, the Islamic and ethical investors do run the risk of losing out in terms of overall performance. For instance, liquor companies in general have been able to withstand the global recession very well, and have been among the world's best performers.
Siddiqui argues that investors in Islamic funds have not lost out at all.

"Faith-based investors are certainly not being penalized by underperformance," he says, adding that due to the limits imposed on the amount of debt that a company can hold or the amount of money it can make from speculative investments means that the Islamic investors are cushioned against corporate meltdowns like Enron and WorldCom. This is especially true for several European and US telecom companies, laden with record debt levels and teetering on the brink of collapse.

The cleansing act continued as in April. AT&T and Motorola were ejected from the Islamic index since their debt-to-average market capitalization ratio breached the 33 percent limit imposed by Dow Jones. As the trend continues - and if Islamic financial products are able to set the alarm bells ringing before Wall Street - Islamic finance will continue to boom. Siddiqui says there are various large markets that are yet to be tapped, and that banks across the world will turn to Islamic finance as they look towards developing innovative products.