Imagine practicing investor relations in a market where religious clerics make the rules, where excessive profit is frowned upon and where paying or receiving interest is illegal. Sounds like a plot line for some bizarre movie.
Well it’s not a movie, it’s reality, and if you’re in IR over the next ten years, it’s likely you’ll be working within these parameters. How so, I hear you ask? Has the world been turned on its head? Has madness overrun the market? Is capitalism dead?
No, Mr Gecko, capitalism isn’t dead – but alternate financial systems are starting to emerge. One such system is the Islamic capital market which, despite its low profile, has actually been in development for almost 20 years and is now growing at a very healthy rate of 15 percent a year.
The rules
Although both western and Muslim investors want the same thing – decent returns – their styles are very different. Unlike the capitalist system, the Islamic capital markets are governed by what is known as Shariah (also Shar’iah, Sharia or Syaria), a Quran-based set of Islamic laws. ‘It is a very simple system that works for the well-being of humanity if properly followed,’ says Ahmad Hafiz, a researcher at Switzerland’s University of Basel.
The central tenet of Shariah is the prohibition of riba or interest. This means Muslims can neither charge nor earn interest on commercial activities, and investment is usually equity rather than debt-based. Basically, you can’t earn money from money.
‘Islamic finance is more like project financing,’ says Yusof Abu Othman, CEO of Malaysia’s Minority Shareholder Watchdog Group. ‘It’s equity-based as opposed to lending money; the lender has a more direct interest. And in its purest form there is no such thing as collateral,’ he says.
‘If money is to be invested, it should be through physical ownership of tangible assets with an income stream that may be attributed to the economic use of the asset,’ explains Stella Cox, an Islamic finance specialist at Dawnay Day Global Investment. She adds, ‘Within the mainstream financial system we are rather more familiar with money itself being the commodity.’
Shariah also bans investment in haram or forbidden products or companies, including those in the alcohol, weapons and adult entertainment industries and those involved with non-halal food like pork. Investments that contain an element of gharar or uncertainty, such as insurance or gambling, are also unlawful.
Building blocks
To date many Muslim investors have shied away from Shariah-compliant investment products because of the underdeveloped nature of the market. ‘Successful capital markets offer investors the ability to trade internationally-rated securities within an established and regulated market environment,’ remarks Cox, who says that until now the Islamic capital markets have not been able to offer this, largely because of the restrictions on capital flows into and out of many Muslim countries.
She continues, ‘Islamic financial products have not historically been rated by the investment agencies which have previously claimed that both levels of disclosure and reporting standards have been insufficient. Until now there has been nothing to assist Islamic investors in determining the investment grade.’
But, as the building blocks of a properly structured financial system are put in place, Muslims and western investors alike are becoming more comfortable with the concept of an Islamic financial model that runs in tandem with the capitalist system. In late 2002 the Bahrain-based International Islamic Rating Agency was established. And a central bank, the Islamic Development Bank, as well as a financial regulator, the Islamic Financial Services Board, which is charged with developing accounting and auditing standards for the Muslim world, are already up and running. If these institutions can gain the trust of those in the mainstream market, investors will become increasingly confident about putting their money in the Islamic system.
The figures
According to the Institute of Islamic Banking and Insurance, more than 200 institutions already manage nearly $200 bn in Islamic funds around the world. But this is just the tip of the iceberg and the value of funds under Islamic management will only increase as more and more Muslims become keen to invest in line with Islamic principles. ‘There’s a huge amount of capital locked up because [some Muslims] don’t believe in the capitalist system,’ says Yusof.
‘Only 1 percent of Muslim money is invested in equity now – there’s almost $800 bn still waiting to be invested,’ points out Lars Hamich, the executive director of global business development at Dow Jones Indexes.
A good indication of how significant the Islamic system is likely to become is its level of importance for Dow Jones. The company has established an entire Islamic family of indexes and tracks Shariah-compliant stocks world-wide. Indexes include the broad DJ Islamic Market Index, dedicated US, Asia-Pacific, European and Canadian indexes, and a technology stocks index. Dow Jones has also just established a Titans index for blue-chip Shariah-compliant stocks.
Dow Jones has its own Shariah advisory board of Muslim scholars from all over the world who have developed a framework that determines which stocks can be incorporated in the indexes. ‘Sin sector’ companies are immediately excluded, for example, as are those with extra high levels of debt, cash, interest-bearing securities or accounts receivables. There are plenty left over: ‘Of the 5,000 companies that are in our global index, the Islamic world has 1,400,’ says Hamich.
The difference
One of the most fundamental differences between the western and Islamic markets is disclosure. ‘The main thing Muslims need to know when they wish to invest according to Islamic rules is whether the institution of interest to them is following the rules or not,’ says Kuwait University’s Dr Turki Alshimmiri.
Asserting adherence to Shariah law is central to good disclosure in the Islamic world – perhaps more important than disclosing the numbers. But, as in the western system, the annual report is a company’s most significant disclosure document. ‘Firms declare the names of the supervisory religious committee in the annual report. Some institutions also distribute brochures about how they contact Islamic scholars,’ says Alshimmiri, adding, ‘In Kuwait, Islamic institutions used to send speakers to the different daily gatherings in different places just to explain and convince people that these institutions follow Islamic rules.’
Most Islamic companies have a Shariah committee, which is responsible for preparing a statement for inclusion in the annual report to the effect that financial activities conform to the laws of Islam. ‘A popular misconception is that the scholars opine on commercial viability or risk,’ says Cox. ‘This is completely incorrect.’
Another major difference between the conventional system and the Islamic system is risk profile. ‘Interest rate risk is totally not a concern as no interest-based transactions are allowed,’ says Alshimmiri.
Despite the differences, there are also many similarities between the two systems. Paramount, of course, is a decent return on investment. Also, robust corporate governance is a big concern of Muslim and western investors alike. ‘No matter what the system is, good corporate governance is never out of the picture,’ asserts Yusof. ‘Islamic investing is still about efficient utilization of capital,’ he notes.
Those involved in the Islamic market are keen to point out that there’s enough room in the global capital markets for both the western and Islamic systems. ‘It’s a parallel system, not a replacement. There’s a place under the sun for both,’ says Yusof. ‘And it’s a fallacy that it’s only for people who believe in Islam.’
Pleasing performance?
Experts are predicting that when the Islamic markets become more mature they will be heavily accessed by both Muslims and non-Muslims. After all, the priority for most investors is good returns – no matter where they come from. And the returns are promising indeed. Dow Jones’ Islamic Titans index consistently outperforms the Global Titans index, and comparisons of energy and telecoms stocks show similarly pleasing performances.
Some argue, however, that Islamic indexes will come under pressure when the financial services industry cranks up again. This is because Islamic indexes usually don’t include financial services stocks as their business is making money from money, which Islamic law forbids. Others believe the very conservative nature of the Islamic system, particularly the aversion to high debt, could produce better returns over the longer term. ‘Islamic finance gives more protection to the investor than the conventional system,’ Hafiz asserts.
Indeed, the high debt levels attached to some of the large companies that have recently collapsed would have been a warning for Islamic investors well before they were taken seriously by the western system. ‘We had Enron and WorldCom in the Islamic indices, but they were deleted under Shariah law in early 2001. The other indices kept them in there until the stock price was sub a dollar,’ claims Hamich.
Due to the screens Shariah places on the Islamic system, ethical investors may be among the first from the western world to start accessing Shariah-compliant stocks. ‘It should appeal to people who look at socially responsible investing because that’s what this really comes down to,’ Hamich says. ‘It’s low-debt, ethical investing.’
Before western investors start flooding the Islamic market, however, a number of issues need to be addressed, not least the limited range of financial products available. Because an element of uncertainty is prohibited, insurance products have been slow to come to market, as have interest-based mortgages. But this is slowly changing as Islamic scholars devise Shariah-compliant products in these areas.
Another challenge is the divergence of views among Islamic scholars. ‘One of the long-standing issues in Islamic finance has been a certain lack of consensus among the scholars as Shariah law is not defined but subject to individual interpretation,’ says Cox. ‘In the past few years the market has endeavored to address this and the development of more diversified and sophisticated Islamic products has prompted additional deliberation. Presently the esteemed scholars at the forefront of the market have great commercial and financial awareness and communication between Shariah advisors and financial practitioners has improved immeasurably.’
The high charges attached to some Islamic investments are also a problem for investors. Costs are high usually because of the expense of having to establish and maintain a Shariah advisory board on top of other corporate governance and compliance requirements involved in the western system. ‘The other problem is the lack of expertise and awareness in this field,’ says Hafiz.
The IR perspective
From an investor relations perspective, the development of the Islamic financial system involves both opportunities and challenges. If the system continues to develop at its current rate, in the very near future IROs will have to start understanding the investor concerns of their Muslim shareholders.
Potentially, IROs will be involved in helping to prepare two sets of financial statements and two different sets of disclosure documents. It’s also possible that separate roadshows will have to be conducted, and annual reports will have to be prepared with an eye on both secular and religious interests. This will likely be the beginning of a huge new learning curve for the investor relations industry; and, in some parts of the world, it could change the nature of the industry itself.
If successful, the Islamic system will provide Shariah-compliant companies with the opportunity to raise significant funds from a huge investment pool not yet widely accessed by western companies.
On the flip side, Muslim investors will be able to invest in a way that is in line with their religious beliefs. And while the West could view the Islamic market as a threat, if conventional investors are open to working within it, everyone could benefit.
Milestone timeline
- 1973 Islamic Development Bank set up
- 995 Dow Jones establishes index
- 1999 FTSE establishes index
- 2002 Islamic Financial Services Board established
- 2002 International Islamic Rating Agency set up
Shariah guidelines
- Bans riba, the charging or receiving of interest
- Bans haram, forbidden products including alcohol, weapons and pornography
- Bans investments involving gharar, uncertainty/speculation
- Frowns on excessive profit
- Encourages the provider and the user of capital to share both the risks and the rewards associated with any investment
