Source: BURSA | Published: February 2021
Stock market is may seem unpredictable especially when the market is volatile. But amidst the volatility market environment and its associated risks, there are opportunities to grow wealth over a period of time. Some stocks may increase in value over time, although the aggregate prices of individual stocks fluctuate on a daily basis. In Islamic capital market, investment in Shariah-compliant stocks is one of the earlier adopters for the Shariah governance framework (SGF). This framework signifies the Shariah rules and guidelines applied within the context of investment activities surrounding the stock market. While investment is permitted from Shariah perspective, the underlying assets for this activity must comply with Shariah rules to make it permissible for investment.
Transactions in the Islamic capital market are carried out only in ways that do not conflict with Shariah law. This necessitates the creation of a specialised stock screening process to identify the Shariah-compliant investable securities. This process is known as Shariah stock screening.
The central purpose of this process is to filter out companies with prohibited business activities, as well as companies with unacceptable levels of financial operations. The focus of the financial operation screening is mainly on ascertaining the levels of conventional debt, liquidity, interest-based investment and tainted income. The information about the company’s business activity can easily be obtained from public domains such as the corporate website and the company’s annual report. Analysing the balance sheet items from the company’s annual financial statement can provide full information about the company’s financial ratios status. All of these processes can be done through an automated programme or manually by a financial analyst.
While the purpose of Shariah stock screening process is standardised, the detailed methodology and approach vary from one jurisdiction to another. In this article, we will look into some of the major stock screening methodologies applied in the Islamic capital market across jurisdictions. The sole purpose of this is to identify the variations in all these methodologies and to understand how they are applied in major indices by the investors and fund managers to determine the Shariah compliance of these investment activities, while upholding the Shariah governance framework. The selection of Shariah screening methodologies includes those promulgated by the following institutions: -
- Accounting and Auditing for Islamic Financial Institutions (AAOIFI), Bahrain
- Dow Jones Islamic Market U.S. Index (DJIMI), USA.
- Standard & Poor's (S&P), USA
- Morgan Stanley Capital International (MSCI), USA
- Financial Times Stock Exchange (FTSE), UK
- Thomson Reuters-Ideal Rating, Canada & USA
- ISRA-Bloomberg, Malaysia & USA
- STOXX Europe, Switzerland
- Almeezan Group, Pakistan
Accounting and Auditing for Islamic Financial Institutions (AAOIFI)
AAOIFI was established in Manama, Bahrain with the aim to provide the standard of Accounting & Auditing practices for Islamic Financial Institutions. Although it is not a regulatory body, AAOIFI is one of the most influential institutions in setting up the standards for Islamic finance practice across jurisdictions. It has issued over a hundred standards in the areas of Shariah, accounting, auditing, ethics and governance for the market and institutions adopting Islamic finance operations. AAOIFI is supported by a number of institutional members, including central banks and regulatory authorities, financial institutions, accounting and auditing firms, and legal firms from over 45 countries.
AAOIFI’s Shariah stock screening methodology looks into the company's main business activities and excludes those that are involved in interest-based activity, any trading or transaction that is involved with uncertainty, gambling or games of chance, or manufacturing or trading of impermissible products or services. On the financial ratio screening process, the AAOIFI sets the rule that the interest-taking deposits and interest-bearing debt must be less than 30% of the stock’s market capitalisation; and the total market value of illiquid assets must be more than 30% of the market value of the total assets.
Dow Jones Islamic Market U.S. Index (DJIMI)
Dow Jones & Company was founded in 1882 and it is one of the world's most influential financial news companies. The Dow Jones Islamic Market U.S. Index (DJIMI) is an Islamic equity benchmark index and a subset of the Dow Jones Global Indexes (DJGI) family, which includes stocks from 34 countries and covers the 10 economic sectors, 18 market sectors, 51 industry groups and 89 subgroups defined by the Dow Jones Global Classification Standard. Like any other Islamic index, DJIMI excludes any Shariah non-compliant stocks with the purpose of providing a definitive standard for measuring stock market performance for Islamic investors, fund managers and market players all over the world. DJIMI was one of the earliest organisations to publish the Shariah stock screening methodology for the Islamic capital market.
DJIMI’s Shariah screening for business activities filters companies that are involved in production, sales and promotion of liquor, tobacco, pork-related products, conventional financial services, entertainment and pornography. Interestingly, the DJIMI also filters and takes out companies that are involved in manufacturing weapons and defence equipment and technology. The screening for the financial ratios excludes companies when its total debt and total cash and interest-bearing securities over market capitalisation is greater than or equal to 33%, or its accounts receivables over the total assets is greater than or equal to 45%. The DJIMI’s Shariah stock screening methodology uses the 24-month average market capitalisation for its computation.
S&P Global Rating (S&P)
S&P Global Rating, previously known as Standard & Poor’s, is an American credit rating agency (CRA) and a division of S&P Global that publishes financial research and analysis on stocks, bonds, and commodities. S&P is considered the largest of the Big Three CRAs in the world. The S&P introduced the S&P Shariah Indices as the increase in Shariah-compliant investment activities soared in 2006.
The S&P Shariah Indices adopt a similar methodology to AAOIFI for the screening of business activities to exclude stocks with interest-based activity, any trading or transaction that is involved with uncertainty, gambling or games of chance, or manufacturing or trading of impermissible products or services. For its financial ratio screening, S&P Shariah Indices require no more than 49% of accounts receivable over market capitalisation; no more than 33% of cash plus interest-bearing securities and total debt over market capitalisation. The S&P’s Shariah stock screening methodology uses the 36-month average market capitalisation for its computation.
Morgan Stanley Capital International (MSCI)
Morgan Stanley Capital International (MSCI) Inc., formerly known as Morgan Stanley Capital International and Barra, is an American financial institution headquartered in New York City and serving as an international financial institution that provides financial services of equity, fixed income, hedge fund stock market indices, and multi-asset portfolio analysis tools. MSCI also publishes index information such as the MSCI BRIC, MSCI World and MSCI EAFE Indexes. In 2007, MSCI launched a universe of a global family of Islamic indices, designed to reflect Shariah investment principles while retaining replicability for international investors, fund managers and market players.
For the screening of the business activity, MSCI follows the similar approach of AAOIFI to screen out companies dealing with financial transactions involving interest, gambling, production of impermissible items such as liquor, any form of intoxicants, pork, and transactions involving uncertainties and speculative investments. Financial ratio screenings are applied to exclude companies having 33.33% or more of their total debt over total assets; cash and interest-bearing securities over total assets; and account receivables and cash over total assets.
Financial Times Stock Exchange (FTSE), UK
FTSE International Limited or FTSE Russell is a British provider of stock market indices and associated data services. It is wholly-owned by the London Stock Exchange and operates the well-known UK FTSE 100 Index and a number of other indices. As an index provider, FTSE Russell provides a comprehensive range of reliable and accurate indices, giving investors the tools they require to measure and analyse global markets across asset classes, styles or strategies.
FTSE uses a similar methodology for business activity screening as the one produced by DJIMI. The main areas of business activity screening include conventional finance, alcohol, pork-related products, tobacco, weapons and entertainment. In addition to that, FTSE introduces an additional screening field for the business activity where it accepts mixed activity business of not more than 5% of the total revenue from the impermissible activity to total annual revenue. The tainted income from this rule will then be cleansed through a dividend income purification process. On the financial ratio screening, FTSE applies 33% rules for the total debt over total assets, cash and interest-bearing securities over total assets and 50% threshold for the total account receivable over total assets. It is interesting to observe that FTSE does not apply the common denominator of market capitalisation in ascertaining the financial ratios.
Thomson Reuters & Ideal Rating
Thomson Reuters Corporation is a Canadian multinational media conglomerate. It is one of the world’s most trusted financial information providers. It brings together information, innovation and authoritative insight to unravel complex situations, and its worldwide network of journalists and editors keeps customers up to speed on global developments relevant to them.
Thomson Reuters was founded by Thomson Corporation's purchase of the British company Reuters Group in April 2008. Ideal Ratings is a specialised financial rating corporation based in San Francisco, USA. It has become the leading provider serving the Islamic finance industry, as well as the Socially Responsible and ESG investments industry. Thomson Reuters and Ideal Ratings formed a venture to publish their own Islamic indices which are in accordance with the AAOIFI standards.
Their screening methodology for business activity combines methodologies from the AAOIFI and DJIMI which include the selection criteria of companies that are free from non-halal food production, gambling, entertainment, financial institutions and insurance companies, as well as business that involves gold and silver trading, and manufacturing and developing weaponry and defence technology. Their screening for financial ratios includes the three areas commonly adopted by other Shariah stock screening methodologies. The ratio of total debt over market capitalisation must not be more than 30%; cash, deposits and interest-bearing investment dividend over total assets must be less than 30%; and the ratio of cash, deposits and receivables over total assets must be less than 67%. The Thomson Reuters-Ideal ratings Shariah stock screening methodology uses the 12-months average market capitalisation for its computation.
ISRA-Bloomberg
The International Shari’ah Research Academy for Islamic Finance or ISRA was established in 2008 by the Central Bank of Malaysia as an Islamic finance and Shariah related research institution. ISRA is recognised globally as a leading Global Premier Research Academy in the Islamic finance industry with numerous accolades and with over 200 Shariah research publications that include textbooks, journals and research papers that are constantly referred to internationally.
The Bloomberg L.P. (Bloomberg) is a privately-held financial, software, data, and media company based in New York City, USA. It was founded by Michael Bloomberg in 1981. Bloomberg provides financial software tools and enterprise applications, such as analytics and equity trading platforms, data services, and news to financial companies and organisations. As a media giant, Bloomberg also broadcasts financial news, a global television network, websites, radio stations, subscription-only newsletters and financial magazines.
ISRA-Bloomberg Shariah stock screening methodology also includes the mixed business activity screening in addition to the common business activity and financial ratios screening approaches. Similar to the FTSE approach on the mixed activity screening requirement, it allows any mixed activity companies to be included in the universe of Shariah investable stocks if the impermissible activity income is less than 5% tolerable ratio over the total income. There are two financial ratios stipulated in the screening methodology of ISRA-Bloomberg, where the total debt over the market capitalisation must be not more than 33% and total cash and interest-bearing securities over market capitalisation must not be more than 33%. The ISRA-Bloomberg’s Shariah stock screening methodology uses the 24-month average market capitalisation for its computation.
STOXX Europe
STOXX Limited is a Swiss globally integrated index provider, covering the world markets across all investment asset classes. STOXX indices are licensed to financial institutions and other users for use with exchange-traded funds, mutual funds, futures, options, structured products, and other purposes. In 2011, the company launched its STOXX European Islamic Index which includes the universe of 50 blue-chip indices designed to provide large-cap equity market exposure in compliance with Shariah principles for the investors, fund managers and financial institutions worldwide.
STOXX’s Shariah stock screening methodology is similar to that of other providers. The business activity screening includes filtering out companies whose primary activities are in non-halal food production like pork, liquor and tobacco, conventional financial institutions, insurance companies, gambling, weapon and arms manufacturing, entertainment and trading of gold and silver. The financial screening includes the criteria to filter the total debt over total assets or total market capitalisation, whichever is greater, and the ratio must not exceed 33%. Cash and interest-bearing receivables over total assets or total market capitalisation, whichever is greater, and ratio cannot exceed 33%.
AlMeezan Group
AlMeezan Group is the largest private-sector asset management and investment advisory firm in Pakistan. It offers a comprehensive range of Shariah-compliant investment solutions. AlMeezan has been in operation for the last 25 years as the only firm in Pakistan providing Shariah-compliant investment management services.
AlMeezan’s Shariah stock screening methodology highlights the exclusion of companies involved in investment activities in Shariah non-compliant securities, conventional banking, conventional insurance, alcoholic drinks, tobacco, pork production, arms manufacturing, pornography or related activities that are deemed not permissible. For its financial ratio screening, the total debt to total asset ratio must be less than 37%, non-Shariah compliant investments to total assets must be less than 33%, Shariah non-compliant income over total revenue must be less than 5%, illiquid assets over total assets must be less than 25%.
Conclusion
The strong growth and rapid development of Shariah stock screening indices and methodologies demonstrate the significance of Shariah governance structure amidst high demand for Shariah investment management solutions. There is strong awareness amongst the investors and market players on the need for proper diligence in managing investment for stakeholders who prefer to invest only in Shariah investable and compliant stocks.
AAOIFI has set the foundation standard of the Shariah stock screening methodology which was meant to be followed and curated to the needs of certain markets and jurisdictions. In most cases of business activity screening, there is obvious uniformity and agreement between the methodology providers and Shariah scholars to follow the base guidelines promulgated by the AAOIFI, in particular, surrounding the prohibition of riba (financial interest and usury), maysir (gambling), gharar (uncertainty) and also activities that are deemed impermissible in Shariah such as the production of pork, tobacco, entertainment and pornography.
In the area of financial ratio screening, there are many variations that different methodology providers offered to the market. The variations include the usage of different denominators in determining the financial ratios such as the market capitalisation vis-a-vis total assets, the quantum of ratios with small variations, and finally the inclusion of mixed activity tolerable benchmarks. The differences in the financial ratios screening between these methodology providers should not be looked at as a problem in the fast-growing Islamic capital market. In the context of financial management, it is good to have more options and opinions to continuously improve the performance to benefit all major players and stakeholders. Islamic finance will continue to undergo metamorphosis that will bring positive changes in many years to come.
Tags: ISLAMIC EQUITIES
