Week 3: Islamic Capital Market Products

Week 3: Islamic Capital Market Products

“Introduction … Choosing Stocks for Islamic Equity Funds … Debt Financing & Growth of Islamic Equity Funds … Growth of Islamic Equity Funds … Challenges for Islamic Equity Funds … Real Estate Investment Trusts (REITS) … Types of REITs … Commodity and Hedge Funds and Islamic Finance”
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Summaries

  • Week 3: Islamic Capital Market Products > Introduction > Unit
  • Week 3: Islamic Capital Market Products > Choosing Stocks for Islamic Equity Funds > Unit
  • Week 3: Islamic Capital Market Products > Debt Financing & Growth of Islamic Equity Funds > Unit
  • Week 3: Islamic Capital Market Products > Growth of Islamic Equity Funds > Unit
  • Week 3: Islamic Capital Market Products > Challenges for Islamic Equity Funds > Unit
  • Week 3: Islamic Capital Market Products > Real Estate Investment Trusts (REITS) > Unit
  • Week 3: Islamic Capital Market Products > Types of REITs > Unit
  • Week 3: Islamic Capital Market Products > Commodity and Hedge Funds and Islamic Finance > Unit

Week 3: Islamic Capital Market Products > Introduction > Unit

  • Islamic capital markets only recognize financial products that are compliant with the Islamic rules and regulations.
  • These products include Islamic equity funds, commodity funds, and shares in Shari’ah-compliant companies, shares in real estate trusts or commonly known as REITs.
  • To be a successful player in any Islamic capital market, the fund manager should know about the distinguishing features and the benefits of these products.
  • Islamic financial institutions can customize most products used by the conventional capital markets for use in the Islamic capital markets.
  • Although these funds can be customized to invest only in areas approved by the Shari’ah, the Islamic law, the principles by hedge fund managers use to make profit do not always comply with Islamic law and its guidelines.
  • Sukuk will be discussed in details in On completing this chapter you will be able to explain the process and the criteria used for choosing stocks for the Islamic equity funds, to summarize the growth of these Islamic equity funds, to describe the challenges that were faced for the growth of these funds, explain the nature of Islamic commodity funds, describe the nature of real estate investment trusts or commonly known as REITS, particularly the aspects relating to tax, who are the decision makers, and what types of properties that they invest in.
  • You’ll be also able to describe the various types of REITs and distinguish between the three different REIT structures and explain the objectives also of and the concerns relating to hedge funds.

Week 3: Islamic Capital Market Products > Choosing Stocks for Islamic Equity Funds > Unit

  • This session will cover choosing stocks for Islamic equity funds.
  • The stocks for SRI funds are also selected according to specialized criteria, just as the stocks for Islamic equity funds are selected based on their conformity to the Shari’ah or Islamic law.
  • To build the portfolio for an Islamic equity fund, managers need to follow two important steps.
  • During screening managers identify all stocks that meet the fund’s financial objectives first, and then from those stocks they select the companies that conduct their businesses according to the Shari’ah guidelines.
  • It is up to the individual fund manager’s discretion what filtering rules they apply and to what extent.
  • Managers can be sure of building a portfolio compatible with the requirements of Islamic capital markets if they consider these factors when screening and filtering stocks.
  • As discussed in a previous section, we looked at the factors which would affect the screening and filtering of stocks for an Islamic equity portfolio.

Week 3: Islamic Capital Market Products > Debt Financing & Growth of Islamic Equity Funds > Unit

  • Fund managers can select stocks of companies that raise a certain percentage of their capital through debt-based financing.
  • Again, scholars are lenient; however, if this interest is a miniscule proportion of the company’s total income.
  • In this case, fund managers can include the stocks of these companies in their portfolio.
  • Muslim people who would buy these stocks need to take two actions to show that they do not endorse whatsoever the means to which this company earns its income.
  • They need to firstly, vocally denounce such income especially at the company’s annual general meeting.
  • This part should be proportional to the income the company earned through interest.
  • If the company earned 10% of its income through interest, the stockholders should donate 10% of their dividend income.
  • The fund managers can also consider the assets of a company as a factor defining the filtering criteria.
  • During filtering, they can reject the stocks of companies that possess only liquid assets.
  • According to Islamic principles, liquid assets represent the cash which companies can sell and purchase only at face value and not at market value.
  • Any profit earned through the trading of shares of these companies is not approved by Islamic law.
  • Profits earned through the trading of shares of companies that have illiquid assets are approved.
  • That is why Shari’ah scholars pronounce the company fit for Islamic capital markets only if a portion of the company’s assets are illiquid.
  • Most fund managers set this portion at a maximum of 33% of the entire assets of the company.
  • Shari’ah scholars approve only ordinary type of stock, which gives the shareholders an undivided ownership in the company.
  • This type of stock does not guarantee a definite return, and it vests both the company and the shareholders with the same liability.

Week 3: Islamic Capital Market Products > Growth of Islamic Equity Funds > Unit

  • Today widespread privatization in Islamic countries has led to an increase in the promotion and sale of Islamic Equity Funds.
  • This has created an opportunity for fund managers to include a wide variety of stocks in their portfolios of Islamic Equity Funds.
  • In Malaysia, more than 50% of the stocks listed on the Kuala Lumpur Stock Exchange are Shari’ah-compliant.
  • This is primarily because the initiatives taken by the Malaysian government to standardize and promote such stocks.
  • Twice a year it screens all the stocks listed on the Kuala Lumpur Shari’ah Index for Shari’ah compliance.
  • Often recognizing the impact of Islamic Equity Funds, many share market authorities worldwide have also introduced exclusive indices for Shari’ah-compliant stocks.
  • The Financial Times Stock Exchange or known as the FTSE set up their own FTSE Global Islamic Index.
  • For example the Dow Jones Islamic Market Index lists only the stocks that investors from anywhere in the world can buy.
  • The screening and filtering processes, news by the Dow Jones and the Kuala Lumpur Shariah Index are also very different.
  • When determining the debt or liquidity levels of stocks, the Dow Jones considers ratio derived from both the income statement and the balance sheet.
  • Again, in contrast the Kuala Lumpur Shari’ah Index determines the debt and liquidity levels based on the ratio derived only from the income statement.
  • Their screening process involves identifying and rejecting stocks of companies that indulge in businesses that violate the Shari’ah norms.
  • To calculate this ratio for a company we determine the total debt for the company at the sum of the short-term and long-term debt.
  • In order to calculate this ratio for a company, calculate the total cash and interest-bearing securities for that company and then they divide it by the 12-month average market capitalization.
  • To calculate this ratio for a company calculate the account receivables for the company at the sum of the account receivables and the long-term receivables then divide the total account receivables by the value of the company’s assets.

Week 3: Islamic Capital Market Products > Challenges for Islamic Equity Funds > Unit

  • Islamic equity funds have the potential for further growth and wider availability.
  • Many companies themselves don’t list themselves on the Islamic stock indices perhaps because of lack of confidence in the prevailing market conditions.
  • The number of stocks traded at the Islamic stock exchanges is relatively small, especially when compared to conventional stock exchanges.
  • Even if fund managers consider the stocks from conventional stock exchanges, the screening and the filtering processes can narrow down their options to build a sound portfolio that diversifies the risk.
  • Liquidity in the Islamic capital markets depends on few stocks and are listed on Islamic stock exchanges.
  • This is not an ideal situation because brokers and malicious investors can manipulate these stocks for their own benefit.
  • The fund manager can use another stock as a replacement during lean periods.
  • This task can be time-consuming and can incur additional transactional costs, and also there’s always a chance that similar stocks may be unavailable during that period.
  • Even if fund managers include Shari’ah-compliant stocks in their portfolios, they themselves can indulge in practices prohibited by the Shari’ah or Islamic law.
  • There is a need for Shari’ah scholars to define standards which define the practices for fund managers as well.

Week 3: Islamic Capital Market Products > Real Estate Investment Trusts (REITS) > Unit

  • Real estate investment trusts, also known as REITs, are companies that own and often operate income-creating real estate.
  • These days, many REITs are listed on major stock indices and most REIT shares are publicly traded.
  • By buying shares of a REIT, investors can diversify their portfolios and thus reduce risks.
  • Most REITs pay all of their taxable income to the shareholders, and as a result, they save on corporate tax.
  • Most REITs invest in various property types, such as residential apartments, hotels, warehouses, self storage facilities, hospitals, shopping centers, factory outlet stores, and offices.
  • A REIT can own and operate or finance only shopping malls or warehouses.
  • A REIT can invest only in healthcare facilities, including acute care centers, rehabilitation, psychiatric hospitals, medical office buildings, nursing homes, and assisted living centers.
  • Let us find out more about these criteria and the corresponding REIT categories.
  • Using these styles of businesses of ownership and lending as a criteria, you can classify REITs into three further types.
  • Equity REITs, they own and operate properties that generate income and engage in diverse real estate activities, such as leasing and development of residential apartments and office buildings.
  • Unlike real estate companies, equity REITs purchase and develop properties to build their own portfolio.
  • The second type, mortgage REITs, they finance owners and operators of properties directly or offer credit indirectly by buying loans or mortgage-backed securities.
  • In summary of the above, equity REITs are Shari’ah-compliant, but the mortgage and hybrid REITs are not.

Week 3: Islamic Capital Market Products > Types of REITs > Unit

  • Most REITs are public, they are listed on stock markets, and some may be included on Shari’a hcompliant indices.
  • REITs have a number of different structures, and let us cover that now.
  • The traditional REIT is based on a structure which owns its own assets directly, and not through an operating partnership.
  • They represent a collaborative venture between REITs and the members of an external partnership.
  • In this partnership, the REIT contributes only the cash, and the partners contribute the property from their external partnership.
  • Both the REIT and the partners receive stakes or units in the operating partnership in proportion to their respective contribution.
  • Typically, a year after operating partnerships have been formed the partners can exchange their units for cash or shares of the REIT.
  • Either the REIT or the operating partnership has to grant permission for this to happen, depending on any previously agreed upon rules.
  • DownREIT, like the UPREIT, represents an operating partnership between the REIT and external entities.
  • In the DownREIT, the REIT can only own and operate assets independently.

Week 3: Islamic Capital Market Products > Commodity and Hedge Funds and Islamic Finance > Unit

  • Hedge funds can trade frequently and can take the maximum possible risks.
  • Many of these characteristics, such as short selling, make hedge funds unsuitable for Islamic capital markets.
  • Hedge funds do not conform to standard trading practices and guidelines defined by regulatory authorities.
  • Therefore most regulatory authorities discourage their average investors from investing in hedge funds.
  • The Securities and Exchange Commission of the United States bars anyone with a net worth less than $1 million from investing in hedge funds.
  • Therefore we can say that hedge funds are privately traded funds and are suitable for investors who are very strong financially and have a high risk appetite.
  • They mainly compete with traditional mutual funds and they try to surpass them by using techniques, such as short selling, derivative investing, and arbitrage.

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