The problem with a Shariah Index Fund

Standard & Poors announced yesterday it is launching a Shariah compliant version of the S&P/TSX 60, which, while their first in Canada, will be their 52nd Shariah compliant index fund. For Standard and Poors to come out with investment products sensitive to a large demographic of individuals (Muslims) is a wise move and should be applauded. Shariah is the body of Islamic religious law, which is the third most prevalent legal system in the world after common and civil law. The term "Shariah compliant" suggests that the holdings in this index represent holdings that meet the criteria as prescribed by Islamic law. However, I do want to cast some healthy doubt on this idea of Shariah compliant indices.

Standard & Poors has a "Shariah Supervisory Board" composed of Islamic scholars that decide what investments do or do not qualify. This is where the confusion arises. For one, there are five schools of law in Sharia (four in Sunni Islam and one in Shia Islam). How likely is it that the group adequately represents the proportional sentiment of each school of thought? "Shariah law is open to interpretation and religious boards frequently hold different views on key Shariah issues," El Waleed M. Ahmed writes in the Arab Times.

For example, companies, whose business consists of alcohol, gambling or pornography, would not qualify for the index. This is probably a universal sentiment. However, they go further. "Companies which have high levels of debt or high levels of interest earnings are also screened out," Alka Banerjee, S&P Index Services Vice President, tells CTV. As most public companies (if not all) have either debt, income derived from interest earnings or both, who decides what is considered "high?" In this case, a group of Islamic scholars decided that, currently, companies that have debt under 33% of market capitalization qualify for the index.

How did they come by 33%? Why not 40%? Or 20%? Each number would have an effect on the resulting portfolio. The idea of a group of layman (and I'm sure they are incredibly pious individuals yet unqualified in portfolio management) picking companies out of an index based on a subjective criteria that might differ from one school of thought to another...perhaps we could be chucking darts at a dartboard?

Therefore, it feels like active management without the active management! An actively-managed investment by a group of people that are religious scholars not financial professionals.

Of course, what's important to keep in mind here is the intention of Standard and Poors, which is to the best of their ability to create an investment product that Muslims can invest in. Muslims, for their part, actually might forego investing in such products based on the fact that they could be investing in companies not compliant with their beliefs. Taking advantage of this effort does, at least, give them an opportunity to illustrate they are trying.

Click "announced today" or "Alka Banerjee" to read yesterday's news release.