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.

Why it is important to tell if your mutual funds are 'closet indexers' and 3 ways to identify it

Pundits and casual observers will debate the pros and cons of mutual funds. Mutual funds are probably the most mainstream vehicle of active management, at least as far as retail investors are concerned. It is the appropriate strategy for critics of the efficient market theory, which is the idea that prices on assets, such as stocks and bonds, reflect all known information. The idea is to take advantage of mispricing in the market. As the strategy is in the hands of a money manager, volatility can be managed by investing in less-risky, high quality companies rather than in the market as a whole. It can also allow investors to take on additional risk to exceed higher-than-market returns. Furthermore, investments that are not highly correlated to the market help diversify a portfolio. This is the argument for active management, and this is where a problem arises.

Closet indexing is a when an active manager doesn't stray too far from the benchmark in their stock selections. They are "...pretending to be a stock-picking manager when you're [they're] really putting together a portfolio not much different from whatever index is the benchmark for your category of fund." (Stoffman 218) With a closet index fund, the MER is more than 2%, which is whopping considering that an index fund or exchange-traded fund charges significantly less.

Money managers are assessed by their ability to beat their relevant benchmark, which is the market index that best represents the portfolio they are managing. Trying to beat their index by a significant amount carries greater risk, so there are mutual fund managers that will fill their portfolio up with investments that make up their index, which means they'll never significantly underperform or overperform by a significant amount.

I'll try and update this blog entry with a more recent static but over 5 years ending June 2008, S&P 500 outperformed 68.6% of actively managed large cap funds, S&P MidCap 400 outperformed 75.9% of mid cap funds and S&P SmallCap 600 outperformed 77.8% of small cap funds. (Dash, Pane) The index has outperformed the majority of active managers. Therefore, following the index will mean outperforming a majority of their peers (also known as their competition), making it easier for the fund company to sell their funds. This does not provide value for the client and undermines a reason for pursuing an active management strategy in the first place, which is to do better than what the markets are doing. It's the reason a client pays a higher fee in the first place.

Following me? The investments and their allocation are incredibly similar between the fund manager 'actively-managing' and the benchmark he or she is being compared to. Therefore, if you're invested in a mutual fund that is a closet indexer, you will see far more value if you invest in an index fund or ETF that tracks these benchmarks themselves. With this, you are paying a significantly lower fee to get a similar result.

A mutual fund manager is guilty of being a closet indexer when (Stoffman 107):

1) It has a high R-squared (gives you a correlation between a fund and its benchmark index). The closer the R-squared is to 1, the more likely a closet indexed fund.

2) Check the annual report of an actively managed and its benchmark index fund. Check to see if similar stocks are held with similar proportions.

3) Compare recent returns of your actively managed fund and its benchmark. Do the returns of the managed fund regularly trail the index by its MER?






Sources:



Dash, Srikant and Roseanne Pane. “Standard & Poor’s Indices Versus Active Funds Scorecard, Mid Year 2008.” Standard & Poors McGraw Hill Companies November 18, 2008.

Stoffman, Daniel. The Money Machine. Toronto: Macfarlane Walter and Ross, 2000, p. 202.