BANK KESHAVARZI IRAN

NEWHORIZON Muharrum–Rabi Al Awwal 1429
IIBI LECTURES
Traditionally, these screened universes have
been used by long equity fund managers.
Now, increasingly, such universes are used
by index providers such as FTSE and Dow
Jones to provide benchmarks for funds.
They are also used by providers of
exchange-traded funds and other indexbased
instruments. Recently, alternative
investment funds have also started to use
them.
He argued that, given this increasing and
varied usage, it is important to have a
robust methodology which is transparent
and verifiable. In addition, there is the
need to bear in mind that the universe of
investible stocks needs to be as large as
possible so as not to detract from the riskmitigating
advantages of portfolio
diversification. Therefore, the screening
of stocks for Shari’ah compliance is
becoming a critical task which demands
thoroughness and professionalism.
Asaria also looked at the rationale behind
the Shari’ah screens and the methodologies
of various providers of these services. This
essentially involves looking at business
compliance and financial compliance. For
business compliance, it needs to be
determined whether a corporation is
engaged in haram industries such as
alcohol, gambling, armaments, tobacco,
pornography or pork. Most Shari’ah
scholars have put a tolerance level of five
per cent on such activities.
For financial ratios, gearing levels,
receivables and interest income all need to
be considered. One can either base the levels
on a proportion of total assets or of the
market capitalisation of the corporation.
Presently, Dow Jones is the only screening
provider that uses market capitalisation. All
other providers, such as MSCI, S&P, FTSE
and Amiri S3, use total assets for the
calculation of financial ratios. Asaria
discussed the rationale of the ratios, and
the benefits and disadvantages of the two
approaches. Asaria said that the basic
methodology of ensuring business and
financial compliance may, at first glance,
seem simple. However, on closer examination,
several critical issues crop up. The
first is of business classification. The broad
category of prohibited categories is clear.
However, corporations are complex entities
and engage in a diverse variety of activities.
For this purpose there are two classification
systems that can be used. One is the
Standard Industry Classification (SIC)
code, the other is the
International
Business
Classification (IBC)
code. SIC codes are
much more detailed,
and delve into
several layers of
corporations’
activities – an
individual company
may have up to
eight SIC codes
associated with its
activities. The IBC
codes are much more
general and tend to look at the core
business of the corporation in question.
Iqbal Asaria,
Afkar Consultants
With the help of some examples he outlined
the complex processes that need to be in
place to keep the screens up to date. For the
purpose of determining whether the
proportion of unacceptable activities
is under five per cent, SIC codes seem to
provide greater robustness. However,
aggregation of activities by their associated
SIC codes is not free from caveats. As an
example, an SIC code could be assigned to
livestock production. It would be difficult
to determine whether this includes pig
farming or not. This would have to be
determined by actual contact with the
corporation concerned. Similarly,
production of beverages presents a host
of issues, including the possible production
or otherwise of alcoholic drinks.
At another level, business compliance also
involves some decisions of principle to
be made. A company specialising in
conventional financial industry publications
is a case in point. Does this activity
constitute a part of the conventional finance
category or the more neutral publishing? If
the latter point of view is accepted, then
what classification would be given, for
example, to a company manufacturing
gaming machines? As one ploughs through
the possible investible stock universe a
multitude of such issues need to be
addressed. In many cases, detailed
discussions with Shari’ah scholars are
needed in order to come to a decision.
For financial compliance, the issues
are somewhat more straightforward
once the definition of terms and
their composition have been agreed.
However, even this area can present
difficult issues. For example, if
a corporation is generally compliant
but the gearing ratio shoots just
over the prescribed limit in a
particular year, should its status
be changed to ‘fail’? This could just
be an aberration due to the arbitrary
year-end date. One thus needs to
determine whether the gearing ratio
represents a long-term change in the
corporation’s operating profile or
a mere blip in its activities. If the latter,
then Shari’ah scholars would need to be
consulted if the current ‘pass’ status is to
be retained for the next period. This could
be quite an issue for large ‘index’
constituents as frequent changes in their
status create instability and unsuitability of
their use as benchmarks.
Finally, Asaria threw some light on the role
of Shari’ah scholars in managing a Shari’ah
screened universe of stocks. He also outlined
a possible affinity with ethical screening and
the possibility of having a unified Shari’ah
and ethical screened universe.
After the presentation, the participants
raised questions about: why there is
divergence in Shari’ah scholars’ opinions
for allowing tolerance levels for stock
screening; what grace period is used for
holding the stock if a company begins to
fail in its Shari’ah compliance; and how the
Shari’ah-compliant index providers cover
the time lag between the actual business
activity and the preparation of financial
statements by corporations.
For information on the upcoming lectures,
please visit the IIBI’s website at
www.islamic-banking.com
www.newhorizon-islamicbanking.com IIBI 41