MSCI, S&P Launch New Sharia-compliant Indexes: Islam-friendly ETFs Next?

On April 24, two major index providers announced the launch of new Islamic equity indexes, with both MSCI Barra and Standard and Poor’s (S&P) moving into the market for Shariah-compliant benchmarks. For MSCI, this represents entry into a new area of indexing, while for S&P it means the expansion of an existing family.

The concept of stock indexes compliant with the beliefs of Islam is not new. The first Shariah-compliant indexes from a major index provider were launched by Dow Jones Indexes in 1999, and FTSE followed suit with its own family in 2000.

However, no new competitors have entered the field for some time, despite growing demand from oil-rich investors in the Middle East. A report released by S&P last year put estimates of current Shariah-compliant assets at $400 billion, and estimated the potential market for Islamic financial services to be in the area of $4 trillion. The new indexes screen out companies that derive more than 5 percent of their revenues from business activities involving alcohol, tobacco, pork-related products, financial services, gambling, and pornography.

“A lack of globally accepted benchmarks and other tailored investment tools is constraining the development of Shariah-related equity investing around the world,” said Alka Banerjee, vice president of S&P Index Services, in a recent press release.

For its part, MSCI plans to launch the flagship indexes in the MSCI Global Islamic Indices series in July 2007, with additional indexes to follow in October. The indexes will screen potential components based on their financial ratios and business activities, and will use “dividend purification” rules to resolve the issue of interest income. The indexes in the Islamic index series are derived from the corresponding indexes in the MSCI Standard Index series.

The MSCI indexes have been OK-ed by an independent Shariah board, and have been reviewed and approved by Dar Al Istithmar, a consulting firm that advises financial services providers on the development of Shariah-compliant products. MSCI’s Shariah advisors will certify the index as Shariah-compliant on a quarterly basis, according to the established methodology.

S&P launched its own family of Islamic indexes last year, offering Shariah-compliant subsets of the S&P 500, the S&P Europe 350, and the S&P Japan 500. This week’s product launch covers the so-called Gulf Cooperation Council [GCC] countries, including Saudi Arabia, Bahrain, Oman, Qatar, United Arab Emirates and Kuwait. The new indexes include the benchmark S&P GCC Composite Shariah Index and the S&P GCC Investable Shariah Index, as well as Shariah-compliant indexes for each country.

Like MSCI, S&P has enlisted the help of a consulting firm, Kuwait-based Ratings Intelligence Partners, to ensure that the indexes are Shariah-compliant.

The two sets of indexes do have slight difference in their screening methodology. S&P screens out some companies with certain advertising and media activities, and those that engage in the trading of gold and silver as cash on a deferred basis. MSCI screens out companies involved in weapons and defense, the music industry (including radio broadcasting), hotels, and the film and television industry (including television broadcasters, cable providers and theaters).

MSCI and S&P anticipate that their indexes will be licensed for use as the basis for investment vehicles, including structured products, mutual funds and exchange-traded funds.