A taste for plain vanilla sours Islamic ETFs' rise

Islamic and other unconventional exchange-traded funds are finding it tough to grow, partly because what is on offer is limited but also because of an unhelpful structure, writes Bernardo Vizcaíno.

One attraction of ETFs is that they can provide investors with access to themes that have a low correlation with equities markets. AF

Unconventional exchange-traded funds are finding it tough to grow, partly because what is on offer is limited but also because of an unhelpful structure, writes Bernardo Vizcaíno

Islamic exchange-traded funds (ETFs) are struggling to attract fresh investors, in contrast to a move by western investors into conventional ETFs.

The difference is due to the Arabian Gulf's "plain-vanilla" investment culture and the way in which institutions choose financial products.

ETFs are funds that track indexes of shares, bonds or commodities and are traded like stocks. Their Sharia-compliant versions follow religious principles such as bans on interest and gambling.

Since demand for some other Islamic financial products, such as sukuk is surging, it might seem reasonable to expect rapid growth in Islamic ETFs, especially since the slump in stock markets in the Gulf and across the world is hurting traditional stock-picking equities investment.

Conventional investors moved US$111.7 billion (Dh410.28bn) into equity exchange-traded products worldwide and $172.4bn out of equity mutual funds last year, a report by the global investment manager BlackRock showed.

Conventional fixed income exchange-traded products produced record-breaking inflows of $25.5bn in the January to April period and $49.9bn last year, according to BlackRock. But amounts of fresh money committed to Islamic ETFs have stayed steady or even dropped.

The trend can be seen in products launched in 2007 by iShares,the world's largest ETF provider.

Combined assets in iShares' three Islamic ETFs stood at $95.8 million on June 25, representing modest growth from $82.9m at inception, iShares data showed. That represented a 42 per cent drop from the all-time high of $164.5m hit in September.

Others have had less success in raising capital. BNP Paribas launched its Islamic ETF in 2007 and had only $27.5m in assets as of this month.

Deutsche Bank launched its own offering in 2008 and had $8.9m in assets as of June.

One attraction of ETFs is they can provide investors with access to themes that have a low correlation with equities markets. But Islamic ETFs focused on asset classes other than equities have yet to appear, even though major index providers offer large families of Sharia-compliant indexes.

Investor interest in multiple Islamic investment themes exists, says Tariq Al Rifai, the director of Islamic market indexes for S&P Dow Jones Indices but it has not so far translated into ETF launches. "Our sukuk index is very popular but products remain manager-driven."

For the foreseeable future, growth of Islamic ETFs is likely to depend mainly on the cash-rich Gulf. But the structure of the region's financial industry is not helpful.

In the United States and Europe, many ETFs are sold by individual financial planners who do not make money based on the cost of the products their clients buy.

The planners have no compunction in introducing clients to ETFs and many clients are drawn by ETFs' low costs, such as that from BNP Paribas, which charges a management fee of just 0.5 per cent.

In the Gulf, institutional investors are usually catered to by placement agents and fund marketers, not financial planners.

These agents, who charge commissions on their sales, prefer to sell private equity, hedge funds and property, where margins are higher for them - a hedge fund can charge a 2 per cent management fee and a 20 per cent performance fee.

"The investment adviser channel in the Gulf has not been as well developed as it could be. That is the issue," Mr Al Rifai says. "At some point it will take off … Give it another three years."

Saeid Hamedanchi, the chief executive of the investment management firm ShariaShares, based in California,says the biggest factor is the "lack of knowledge of the ETF industry in the GCC". This is aggravated by most ETF providers having a limited Gulf presence, he adds.

Also, analysts still note a preference for more familiar property and private-equity investments among Gulf investors - perhaps because with economies growing strongly and some property markets such as Saudi Arabia's still strong, local investors are thinking in terms of big pay-offs.

In the West, slow growth and weak asset markets have prompted investors to focus more on minimising their investment costs - one of the major attractions of ETFs.

For ETFs to be fully cost-effective, however, they need to reach an optimal size - and Islamic ETFs may not yet have arrived at this threshold.

* Reuters