Shariah Investing: Focusing on Fundamentals
investors would continue to benefit from a lack of exposure to the volatile financial sector. The second being that as conventional markets stabilized and financials in particular moved into recovery Shariah indices would begin to loose their trend of strong out performance and the alpha built over the credit crisis period would begin to give way.
Looking back on 2009, both assumptions appear to have been affirmed. At the end of the last year, the MSCI World Islamic Index had outperformed the MSCI World Index and continued to be the stronger performer over the last 10 challenged quarters as demonstrated in Figure 1. However, in USD terms, the 2009 performance of both indices shows that the Islamic index returned 27.08% and the conventional returned 26.98%, a less dramatic out performance than in 2008 where the Islamic index outperformed its conventional counterpart by 5.74% or in 2007 when the out performance was 8.22%
Figure 1: MSCI World Index vs. MSCI World Islamic Index 01/01/2004 to 31/12/2009
Comparative performance of MSCI Indices (rebased to 100)
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Source: MSCI, in USD from January 1, 2004 to December 31, 2009.
Looking back at Q4
In the last quarter of 2009, the MSCI World Islamic Index’s allocation to low-debt companies and non-financial stocks continued to work in its favour. Financials were the worst-performing sector for the quarter, falling both on fears surrounding the potential for default on Dubai World’s debt as well as increased European forecasts regarding the amount of bad debts still remaining on bank balance sheets. Although there were positive signs of recovery throughout the quarter, the Islamic Index continued to benefit strongly from its lack of exposure to these troubled sectors, illustrated by its out performance of the conventional index by more than 3.5%.
Among the sectors that are more sensitive to changes in the economic cycle (cyclical sectors), Materials led the way in Q4, climbing in line with a surge in copper, gold and other metals. Energy and Information Technology also outperformed the overall Islamic index, as oil prices moved higher and technology companies continued to show good prospects for the upcoming year. The cyclical Industrials sector slightly underperformed the index, joined by the more defensive Utilities and Telecommunications sectors among the laggards.
Looking back further than the last quarter, Figure 2 below highlights contributors to Industry return over the last 10 challenged quarters. The chart shows the return impact of the top ten industry positions of the MSCI World Islamic index and that, when compared to the MSCI World Index, a deviation in allocations to Banks (underweight), Diversified Financials (underweight) and Pharmaceuticals & Life Sciences were the top 3 drivers of alpha (excess return) for the Islamic Index. This is consistent with the discussion that Shariah investors have benefited from a lack of exposure to the financial sector. However some of this alpha was offset by an overweighting of cyclical sectors. Shifts in sector leadership and volatile swings in cyclical industries such as Energy and Consumer Goods resulted in them detracting from the Islamic index in relative terms.
Figure 2: Top Ten Industry Exposures Returns of MSCI World Islamic Index relative to MSCI World Index 01/07/2007 to 31/12/2009
Source: MSCI in USD from July 1, 2007 to December 31, 2009.
Focus on Quality
Although there were signs of improvement in the world economy during the past year, SEI believes the pace of gains is likely to be more tempered in 2010. The market rallies in 2009 were mostly driven by riskier assets with higher leverage and poorer-quality earnings - the opposite selection criteria for Shariah stock. This dampened Shariah indices’ trend of strong outperformance.
Conventional indices are likely to perform better than their Islamic counterparts if assets that are perceived to be riskiest continue to stoke positive rallies and as economic activity revives and corporate profitability improves, the magnitude of the outperformance should diminish. However SEI believes it will not only be the recovery of riskier stocks and sectors that will close the gap between the conventional and Islamic indices. If 2010 sees the market transition to a more fundamentals-driven recovery where companies are judged individually based on their position in the market and their growth prospects, the stock selection criteria of Shariah and Conventional investing will likely overlap.
A point to note is the importance of Asset Selection as a driver of alpha for Shariah Indices. Figure 3 below highlights that over a 30 month period beginning in July 2007, Industries and underweight towards other sectors (as highlighted in Figure 3) contributed almost 50% of the outperformance (5.61% over the performance of the MSCI World Index), followed by Asset Selection contributing 3.77%. The quarterly asset selection in the Islamic Index is a result of the parameters and guidelines placed on prohibiting companies engaged in non-Shariah-compliant activity in addition to those that exceed the debt to equity guidelines.
Figure 3: Cumulative Contribution to Excess Return of MSCI World Islamic Index over MSCI World Index 01/07/2007 to 31/12/2009
Source: MSCI, in USD, from July 1, 2007 to December 31, 2009.
Moving forward, SEI believes the key attributes of Shariah investments’ performance will continue to be: asset selection, avoidance of financials and a focus on quality stocks. If conventional markets and Financials in particular move into a broad market recovery, the gap between the MSCI World and MSCI World Islamic Indices should narrow as we saw in 2009 and return to the pattern they followed up until April 2007. However, if fundamentals and quality stocks lead the 2010 markets, we should anticipate a broadening of leadership by Shariah Indices over conventional.
Summary: Navigating 2010
If 2010 continues to see the market transition to a more fundamentals-driven recovery, Investment Managers – including Shariah Managers - with a track record of strong security selection capabilities may be in a better position than other managers to navigate such an environment. Managers who follow strong due diligence processes and stringent risk management practices may be better positioned to make more consistent and less risky returns for their investors.
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SEI currently manages four Shariah Compliant funds under the SEI Islamic Investments Fund PLC umbrella. This range includes the SEI Islamic US Equity, SEI Islamic Pacific Basin Equity, SEI Islamic European Equity and SEI Islamic Emerging Markets Equity Funds.
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