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BWFS2083

ISLAMIC FINANCIAL MARKETS, INSTRUMENTS, AND INSTITUTIONS

TOPIC 5ISLAMIC CAPITAL MARKET

EQUITY INSTRUMENTS

ISLAMIC CAPITAL MARKET EQUITY INSTRUMENTS

DEFINITION

THE ROLE OF EQUITY FINANCING AND

STOCK MARKETS.

THE DEVELOPMENT OF THE ISLAMIC EQUITY

MARKET.

SHARIAH COMPLIANT STOCKS AND OTHER

EQUITY-LINKED PRODUCTS

EQUITY INSTRUMENTS

Document as a legally applicable evidence of the ownership right in a firm, like share certificate.Issued to company shareholder to fund the businessExamples : common stock and preferred stock

ISLAMIC CAPITAL MARKET

Shariah-compliant instruments for long-term investment & financing activities

DEFINITION

The role of equity financing and stock markets

• To provide funds for expansion – in the form of ownership share– Sharing profit as well as losses– Dividend payment is not obligatory

• Residual owner – in terms of earnings as well as claims to asset in the event of liquidation

DisadvantageThe main disadvantage of equity financing is that the founders

must give up some control of the business. If investors have different ideas about the company's strategic direction or day-to-day operations, they can pose problems for the entrepreneur.

In addition, some sales of equity, such as initial public offerings, can be very complex and expensive to administer. Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations.

equity financing is more complex – need to use third party service such as lawyers and accountants.

STOCK MARKETS

Two types:

A. Supporting the growth of the industry and commerce in the country.

B. A platform for the buyers and sellers of

these stocks that are listed at the stock

market.

A) SUPPORTING THE GROWTH OF THE INDUSTRY AND COMMERCE IN THE COUNTRY.

A pivotal role in the growth of the industry and commerce of the country.

Important from both the industry’s point of view as well as the investor’s point of view.

Issue shares through the stock market when a company wants to raise funds for further expansion or settling up a new business venture.

Primarily the place where these companies get listed to issue the shares and raise the fund.

For the companies which are going public for the first time, they need to start with the Initial Public Offering or the IPO. In both the cases these companies have to go through the stock market.

B) A PLATFORM FOR THE BUYERS AND SELLERS OF THESE STOCKS THAT ARE LISTED AT THE STOCK MARKET.

The secondary market of the stock exchange where retail investors and institutional investors buy and sell the stocks.

For investing in the stocks or to trade in the stock the investors have to go through the brokers of the stock market.

The brokers basically act as a middle man between the buyers and sellers.

The demand and supply of the stock of a company determines the price of the stock of that particular company.

Stock market is not only providing the much required funds for boosting the business, but also providing a common place for stock trading.

It possible to sell the stocks at any point of time and get back the investment along with the profit.

DEVELOPMENT OF ISLAMIC CAPITAL MARKET

The establishment of Pilgrim Funds Board (1969) is the main source for Islamic finance industry.

Introduction of Islamic Banking Act (1983) and Takaful Act (1984) provides specific legal framework of Islamic financial institution to operate.

List of the development of Islamic Capital Market in Malaysia : 1990 - Issuance of first Islamic corporate bond by Shell

MDS Sdn Bhd. 1993 - Launch of first Islamic equity unit trust fund by

Arab Malaysian Unit Trust Bhd.

1994 - First full fledged Islamic stock broking company, BIMB Securities Sdn Bhd.

1995 - Establishment of the Islamic Capital Market Unit within the SC.

1996 - Establishment of the Syariah Advisory Council (SAC) by the SC to advise on Syariah compliance matters

for Islamic capital market activities. 1997 - Khazanah Nasional Berhad launched the Islamic zero-

coupon bond function as a benchmark for the Islamic bond market.

1999 - Launch of the country’s second Islamic equity index, the KLSE Syariah index.

2000 - Launch of the first Islamic bond fund by RHB Unit Trust Management Bhd Establishment of

Labuan International Financial Exchange (LFX).

2001 - Launch of the Capital Market Master plan.

2002 - Issuance of the world’s first global Islamic bond by Kumpulan Guthrie Bhd.- Issuance of the world’s first global sovereign Islamic bond by the Malaysian government.- Launch of the first Syariah index fund by MBF Unit

Trust Management Bhd.

2003 -The Islamic Capital Market (ICM) generally refers to capital market activities that are carried out in a

Syariah- compliant manner, which do not go against the teachings of Islam.

2004 -The government proposed a measure to increase financing through the use of Islamic corporate bonds with a

more comprehensive tax treatment similar to conventional bonds.

SHARIAH COMPLIANT STOCKS

• Securities (ordinary shares/equities) of company listed on Bursa Malaysia which is classified as Shariah permissible for investment.

• Primary business and investment activities that generate income for the company must confirm with Shariah principles.

• Two-tier screening: a) Qualitative

b) Quantitative

Qualitative Screening

• The qualitative screen involves excluding the companies that participate in business activities prohibited by Shariah.

• The underlying business activity of the company must be evaluated and deemed to be compatible with Shariah restrictions with respect to exposure to certain business activities.

• Ineligible for investment and must be excluded from the stock universe.

INSURANCE All insurance companies are excluded

BANKING Conventional financial activities are excluded since they are interest based

PORK Producers, distributors and meat stores are excluded. Special attention is focused on companies that are involved in handling pork products, such as supermarkets, hotels & restaurants

ALCOHOL Producers/Distributers/Liquor stores are excluded. Special attention is focused on businesses that derive significant income from this area, such as supermarkets, hotels & restaurants

GAMBLING Casinos, hotels and bookmakers are excluded

ENTERTAINMENT Companies involved in adult entertainment are excluded

TOBACCO Companies involved in tobacco production are excluded

DEFENSE Companies that derive significant income from defense and armaments are excluded

• For the companies comprising both halal and non-halal elements, SAC (Shariah Advisory Council) considers two additional criteria:

1) The public perception of the company, which must

be exemplary.

2) The core activity of the company must be considered

to be in the public interest, with non-halal elements as a

negligible part of their activity.

Quantitative Screening

• Financial screen that examines the corporate structure of the company.

• Focuses on leverage, liquidity and interest of the company.

• Shariah scholars created acceptable thresholds for the degree of involvement in non acceptable practices.

• The general rule for financial ratio screening is that debts must not exceed 33%, interest income must be less than 5% and receivables of the company income, less than 47%. For trading purposes the company must own a certain level of illiquid assets

Liquidity

• Conventional Analysts regard a high liquidity ratio as a positive sign that indicates a company’s ability to meet its short-term debts.

• Shariah perspective, a company should generate returns from illiquid assets therefore a Shariah compliant company should have a low proportion of liquid assets.

Interest Income

• Shariah scholars have allowed interest income as long as it makes up a small proportion of total income.

• Typically, companies that have an interest income of less that 5% of total income are acceptable.

Leverage

• Since Shariah prohibits paying interest, leverage levels of a company should be within the acceptable thresholds in order to be Shariah complaint.

• This is a situation that is favor under conventional financial analysis since low debt levels are considered to be a positive sign for investment.

• Typically, acceptable levels of leverage are 33% of total assets.

Preferred Stock

Definition :- Stock with dividend priority over

common stock with a fixed dividend rate and sometimes without voting rights.

Hybrid security - Characteristics of both common stock and bonds

Features Of Preferred Stock

Cumulative Preferred Stock Dividend are cumulative that is if the dividend

is not paid in a given year, it will accumulate

for future payments in subsequent years.

Non- Cumulative Preferred Stock If the company is unable to make the dividend

payment, the obligation is not carried forward.

Claim on Assets and Income Must pay dividends to preferred stockholders before it pays common stockholder dividends.

Protective Provisions Generally allow for voting rights in the event of non payment of dividends.

Convertibility Many preferred stock can be converted into a predetermined number of shares of common stock.

Other Islamic Equity Instruments• I-REITS• Islamic exchange traded funds (ETFs)• Islamic real estate investment trusts (REITs)• Bursa Malaysia best practice guidelines for Islamic stock broking• Securities Commission Malaysia guidelines for Islamic portfolio fund management• Securities Commission Malaysia guidelines and best practices for Islamic venture capital companies

I-REITS

• Securities Commission : Malaysia issued guidelines for I-REITS in November,2005, facilitating the creation of a new asset class for investors

• The guidelines on I-REITS can be considered a supplement to the conventional guidelines

• It outlines the criteria according to which a certain real estate in considered permissible

MALAYSIAN SHARI’AH PERMISSIBLE INVESTMENTS FOR I-REITS

1. Real estate : physical land and man-made items attached to the land

2. Real estate-related assets : units of other I-REITS, Shariah compliant securities of property companies and Islamic bond securities issued by property companies

3. Single propose companies : private companies whose principle assets comprise real estate

CONT.4. Liquid assets : Shariah complaint securities of non property campanies.

5. Non real estate related assets : cash, deposits or other instruments convertible into cash within 7 days

6. Asset backed securities : Islamic bonds issued from securitization transaction

• I-REITS has a potential to develop into a viable investment alternative, however, following major issues needs to be resolved:

Universally acceptable regulatory framework Shariah consensus on assets types

Cross border trading Tax benefits and double tax treaties

Islamic ETF

ISLAMIC ETF

• An ETF (exchange-traded fund) basically is a unit trust fund that is listed and traded on a stock exchange.

• It is open-ended, with a unique in-kind creation and redemption mechanism supported by a system of participating dealers and liquidity providers.

• the difference between ETFs and other unit trust funds is in the manner in which their units are bought and sold.

•ETF is listed and hence its unit can be bought and sold anytime during stock exchange trading hours. Investors buy and sell ETF units through stockbrokers rather than unit trust agents.

Conventional ETF Vs Islamic ETF

• An Islamic ETF and a conventional ETF share common characteristics.

•The main difference between them is the benchmark index that the Islamic ETF tracks. An Islamic ETF only tracks an Islamic benchmark index where the index constituents comprise companies which are Shariah compliant.

• An Islamic ETF is also required to appoint a Shariah adviser/ committee to provide expertise and guidance to ensure that its structure, investments, and all matters related to the funds’ activities comply with the Shariah.

How does Islamic ETF works?

DIAGRAM 1: BASIC STRUCTURE OF AN ISLAMIC ETF

BENEFITS OF investing in ETF

1. Diversification Similar to index funds, ETFs provide investors with similar diversification benefits derived from holding the benchmark index’s constituent stocks without having to invest in that stocks directly.

2. Lower expense ratio As a passively managed fund, ETF incurs lower management fee and lower transaction costs compared to an actively manage fund.

3. Lower transaction cost. ETFs are bought and sold at the same transaction cost as those charged for trading shares on the stock exchange. For normal unit trusts, usually the transaction costs are generally higher.

4. Tradability ETF units can be bought and sold at anytime during trading hours of the stock exchange

5. Transparency ETF prices are disseminated throughout trading hours on the stock exchange. The constituent stocks of the index which the ETF tracks are normally published on the fund or index provider’s websites.

6. Shariah-compliant investment As for Islamic ETFs, an additional benefit is its conformity to the Shariah principles and practices, which is important to Muslims. Non-Muslims may also wish to invest in such funds based on Shariah principle.

THE Risks IN Islamic ETF

a) MARKET RISK ETF prices are exposed to the economic, political, currency, legal and other risks related to the index that ETF tracks.

b) TRACKING ERROR Though the main objective of an ETF is to track the performance of its benchmark index, the ETF’s performance may deviate from the performance of the benchmark index.

c) LACK OF MANAGER’S DISCRETION In this passive management strategy, the manager does not try to outperform the benchmark index.

d) LIQUIDITY RISK the listing of an ETF does not guarantee that there will be an active trading market for it. There is no certain basis for predicting the sizes or actual prices at which the ETF units will trade.

Bursa Malaysia best practice guidelines for Islamic stock broking

• Bursa Malaysia Berhad urged stock broking companies to offer Islamic stock broking business or services in an effort to broaden the development of overall Islamic financial services in Malaysia as well as bring in new global funds to the capital market.

• The new Bursa Malaysia’s Best Practices Guidelines in Islamic Stock broking Services is a set of voluntary guidelines that outline key areas covering the operations and compliance aspects of an Islamic stock broking business.

• The framework sets out the recommended best practices in carrying out stock broking services in accordance with Shariah principles.

Securities Commission Malaysia guidelines for Islamic portfolio fund management

1)An Islamic fund manager must ensure that its investment activities are limited to Shariah-compliant investments.

2)For investment in listed securities on Bursa M’sia,an Islamic fund manager should invest only in securities listed on the SAC’s list of Shariah-compliat securities

Cont..3)For investment in unlisted securities,an Islamic

fund manager is encouraged to follow the SAC’s methodology in determining the Shariah status of listed securities.

4)For investment in securities traded on a recognized stock exchange,an Islamic fund manager should only invest in securities endorsed by the Shariah advise of the recognized stock exchanged or by an international Shariah standard setting body.

Securities Commission Malaysia guidelines and best practices for Islamic venture capital

companies

1. An independent Shariah adviser must be appointed to provide expertise and guidance on conformance to the Shariah principles in all matters of the Islamic VCC/VCMC.

2. The activities of the venture companies must be Shariah compliant.