Shariah Quarterly July September 2017 PERSPECTIVE FROM TEMPLETON GLOBAL EQUITY GROUP ALAN CHUA, CFA Executive Vice President Portfolio Manager / Research Analyst Templeton Global Equity Group PETER WILMSHURST, CFA Executive Vice President Portfolio Manager / Research Analyst Templeton Global Equity Group Overview This paper explores the complexities that could arise from Shariah equity investing. To be sure, implementation of the Shariah standards on investments, such as stocks, can be challenging as well as subjective as different Shariah scholars have their own interpretations of the Islamic principles. This can lead to varying approaches, when screening for Shariah-compliant stocks, and different input in the calculation of financial ratios, which are used to gauge the debt, cash and liquid assets of companies. Such ambiguities can indeed create dilemmas and confusion for Muslim investors and fund managers with regard to which method to adhere when selecting Shariah-compliant equities. Many of these issues, however, can be resolved if professional investors collaborate with reputable Shariah supervisory boards and engage experienced stock-screening companies that have in-depth knowledge of the Islamic principles. To ensure continuous adherence to internationallyaccepted Islamic tenets for our Shariah-compliant equity funds, Franklin Templeton Investments (FTI) partners the Amanie International Shariah Supervisory Board, whose scholars provide initial approval on the objectives and strategies of the funds as well as ongoing supervisory and monitoring services. FTI also engages the services of IdealRatings, whose stockscreening capability covers about 40,000 stocks around the world and has powerful quantitative tools to ascertain which counters are Shariah-compliant. Combining FTI s asset management expertise with the extensive knowledge and guidance from the Amanie International Shariah Supervisory Board, plus the stock screening proficiency of IdealRatings, investors of our Shariah-compliant equity funds can be rest assured that their money are managed by the best-in-class specialists in the area of Islamic investing. Restrictions and Prohibitions of Shariah Investing Shariah, which means way or path, explains the full details of Islamic concepts with regard to money, capital, relationship between risk and profit, and social responsibilities. In essence, Shariah investing is about putting money in investments that comply with Shariah concepts and principles that are appropriate for Muslim investors. Based on Islamic canonical directives, a financial instrument or transaction under Shariah guidelines must be free of Riba (interest or usury), Rishhwa (corruption), Maysir (gambling), Gharar (excessive risk), and Jahl (ignorance). 1
Muslims cannot invest in haram businesses that are considered illegitimate under conventional Islamic laws, such as those related to alcohol, tobacco, pornography, prostitution, gambling, pork, movies, TV, music, and weaponry. Traditional banking (which involves interest-based lending and borrowing as well as intermediation between depositors and borrowers), conventional insurance, and mainstream financial services are other areas that would typically be excluded from a Shariah-compliant investment portfolio. Based on Islamic investment guidelines, companies are only deemed to be Shariah-compliant if the total sum of non-permissible income is less than 5% of their total income. In addition, investing in companies with too much cash (or liquid assets) and excessive debt in their balance sheets is forbidden under Islamic principles. Shariah-compliant companies should have total conventional debt not exceeding 33.33% of their total assets or average market capitalisation over a 24- to 36-month period. In addition, their total amount of cash and value of interest-bearing securities shouldn t be more than 33.33% of total assets, while their sum of accounts receivables and cash should be less than 50% of total assets. Likewise, in accordance to Shariah laws, speculative activities, such as excessive trading, shorting of financial securities as well as the use of financial derivatives, are prohibited. Islamic finance also places great emphasis on the fairness, validity and transparency of contracts. For instance, no unfair penalty clauses are allowed in investment contracts, which must be put in writing, detailing all terms and conditions. Furthermore, contracts have to follow clear guidelines to ensure no dispute can arise in the future (see Illustration 1 for the lowdown on Shariah investing). Illustration 1: Shariah-Compliant Investment Universe No Interest Involved in the Transaction Profit and Loss Sharing No Excessive Risk/Uncertainty Investable and Barred Shares Common shares are compliant with Shariah laws as they are deemed by Islamic scholars to be securities of an altered version of partnerships, where profits and losses are generally shared among partners at an agreed-upon ratio or in proportion to their contributed capital. Preference or preferred shares, however, are incompatible with Shariah principles because these investment vehicles give more rights to shareholders without adequate justification, according to Islamic scholars. Preference shares also go against the Islamic tenet that all stakeholders should share gains and bear losses equally or on a pro-rata level that is based on their capital participation. Although preferred shares carry no voting rights, they have priority over common stocks when it comes to dividends, which must be paid out to preference shareholders before any payments are made to common stock investors. Preferred share investors also have precedence over ordinary shareholders with regard to claims on a company's assets if they are liquidated. As such, a Shariah-compliant equity fund can only invest in common shares while preferred shares, on the other hand, are not investable. Intricate Stock Screening Process To have a list of investable stocks that could be included in the portfolio of a Shariah-compliant equity fund, securities have to be screened thoroughly to remove companies that are involved in haram businesses as well as those with high level of debt, cash and liquid assets. The screening process to identify Shariah-compliant stocks starts by evaluating the business activities of companies in order to identify and remove traditional financial services companies as well as those that are involved in commercial dealings that are forbidden under conventional Islamic laws. After removing companies with non-compliant business activities, financial ratios are then used to ascertain those with excessive leverage, substantial cash holdings and high percentage of revenues derived from non-compliant activities. Permissible Business Activities Transparent, Fair and Valid Contracts and Rights Given the complexity of the screening process, identifying an investable universe of Shariah-compliant stocks in countries, regions and around the world is 2
likely to be too tedious and time consuming for most investors. That is why some Muslim investors opting a less arduous way to Shariah equity investing only select stocks from the already-screened constituents of Islamic equity indices, such as those provided by Dow Jones, S&P, FTSE, and MSCI. There are, however, drawbacks to this stock selection approach. To be sure, if investors were to only select from a small universe of constituent stocks that are part of Shariah-compliant equity indices, they could miss out on potential winners that are not part of these indices. In addition, the differing interpretations of Islamic laws by the various Shariah index providers, which have dissimilar ways to include and exclude stocks in their indices, can also be problematic. For example, the FTSE Shariah Global Equity Index Series filtered out weapons and arms manufacturing companies while these defense firms are allowed in the S&P Shariah Indices. Shariah index providers also use different inputs in financial ratios, which are used to measure the debt, cash and liquid assets of companies. For instance, S&P and Dow Jones use market capitalisation as the denominator for their financial ratios while FTSE and MSCI use total assets. Using market capitalisation as the denominator for financial ratios to screen for Shariah-compliant stocks could be challenging for value-oriented investors. Indeed, some stocks with declining valuations that might look attractive to value investors could suddenly become ineligible from a Shariah perspective should their market capitalisation fall significantly relative to their liquid assets or debt. Engaging External Expertise To have access to a big universe of Shariah-compliant stocks, including the non-benchmark names, FTI engages the services of reputable stock screening provider IdealRatings, whose main task is to identify stocks around the world that are Shariah compliant. IdealRatings screening capability covers about 40,000 stocks around the globe. It uses two main sets of criteria, namely business activities and financial ratios, to determine if equity counters are investable under Islamic laws. Stocks that are already screened and deemed investable under the Islamic principles would still require the final approval from a Shariah supervisory board before they can be invested and included in the portfolio of a Shariah-compliant equity fund. A Shariah board also issues guidelines or opinions, called Fatwa, on the compliance process and is integral to the investment selection and review process of a Shariahcompliant fund. That is why it is important for fund managers of Shariah-compliant funds to secure the services of Shariah supervisory boards that have strong expertise and in-depth knowledge in the area of Islamic laws. To ensure continuous compliance to internationallyaccepted Islamic principles and standards for our Shariah-compliant equity funds, FTI works closely with the Amanie International Shariah Supervisory Board. In essence, the process of declaring whether a stock is (or not) Shariah compliant is actually done by the Amanie International Shariah Supervisory Board, on behalf of FTI. Initial approvals with regard to objectives and strategies of the funds as well as ongoing supervisory and monitoring services are also provided by the board. The Amanie International Shariah Supervisory Board, known for its extensive Shariah knowledge and technical understanding, also offers expertise in the purification process of non-core revenues from nonpermissible activities. A Shariah-compliant company, like an airline operator, may have a small portion of income that is derived from non-permissible activities, such as the sales of alcoholic beverages. As such, revenues from non-core business activities that are considered to be haram have to be purified, according to Shariah scholars. This is done by donating a percentage of the non-compliant revenues to charities approved by a fund s Shariah supervisory board, which will issue guidelines to quantify the donated amount based on complex purification ratios. Shariah Investing With TGEG s Value Approach Founded in 1940, Templeton Global Equity Group (TGEG), which is part of FTI, uses a disciplined, yet flexible, long-term value approach to identify fundamentally-sound, high-quality companies around the world that are trading at significant discount to their intrinsic value. This investment approach is based on three tenets: value, patience and bottom-up stock selection, all of which we believe are critical to successful long-term investing. TGEG uses comprehensive fundamental analysis with key focus on earnings and cash flow to gauge 3
companies long-term intrinsic value. Stocks that are trading at attractive prices below their intrinsic value are further assessed for quality by analysing the prospects of their businesses, management strength, ownership structure, corporate governance, and commitment to create shareholder value. by IdealRatings and approved by the Amanie International Shariah Supervisory Board. Only those that comply with the rules of Islamic investing as well as fulfill TGEG s criteria will become potential holdings of the Templeton Shariah Global Equity Fund (see Illustration 2). Equities that have successfully passed TGEG s rigorous investment criteria will be divided into two groups, namely the Bargain List and the Core List. The Bargain List comprises stocks that are mispriced by the market and most undervalued relative to their business prospects based on five-year normalised earnings or cash flow forecasts. The Core List, on the other hand, consists of companies that are still attractively valued but above the Bargain List cut-offs. These undervalued stocks still have significant upside potential and many of them form the core components of TGEG s portfolios. In addition, there is a Source of Funds list, which is made up of companies that are considered fully valued and in the process of being divested. To be sure, equities that are considered for inclusion to the portfolio of the Templeton Shariah Global Equity Fund (or those of any other TGEG s equity funds) are selected from the Bargain and Core Lists. These securities are subsequently matched against a Shariah-compliant global stock list, which is generated In a nutshell, Shariah-compliant stocks form a subset of TGEG s investment universe. Investors of the Templeton Shariah Global Equity Fund are essentially getting a subset of our broader equity portfolios that is compatible with specific Shariah principles. While there is a smaller pool of investible companies to choose from, TGEG is still able to find plenty of potential opportunities in the Shariah global equity space. Constant Monitoring Without a doubt, active Shariah equity investing entails a dynamic process to constantly monitor stocks in the investable universe as newly-approved counters are added while others get kicked out of the Shariahcompliant list. Often times, stocks could be excluded from the list due to transitory non-compliant reasons, such as changes to their balance sheets and income statements. Indeed, a company that was previously in the Shariah investable universe, for instance, could be deemed non-compliant due to a change in the frequency of Illustration 2: A Disciplined and Rigorous Process for Shariah Investors 4
dividend payouts, which could make a difference to eligibility. According to Shariah guidelines, a company that hoards large amount of cash throughout the year, before paying it out in the form of dividends, runs the risk of becoming non-compliant. On the other hand, a current non-compliant cash-rich stock may become a Shariah-eligible investment once it pays out the bulk of its cash holdings as dividends. The issues of dividend-payout frequency and the grace period given for the divestment of non-compliant stocks could add another layer of complexity for fund managers running Shariah-compliant equity portfolios. If an invested stock falls out of Shariah compliance, the standard practice for a portfolio manager of a Shariahcompliant fund is to divest that position within 90 days. But the grace period for the divestment of a noncompliant stock could vary from one fund manager to another, depending on the guidelines given by the Shariah supervisory board. If the grace period to sell non-compliant stocks is short, a fund manager may be forced to divest a cash-rich stock that pays dividends infrequently in a year. Conversely, if the grace period is longer, such as three months, the fund manager can choose to hold on to a cash-rich stock, which has been deemed recently as a non-compliant counter due to its high cash holdings, if the company is scheduled to pay substantial dividends in the near future. To be sure, that company will become Shariah compliant once again when it reduces cash in its balance sheet through dividend payouts. As such, invested companies that are near the limits of Shariah acceptability due to varying cash and debt levels or a sudden spike in revenues from noncompliant business activities should be closely monitored by portfolio managers of Shariah-compliant funds. For stocks that frequently oscillate between compliant and non-compliant status, a fund manager should decide whether it is worthwhile to hold on to these relatively unstable holdings, which over the longer term could lead to higher portfolio turnover for a Shariah-compliant equity fund. Positive Side to Shariah Investing While there are quite a few daunting aspects to Shariah equity investing, which subjects investors to a slew of constraints and restrictions as well as a narrower universe of stocks that requires on-going monitoring, there are also positive facets to this unique way of investing. At the outset, annualised returns were better for investors who had invested in Shariah-compliant global stocks (as measured by the MSCI World Islamic Index) over a 10-year period ended April 28, 2017, as compared to those who had invested in conventional global stocks (as measured by the MSCI World Index) over the timeframe (see Table 1). Not only did Shariahcompliant global stocks outperformed their conventional peers, they did it with less volatility, as measured by standard deviation, over the 10-year period. In addition, Shariah-compliant global equities outshined their conventional counterparts six out of the 10 calendar years from 2007 to 2016 (see Table 2). Table 1: Annualised Returns and Risk of Shariah Equity 1 vs Global Equity 2 10-Year Ann Ret (%) 10-Year Ann Std Dev 3 (%) MSCI World Islamic Index 4.86 15.69 MSCI World Index 4.51 16.49 Source: MSCI (in US dollar terms, as of 28 Apr 2017) 1. Shariah Equity is represented by MSCI World Islamic Index. 2. Global Equity is represented by MSCI World Index. 3. Standard deviation is a risk indicator that measures the dispersion of returns from the mean. Table 2: Annual Returns of Shariah Equity 1 vs Global Equity 2 MSCI World Islamic Index (%) MSCI World Index (%) 2016 8.33 8.15 2015-4.11-0.32 2014 3.77 5.50 2013 23.16 27.37 2012 11.4 16.54 2011-3.12-5.02 2010 13.79 12.34 2009 30.81 30.79 2008-34.71-40.33 2007 17.67 9.57 Source: MSCI (in US dollar terms, as of 31 Dec 2016) 1. Shariah Equity is represented by MSCI World Islamic Index. 2. Global Equity is represented by MSCI World Index. 5
Moreover, Shariah equity investing enables Muslim investors, many of whom remain marginally served in the traditional financial services industry, to potentially increase their hard-earned savings in accordance to their religious beliefs. With the world s Muslim population expected to grow to 2.76 billion by 2050 (or nearly one-third of the world s population) from 1.6 billion in 2010, according to a 2015 report by the Pew Research Centre, demand for Shariah-compliant investments, including equities, could grow significantly over the next few decades as affluent Muslims start investing more of their burgeoning disposal income and wealth. Among Islamic countries, Malaysia represents one of the biggest markets right now for Shariah equity investing, fueled by asset growth of its national pension scheme, known as the Employees Provident Fund (EPF). For the period ended March 31, 2017, equities made up 41.76% 1 of the EPF s total investment assets, which amounted to RM747.17 billion 1. With growing interests from investors of other Muslim nations, including those from the rich Gulf region, Shariahcompliant equities around the world are likely to be well-supported in the years ahead. To sum up, Shariah equity investing is certainly more challenging than traditional stock investing. But coalescing FTI s investment capabilities with the indepth knowledge of the Amanie International Shariah Supervisory Board, coupled with the stock screening competence of IdealRatings, we believe there isn t any major obstacle that cannot be overcome in the area of Shariah equity investing. 1. Source: EPF s 1Q 2017 Quarterly Report on Investment (for period ended Mar 31, 2017). IMPORTANT INFORMATION This document is intended to be of general interest only and does not constitute legal or tax advice nor is it an offer for shares or invitation to apply for shares of any of the Luxembourg-domiciled SICAV Franklin Templeton Sharia Funds (the Fund ). Given the rapidly changing market environment, Franklin Templeton Investments disclaims responsibility for updating this material. Subscriptions to shares of the Fund can only be made on the basis of the current prospectus of the Fund, accompanied by the latest available audited annual report and the latest semiannual report if published thereafter. An investment in the Fund entails risks which are described in the Fund's prospectus. The value of shares in the Fund and income received from it can go down as well as up, and investors may not get back the full amount invested. Past performance is not an indicator or a guarantee of future performance. Currency fluctuations may affect the value of overseas investments. When investing in a fund denominated in a foreign currency, your performance may also be affected by currency fluctuations. In emerging markets, the risks can be greater than in developed markets. Investments in derivative instruments entail specific risks that may increase the risk profile of the fund and are more fully described in the Fund s prospectus. If the fund invests in a specific sector or geographical area, the returns may be more volatile than a more diversified fund. The investment activities will be undertaken in accordance with the Shariah Guidelines. As a consequence, the performance of a Fund may possibly be lower than other investment funds that do not seek to strictly adhere to the Islamic investment criteria. The requirement to purify cash holdings or dividend income will likely result in payments being made to charities. The return to investors will be reduced by the amount of such payments. The International Shariah Supervisory Board of Amanie Advisors Sdn Bhd has certified that the Fund is in compliance with the requirements of the Shariah principles. No shares of the Fund may be directly or indirectly offered or sold to residents of the United States of America. Shares of the Fund are not available for distribution in all jurisdictions and prospective investors should confirm availability with their local Franklin Templeton Investments representative before making any plans to invest. Opinions expressed are the author s at publication date and they are subject to change without prior notice. Any research and analysis contained in this document has been procured by Franklin Templeton Investments for its own purposes and is provided to you only incidentally. A copy of the latest prospectus, the annual report and semiannual report, if published thereafter can be found on our website: www.franklintempletongem.com or can be obtained, free of charge, from the address below. Issued by Franklin Templeton Investments (ME) Limited, authorized and regulated by the Dubai Financial Services Authority. Dubai office: Franklin Templeton Investments, The Gate, East Wing, Level 2, Dubai International Financial Centre, P.O. Box 506613, Dubai, U.A.E., Tel.: +9714-4284100 Fax:+9714-4284140. All MSCI data is provided as is. The portfolio described herein is not sponsored or endorsed by MSCI. In no event shall MSCI, its affiliates or any MSCI data provider have any liability of any kind in connection with the MSCI data or the portfolio described herein. Copying or redistributing the MSCI data is strictly prohibited. www.franklintempletongem.com Copyright 2017 Franklin Templeton Investments. All rights reserved. 6