Where are Islamic ETFs heading?

For the upcoming Budget, it’s worth remembering that these financial products can help to position the country as a global hub.

EXCHANGE-TRADED Funds (ETFs) have emerged as one of the most innovative financial instruments of the 20th century. They are structured similarly to mutual funds, track an index and trade like a common stock on a stock exchange. The ETF’s advantages for investors include diversification, index tracking, transparent portfolio holdings, low fees and tax efficiency, to name a few.

According to Bloomberg, the global ETF market is currently worth more than US$4 trillion (RM16.9 trillion). While there has been unprecedented growth of conventional ETFs, syariah-compliant or Islamic ETFs stood at US$300mil (RM1.27bil) only – about 0.01% of the global ETF market size – since the listing of the first Islamic ETF on the Istanbul Stock Exchange in 2006.

Islamic and conventional ETFs share common characteristics. The main difference between the two is the benchmark index that the Islamic ETF tracks.

An Islamic ETF only tracks an Islamic benchmark index, comprising syariah-compliant companies or assets.

In Malaysia, the first Islamic ETF, launched in January 2008, tracks the Dow Jones Islamic Market Malaysia Titans 25 Index as a benchmark index.

As one of the most developed Islamic capital markets, Malaysia has four Islamic ETFs listed on Bursa Securities at present, making the nation the largest Islamic ETFissuer globally.

Islamic ETFs have the potential to position Malaysia as a hub for Islamic finance. They can be the next big thing for Islamic capital markets after sukuk, which has made inroads in the global Islamic capital market landscape.

Islamic ETF’s feature as an innovative financial product has a unique market attraction to Gulf Cooperation Council countries, Europe and the Malaysian market. But what should be done to develop and strengthen the Islamic ETF market?

To catch up with conventional ETFs, Islamic ETFs need to reach an optimal market figure to be cost-effective. However, none of the current Islamic ETFs has assets of more than US$100mil (RM423.5mil), whereas bigger conventional ETFs have assets under management of few hundred billions in value.

In order to reach the optimal market size, Islamic ETF market players could learn from how the Japanese developed their ETF market. The government of Japan introduced the ETF buying programme through the involvement of the Bank of Japan.

In Malaysia, institutional investors could play a similar role to further boost the Islamic ETF market by having a portion of their investment portfolio represented by Islamic ETFs.

In the retail market space, there are clear differences in the way the funds are marketed to investors in the United States and Asia. An estimated 90% of funds in Asia is commission-based.

A vibrant ETF market depends on the evolution from commission to fee-based distribution networks. Because ETFs are structured as lowcost funds, the market players may have less motivation to grow the ETF market segment. To overcome this issue, Malaysia may want to consider incentivising a package of Islamic ETFs with a fee-based advisory model for retail investors.

Recent initiatives by the Securities Commission, such as the issuance of syariah parameters on Islamic ETFs based on gold and silver, the launch of the Islamic Fund and Wealth Management Blueprint, and the establishment of an ETF taskforce to lower the minimum capital requirement for issuers and widen distribution channels, are definitely positive moves for the Islamic finance and ETF industry.

A framework is also in the pipeline to diversify the ETF products, including futures-based, leveraged and inverse ETFs, which will provide investors with cost-efficient entry points to access more sophisticated investments.

Nonetheless, due to the phenomenal growth and fears of a growing bubble, ETFs are attracting the market and regulatory attention. A case in point is Ireland’s central bank, which recently called for greater scrutiny of how the ETF industry works and whether the existing ETF guidelines were adequate. In this current scenario, Malaysia can learn from other developed ETF markets to enhance market transparency and resilience through Islamic ETFs, and to introduce a proper control mechanism should the ETF market bubble and burst.

Budget 2012 announced an allocation of RM200mil as seed monies for ETFs, as an incentive programme to promote the development of the ETF market.

Five years have passed and only three Islamic ETFs were issued postBudget 2012. Perhaps it is time to revisit the potential of the Islamic ETF segment and to provide some market incentives in the next Budget?

We will never know where the Islamic ETF is heading and how far it can fly. It may require significant structural and regulatory changes before taking off. But with real focus and concerted effort to develop this trillion-dollar market, sudden upside surprise is not impossible.

Exchange-Traded Funds (ETFs) have emerged as one of the most innovative financial instruments of the 20th century.