Islamic ETFs find favour among investors, though growth challenges persist

Exchange-traded funds (ETFs) have become a cornerstone of the global investing landscape, offering investors a flexible, cost-effective way to diversify their portfolios. 

These instruments often track major indices like the S&P 500 or the MSCI Index, offering liquidity and exposure to various asset classes. For Sharia-compliant investors, Islamic ETFs combine portfolio diversity with the ethical principles of Islamic finance.

An exchange-traded fund is a basket of securities, such as stocks, commodities or bonds, that is listed and traded on an exchange. Sharia-compliant ETFs are screened to ensure compliance with Islamic law, excluding companies involved in prohibited activities.     

Accordingly, Islamic ETFs have experienced steady growth, particularly in regions like the Middle East, North Africa, and Southeast Asia. Assets under management of ETFs linked to Islamic Indices have risen from $326 million in 2018 to $2.33 billion by end of September 2023, according to an S&P report. 

Hadeel AbuShoumar, product head at Dubai-based Alkhair Capital, believes Islamic ETFs are well-positioned thanks to their appeal to a broad range of investors.

“They’re [Islamic ETFs] perfectly positioned to become a go-to option for retirement and pension funds in MENA and Southeast Asia,” she said. “These regions have huge expat populations and significant local wealth that could be funnelled into Sharia-compliant funds.”

Given that Islamic finance aligns with the broader environmental, social, and governance (ESG) principles, the growth of the Islamic ETF market has also been bolstered by a rising demand for ethical investing.

Access to halal assets
One of the key advantages of Islamic ETFs is their ability to provide access to halal assets that are otherwise difficult or costly for individual investors to purchase directly. 

For example, Sukuk, a Sharia-compliant instrument with similar characteristics to a bond, is becoming widely available. But high transaction costs and limited market options often make it challenging for retail investors to access it independently. 

Sefian Kasem, head of investment specialists, ETF Strategy at HSBC Asset Management, sees significant potential for growth in this area. 

“[As] Sukuk markets continue to grow at pace, we believe there is likely to be a richer range of funds and ETFs covering different segments of the Sukuk market, in turn broadening out the range of fixed income risk profiles available to Sharia-compliant investors globally,” he explained.

Islamic ETFs can also be structured to target specific sectors, giving investors more focused options. AbuShoumar says there is an opportunity to develop thematic ETFs.

“There’s room for innovation here - imagine thematic Islamic ETFs that focus on sectors like clean energy or tech,” she said. “[Plus], as more people see the overlap between Islamic finance and ESG principles, there’s an opportunity to attract socially conscious investors, Muslim and non-Muslim alike.”

Despite potential diversity for Islamic ETFs, the market remains heavily concentrated in a few asset classes, gold being the dominant one. Shariah-compliant gold-backed ETFs have become the most popular product in this space, owed to the bullion’s status as a ‘safe haven’ asset, particularly in precarious economic times. 

That could potentially hinder growth and innovation, say some market practitioners.

“The Islamic ETF universe market cap is dominated by a massive, physically-backed gold product,” said Akber Khan, acting chief executive officer of Al Rayan Investment. “Incumbent ETF issuers haven't really been bothered to offer a multi-asset Islamic product suite while most Islamic managers have been slow off the mark.”

But HSBC’s Kassem believes there is enormous scope to create a broader range of Sharia-compliant ETFs that can do a better job of spanning conventional asset classes, including public equities and fixed income. 

Barriers to growth
To create a gamut of Sharia-compliant ETFs, key challenges that erode asset growth must be addressed. 

Liquidity remains one of the most significant obstacles. While conventional ETFs benefit from deep pockets due to the size and maturity of the underlying markets, Islamic ETFs often struggle with smaller scales and limited funds. 

“For Islamic ETFs, there’s a lack of tradability and liquidity, and the market offering is still small when compared to conventional ETFs. This is because primarily in many OIC (Organisation of Islamic Cooperation) nations, ETF development has not received much attention as there are more pressing priorities like bankability, let alone availability of Sharia-compliant investment products,” said Bashar AlNatoor, head of Islamic finance at Fitch Ratings.  

The situation differs for Sukuk-focused ETFs. “With Sukuk markets, the liquidity profile is a little different and closer to emerging markets’ fixed income rather than developed markets’ fixed income,”  added Kassem.

Moreover, many Islamic ETFs are listed in emerging markets, where regulatory frameworks and financial infrastructure are still being developed. This impedes daily trading activity, bid-offer spreads, liquidity and ultimately, pricing, added Al Rayan Investment’s Khan.

Fitch Ratings’ AlNatoor added: “In many cases there is large room for development mainly due to a developing ETF ecosystem and legal infrastructure in general. In the long-term, there is a lot of potential for Islamic ETFs, however, short-to-medium term headwinds remain.”

The cost structure of Islamic ETFs also presents a huge barrier to their adoption. Regular Sharia screening and monitoring are essential to ensure fund compliance, which can often lead to higher operational costs compared to conventional ETFs.

“It can be difficult for retail investors to access halal ETFs. There are difficulties with regards to trading costs in different geographies,” explained Monem Salam, executive vice president at US-based Saturna Capital. “This is largely related to tax legislation and other related costs in different markets.”

However, to ensure that management, administrative, operational and other practices are Sharia-compliant is equally important, added Sefian Kasem. Additional processes require monitoring by a credible Sharia board and carry associated costs.

“They are essential to ensuring Sharia compliance, but having said that, we believe it is important for asset managers like us to ensure that these costs are correctly and fairly balanced versus additional requirements associated with Sharia-compliant investment funds,” he explained.

The general lack of awareness regarding these assets also chips away at their growth, given that relevant information on what separates an Islamic ETF from its conventional peer is largely absent. AbuShoumar believes that educating the public about Islamic ETFs will be key to increasing adoption.

“Financial institutions need to make it easier for people to understand what these funds are and why they matter,” she said. “Working with fintech platforms or even social media influencers could make a huge difference in reaching younger audiences.”