Definition and Purpose
A Shari'ah Index, as addressed in Islamic finance standards No. 27 (Indices), is a stock market index composed exclusively of shares that meet Shari'ah compliance criteria. Its purpose is to serve as a benchmark for Shari'ah-compliant portfolio performance. Examples include the FTSE Shariah Global Equity Index, the DJIM (Dow Jones Islamic Market Index), and the MSCI Islamic Index. These indices allow Shari'ah-conscious investors to track their portfolio performance against a compliant baseline. the Indices standard governs both the construction methodology and the ongoing review (typically quarterly rebalancing) of such indices.
Screening Methodology
Step 1: Negative Screening (Business Activity)
The index provider (e.g., FTSE, Dow Jones) first eliminates all companies engaged in prohibited industries: conventional banking, insurance, alcohol, pork, weapons, gambling, entertainment, and other haram sectors. This step reduces the universe of available companies by approximately 20–30% depending on the starting market.
Step 2: Positive Screening (Financial Ratios)
From the remaining (compliant-business) companies, the index applies financial ratio tests per (1) Debt Ratio: Interest-bearing debt should not exceed 33% of market capitalization (or total assets, depending on the index provider's methodology). (2) Haram Income Ratio: Interest income or other non-compliant income should not exceed 5% of total revenue. (3) Cash Ratio: Cash and equivalents should not exceed 33% of market cap (to minimize interest-earning cash). Companies exceeding any threshold are excluded.
Step 3: Index Construction
Remaining qualified companies are assigned weightings based on market capitalization or other methodologies. The index is rebalanced quarterly or semi-annually to maintain compliance. If a company falls out of compliance (e.g., takes on excessive debt), it is removed from the index on the next rebalancing date.
Index Components and Characteristics
| Characteristic | Description |
|---|---|
| Rebalancing Frequency | Quarterly (most indices); semi-annual or annual depending on provider |
| Screening Timing | Financial data from most recent quarterly or annual reports |
| Reconstitution | If company falls out of compliance, removed on next rebalancing date |
| Historical Performance | Shari'ah indices typically track near-equal to global equities, with slightly lower volatility |
| Composition Variation | Index composition differs based on provider methodology and screening thresholds |
Purification of Non-Compliant Income
Even companies included in a Shari'ah index may have some non-compliant income (below the 5% threshold). Index holders are advised to: (1) Calculate the proportion of haram income earned by index holdings. (2) Donate a proportional amount of returns to charity. For example, if the index portfolio earns returns that include 1% from haram income sources, investors should donate 1% of their returns to qualified charitable uses.
Trading and Usage of Indices
Shari'ah indices are reference benchmarks; they are not themselves traded. However, exchange-traded funds (ETFs) and mutual funds are created to track these indices. An investor cannot directly buy "the index"; instead, the investor buys an ETF that holds the same companies in the same proportions as the index. Index providers license their indices to ETF managers for this purpose.
Shari'ah Basis for Indices
- Maqasid (Objectives): Indices serve transparency and justice by providing a clear, consistent standard for compliance.
- Ijma' (Consensus): The screening-based approach is widely accepted among contemporary Islamic finance scholars.
- Practical Benefit: Indices enable institutional investors to manage large, diversified Shari'ah-compliant portfolios.