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» Indices and Islamic Finance

Delicately designed indices to reflect the real situation of an efficient capital market also reflect the economic situation of the state. Indices can be used to forecast the economic changes a while before it happens. The markets are called Bullish if the index value is going higher, while it is called Bearish if the value of the index is going lower.

Definition of index according to Investopedia site: A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is an imaginary portfolio of securities representing a particular market or a portion of it. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. Thus, the percentage change is more important than the actual numeric value.

Financial and portfolio managers benefit from indices by comparing their performance and returns over long term periods with indices values. As an example of indices we have to mention the most famous one’s Dow Jones, FTSE and Standard and Poor’s 500 which calculates the prices of 500 companies of the major companies at the US markets.
Photo of Dow Jones index Tuesday 2nd of April, 2013. See: http://online.wsj.com/mdc/public/page/2_3022-usclosingstk.html.
Islamic Finance industry without doubt is the rising star in the arena of global economy after the earthquake of 2008 financial crisis. Islamic finance size exceeded the amount of a trillion dollar in a few years only and still growing rapidly.

The need to invest in Halal stocks and financial instruments simultaneously occurred with Islamic Finance. As a result many Credit Rating Agencies provided services dedicated to monitor Sharia compliance and among these services was WVB Sharia Rating Reports which aimed at widening the scope of investment for Islamic Finance industry.

One of the natural developments that coincided with the rapid sustainable growth of Islamic finance, that Credit Rating Agencies issued Sharia indices which include exclusively companies in compliance with Sharia. Companies’ compliance with Sharia is determined by applying certain criteria upon it and hence deciding whether to be included in the index or not by the Sharia board responsible for Sharia supervision of the index. The criteria are usually taken from AAOIFI Shari’a Standards.

Sharia indices enable Islamic finance parties to avoid predictable market risks and to take the chances of foreseen growth in certain time frames in accordance with the readings of such indices. Among these indices are Standard and Poor’s and FTSE Shariah indices. Uses of indices that are really crucial to the investors are: Evaluation of investment portfolios fast by comparing its yields with the change in the index value considering the index as a portfolio contains a diversified range of stocks. Judging the performance of professional financial managers using the notion of naive diversification means that an investor owning a well diversified portfolio chosen randomly will make a profit. The profit is approximately equal to the market yield and expecting the professional manager to make a higher rate than the average market yield. AAOIFI issued a Shari standard numbered 27 and labeled indices, where it defined the Halal and Haram ways of using indices and the guidelines for issuance of a sharia index. Halal ways of using indices include permissibility of using it to know the size of changes in markets, to judge the performance of financial managers, creating a vision about an investment portfolio and estimating its risk, forecasting the future trend of the market and finally it is of no sin to use indices as clues while concluding transactions. It is permissible to use indices to figure out the quality of the performance of Funds and Sukuk and to relate between the remuneration of financial managers and the indices indications of market yield compared to the returns accomplished by the manager. Indices can be used to determine the changing fare. It is also possible to confine financial managers with a certain value for an index, that if it appears he will have to take a certain act such as selling with the market price or buying a certain amount of an item with the market price. Among Haram ways that AAOIFI mentioned in the Indices Standard is to trade with the indices itself, receiving money or paying it upon a certain value occurrence without any real sale or purchase of the items represented by the index even for the purpose of hedging. Options and futures are not allowed to be concluded using index contracts multiplier. It is not allowed to suspend a contract that is not allowed to suspend by Sharia, such as sale contracts, over the occurrence of a certain value of an index. It is haram to relate Cash debts to a price index.

AAOIFI has determined a set of rules to be observed when setting a sharia index:
To exemplify constant adherence to Sharia conditions and technicalities of forming an index, one of the Sharia conditions regarding setting up a sharia index is that the companies within its scope are working in activities that do not contradict with sharia rulings. Sharia indices must be subject to the supervision of a sharia board. To conclude, we must say that Islamic finance -the promising industry- is in need of Sharia indices to maintain its identity, sustainable growth and to open new markets for it. It is also a great potential for the financial institutions, which are suffering from the recklessness of the Central Banks in printing currencies, to invest with the rulings of Islamic Markets that depends only on tangible assets and true development away from virtual economic practices that caused the 2008 world financial crisis nightmare.