As the largest bourse in the Middle East, the Saudi stock exchange (Tadawul) has a market capitalisation of $292.78bn and accounts for nearly three quarters of the entire value of stocks traded on all GCC exchanges.

Yet traditionally, despite dwarfing the region’s other exchanges, the Tadawul has in many respects been the most opaque and least progressive of all the region’s bourses.

However, since the start of the year, in a sign that it is entering a new period of development, it has granted four institutions licences to launch indices tracking the performance of sharia-compliant companies listed on the exchange: Saudi investment bank Falcom Financial Services, US index providers Dow Jones and Bloomberg Finance, and ratings agency Standard & Poor’s.

Key fact

S&P’s Sharia Index outperformed conventional equities by 4  percentage  points this year

“These index launches are part of efforts to satisfy the regional growth in appetite for more sophisticated products and trading,” says Alka Banerjee, global product manager of sharia indices at Standard & Poor’s.

Indices are considered important tools for measuring a market’s performance and can also be used as the basis for structuring and evaluating financial products. They can help to increase transparency and encourage funds to launch more diverse products and create a greater range of investment opportunities in a market.

The strong position of Islamic finance in the kingdom means that investor demand for sharia-compliant products is healthy. However, there is also strong demand worldwide for such products. According to Singapore-based data provider Eurekahedge, which tracks the global funds industry, there are now more than 608 Islamic investment funds globally, valued at $60bn in total.

In January, Falcom launched the Falcom Shariah Index to track the performance of sharia-compliant equities. The index is unique in that it offers a pre-market feature that allows investors to review the market position of their portfolios before the market opens, and in this way serves as a strategic tool enabling market participants to place their trades accurately. The index tracks 112 companies that comprise nearly 78 per cent of the Tadawul All-Share Index (Tasi).

“The Tadawul is the leading exchange in the region and has taken a lot of steps recently to come up to speed with the latest systems and to become more integrated with global equity platforms,” says Banerjee.

In July, the US’ Dow Jones Indexes became the first international index provider to offer indices on the Tadawul. The agreement enables Dow Jones to use real-time Tadawul prices and other data to create indices, which can measure the performance of Saudi stocks.

“Asset managers can now securely deal with an authorised, international index provider when using indices containing Saudi data,” said Abdullah Suweilmy, chief executive officer of the Tadawul, at the signing of the agreement. 

It is hoped that the Dow Jones indices will help set new standards for index performance in Saudi Arabia and prove attractive to both domestic and international investors.

In mid August, Dow Jones launched an additional set of indices that includes the GCC Index, the GCC Islamic Market Index, and the GCC Titans 50. “Before, there were not many international index choices for investors,” says Deborah Ciervo, senior director, international markets and products, at Dow Jones Indexes.

“Now that there is a wider array of indices, they [investors] have more flexibility and control, which means they can consider what the most appropriate benchmark is, rather than just what is available.”

In late August, Standard & Poor’s was also granted a licence to use the Tadawul’s securities data to maintain current and launch new indices for the equity market.

And in September, Bloomberg Finance joined the growing list of authorised international index providers allowed to use real-time Tadawul prices and other data to create indices. 

“There is huge investor appetite for sharia-compliant equity indices,” says Banerjee. “We see demand across the Gulf, but even more so in Saudi Arabia because of the size of the market. This is not a passing phase; it is organic growth that will continue at a rapid pace.”

Strong performance

Although 2009 has been a turbulent year for equity markets, sharia-compliant equities have been outperforming non-sharia-compliant stocks.

Standard & Poor’s GCC Composite Sharia Index produced a 27.65 per cent return over the second quarter of this year, beating its GCC Composite Index, which returned 23.65 per cent over the same period. 

Return on equity, return on assets, three-year earnings growth and operating margins have all been higher for sharia-compliant than conventional stocks this year. In particular, the Standard & Poor’s Global Benchmark Sharia Index series has benefited from the recent boost in IT, healthcare and energy stocks, which were the best performing sectors in the second quarter, with gains of 20.1 per cent, 19.5 per cent and 16.8 per cent respectively.

“There is huge investor appetite for sharia-compliant indices. This is not a passing phase; it is organic growth”

Alka Banerjee, Standard & Poor’s

The development of sharia-compliant equity indices has encouraged the launch of more sophisticated investment products such as exchange-traded funds (ETFs). ETFs are open-ended index-tracking funds listed and traded on exchanges in a similar way to shares. By trading a single share, users can effectively gain access to an entire index without the burden of investing in each of the constituent stocks, making them a highly efficient and cost-effective investment tool. 

It is now hoped that the proliferation of sharia-compliant equity indices on the Tadawul will serve as the underlying tool for third-party investment products such as ETFs, mutual funds and other products that enable investors to engage in trading activity on the exchange.

In April, Saudi Arabia’s Capital Market Authority (CMA), which regulates the Tadawul, said that it was considering introducing ETFs. Given the advantages that such products have for investors, the market is now eagerly awaiting news on this.

Investment advantages

Sharia-compliant ETFs have significant advantages for investors compared with traditional means of gaining exposure to sharia-compliant products, which tend to be less diversified and more expensive.

In the future, index providers will be keen for more products to be introduced onto the Tadawul to boost trading levels. At the time of the launch of its index, Falcom said that it expected its index to be used in futures as the basis for sharia-compliant ETFs, over-the-counter products and index-linked equity funds.

The CMA has also talked about introducing derivatives, which Banerjee says would open up the opportunity to create futures and options based on sharia-compliant equity indices. “Scholars have not yet reached a resolution that is acceptable,” says Banerjee. “But they are continuing to look at creative ways of finding alternative instruments that can drive liquidity.”

While sharia-compliant equity indices are being launched worldwide, their active trading levels are still considerably lower than on conventional exchanges. However, it is hoped that product innovation and a maturing market will play key roles in growing activity.

In December 2008, Kuwait Finance House estimated that Islamic mutual funds and equity funds accounted for just 4.2 per cent and 2.9 per cent respectively of the total $840bn sharia-compliant assets held globally. But given that the industry is still thought to be growing at an average rate of 15 per cent a year, demand for equity products looks set to boom.

In June, the sharia-compliant Russell-Jadwa Shariah Index was launched by US-based investment company Russell Investments and local Islamic investment bank Jadwa Investment. Selected from the 10,000 stocks on the Russell Global Index Universe, the Russell-Jadwa Index will contain more than 2,700 securities from more than 60 countries. The indices are divisible by market capitalisation, region, country and sector.

“The indices were launched in response to the large and growing number of institutions engaged in sharia-compliant investment throughout the world,” says Paul Gamble, head of research at Jadwa Investment.

“We are yet to launch our indices for the Saudi market, but the Tadawul is an important emerging market and one that foreign investors are increasingly turning their attention to now that it is opening up.”

“Saudi Arabia is widely expected to be a huge growth spot, more than anywhere else in the Middle East”

Deborah Ciervo, Dow Jones Indexes

The increasing number of indices monitoring the performance of sharia-compliant stocks is already helping to make the Tadawul more structured and transparent.

By signing special agreements with globally-renowned institutions, the Tadawul will benefit from their wealth of expertise and unique offerings, such as Standard & Poor’s sharia scorecard, which reviews the performance of its indices on a quarterly basis.

Despite the prevailing financial climate, the Tadawul has been making concerted efforts to develop the market and diversify its product offering. In June, for example, the exchange launched a debt securities market that will provide a range of services including trading in Islamic bonds (sukuk) and conventional bonds.

Through offering long-term financing, bonds will help bring stability to the market, and in this sense they are a welcome addition, given the volatility experienced in the stock markets over the past year.

The Tadawul has suffered badly as a result of the global financial crisis. Since January 2008, its market capitalisation has plunged from about $518bn to its current $292bn, but it remains a highly attractive platform.

“Saudi Arabia is widely expected to be a huge growth spot, more than anywhere else in the Middle East,” says Ciervo. “Despite its size, it is still a relatively nascent market.”

The challenge now for index providers will be educating the local investment market and securities regulators about new products, and the contribution they can make to the long-term development of the Tadawul.