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Report: Current Shari'ah screening method insufficient.

The current method used to screen companies for Shari'ah compliance has the potential to misclassify some of the biggest names in the market, according to a new report from Ratings Intelligence

The current industry status quo is essentially to use an information-based approach, but the report found that such an approach, which has the potential to misclassify some of the biggest names in the international/regional markets, probably is insufficient to maintain the integrity and reputation of the Islamic fund management industry.

Clearly the cost of screening rises as the screening approach becomes more complex. On the other hand the more sophisticated approach reduces the number of potential misclassifications. A balance needs to be struck between cost and accuracy, said the report. It wouldn't make commercial sense to spend an infinite amount of resources to ensure that there is almost a zero error rate. So, the report asked, what degree of accuracy is acceptable?

The new research paper demonstrates how Shari'ah equity screening results differ based on the screening approach adopted by the screening provider. It examines and discusses compliances of various sample stocks over the two industry used approaches to screening. The paper advocates the use of a knowledge-based Shari'ah board guided screening approach, which Ratings Intelligence believes is a step up from the current industry standard of using a research-based or information-based approach.

Screened lists of stocks are often provided by independent screening providers (ITES firms), International index providers as well as integrated Shari'ah Advisory firms. Whilst all these service providers use quite similar Shari'ah criteria to arrive at a list of permissible securities, the results have often been quite different. This leads us to question the approach and research methodology used to arrive at such screened lists.

The paper sought to highlight the varying quality of screening and attempts to find the most appropriate approach to equity screening.

It said that an information based approach requires learning facts about the company under review. Here, in addition to an elementary algorithmic processing of data based on pre-assigned values in a 'Compliance Matrix', the reviewer would need to gather additional 'information' about the companies and ascertain if it breaches any of the Shari'ah parameters. However, the amount of information one gathers must be balanced with the cost of acquiring that information, it warned.

The report found a mere data processing approach to equity screening leads to an elementary compliance assignment of stocks, which needs further refinement; obtained by adopting an information based approach. Of the 13 sample stocks under consideration in the study it found seven stocks changing compliance after the adoption of more detailed information-based approach.

A knowledge-based approach should be a natural progression for the industry, concluded the report.

2012 CPI Financial. All rights reserved.

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Publication:CPI Financial
Article Type:Report
Date:Nov 13, 2012
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