Islamic equity investing costs more than conventional investing

People new to Islamic finance are often surprised that it costs more than conventional finance. I have explained previously (see link in article below) why you should expect an Islamic mortgage to cost more than a conventional mortgage.

For my February column in the magazine "Islamic Finance News" I decided to look at the cost differential for managed equity funds. To ensure that I was comparing "like for like" as far as possible, I chose two exchange traded funds from the same fund provider.

What is the extra cost of Islamic equity investing?

Very briefly, I believe that unless they are particularly knowledgeable about investing, such an ETF is the only equity investment that individuals should buy. Extensive research shows that over the long run most active investment managers (meaning investment managers running funds that seek to select shares they expect to outperform) fail to beat stock market indexes once the higher charges of the active manager are taken into account.

(ETFs of this type have low charges since all of their processes can be computerised, and they engage in relatively few buying and selling transactions.) While some managers do beat the market index, the problem is identifying them in advance rather than retrospectively.

In my 6 June 2018 IFN column “Does having principles make you poorer or richer?” I asked whether a Shariah compliant investor should be expected to do better or worse than a conventional investor. (The data in the article was only about stock market indexes because data on the universes of all Shariah compliant / conventional active managers is not available.)

Today I want to tackle a different, but related issue. How do the costs of conventional and Shariah compliant ETFs compare? (It is well known that Islamic banking is typically more expensive than conventional banking. See my 8 March 2017 IFN column “The relative costs of conventional and Islamic mortgages.”)

To make this comparison fairly, you need to look at two ETFs that are otherwise as similar as possible. I compared the following, which come from the same ETF provider, Blackrock, and which track similar indexes:

Both track global developed markets indexes compiled by MSCI, and both use the technology and business infrastructure of their provider, Blackrock, which makes them as comparable as possible. As I expected, their sizes are very different. At 31 December 2022 Conventional ETF had total assets 2022 of $2.5 billion while Islamic ETF had total assets of only $375 million.

I expected Islamic ETF to cost more, because it is much smaller, and because Shariah screening entails costs that conventional investing does not. Accordingly, I was pleasantly surprised to find that the cost differential is smaller than I expected.

Conventional ETF has a total expense ratio of 0.24% per year, while Islamic ETF’s total expense ratio is 0.3% per year. The extra cost, 0.06% per year may not seem much, but it means Islamic is ¼ more expensive than conventional.

I suspect that Islamic ETF receives an effective cross-subsidy, since if it had to replicate Blackrock’s computer technology just for itself, the costs would be prohibitive with assets of only $375 million.

The effect of the extra charges is still significant over time. I always use a projected nominal (i.e. before allowing for inflation) rate of return of 8% before charges.

Investing $10,000 in Conventional ETF for 30 years will leave you with $94,129.87 whereas an investment in Islamic ETF for the same 30 years with the same 8% return before charges will leave you with only $92,570.18, which is $1,559.70 or 1.68% less.

Mohammed Amin is an Islamic finance consultant and former tax partner at PwC in the UK.

Postscript added 28 March 2023

The above difference in outcomes of 1.68% after 30 years may not seem much. However it arises from annual charges that differ by "only" 0.06%.

This means that after 30 years the difference in the amount of money you have is 28 times the size of the annual charges differential.

The other way to look at it is how much your money has grown, since you started with $10,000. The Conventional ETF has grown by $84,129.87 while the Islamic ETF has grown by only $82,570.18, a difference of 1.89% which is 31 times the annual charges differential. The fact that it is more than 30 times the annual charges differential is due to compounding over the 30 years.

These calculations illustrate how important annual charges are, because their effect compounds over time.