Islamic investment funds

1. Islamic investment funds • A general introduction • Abu Dhabi

2. Agenda • Role of Investment Funds • Types of Investment Funds • Key Principles of Islamic Investment Funds • Islamic Fixed Income Funds • Islamic Equity Funds • Screening methodologies • Purification approaches • Islamic Real Estate Investment Funds

3. Benefits of Collective Investment Funds • Alternative savings • Economies of scale • Diversification • Liquidity • Professionalism

4. Types of Investment Funds By investor’s cash-flow profile: • Closed-ended funds • Open-ended funds • Interval funds • Defined maturity funds • Exchange Traded Funds (ETFs) By assets: • Equity funds • Money-market, fixed-income funds • Balanced funds • Real Estate Investment Funds/Trusts (REIFs/REITs)

5. Types of Investment Funds (cont’d) By style of management : • Active management funds • Index funds (passive) Special fund: • Private Equity/Venture Capital Funds

6. Assets of Islamic Investment Funds • Islamic Money Market Funds • Money market sukuk (short-term) • Deposits in Islamic banks • Islamic Fixed Income Funds • Sukuk • Islamic Equity Funds • Sharia-compliant equities • Islamic Real Estate Funds (REITs) • Sharia-compliant real estate investments • Cash and liquidity must always be placed in Sharia-compliant manner (in Islamic banks, money market sukuk, or in conventional banks but without interest)

7. Key Principles of Islamic Investment Funds • Established to invest only in Shariah-compliant securities  stipulated in fund prospectus or investment contract • Consistently invest and operate in Sharia-compliant manner  regular certification for compliance is required • No repo; no short selling; no derivatives; no borrowing • Sharia compliance officer and Sharia Advisor • Established approach to ‘purify’ itself from possible non-Sharia compliant investment • Other principles for best practices for investment funds apply: e.g. professionalism/competence, management of conflict of interest, segregation of clients assets etc.

8. Typical Structure of Investment Funds Sharia Advisor Investors Fund Manager (Wakeel) Investment Fund Custodian • Wakala structure • The fund may take form as a Trust, Collective Investment Contract, or Company (Special Purpose Entity) • Custodian needs not be Islamic bank, but conduct upon assets must be within Sharia (e.g. no interest on cash; no repo on securities) Investments (Securities)

9. Money Market and Fixed Income Funds • Invest only in eligible fixed income instruments: sukuk , money market sukuk, deposits in Islamic banks • Main challenge for Islamic money market and fixed-income funds: • Availability of instruments • Diversity of instruments/issuers • Liquidity of instruments, thus liquidity of the funds • Thus, development should starts with government sukuk • Making instruments available at different maturities • Regularity of issues ensure supply • Creating benchmark for private securities

10. Islamic Equity Index • List of eligible equities (members of an Islamic equity index) is fundamental in Islamic equity funds • Prepared by the Exchange or other index providers; approved by a Sharia Advisory Board • Screening methodology • Core Business: must not be prohibited activities • Prohibited businesses: • Conventional financial services (based on riba ) • Conventional insurance • Gambling and gaming • Manufacture or sale of tobacco products • Production or sale of non-halal products (e.g. pork, liquor) • Non-permissible entertainment businesses • Weapon production and distribution • Others non-permissible activities (including businesses that invest in or deal with non Sharia-compliant investments) • Could be expanded and combined with other Social Responsibility features (e.g. environment, child protection)

11. Islamic Equity Index (cont’d) • Screening methodology (cont’d) • Non-core, ancillary, and other businesses may include activities that are common part of business (e.g. hotel selling liquor), unavoidable activities (managing cash in banks with interest), or even those strictly non-Sharia permissible, as long as they are small. • Quantitative assessment of business: • Single-limit approach (e.g. MSCI, DJI): for all non-permissible activities  no more than 5% of total business • Multiple-benchmark approach: • Strictly prohibited business (e.g. banks): 5% • Rental from non-compliant activities; hotel operations; stockbroking: 20% • Calculations based on (i) revenue; (ii) pre-tax profit.

12. Islamic Equity Index (cont’d) • Screening methodology (cont’d) • Financial Screening: • Leverage: the use of debt to finance the company • Liquidity: interest-generating assets (cash, securities) • Calculations based on (i) assets; (ii) enterprise value. • Monitoring • Regular monitoring based on availability of information (annually, semi-annually, quarterly) • Screening done not limited to the existing index members, but the whole universe (screen-in and screen-out) • Rebalancing of index • Information; disclosures • Methodology must be transparent • Immediate announcement of screening results • Dividend information, for cleansing/purification purposes

13. Islamic Equity Index – Screening Approach Market Universe • Screening out companies with non-permissible core businesses Eligible List - Core • Screening out companies with non-permissible activities within the business mix Eligible List • Financial screening of eligible companies: • Financing composition (leverage) • Financial asset composition Approved List

14. Purification/Cleansing Approaches • Key principle: income received from the non-permissible portion of investment must be purified • Purification at the Index level • A portion of dividend representing non-permissible income should be deducted from the index’s return. E.g. from liquor sales of a supermarket; insurance business of a holding company • Dividend to be deducted (purified) = Dividend x (Non-Permissible Revenue or Earnings* / Total Revenue or Earnings) • Include interest income

15. Purification/Cleansing Approaches (cont’d) • Purification at the Fund level • For all funds: The portion of dividend coming from non-permissible activities should be given out for charitable purposes (clearly defined in prospectus) • Use same calculation as a above • Funds with active management: additional purification resulting from gain on sale of equities that are subsequently considered as non-compliant • Key principle: If an equity drops from the compliant list, the funds cannot continue to hold it – thus: sell. • If price > cost, and the sale is conducted immediately after announcement (on the same or immediate trading day), capital gain may be kept • If price > cost on the announcement date or immediate trading day, and the sale is conducted after a period of lapse, only a portion of capital gain up to the announcement date/immediate trading day may be kept. Any gain left should be given out • If price < cost on the announcement date/immediate trading day, sale may be postponed until equity price (+ any dividend paid) equal the cost.

16. Purification/Cleansing Approaches (cont’d) Example: After a period of lapse At the time of announcement on non-compliance At the time of purchase • Notes: • The fund cannot buy to reduce the average cost • Common question: how long can the fund wait until it has to sell?

17. Purification/Cleansing Approaches (cont’d) • Purification at the Fund level (cont’d) • The fund cannot buy equities not listed in the compliant list: • Any purchase in this nature is considered non-compliant, and thus subject to sanction (on the fund manager, not the fund) • Still need a remedy: • Must be sold immediately if cost is recoverable. Any gain (+dividend) should be given out • If cost is not yet recoverable, sales may be postponed within a certain period (e.g. 1 month) • Index (passive) funds do not have purification other than for dividends (like purification for the Index)

18. Islamic Real Estate Investment Funds • Real estate is usually a debt-heavy investment • Financing real estate construction using equity is extremely expensive • Unless financing via sukuk, real estate equity investment is usually non Sharia-compliant • Conventional REIT/REIF • Originally established to: • Mobilize savings (institutional and individual) for development • Provide steady, long-term income from investment • Exposure to improved property value • Characteristics: • Assets mostly (70%-90%) in income generating property • Most income (>70%) after operations is distributed through dividends • Eligible for tax breaks (corporate income tax, dividend tax, and others) • Certificate (shares) tradable on stock exchanges

19. Islamic Real Estate Investment Funds (cont’d) Sharia Advisor Investors Trustee Management Company (Mudharib) Investment Fund (listed) Property Manager Real Estate

20. Islamic Real Estate Investment Funds – Key Issues • Property development and its financing • Fully operating property should be financed by equity. Debts can be refinanced by equity more cheaply – REIF can be issued for that purpose • If Islamic REIF assets include property under construction, financing should be Sharia-compliant. Regulation should set limit on % of property under construction • Use of real estate and tenancy • Should be mainly for Sharia-permissible businesses. Tenancy for non-permissible businesses must be limited • Limits can be differentiated based on: • Existing tenants vs. new tenants (e.g. 20% and 100% permissible, respectively) • Tenancy of newly acquired property (e.g. at least 80% permissible) • Sub-tenancy (?)

21. Islamic Real Estate Investment Funds – Key Issues (cont’d) • Purification • Cash management • Insurance

22. Closing Points • Islamic investment funds – important part of the Islamic finance ecosystem • Business foundations for Islamic investment funds: • Availability of investible assets • Presence of asset management business and its supportive enabling environment • Government initiative in developing sukuk market is needed for Islamic funds (especially fixed-income funds) • Different methodologies and approaches exist; policies should strike a balance between international acceptance and local context • Some opportunities may exist today; but there are detailed works to do.

23. Annex • Comparison in Islamic Equity Index Methodologies

24. Islamic Equity Index – Business Screening • General guidelines; exception applies

25. Islamic Equity Index – Financial Screening • General guidelines; exception applies

26. Thank You • Ketut A. Kusuma; kkusuma@ifc.org; +1-202-458-4987