A look into Shari'ah Investing

1. A look into Shari'ah Investing By Yusuf Moola

2. Islamic Asset and Fund Management Principles of Islamic Investments • Definition of an Islamic Investment: • In an economic sense, an investment is the use of resources/assets to earn income or profit in the future. An investment based on Shari'ah approved methods is an Islamic Investment. Importance of Investments in Islam • Islam encourages the investment and circulation of wealth • Frowns upon the hoarding of wealth. • Scholars have written volumes on methods of investments e.g. Mudhaaraba, Mushaaraka, Wakaalah. This Prophetic tradition highlights the importance of investments in Islam: • "He who sells a piece of land, or a house, and does not utilize the funds derived from the sale, in a similar venture, he (his wealth) will not be blessed." Investment Objectives • Muslim investors are bound to adhere to the principles of Islamic economics, and seek public and individual gain. • They would therefore have additional objectives over and above the usual investment objectives of preserving one's capital, seeking a maximum return, and ensuring access to liquidity. • Their additional objectives would be fulfilling the commands of Allah, by ensuring compliance with Islamic economic principles in all respects.

3. Acceptable Investments in Islam • The method of investment and the assets invested in should always be legitimate (Halaal). The following investment activities are prohibited (Haraam): • Depositing with, or borrowing from, conventional banks, where interest is involved. • Conventional insurance and re-insurance. • Producing, selling, transporting and marketing alcoholic beverages and all intoxicants. • Casinos, gambling, sports betting and lotto. • Processing and selling pork as well as other meats not slaughtered or processed according to Islamic rites. • Businesses that include sexually explicit entertainment, prostitution, night clubs etc.

4. Islamic Investment Funds • Definition of an Islamic Investment fund: • a combination of surplus funds by investors, amalgamated to preserve these funds, and yield Halaal profits, in a manner that conforms to Islamic principles. Two basic principles for Islamic Investment Funds • The principal amount and the rate of return cannot be guaranteed. Returns will be based on actual profits or losses accrued to the fund. • Funds must be invested in Shari'ah compliant businesses.

5. Islamic Investment Funds contd. • Cash and debt can only be traded at its par value, • if the liquid assets of a business or a fund is combined with other tangible assets, the business or units of such a fund can be sold at market value or any other value agreed upon between the contracting parties. • This is subject to a condition that the liquid assets do not exceed 70% of the total assets of the business or the fund. • Example: A wants to sell his business which comprises of the following assets: • Cash R20 000 • Receivables R15 000 • Tangible assets R40 000 • This business can be sold at any value agreed upon between the contracting parties as the liquid assets do not exceed 70% of the total assets. • If the business comprised of the following assets: • Cash R20 000 • Receivables R20 000 • Tangible assets R10 000 • This business cannot be sold at any value agreed upon between the contracting parties. The liquid assets will be sold at its par value.

6. Fixed Income Funds - Muraabaha Funds • Two types of Fixed Income funds: • Muraabaha Funds • Ijaara Funds Muraabaha Funds • An Islamic fund manager is not permitted to create a portfolio of conventional debt securities as they involve Riba. • All types of conventional debt funds, such as bond funds, money market funds etc, are impermissible for Islamic investors. • An Islamic alternative to debt funds may be developed; where funds are invested in Muraabaha operations. • After selling a commodity on Muraabaha, the purchase price becomes a debt, which is specified. The returns on such a fund are therefore predetermined, similar to a conventional debt instrument. The fund will bear the risk of owning physical assets, though for a very short period. • Investors place funds within an Islamic fund. • The fund purchases assets/ commodities, and takes possession of the assets/commodities. • The fund sells the assets/commodities to a third party on a deferred basis. The mark-up or profit is disclosed to the third party. • Third party pays the Islamic fund installments which are predetermined. • Investors benefit from profits. • The above-mentioned fund is a closed-end fund. The units are also not transferable in the secondary market. The reason is that the commodities are sold immediately after their purchase. The purchase price becomes a debt on the third party. The portfolio therefore does not own any tangible assets, rather it comprises of cash or receivables. Liquid assets can only be sold at par value.

7. Fixed Income Funds - Ijaara Funds • Assets are purchased for the purpose of leasing them out. • The rentals received will be income for the fund. • Profits will be distributed pro-rata to ownership in the fund. • The units of this fund represent ownership in tangible assets; and are therefore transferable in a secondary market. • Investors can be given certificates that denote ownership in the fund. • These certificates are called Sukuk.

8. Equity Funds Permissibility of Investing in Stocks • Contemporary scholars of Islamic Commercial Law have mentioned that it is lawful to invest in the stock market, subject to certain conditions. • When an individual purchases shares in a company, he acquires an equity interest, and is in actual fact a partner in the company. • As a partner, his equity is exposed to risk, and he therefore shares in either profits or losses. • The Islamic Fiqh Academy of Jeddah and the Islamic Fiqh Academy of India have both resolved that investing in shares on the stock exchange is permissible.

9. Equity funds – The Industry Screen The Islamic Stock Selection Process • This process comprises of two screens: • The Industry Screen • The Financial Screen • The Industry Screen: The underlying business activity of the company should be compliant with Islamic Law. Any company engaged in an activity contrary to Islamic Law will be removed from the stock universe. • The following companies will be excluded from the stock universe: • Conventional financial institutions, which are interest based, including banks, insurance companies, brokerage and finance houses, leasing companies; • Gambling, gaming or casinos; • The manufacturing, packing and distribution or sale of non-Halaal food and beverages, particularly pork and alcoholic or other intoxicating products, restaurants and supermarkets are also analyzed; • Entertainment including cinemas, hotels, pornography, adult entertainment, publications and music, and the production or distribution or sale of such entertainment, such as television channels and radio stations; • The manufacturing and sale of weapons or military equipment, • The manufacturing, packing and distribution or sale of tobacco products (not universal); • Other immoral or unethical activities. • The analyst will evaluate the holding company as well its subsidiary. Once the industry screen is completed the analyst will proceed to the Financial Screen.

10. Equity funds – The Financial Screen • The Financial Screen: • The analyst will conduct a review on the financial statements of the company • Analyst ensures that it complies with certain financial ratios. • Scholars have differed on the financial ratios to be applied. • Below are frequently used ratios:

11. Equity funds - AAOIFI Shari'ah Resolution AAOIFI Shari'ah Resolution Shari'ah Standard no. 21 • 3/4 The fundamental rule is that of prohibition of acquiring shares of and transactions (investment and trading) in the shares of corporations that sometimes undertake transactions in Riba and other prohibited things even when their primary activity is lawful. • From this rule subscription and transactions (investment or trading) are exempted with the following conditions: • 3/4/1 That the corporation does not state in its memorandum of association that one of its objectives is dealing in interest, or dealing in prohibited things like pork (swine) and other things. • 3/4/2 That the collective amount raised as loan on interest whether long-term or short-term debt does not exceed 30% of the market capitalization of the corporation, knowing that raising loans on interest is prohibited whatsoever the collective amount is. • 3/4/3 That the total amount of interest-taking deposits, whether short-medium- or long term, shall not exceed 30% of the market capitalization of total equity, knowing that interest-taking deposits are prohibited whatsoever the collective amount is. • 3/4/4 That the amount of income generated from the prohibited component does not exceed 5% of the total income of the corporation irrespective of the income being generated by undertaking a prohibited activity, by ownership of a prohibited asset or in some other way. If a source of income is not properly disclosed then more effort is to be exerted for identification thereof giving due care and caution in this respect.

12. Equity funds - AAOIFI Shari'ah Resolution • 3/19 if the assets of a corporation are composed of tangible assets, benefits, cash and debts, the rule for trading in the shares of such a corporation will differ according to the primary asset, which conforms to the objective of the corporation and its usual activity. • If its purpose and activity pertain to trading in tangible assets, benefits and rights, trading in its shares is permitted without taking into account the rules of Sarf or transactions in debts; irrespective of their size as in such a case these are secondary. • This is subject to the condition that the market value of the assets, benefits and rights are not less than 30% of the total assets which includes the tangible assets, benefits, rights, cash and debts. • If however, the objective of the corporation and its usual activity is dealing in gold, silver or currencies, it is obligatory to undertake trading in its shares in the light of the rules of Sarf. If however, the objective of the corporation and its usual activity is dealing in debts, it is obligatory to undertake trading in its shares in the light of the rules of trading in debts.

13. Equity funds – Dow Jones Dow Jones Screens for Acceptable Financial Ratios: • After removing companies with unacceptable primary business activities, the remaining stocks are evaluated according to several financial ratio filters. • The filters are based on criteria set up by the DJIM Index Shari`ah Supervisory Board to remove companies with unacceptable levels of debts or impure interest income. • All of the following must be less than 33%: • Total debt divided by trailing 12-month average market capitalization • The sum of a company’s cash and interest-bearing securities divided by trailing 12-month average market capitalization • Accounts receivables divided by trailing 12-month average market capitalization Source: Dow Jones IMI rule book

14. Equity funds – FTSE FTSE Company Debt • According to Shariah Law, a company should ideally have no interest based debt • However scholars have developed a formula to screen the company's debt and thereby exclude companies with excessive leverage (and, by extension, involvement in interest earnings and payments) Asset Liquidity rule • Accounts receivables and liquid assets (such as bank accounts and marketable securities) to Total assets must be below 45% of the company’s total assets Cash and Equivalents • The ratio of cash and equivalent holdings (which generate interest income) to total assets should not exceed 33% Source: www.ftse.com/Indices/FTSE_SGX_Shariah_Index_Series/Downloads/Shariah_Com

15. Equity funds - The screening method of the Shari'ah Advisory Council (SAC) of the Securities Commission of Malaysia For companies with activities comprising both permissible and non-permissible elements, the SAC considers two additional criteria: • The public perception or image of the company must be good • The core activities of the company are important and considered maslahah (‘Benefit’ in general) to the Muslim ummah (nation) and the country, and the non-permissible element is very small and involves matters such as `umumbalwa (common plight and difficult to avoid), `uruf (custom) and the rights of the non-Muslim community which are accepted by Islam. To determine the tolerable level of mixed contributions from permissible and non-permissible activities towards turnover and profit before tax of a company, the SAC has established several benchmarks based on ijtihad (reasoning from the source of Shari'ah by qualified Shari'ah scholars). If the contributions from non-permissible activities exceed the benchmark, the securities of the company will be classified as Shari'ah non-compliant.

16. Equity funds - Benchmarks of the SAC of the Securities Commission of Malaysia • The 5-percent benchmark This benchmark is used to assess the level of mixed contributions from the activities that are clearly prohibited such as riba (interest-based companies like conventional banks), gambling, liquor and pork. • The 10-percent benchmark This benchmark is used to assess the level of mixed contributions from the activities that involve the element of “umumbalwa” which is a prohibited element affecting most people and difficult to avoid. An example of such a contribution is the interest income from fixed deposits in conventional banks. This benchmark is also used for tobacco-related activities. • The 20-percent benchmark This benchmark is used to assess the level of contribution from mixed rental payment from Shari'ah non-compliant activities such as the rental payment from the premise that involved in gambling, sale of liquor etc. • The 25-percent benchmark This benchmark is used to assess the level of mixed contributions from the activities that are generally permissible according to Shariah and have an element of maslahah to the public, but there are other elements that may affect the Shari'ah status of these activities. Among the activities that belong to this benchmark are hotel and resort operations, share trading, stockbroking and others, as these activities may also involve other activities that are deemed non-permissible according to the Shariah.

17. Equity Funds - Purification of Earnings • Profits are either derived through dividends distributed by the company or due to the appreciation in the price of shares. • If profits are earned through dividends the proportion of the dividend earned from impermissible sources should be donated to charity. • Contemporary scholars have differed as to whether profits earned through the appreciation in the share price should be donated to charity. • AAOIFI has however resolved that purification should be done on both capital gains and dividends earned.

18. Equity Funds - AAOIFI Shari'ah Resolution AAOIFI Shari'ah Resolution Shari’ah Standard no.21: • 3/4/6 It is obligatory to eliminate prohibited income specific to the share that is mixed up with the earnings of the corporations, and this is in accordance with the following: • 3/4/6/1The elimination of prohibited income is obligatory on one who is the owner of the share, whether an investor or trader, at the end of the financial period, even if the payment is due at the time of issuance of the final financial statements whether quarterly, annual or for other period. Accordingly, elimination is not obligatory for one who sells the shares before the end of the financial period. • 3/4/6/2 The subject matter of elimination is the prohibited income specific to the share whether or not the profits have been distributed and whether or not the corporation has declared a profit or suffered a loss. • 3/4/6/3 Elimination is not obligatory for the intermediary, agent or manager out of part of their commission or wages, because it is their right in lieu of the work they have undertaken. • 3/4/6/4 The figure, whose elimination is obligatory on the person dealing in shares, is arrived at by dividing the total prohibited income of the corporation whose shares are traded by the number of shares of the corporation, thus, the figure specific to each share is obtained. Thereafter the result is multiplied by the number of shares owned by the dealer, individual, institution, fund or another and the result is what is to be eliminated as an obligation.

19. Equity Funds – Engagement with Companies • The Shari'ah Scholars of a fund or the fund manager should engage with companies informing them of Shari'ah requirements, and requesting companies to abstain from activities that are not consistent with Shari'ah principles. • Issues of importance to Muslims should be communicated accurately and effectively.

20. Q & A Thank you