What is a Shariah Compliant Investment

Mufti Ismail Ebrahim Desai

 

 

Financial markets are seeing a growing success story with Islamic finance, a unique form of investment which corresponds with the values of socially responsible investing which is also Shariah Compliant.

Islamic finance is an equitable mode of finance that derives its principles from the Shariah, the Islamic law. The most distinctive element of Islamic finance is the prohibition of interest, whether nominal or excessive, simple or compound, fixed or floating. Shariah Compliant financial transactions are based on the essential maxim of sharing risk and reward. The customer and the financier share the risk of any investment on agreed terms and divide any profits between them. Islamic finance does not allow creating new financial risks in order to gain profit; it is about protecting society from trickery, fraud and social tensions.

Shariah products also stress accountability, fairness, and transparency. In addition to risk sharing and the prohibition of interest, under the principles of Shariah, investment is also disallowed in businesses that deal with alcohol, pork, gambling, weapons, tobacco, media, ‘conventional’ financial institutions, pornography and anything else which it deems ‘Haraam’ (unlawful). It also ensures that not only underlying investments but also the contractual terms agreed between investors and the investment manager conform to Islamic principles.

Islam also disallows certain contracts due to inherent elements which render them ‘Haraam’ (unlawful). This concept covers particular types of uncertainty or contingency in contracts such as options trading, short selling, futures, derivatives, and conventional insurance. All Islamic investment fund companies have appointed Shariah boards which not only provide approvals on individual investments on a regular basis but also conduct a Shariah audit annually to ensure all activities of investment funds are fully compliant. All dividends and profits are screened by the Shariah Audit Committee to ensure full Shariah Compliance of the final declared dividend or profit.

 

Shariah Compliance Screening

There are certain criteria which must be fulfilled when investing in a company for such an investment to be Shariah Compliant. There are essentially two stages involved in the Shariah screening process. It is important that the holding company including the subsidiary company fulfills the industry screen. For example, a vehicle asset manufacturing company may have a vehicle asset financing subsidiary which generates impermissible income via conventional and interest-bearing lending practices, therefore investing in the holding company would be impermissible.

 

1. Sharia Industry Screen

The following business activities are impermissible from a Shariah point of view: 1) Conventional Banking and Insurance  2) Alcohol  3) Pork and all non-Halal food items  4) Gambling  5) Tobacco 6) Adult Entertainment and all other impermissible actions as decided by the Shariah Supervisory Board 7) Conventional derivatives and  8) Weapons

 

2. Shariah Financial Screen

The Shariah Financial Screen monitors the impact of non-Shariah Compliant practices of a company and its potential impact on corporate performance. The investment companies must be compliant with the Shariah Financial Ratios as decided by the Shariah Supervisory Board.

Screening means that: 1) Conventional Debt/Total Market Capitalization must be less than 33 percent  2) Cash +Interest Bearing Deposits/Total Market Capitalization must be less than 33 percent  3) Total Interest/Revenue must be less than 2 percent.

 

Shariah Governance and Shariah Board

Shariah Governance refers to the structured policies and procedures of the Islamic Investment Fund to ensure full Shariah Compliance. All Shariah-compliant investments must be certified by experts in Shariah, generally through a panel or board comprised of respected Shariah scholars who are qualified to issue “Fatwas” (religious rulings) on financial transactions. This panel of Shariah experts ensures full compliance of all Shariah-compliant investment funds. The Shariah Supervisory Board not only provides initial approvals on investment objectives and investment strategy of all funds but also reviews the investments periodically to ensure the continued compliance of the investments of the funds to Islamic principles. Moreover, the Shariah Audit Committee conducts annual Shariah audits of all funds to ensure adherence to their rulings during the year.

 

Common Shariah Investment Funds

The most common forms of Shariah-compliant investment funds are equity funds, private equity funds, trade finance funds, real estate funds, and money market funds. Such funds are either unlisted private funds, listed funds, private or public partnerships. These investment funds employ Islamic contracts which ensure that the terms and rights of all parties are safeguarded in conformity with Islamic principles (examples and definitions are given below).

 

Musharakah: A partnership where profits are shared according to a pre-agreed ratio while losses are shared in proportion to the capital investment of each partner. This equity financing arrangement is widely regarded as the purest form of Islamic financing.

Mudarabah: An investment partnership under which the investor (the “Rab-ul-Mal”) provides capital to the investment manager (the “Mudarib”) in order to undertake a business or an investment activity. While profits are shared on a pre-agreed ratio, losses are borne only by the investor.

Ijarah: An Islamic lease agreement. Instead of lending money and earning interest, Ijarah allows the investor to earn profits by charging rentals on the asset leased to the user.

Murabaha: Purchase and resale of an asset. Instead of lending money, the investor purchases the specific asset from a third party and resells it at a predetermined higher price to the user. By paying this higher price over installments, the user of the asset effectively obtains credit without paying interest.

The classical equity instruments in Islamic commercial law (musharakah and mudarabah) require partnership and profit sharing. In financial markets, investing in stocks and equity funds is permitted but must conform to certain guidelines. Conventional interest-based lending or bonds are not permitted. Islam encourages asset-backed financing with the risk being shared by the provider and the user of the asset.

 

Basic Fundamentals

Shariah Investments must follow the same rigorous regulatory and compliance requirements as conventional funds to ensure transparency, reliability, and sustainability for investors. A mere Shariah certificate is not sufficient proof or attestation to the credibility of Management or the business case of such investment funds. Investors should seek proper professional advice and conduct background checks before undertaking to make any investment.

Investors must seek the following basic fundamentals in any investment:

1. Regulatory Compliance– Never invest your hard earned money in a non-regulated entity as the funds are not monitored or reported to the regulator and there is very little recourse in the event of default or irregularity. A Shariah fund does not mean your money is necessarily protected from fraud, theft, and mismanagement. It has happened in the past,  so beware.

2. Governance Structure – Never invest in one-man band investments as that is a recipe for Ponzi schemes and financial ruin. Investigate Management and Ownership carefully. There are many wannabe investment gurus and financial advisors who have little or no experience in financial investment management.

3. Risk and Audit – Always seek audited financials signed and endorsed by a reputable firm before investing in any company. The investment fund must have an audit and risk committee that oversees risk management and internal audit functions.

4. Target Assets – Always understand the underlying assets of the fund. Many Shariah funds are not balanced and are over-aggressive exposing you to unnecessary high risk.

5. Shariah Audit – A Shariah Audit signed by a reputed scholar is extremely important as that allows external parties to review the operations of the fund internally.

6. The rate of Return (ROI) – Always seek market-related returns or slightly above average. High returns are signs of systemic and inherent financial risks to the business models of such investment funds which offer high returns. Remember if it is too good to be true, it probably is. The fund fact sheet will be a good indicator of historical performance.

7. Shariah Certification – A fund being Shariah Compliant is not an endorsement of the credibility of any investment. Every individual must conduct their own research and investigation before making a decision.

8. Emotion – Greed, and fear are the most common emotions which have led to the destruction of many empires. Let your decisions be guided by sound and robust financial and economic wisdom.

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