Islamic investment wealth management funds allow Islamic investors to invest in funds structured through Shariah-compliant contracts. The funds invest in shares or units of Shariah-compliant assets.
Increasingly, Islamic funds have been authorised by a variety of international regulators and listed on international exchanges. This has provided Islamic wealth management with a growing global audience with mainstream financial institutions providing Islamic investment funds.
Characteristics of an Islamic fund
In many respects, the structural characteristics of a Shariah-compliant fund will not differ from those of a conventional investment fund. For example, the choice of legal structure for the investment vehicle and the choice of jurisdiction will still be driven by considerations such as:
(i) a flexible, cost-efficient regulatory framework, particularly with regard to the need to obtain approvals from supervisory authorities and possibly seek a stock exchange listing; and
(ii) a favourable tax regime.
A primary feature of an Islamic fund is an independent Shariah board of three to five Shariah scholars. This board will establish compliance parameters for the fund, usually prior to the establishment of the fund and before any assets are acquired. The Shariah board will also be responsible for publishing an annual statement which sets out how the fund has complied with Shariah. The statutory documents of the fund need to clearly set out the roles and responsibilities of both the Shariah board and the fund manager to avoid any potential conflicts of interest, which is an area of particular concern to international regulators.
Islamic stock screening
In order for an investment fund to be Shariah-compliant, the stock of the company in question must be screened to ensure that the potential investment is suitable under Islam. Under Shariah law, the ownership of shares in a company is considered a proportionate share of that company's business and assets with the result that Islamic investors cannot own a company that is involved in any haram activity. Investors will seek guidance from the fund's Shariah board on the permissibility of an investment or business venture.
In order to increase access to the financial markets for Islamic investors, a group of leading Shariah scholars developed a series of screening criteria which aimed to identify the non-Shariah-compliant elements of a company and impose means of avoiding or dealing with them in a manner consistent with Shariah principles. Through this screening process, Shariah-compliant investors can therefore invest in companies which fulfil these screening criteria.
The screening criteria are applied at the time of the investment decision and during the subsequent ongoing monitoring process by the Shariah board to ensure that the company remains Shariah-compliant during the investment period.
There has been significant debate as to the interpretation and application of the screening criteria which will often vary on a case-by-case basis. However there are two basic screening processes which are applied to companies with the potential to form part of an Islamic investment portfolio.
The first "Industry Screen" examines the underlying business of the company and is intended to eliminate any haram businesses which are contrary to the principles of Shariah. Such businesses include conventional banking, insurance, alcohol, pork related products, non-compliant food production, gambling, certain tobacco production, pornography and weapons manufacturing. It is not sufficient for the holding company alone to be compliant with the industry screen, all of the subsidiaries also need to comply.
Once this initial screen is passed, the "Financial Screen" is used to determine the extent of a company's non- Shariah compliant financial behaviour. This presents a significant challenge as there are very few companies operating in the current global market that are completely Shariah compliant. As a result, the majority of Islamic scholars agree to use certain financial ratios in order to determine whether a company is financially Shariah compliant. While these ratios vary based on a specific Shariah board's discretion, a commonly used standard developed by the Securities Commission of Malaysia and the Accounting and Auditing Organisation of Islamic Financial Institutions ("AAOIFI") is as follows:
- Total interest and income from non-Shariah compliant activities must be less than 5% of the total revenue of the company.
- Both conventional debt and cash and interest bearing deposits must be less than 30% of the total market capitalisation.
By utilising the total market capitalisation figure the entire value of the company (including intangible assets) can be considered enabling more companies to be Shariah compliant. Any of the company's income derived from non-Shariah compliant activity can be purified by donating the income to charity.
Management of risk
Shariah requires parties to be fair, just and ethical in their dealings with one another and for the balance of risk (and its accompanying rewards) to be fairly apportioned. The aim is to prevent a party with a stronger bargaining position from exploiting another party who is less able to negotiate fair and equal terms for a transaction.
There is increasing focus on ensuring that the level of risk is commensurate with the risk the client is willing and able to accept. Whilst Islamic principles require the acceptance of risk to justify the earning of a reward, the concept of maisir (speculation) forbids speculation (risk taking) that is akin to gambling.
As a result, one of the primary difficulties for Islamic fund managers is providing an investment fund that minimises the potential risk to the investor. Unlike mainstream funds that can hedge their risk by diversifying the portfolio of investments, Islamic funds are severely restricted to investments that pass the screening criteria. Traditional derivatives instruments, such as futures, are generally not permitted. There has been a recent trend for permitted options that can hedge the risk of equity, commodity and currencies. However, the primary method of managing risk is in the form of capital protected equity structures. These require the investor to use a small portion of the overall portfolio as a down payment (Arbun) for a basket of shares which will be delivered at a forward date. The disadvantage of this structure is that it reduces the short-term liquidity of the investment and requires the investor to relinquish redemption frequency.
Recent developments
Islamic funds will face increasing challenges, particularly when diversifying to non-Islamic jurisdictions. Recent regulatory developments in Europe (such as the incoming Alternative Investment Fund Managers directive) will impose further restrictions on fund managers.
Many of the tenets of Islam already lend themselves to compliance with the latest European regulations. The risk-reward profile of Shariah-compliant investment funds is mirrored in the increased focus of European regulators on suitability of products provided by wealth managers to their clients. There is a clear obligation on the wealth manager who makes a personal recommendation or exercises its discretion to trade to ensure that the recommendation or trade is suitable for a client. This obligation flows from the mainstream principles to act in the best interest of clients and to treat them fairly.
Islamic fund managers are substantially more restricted in their ability to exercise discretion on behalf of their investors and have to satisfy the additional investor requirement of linking investments to moral objectives. While there has been limited research done on whether Shariah principles actually hinder the performance of Islamic funds recent academic studies have concluded that Islamic funds perform similarly (if not better) than their mainstream counterparts with extensive screening actually serving to prevent losses.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
