What is an Islamic investment fund, what differentiates them from conventional investment funds and why are they so popular?
When compared with the conventional sector, Islamic investment funds are still in their infancy, but many of the lessons learnt by conventional fund managers have been passed on to Islamic funds managers so the market is now developing quickly.
The first Islamic investment fund was established during the late 1980s, but the real catalyst to the development of these funds was a ruling by the Fiqh Academy of the Organisation of Islamic Countries, whereby ‘shares’ in a company were defined as an ‘undivided portion of the company assets’. Prior to this there had been much debate about whether investing in shares (or equities) was allowable under Shariah law. The ruling, however, opened up the sector to the millions of Muslims throughout the world who wanted to invest their surplus earning or savings in accordance with Shariah law. The natural consequence of this ruling was the development of Islamic investment funds. The main advantages of a fund are that investors pool their resources with other investors to purchase a wider range of shares than they would have been able to acquire as individuals, thereby reducing their risk, and the investor also has access to the services of a professional manager.
Definition and asset classes
Investment funds have been defined by the Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI) as follows:
“Funds are investment vehicles, which are financially independent of the institutions that establish them. Funds take the form of equal participating shares/units, which represent the shareholders’/unitholders’ share of the assets, and entitlement to profits or losses. The funds are managed on the basis of either mudaraba or agency contract.”
The definition continues by setting out the Shariah ruling that governs Islamic investment funds: “Investment funds are permissible by Shariah. Because funds are a form of collective investment that continue throughout their term, the rights and duties of participants are defined and restricted by the common interest, since they relate to third parties’ rights. Hence, in cases where the fund is managed on the basis of agency the shareholders/unitholders waive their right to management, redemption or liquidation except in accordance with the limitations and conditions set out in the statutes and by-laws.”
Investment funds can be established to own many different types of assets, but the most common of these are shares in other companies, or in some cases other funds. Generally these are shares that are traded on a major stock exchange, but specialist funds investing in shares of companies for which there is either no market or a very limited one have become increasingly popular with ‘expert’ investors. These funds are usually termed private equity funds and, by their nature, the shares in these funds tend to be very illiquid such that the fund will normally be classified as a closed fund.
Normally Islamic Investment funds are established as a limited liability company. However, depending upon the jurisdiction, and/or other factors, funds will often be formed as limited partnerships, unit trusts or other entities. The appropriate structure to select will depend upon many factors, such as the nature of the underlying assets to be acquired, the jurisdiction in which those assets are located, whether the fund is targeted at a retail or institutional market and where that target market is resident. The promoter should seek professional advice before deciding on how the fund is to be structured.
The management company will normally be directly associated with the institution promoting the fund and the actual functions to be undertaken by the manager in performance of this role and the basis of the manager’s remuneration will normally be the subject of a separate agreement between the entities. There are commonly two ways in which a manager may be remunerated:
- By way of a share of the profits generated by the fund; in a Shariah context where the management of the fund has been undertaken on a mudaraba basis and the manager is acting as the mudarib.
- 2. By way of a fixed fee arrangement, or where the fee is calculated by reference to the value of the fund itself; in a Shariah context where the manager is acting on an agency basis.
In some cases a combination of these two methods is employed, such that the manager receives a basic annual fee, plus a performance fee that will normally be calculated by reference to the fund exceeding certain performance hurdles, such as a percentage of the amount by which growth in the net asset value of the fund exceeds an annual percentage.
This type of arrangement can be particularly useful in ensuring that the manager is appropriately rewarded for its efforts in managing the underlying pool of investments, particularly where the hurdle is linked to an appropriate investment index.
In this example, the investors will purchase participating redeemable shares. In an Islamic fund, it is essential that all the shareholders be treated equally in accordance with the principles of the Islamic Shariah, so there will only be one class of shares issued to investors. The terms under which these have been issued will be governed by the funds constituting documents (in the case of a company, generally the memorandum and articles of association). These terms will cover such matters as:
- rights to dividends;
- dealing and valuation days;
- calculation of dealing prices; and
- voting rights.
Shariah supervisory board
The other important party in the structure is the Shariah supervisory board. To ensure compliance with Islamic Shariah principles, a fund’s investment opportunities will be pre-screened and approved by a Shariah supervisory board. The manager of the company will select the underlying investments in accordance with the rulings issued from time to time by the Shariah supervisory board; all such rulings and decisions of the Shariah supervisory board are binding on the fund and the manager whose actions will be subject to periodic review by the Shariah board.
The role of the Shariah supervisory board includes but not limited to the following:
- Studying the fund’s offering memorandum, constitutional documents and any major agreements controlling the relationship between the functionaries of the fund.
- Giving general advice to the manager or investment adviser regarding compliance with Islamic Shariah.
- Determining suitable criteria for the selection of companies in whose securities the fund may invest
- Advising on the use of instruments and techniques for hedging and efficient portfolio management, and their compliance with the principles of Islamic Shariah.
- Advising on the separation of non-Shariah compliance profits of the fund and to specify the charitable activities to which they will be directed.
- Preparing an annual Shariah audit and review concerning the fund’s activities and issuing a report to investors in the fund.
Probably the most important function of the manager is the selection of fund investments. In the context of an Islamic investment fund these investments will have to be Shariah compliant and the selection process will be guided by the rulings of the Shariah supervisory board. It is not possible for the manager to approach the scholars who constitute the Shariah board for a ruling on each potential investment. Therefore, in practice, the manager will determine Shariah-compliant investments by screening and selecting from an overall universe of investments that would meet the fund’s investment objectives. Once this restricted investment universe has been established the scholars will review the application of their criteria by the manager to ensure compliance and an outline investment universe will be agreed and signed off.
The criteria that the manager will be required to work within can be split into two distinct categories. First are the qualitative criteria that will consider the actual business activities of the target company, and secondly certain quantitative measures that will consider certain financial ratios derived from the target company’s accounts.
The following list provides a summary of the qualitative investment restrictions for one fund connected with Volaw Trust & Corporate Services Limited (The Middle Eastern Fund for Japanese Equities):
- Companies that produce, sell, distil or distribute alcoholic beverages and products.
- Companies that produce, sell, distribute or slaughter pork and pork-related products.
- Companies engaged in gambling, casinos, lotteries and related games.
- Companies whose principal activity is in the entertainment businesses (i.e., whose principal activity is in films, videos, theatres, cinemas, etc).
- Companies engaged in pornography and obscenities in any form.
- Companies producing weapons.
- Companies that produce tobacco and tobacco-related products.
- Companies engaged in products related to aborted human fetuses.
- Companies engaged in human cloning.
- Companies with bad and harmful environmental records (where there is publicly available evidence).
- Companies with bad employee records (where there is publicly available evidence).
- Conventional (non-Islamic) banks, financial institutions and insurance companies.
- Companies with any impure activity exceeding 5 per cent of revenues.
Some of the disallowed activities are very easy to monitor, but others are much more subjective and sometimes very difficult to determine (note the ‘where publicly available evidence’ clauses). A further difficulty arises from the actual nature of many of the institutions that make up any investment universe. In these days of multinational conglomerates it can be very difficult to find a company that does not participate in some form of an impure activity. The common solution is to purify the income and profits arising from this investment by making an equivalent gift to a charitable account that will be distributed in accordance with the directions of the Shariah supervisory board.
Having established an initial investment universe by eliminating companies with unacceptable primary business activities, it is then necessary to further refine the universe to ensure that any income derived from the target investment has been generated using appropriate financial resources. To do this, the manager will undertake a quantitative analysis of the accounts of the underlying investment to ensure that the company is managing its affairs in accordance with certain Shariah principles.
This is an area over which there was significant debate in the early days of Islamic investment funds and the actual ratios to be applied varied widely from fund to fund. However, the advent of the Dow Jones Islamic Market (DJIM) Indexes in 1999 effectively codified best practice in this area. These financial measures are now widely adopted by the managers of Islamic equity-based products.
Dow Jones Islamic Market Indexes
- Total Debt Exclude companies if Total Debt divided by Trailing 12-Month Average Market Capitalization is greater than or equal to 33%. (Note: Total Debt = Short-Term Debt + Current Portion of Long-Term Debt + Long-Term Debt).
- Cash and interest bearing securities Exclude companies if the sum of Cash and Interest Bearing Securities divided by Trailing 12-Month Average Market Capitalization is greater than or equal to 33%.
- Accounts receivable Exclude companies if Accounts Receivables divided by Total Assets is greater than or equal to 45%. (Note: Accounts Receivables = Current Receivables + Long-Term Receivables).
It is important to recognize that this investment universe is not fixed. Companies merge, sell key subsidiaries or change their own activities to meet market conditions. More importantly, their underlying financial ratios will vary on a daily basis, as these depend on their profitability and share price in the market place. How often the manager actually reviews these ratios is a matter that will be agreed within the fund documentation and approved by the Shariah board. The following are some of the factors that will influence this:
- The availability of financial information (some companies may only publish financial information on a six monthly basis).
- The size of the holding in the underlying entity (if the holding is not material to the overall assets of the fund, the impact of this holding on the purification process will be marginal).
- The liquidity of the holding in the underlying investment (in cases where there is little or no ready market for the investment, the manager may have little choice other than to continue to hold the investment).
In practice the manager will normally agree certain parameters with the Shariah supervisory board such that no investment is made in any underlying entity whose financial ratios are within a certain percentage of the agreed limitations. If the manager becomes aware of an investment where the financial ratios start to approach the agreed limits, then that investment will normally be placed on ‘watch’ such that it will be monitored on a regular basis and, where there are indications that the ratios will continue to deteriorate, the manager will be expected to take steps to reduce the fund’s holding in the investment.
It follows that in addition to the performance of their normal roles in managing the fund, and supervising the investment process, in the case of an Islamic investment fund, the manager is required to perform additional roles to ensure that the underlying investments are Shariah compliant, both at the time the initial investment is made, and also for the period that the investment continues to be owned by the fund. This role is not new. ‘Ethical’ investment funds have been a feature of the investment world since the 1970s, and ethical investment – or socially responsible investment (SRI) – as it relates to investing in the stock market can be traced back to the 1920s. The first ethically screened investment fund, the Pax World Fund, was established in 1971 in response to the demand for investments that did not benefit from the Vietnam War. In the 1980s, opposition to South African apartheid fuelled the ethical investment movement, and it is the skills developed to satisfy this demand that are used in the screening of investments for Islamic investment funds.
Purification of earnings
The question arises what happens when changes in an underlying investment lead to unacceptable levels of prohibited activities in that entity (for example, new shops within a shopping mall sell haram products), or an unacceptable level of income generated within the investment is haram (such as a high level of bank interest being received on surplus funds within the entity). In such cases it is necessary to purify the earnings by deducting from the returns on the investment those earnings emanating from an unacceptable source from a Shariah point of view. In an investment fund, the most common of these sources is interest earnings, but calculating the actual amount of income attributable to interest can be very difficult as ‘interest earned’ may not be a separate heading in the income account, or may be disguised by offsetting interest against certain types of expenditure.
It is simply not possible to obtain all the detailed information necessary to be absolutely accurate in determining the amount of haram earnings that may arise within a pool of investments that may include the shares of over 100 different entities, and in many cases the effort in performing the analysis will totally outweigh the benefit in having exact figures. For this reason, many managers and Shariah supervisory boards will agree on a particular percentage of all income from dividends being deducted from the fund’s total income by the manager and distributed to suitable charities under the supervision of the Shariah board. Alternatively, the manager may advise investors in the fund of the amount of impure income arising from their investment and they may then dispose of this amount themselves.
There is no doubt that the potential market for Islamic investment funds greatly exceeds the current supply by a very significant factor. Educating that potential target market takes time and resources, and this is one area where the conventional Western-backed institutions still have a significant lead over Islamic financial institutions. The other area where Islamic investment funds are lagging behind conventional funds is in providing their investors with the opportunity to trade actively, moving in and out of the funds as they wish. For this to happen, the funds must be tradable on a daily basis and information on their performance must be made readily available to investors.
A first step in this area is for the fund to be listed on a stock exchange. There are many advantages of a listing, both for investors and promoters, and these can be summarised as follows:
- A listing increases the fund’s potential investor base. Many institutional investors are restricted or prohibited from investing in unlisted securities, and a listing will enable the fund to be marketed to such investors.
- A listing promotes information flows to investors. By listing on a stock exchange an investor will be given access to the fund’s net asset value whenever this is calculated, while other information and announcements relating to the fund’s activities can also easily be passed to investors.
- A listing allows investors to mark their fund investment to market. Many fund investors, particularly institutional investors, require a publicly quoted stock exchange price for their investments, which they are required to use in their own accounting.
- For closed-ended funds, where there is no facility to redeem, a listing can be a first step in providing information whereby a secondary market for both buyers and sellers can develop.
This article has concentrated on the application of Shariah principles to a fund investing in the shares of a company. The same principles will apply whether the fund is investing in shares, real estate, commodities, leasing contracts or any of the other specialist forms of fund.
Islamic investment funds are still a relatively new product, but the expansion and diversity of these funds is expected to continue to grow as Muslims (and others) become better informed as to the products and services on offer.