Islamic investments have found their footing in the global stock exchanges by offering Shariah indexes and ETF’s. Mufti AHMED SULIMAN and YUSUF MOOLA discuss their features.
Investment in the stock exchange is not exclusive to any one state or country. The global trend has shown that stock market investments play a significant role in the economy. A good economic state of affairs leads to a boom in the stock market while a poor state of affairs sends the stock market crashing.
Setting the scene
The purchase of an ordinary share in a larger business is referred to as a Musharakah (partnership). Upon acquisition of the share one becomes a partner in the business.
There may be two scenarios here:
a. The company has liquid and illiquid assets
b. The company only has liquid assets (cash).
In the first case, one may pay any amount of money with mutual consent of the buyer and seller for the purchase of the share. However, in the latter case, one may only pay an amount equal to the value of the share being bought. For example, if the liquid assets of the company amount to US$1 million and one is purchasing a stake in the company equal to one tenth of the company, then one may not pay more or less than US$100,000, as this is regarded as an exchange of cash for cash, which may only be done at par value according to Shariah law principles.
Preference shares, conventional bonds and other conventional financial instruments are not regarded as Shariah compliant investment options.
Shariah has laid down the law as to what may and may not be purchased. Keeping this rule in mind, Shariah scholars have set certain investment principles for trading in the stock market.
Industry screen refers to the screening of the company based on the main business activities of the company. The company should not be trading in prohibited industries as a core function of its business.
The following industries have been ruled as impermissible:
1. Conventional financial institutions such as banks and insurance companies;
2. Gambling houses and casinos;
3. Companies that manufacture, sell, pack or transport pork, alcohol and non-halal food and beverages;
4. Tobacco based industries;
5. Entertainment based companies, including cinemas, clubs, pornography, television and radio stations and music.
Companies may have mixed income, for example, retailers that sell permissible items may also have an alcohol section or butchery as part of their business. Contemporary Shariah scholars have allowed the purchase of shares in a company if the income derived from the alcohol/butchery (non-permissible source) is negligible. Similarly, these companies may have some sort of investment or bank account that earns interest.
Scholars have set the tolerance level at 5%, which is the total interest income (not net interest income), and other non-permissible revenue should not exceed 5% of total revenue. If non-permissible revenue exceeds 5% then investment would not be allowed. Similarly, if the sum of interest income and other non-permissible income is less than 5% of the total revenue, then the investment will be allowed. However, all impermissible earnings will be donated to charity and the investor may not derive any personal benefit from this amount, no matter how small.
The property sector has proven to be a challenge for Shariah scholars and the cause of vigorous debate. This problem may be more challenging for Muslim minority countries, where retail and warehousing property companies house a significant number of ‘non-compliant’ tenants, like conventional banks, cinemas and such.
The following ratios have been set as a tolerance bench mark:
a. Total interest bearing debt vs total assets – 30%: The total interest bearing debt (including debentures, preference shares, bonds and such) should not exceed 30% of the company’s total assets.
b. Total interest based assets – 30%: The total interest based assets (including fixed deposits, bonds and such) should not exceed 30% of the company’s total assets.
c. Liquid assets to total assets – 70%: The company’s liquid assets (cash + trade debtors) should not exceed 70% of the company’s total assets.
Some scholars have also added the following ratio:
d. Liquid assets to market cap: The company’s liquid assets (cash + trade debtors) should not equal nor exceed the market cap of the company.
This last ratio is not universally accepted. The Shariah standard of AAOIFI has excluded this ratio. In fact, the members of the AAOIFI Shariah board have explicitly mentioned that the inclusion of this last ratio is unnecessary.
Companies are screened periodically, depending on the timing, presentation and disclosure of financial results. In some countries, companies present their financial statements twice a year, showing interim and final results. In such cases, it would not be possible to perform the Shariah screens more than twice a year.
One may also find that some investment managers use a 33% ratio as opposed to 30%. This is also acceptable. The limit is set as one third.
Another interesting difference is the use of market capitalization instead of total assets. Market capitalization (cap) refers to the price per share multiplied by the number of shares in issue. The market cap of a company may be influenced by factors outside the company. It is also largely driven by investor perception of the company. During market booms one may find that the Shariah universe of shares may increase tremendously due to the rise in the base (market cap) and the opposite will occur when markets come crashing down.
Total assets on the other hand, are held by some as a more stable basis for calculating these ratios. The total assets, as shown in the balance sheet of a company, reflect the true position of the company and are not driven by ‘perception’. The effect in times of upward trends and downward trends may not be as challenging when using total assets as a base.
A possible resolution could be to apply total assets as a base for companies that have asset bases and leverage of their asset bases and to use market cap as a base for companies.
These companies spend money on growing intellectual capital which is temporarily disallowed to be presented as an asset in the balance sheet. For example, an IT company developing software or a healthcare organization spending huge amounts of money to develop new medicine but cannot account for research in its balance sheet.
Non-permissible income (NPI)
Non-permissible income refers to any kind of income that is regarded as impermissible according to Shariah law. As explained above, a company may earn interest from cash in its bank account. Such interest is calculated and donated to charity. Shariah investors do not gain any personal benefit from such NPI.
Shariah Supervisory Board (SSB) or Shariah Advisory Council (SAC)
SSB/SAC members consist of Shariah scholars who are experts in Shariah laws in general, however specializing in Islamic commercial law.
The appointment of an SSB or SAC is an additional governance requirement for companies that offer Shariah products and services. The core function of this board/committee is to provide guidance on Shariah law and its implementation within the framework of the company.
This board/committee provides a compliance certificate confirming that the products offered by the company are Shariah compliant. Periodic audits are also performed to ensure that the company complies with the rules and guidance of the SSB/SAC.
When creating a Shariah universe of investable stock, fund/portfolio managers may find themselves trading with smaller constituents than their conventional counterparts. Yet we find in some cases that Islamic managers outperform their conventional counterparts.
Mufti Ahmed Suliman of Shariah Consultancy is an expert Shariah scholar and can be contacted at [email protected] . Yusuf Moola, senior Shariah portfolio manager at Sanlam Private Investments, can be contacted at yu[email protected] .