Sharia law differentiates Islamic finance from conventional finance. The Islamic financial system is constructed on economic concepts specified by sharia — a code of conduct that guides Muslims (the followers of Islam) in social, economic, and political matters. Sharia promotes balance and justice and discourages behaviors of excess. Some of the core ideas promoted by sharia include the following:
Allah (God) is the owner of all wealth. Humans are merely the trustees of wealth, which belongs to Allah. Humans must manage wealth according to Allah’s commands, which promote justice and prohibit certain activities, including wasting or destroying resources. Muslims have the right to enjoy whatever wealth they acquire and spend in sharia-compliant ways.
Material pursuits must be balanced with an individual’s spiritual needs. A Muslim’s economic activities and pursuit of wealth should balance with the spiritual aspects of life. Economic activity conducted according to sharia is, itself, an act of worship, but finding balance between economic activities and spirituality is key. A Muslim is expected to seek moderation in the material world — to avoid being either miserly or too materialistic.
An individual’s needs must be balanced with society’s needs. A Muslim needs to consider society in general when enjoying Allah’s bounties. These considerations include promoting justice in all economic activities, remembering that all people have mutual responsibility for all others, and using the earth’s resources wisely.
Economic transactions should take place within a just, responsible, free-market economy. Islam does not restrict economic activity but instead directs it toward being responsible to other people, to the earth, and to Allah. Islam allows for a free-market economy where supply and demand are decided in the market, but it directs the function of the market mechanism by imposing specific laws and ethics. A primary purpose for imposing these laws and ethics is to promote social justice: a balance in which wealth is not accumulated only by a few while most others suffer.
In support of these principles, sharia prohibits business transactions based on the following:
Interest: Riba, the Arabic word for interest, means to increase, grow, or multiply into more than what would be due. Riba is prohibited by Islam because it creates societal injustice; in a riba-based transaction, the owner of the wealth gets return without making any effort, and the borrower carries all the risk.
Uncertainty: The Arabic word gharar means uncertainty or to cheat or delude. Transactions based on gharar are unclear or ambiguous; not everyone involved knows what to expect and can make an informed decision. Gharar exists when two parties enter a contract and one party lacks complete information or when both parties lack control over the underlying transaction.
Gambling: Two Arabic words — maysir and qimar — refer to transactions that involve gambling. Maysir is the acquisition of wealth by chance instead of by effort. Qimar refers to a game of chance. Both types of transactions are based on uncertainty; no one can know how a gamble will pay off.
Prohibited products and industries: Islam prohibits products and industries that it considers harmful to society and a threat to social responsibility. Examples include alcohol, pork, prostitution, pornography, tobacco, and any products based on uncertainty or gambling.
What is a Shariah-compliant investment?
Investments which are in accordance with the Islamic Principles are called Shariah-compliant. There are three principal rules which need to be adhered to when analyzing an investment from the standpoint of Shariah permissibility. The first is the absence of interest (riba) in the investment. Islam has strictly prohibited interest (riba). This is based on the principle that it is unacceptable in and of itself for same commodity, including money, to increase in value merely by being lent to another person. The prohibition is bilateral, which means that the lender cannot receive it and the borrower cannot pay it. However, Shariah does not prohibit the making of a return on capital if the provider is willing to share in the risks of a productive enterprise. The conclusion then is that whenever capital is “lent” rather than “invested”, interest (Riba) is the return rather than profit. The second is the potential for ‘unethical concerns’ in the investment mix. Muslim scholars have put together the following benchmarks clarifying what is not acceptable as an investment under Shariah.
- Alcohol – Brewers or distillers of alcohol or any firm exclusively involved in the production or sale of alcohol.
- Banks – and other banking Institutions involved in interest. (Insurance companies are usually included in the this section too)
- Gambling – Casino and gambling outlets
- Pornography Manufacturers, retailers and distributors of pornographic material as well as firms involved in pornographic activity.
- Tobacco – Manufacturers of tobacco and tobacco related products.
- Ancillary Activity – Any business though not directly engaged in the above, derives greater than 5% of its income from the above.
- Or any other forms whose activities the Shariah Board feels are prejudicial to the interests of Islam or Muslims.
The final area relates to the nature of the contract between the parties involved. Islamic finance also places great emphasis on the validity and transparency of contracts. In addition to insisting on investment contracts being put in writing, there are clear guidelines on ensuring that all terms and conditions of the investment contract are detailed in a manner in which no disputes can arise in the future. Any contract failing to pin down its key components (e.g. price, subject matter, delivery date etc) in a manner in which the uncertainty may cause a dispute between the contracting parties is guilty of containing “gharar” (Unacceptable Uncertainty) and is null and void in the eyes of Shariah.
The term “Islamic Investment Fund” means a joint pool wherein the investors contribute their money for the purpose of investment to earn halal profits in strict conformity with the precepts of Islamic Shariah. The concept of Islamic Mutual Funds has its roots in “Musharaka”, an Islamic investment vehicle. ‘Musharakah’ is a word of Arabic origin which literally means sharing. In the context of business it means a joint enterprise in which all the investors or “partners” share the profit or loss of the joint venture.
- In an Islamic Fund the investors have the relationship of partners amongst themselves, so they are eligible to share proportionately the profit earned (or loss incurred) on their investment.
- The Fund Manager of an Islamic Fund works as the investment agent and manages the investment activities on behalf of the investors’ collective investment, against a fixed fee (known as the Management Fee).
- An Islamic Fund can not offer a fixed return on investment; they must carry a pro-rated profit actually earned by the Fund. Therefore, neither the principal nor a rate of profit (tied up with the principal) can be guaranteed (unless a capital protected fund).
As opposed to conventional funds, Islamic Funds are in total compliance with the Shariah rules and regulations to earn “halal” profits in strict conformity with the precepts of Islamic Shariah. The instruments selected for investment by the Fund Manager are approved and monitored by the Shariah Advisory Board of the Fund as Shariah-compliant. Keeping these basic requisites in view, the Islamic Investment Funds may accommodate a variety of modes of investments, such as equities, income, or balanced.
Islamic Income Funds aim to provide a regular source of income to investors while endeavoring to preserve the principal investment. To achieve this goal, funds are generally invested in low-risk assets such as Islamic Banks’ Term-deposit accounts, Sukuks (Islamic Bonds) and Ijarah (Islamic Leasing).
- Sukuks, also known as Islamic Bonds, is the name of Shariah-compliant Investment Certificate issued by the Government or a private institution. Such certificates normally represent investors’ ownership in a fixed asset leased to the issuer. The issuer pays periodic rentals which generate profit for the investors.
- Ijarah is the name of Islamic Leasing products issued by the Government or a private institution. In Ijarah, the subscription amounts are used to purchase assets like real estate, motor vehicles, or other equipment for the purpose of leasing them out to their ultimate users. The ownership of these assets remains with the Fund and the rentals are charged from the users. These rentals are the source of income for the fund which is distributed to the subscribers.
In an equity fund, the investors’ money is invested in the shares of joint stock companies. The profits are mainly achieved through capital gains (purchasing shares and selling them when their prices are increased. Profits are also achieved by the dividends distributed by the relevant companies. Dealing in equity shares can be acceptable in Shariah subject to the following conditions:
- The main business of the company is not in violation of Shariah. Therefore, it is not permissible to acquire the shares of companies providing financial services on interest, like conventional banks, insurance companies, or the companies involved in some other business not approved by the Shariah (as mentioned earlier).
- If the main business of the companies is Halal, like automobiles, textile, etc. but they deposit there surplus amounts in an interest-bearing account or borrow money on interest, the proportion of such income in the dividend paid to the share-holder must be given as charity, and must not be retained. For example, if 5% of the whole income of a company has come out of interest-bearing deposits, 5% of the dividend must be given in charity.
- The shares of a company are negotiable only if the company owns some non-liquid assets. If all the assets of a company are in liquid form, i.e. in the form of money that cannot be purchased or sold, except on par value, because in this case the share represents money only and the money cannot be traded in except at par.