Purification in Islamic Equity Fund

Meaning of purification

Purification simply means: deducting from one’s investment those earning the source of which is not acceptable from Shari’ah point of view. In the case of equity investment, this refers primarily to interest earning and incidental income from other non-permissible sources such as sale of liquors or pork. While the idea looks simple, infact it is not. A company is a going concern. It is a living entity with far reaching activities and a widely stretched concerns. It is also very complex from accounting and financial point of view. Things are not as simple as they may look. Therefore, estimating such income is a formidable task. One that require an excellent knowledge of accounting and corporate finance and exceptional ability to handle Shari’ah issues, a combination that is not always within reach.

Shari’ah basis for purification

Although the Islamic equity investment program gains more and more acceptance everyday from an increasing number of Shari’ah scholars and the public at large, it remains that some still believe that its Shari’ah basis are doubtful. It is not the same for the concept of purification. Purification finds clear Shari’ah basis exemplified in the classical annals of fiqh and statements of major learned scholars of the early centuries based on their understanding of the texts (Qur’an and Sunnah).

However, articulating those Shari’ah principles into a formal procedure for purification is quite a heroic task and one with a number of unsettled issue. For example: what is exactly to be purified? Is it dividend and therefore if the company doesn’t distribute dividend no purification is required, or capital gain, although capital gain is a market earning that derives no direct income from the company, or both. Do we treat interest earning as net or gross variable. For the first, we will then assign no expenses on such earnings for the second, interest earned will be netted by deducting operating expenses.

Methods of purification

We have deducted several methods of purification which will be present below. Each method is based on assumptions the purpose of which is to embody Shari’ah requirements in a formula that lends itself easily to implementation by fund managers. All the methods presented here are already in practice, and are used by fund managers. However, these; I am sure, are not the only methods. Nevertheless, 1 am quite confident they are the most common. In each methodology we are trying to find factor P, by which we can estimate interest income.

First method:

Let us assume that we have a portfolio of company shares. On January 1 (tl) we have an investee companies (c) each earning interest equal to l¢hence we have interest income equal

let us assume that the net operating income for any company is y hence the total net operating income for the portfolio is

let us assume that the net asset value of the fund on Jan 1 equal NAVtl. Then calculate Z which equals NAVt2 – NAVt1 purification factor P will then equal ZH = P Hence for every dollar invested, the investor must multiply by P and donate this amount to charity. If P = .007 and the investor's Z = $ 2000 then he must dispose of $ 14.00

Second method:

Assume we have n companies in the portfolio: C1, C2....Cn Dividend yield = market value dividend = d then annual portfolio dividend yield = dc1 + dc2 + …..+ dcn

calculate interest income ratio = = l¢ net operating income interest income for the portfolio = c c cn l¢ + l¢ + ......+ = l¢ 1 2 purification = (d) ( l¢) = P Hence for every dollar invested the amount of $ P must be donated annually to charity

Source: An Introduction To Islamic Banking, Shaykh Dr Mohamed Ali Elgari. Republished with permission.