Islamic Equity Funds

Islamic Equity Funds are Basically “Ethical Investing”

Ethical Investing is not new. It goes back to the 1920’s. They became popular, however, in the 1970’s and thereafter. In 1971 a group of Methodist clergy in the USA discovered that their church regularly received letters from individuals asking how to invest in companies not manufacturing weaponry. After finding that no organization specializes in this kind of investment, the ministers went to Wall Street firms asking for assistance in setting up a fund for this purpose. Pax World Fund may be the first equity fund to adopt a full set of ethical issues in its screens. The pioneer fund which excluded companies producing alcohol & tobacco from its portfolio holding was available to investors in 1928. Then the environmental movement and the equal employment opportunities programs in the 1970’s produced a number of equity funds tailored to the preferences of investors who are concerned about these issues, and want their money to help influence the business sector into more compliance. Dreyfus third century fund was pioneering in this regard. Such funds do exist now in USA & Europe.

Islamic Equity Funds are, therefore, part of a larger group of ethical investment programs. They address the needs of a class of investors, who are concerned about public issues and social justice. However, the main concern of Islamic “ethical” investor is the sources of his income. He is obliged religiously to make sure his earnings always come from “clean” sources.

Three Shifts in Islamic Banking

Islamic equity funds came a mid fundamental shifts that were taking place in the development of Islamic banking in the 1990’s. These changes gave rise to these Islamic equity funds and other investment and financial innovations, and will sustain a phenomenal rate of growth for them in the near future. They are:

From defensive to positive Islamic banking:

In the 1970’s & 1980’s the major concern of the clients of Islamic banking is just the avoidance of interest. Islamic banks, at that time, were “brimming” with free-money in current account deposits. The major worry of these deposit holders was to make sure that their funds are distant from usurious transactions. The 1990’s witnessed an important shift. More and more Muslims who want to stay away from interest, also want their money to earn a return. This created opportunities for innovations to bring to the market investment programs that, while abiding by the Shari’ah prohibition of interest they are capable of providing reasonable return on investment.

From Non-Islamic to Islamic:

Islamic religious revivalism is now disseminated into segments of the Muslim societies which are wealthy, more influential and educated. These groups of people are not new to business and investment but their religious solace included a movement from conventional to interest-free banking. It is because of this private banking departments catering primarily to HNW individuals are the most active in the provision of Islamic banking service in many conventional banks. Islamic equity funds are responding to the needs of this group of investors.

From local to international:

Banking and financial services are being globalized. Islamic banking and investment are no exception. More and more Muslims now are looking outward, searching for investment opportunities beyond the boundaries of their home countries. They no longer identify Islamic banking with Muslims or Muslim countries. An increasing-number of investors are adopting selection criteria based on examination of the transactions and investment offers to ascertain Shari’ah compatibility, rather than relying on the vendor name. This created opportunities for major financial institutions in the west to cater to the needs of these investors. Equity funds play a major role in this regard.

Islamic Equity Funds are Recent Phenomenon

The oldest Islamic Equity Fund offered the public goes back to only 2 years ago when the National Commercial Bank in Saudi Arabia decided, with the help of the Wellington Management Company of Boston, Massachusetts, to launch a global equity fund that follows the Shari’ah restrictions on investing in shares. NMCC, a consultant of NCB, worked very hard to articulate the relevant Shari’ah principles into workable screens that can be used by the manager in the selection of the portfolio holdings, and the daily operation of the fund. Through the joint effort of the three institution, the first ever Islamic equity fund was launched in January 1995. It was not too long when other funds were to follow. In less than 2 years, already five equity funds are in the market, based on the same basic model.

The Religious Foundation of the Islamic Equity Fund Design

Like any legal system, Shari’ah is a set of do’s and don’ts. The difference, however, is that Shari’ah is not just worldly, but a part of a system of beliefs that relates life to the hereafter. Therefore, a believer is supposed to internalize in his method of judgment and “cost-benefit” analysis this aspect of heaven & hell. This means that, through Shari’ah, the now and the hereafter are united into one spectrum. Because of this, believers are keen to make sure that their investment decisions are in tune with religious requirements by abiding by Shari’ah rules. As a result Shari’ah approval of structure & operation is the most important element of the working of equity funds.

Shari’ah Aspects of Islamic Equity Funds

Investment funds are created when investors pool their money for a shared investment goal. Collective power affords an opportunity to participate in a well diversified, professionally managed investment portfolio. To be acceptable from Shari’ah point of view, it is essential to examine certain aspects of investment funds. In particular we will evaluate the contractual relationships between the parties involved in the working of a fund, choice of portfolio holdings as well as some operational elements of such funds.

Contractual Relationships in Fund Management

The most visible is the relationship between investors and the manager of the fund. Fund management may be based on Mudarabah, where the manager, either individual or institution, the Mudarib and the investors are rab-ul-mal (providers of funds). In such a case, manager will only share in the profits generated. Sharing of profit must be in accordance with the ratio spelled-out in the prospectus which constitutes, from Shari’ah point of view, a contractual relationship. His income will be based on the difference between the initial NAV and the NAV at the pricing date which represent profit in such arrangement. Pricing date represents the accounting liquidation of the Mudarabah.

Many managers would not like their compensation to be tied to profit, but rather prefer to get a fixed remuneration. In such case, the relationship can be based on the Ijarah contract. The manager is, then entitled to an income linked to his managerial effort. Most investment funds management is based on such arrangement. In this case, the manager charges a percentage of the NAV at the pricing date. Ijarah is a permissible contract. However, compensation in the Ijarah contract, like any exchange contract in Shari’ah, must be known at the beginning of the period (time of contracting) not the end (time of liquidation), otherwise gharar will be present which may void the contract. Such compensation will not be known exactly at the time of contracting (since it is based on end-of-the-term NAV), but only known in approximate amount, which reduces such gharar, though by no means eliminate it. Although the writer is of the view that such Ijarah is permissible, there are some contemporary scholars who think otherwise. Making compensation for the next period depend on last period’s NAV is a straightforward solution.

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