What makes a stock Shari'ah-compliant? Robin Amlot review the screening processes in place to ensure that investments dubbed 'Islamic' really are acceptable.
The main objective of screening is to ensure that the stock or security that one purchases or invests in does not contain any prohibited elements that make it Sharia'h non-compliant. Stocks and shares that are deemed to be Shari'ah-compliant may be screened not once but twice - first on their business activities and second on their financial performance.
It is only recently that pro-active screening, which has already been used by some conventional ethical investment funds, has begun to be considered. This would add a third screening process that selects companies that make a "positive contribution" to society in terms of their business activities and practices.
There are a number of Islamic index providers. Some $7 billion in assets is held in funds benchmarked to largest group, the Dow Jones Islamic market indexes. The past nine troubled quarters have shown that Sharia'h investors do not need to put ethical or religious beliefs second to investment performance expectations.
In addition to investment funds, there is a growing number of tradeable Islamic securities. The world's first Islamic Exchange Traded Fund (ETF) was listed in Istanbul in 2006 (based on the Dow Jones Islamic Market Turkey Index); Europe's first Islamic ETF was listed in Zurich in 2007 (based on the Dow Jones Islamic Market Titans 100); and in 2008 Dow Jones licensed the Islamic Market Malaysia Titans 25 for listing in Kuala Lumpur.
Sectoral screening
Islamic funds and index providers carry out a sectoral screening process that filters stocks out of their investable universe. A standard measure is to remove those companies that derive more than five per cent of their business activities from a sector that is Haram - trading activities including pork, alcohol, gambling, tobacco, pornography and any finance that is interest-based (Riba).
This threshold should be applied all the way through the value chain. For example, a glass manufacturer that produces bottles for breweries and derives more than five per cent of its income from this activity would be screened out.
The Securities Commission of Malaysia (SCM), for example, lists the non-permissible core businesses as follows:
Financial services based on Riba (interest);
Gambling and gaming;
Manufacture or sale of non- Halal products or related products;
Conventional insurance;
Entertainment activities non-permissible according to Shari'ah;
Manufacture or sale of tobacco-based products or related products;
Stock broking or share trading in Shari'ah non-compliant securities;
Other activities deemed non-per missible according to Shari'ah
Perhaps unsurprisingly, there are some differences in approach among Islamic scholars about what is permissible. Datuk Noripah Kamso, the Chief Executive at CIMB-Principal Asset Management Berhad, notes, "What is a permissible stock is the same, but there are differences with ratios. For me this is because there are different cultures in different jurisdictions. Scholars in Malaysia are a lot more liberal, Malaysia doesn't use
financial ratios."
In his paper on the stock screening process Professor Datuk Dr. Syed Othman Alhabshi of the International Centre for Education in Islamic Finance (INCEIF) notes that Shari'ah Advisory Committee of the SCM does have additional criteria that are applied to companies with activities comprising both permissible and non-permissible elements:
the public perception or image of the company must be good; and
the core activities of the company
are important and considered Maslahah (benefit in general) to the Muslim Ummah and the country and the non-permissible element is very small and involves matters such as Umum Balwa (common plight and difficult to avoid) 'Uruf (custom) and the rights of the non-Muslim community which are accepted by Islam.
The SCM has a scale of five To 25 per cent for the tolerable level of various non-permissible elements.
The Dow Jones Islamic Market indexes do use financial ratios as a secondary screening process. To be considered for inclusion, a company must meet specific financial constraints. Its debt ratio must not exceed 33 per cent, the ratio of accounts receivables to total assets must remain below 45 per cent and interest income should represent less than five per cent of total revenue.
There is some question of how effective sectoral screening has been. It is relatively easy to screen out primary business activities to remove those companies with core activities that are not Shari'ah- compliant. Identifying those companies that generate more than five per cent of their revenues from prohibited activities can be more challenging.
If at any point a stock once deemed Shari'ah-compliant becomes non-compliant, any capital gain arising from the disposal of the securities made at the time of the announcement may be kept by investors. However, excess capital gain derived from the disposal after the announcement day at a market price that is higher than the closing price on the announcement day ought to be given to charity.
Under SCM rules investors are allowed to retain their securities if the market price is below the original investment cost and may hold such investments and retain any dividends paid until the total of such payments and the market value match their original investment cost - at this point the stock should be sold.
Outperforming conventional investments
Scott Dakers, Head of strategic alliances at Scottish Widows Investment Partnership (SWIP), part of the Lloyds TSB banking group in the UK, commented, "In the past 12 months, because of the lack of exposure to financials, Islamic funds are actually starting to look quite good, and it is certainly no longer the case that people just buy an Islamic fund for moral reasons. People are now actively starting to look for Islamic funds because of performance."
What is clear from the charts is that key Islamic indexes are running ahead of their conventional counterparts. Those companies that are held by managers of Islamic funds may be seen as more financially robust because of the debt ratios requirements but the key reason seems to be the exclusion of banks and other financial groups. Jahangir Aka of SEI Investments (Middle East) said, "The assumption that Shari'ah performance is inversely correlated to the financial stocks recovery appeared both fair and correct in April 2009.
"We do not anticipate seeing the story of Shari'ah investing outperformance shifting to one of underperformance just yet. Islamic investors should continue to benefit from their lack of exposure to the volatile financial sector and erratic market swings. The favouring of low-debt companies should continue as a positive quality. Burnt by the implosion of highly leveraged companies, we might also see conventional investors gravitate to those companies with sound underlying fundamentals and valuations.
"However, looking further forward, we do expect that Shari'ah will begin to lose its trend of strong out performance eventually. The alpha that has been built over the credit crisis will begin to give way as conventional markets and financials in particular move into recovery."
But what will happen to Shari'ah investments if this convergence of performance does take place? Jahangir Aka is not troubled by this, "The perception that Shari'ah-compliant investing is a poorer cousin to conventional has been challenged, as Shari'ah investing has delivered a good track record in difficult times with out performance and lower volatility.
"Shari'ah investing has passed its first major test in one of the world's worst economic episodes and it is not unfair to anticipate that it will perhaps do so again in the boom and bust cycles typical to a debt
related economy."
© Islamic Business and Finance 2009
