|28 March, 2019

Investing within shariah: A guide to Islamic financial products

An investment strategy that has its basis in Islamic finance is not only true to shariah law, but also avoids some of the excessive risks associated with financial leverage

Image used for illustrative purpose. Young Arab investor monitoring his investments.

Image used for illustrative purpose. Young Arab investor monitoring his investments.

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When economists raked over the ashes of the global economic meltdown of 2008 they realised that while banks and financial institutions in almost all countries across the world were adversely affected, the Islamic financial industry was especially quick in its recovery compared to conventional banking. This has encouraged millennial investors in the Middle East to build an investment strategy that complies with Islamic, or shariah, rules. According to Thomson Reuters’ Global Islamic Asset Management Outlook, global Islamic funds under management are expected to reach $77 billion by 2019.

Islamic finance is the financial system or activity that operates on the principles of shariah law, which seeks to strike a balance between the needs and interests of individuals and those of society.

From an investment perspective, this relates to products that are permissible. Broadly, investors contribute money that is invested in a financial activity that earns them a certain amount of profit that is permissible under shariah law.

“While the basics of investing remain the same – for instance, assessing the risk-reward relationship and doing due diligence on products – the demand for shariah-compliant investible options is higher in the Middle East, Malaysia and Indonesia due to the demographic profile. Interestingly, the rest of the world too is asking for more and London is one of the world’s strongest centres of Islamic finance,” said Mayank Sawhney, partner at accountancy firm Crowe.

According to Ashish Gupta, a director at MaxGrowth Consulting, a financial advisory firm, growing demand is driving Islamic financial institutions to increase the depth and breadth of their product offerings.

“There is more innovation in structuring of financial products to offer a wider range of options to Islamic investors. At the same time, major conventional banks and financial institutions – like HSBC and Standard Chartered – are opening and expanding ‘Islamic windows’ to cater to the demand, especially in their Middle East operations,” he said.

Framework of Islamic finance

Islamic finance operate within a framework based on Quranic laws that prohibit business practices that lead to social harm or are morally wrong. Three linchpins of the framework are:

Riba (interest): Collection of interest is forbidden as Islam considers it to be usury. Risk and profit are to be shared. The borrower is not allowed to receive interest and the lender is forbidden to pay it.

Haram (forbidden): Investment in businesses and financial products that are haram in Islam is prohibited. This includes investment in alcohol, pork, gambling, weapons or pornography. 

Gharar (ambiguity):  There should be no uncertainty or ambiguity in a contract and financing must be backed by a real underlying asset. According to most interpretations, this rules out investment products like futures, derivatives and conventional banking and insurance products.

Based on the above principles, Islamic law allows the following main types of contracts:

Musharakah: Both parties form a joint-venture project by investing capital and entrepreneurship. Parties agree to share profits in a specific pre-arranged ratio and losses are shared in proportion to the amount of capital invested by each partner. This is considered as the purest form of Islamic financing.

Mudarabah: One partner (called rabb-ul-maal) provides capital to an entrepreneur (called the mudarib) who provides the human capital to run the activity. Both parties share profits in a ratio that is pre-agreed. All losses are borne only by the investor.

Murabahah: A sales contract in which the buyer and seller of an asset agree on a sale price which includes a profit margin. The investor, who owns the asset through purchase from a third party, resells it at a cost-plus price to the buyer. This is the most widely-used Islamic financial contract.

Ijarah: An agreement where the investor earns profit by charging a pre-agreed rent for the use of an asset over a fixed period of time. At the end of the period, the ownership of the asset is transferred to the lessee. 

Istisna: A contract of exchange to manufacture goods, assemble or process them to be delivered by the seller to the purchaser upon completion. The buyer agrees to make payment to the seller either in advance, or in instalments or upon delivery of the asset.

Access for investors

Since the development of modern Islamic finance, banks and financial institutions have structured many instruments and investment methods that conform to shariah law while offering returns comparable to conventional investments.

For investors in the Middle East region, the easiest way is to invest through funds offered by Islamic banks or asset managers. The funds are carefully screened by fund managers and shariah scholars to ensure they strictly conform to the guidelines.

Equity funds: Islamic unit trusts and mutual funds are the most popular investment vehicles. They pool money from many investors and purchase equity shares in joint stock companies. Returns accrue from capital gains and dividend payments. The profit is shared between the fund manager and the investors, with the latter’s share of profit distributed on a pro rata basis.

Real estate funds: These are investment vehicles that pool money from many investors to buy, manage and sell commercial properties. Islamic real estate investment trust (I-REIT) is a shariah-compliant investment tool that focuses on the real estate sector. UAE’s Emirates REIT and ENBD REIT are both shariah-compliant trusts listed on Nasdaq Dubai.

“Conventional and Islamic REITs both invest in real estate assets. The difference is that an Islamic REIT will carve out non-compliant parts of an asset portfolio – such as a restaurant in a community development that serves alcohol – before bundling it into an investment compatible with shariah. If, for instance, an Islamic REIT acquires an asset that is financed through conventional, interest-bearing loans, this will be converted to Islamic financing before offering it to investors,” Sawhney said. 

Murabahah funds: This is structured on the basis of a murabahah contract. Investors contribute to such a fund to buy assets with the purpose of resale against deferred payment at an agreed mark-up over the actual cost, which constitutes the profit. The profit is shared between the fund manager and the investor with the latter’s share distributed as per his shareholding in the pool.

Ijarah funds: These are structured on the basis of an ijarah contract. Investors pool together to invest in assets that will generate leasing returns. Such funds usually invest in assets such as real estate projects, equipment, machinery, vehicles, etc. The income is generated through the rent paid by the lessees and profits are shared on a pro rata basis.

Islamic bonds or sukuk

Sukuk, also known as Islamic bonds, are certificates that represent an investor’s ownership in an underlying fixed asset. The sukuk holder receives a share in the revenues generated by the asset. A sukuk may be redeemed on maturity at a pre-agreed exercise price. This is one of the fastest growing segments of Islamic finance.

A sukuk may be asset based or asset backed. In an asset-based sukuk the asset remains with the originator throughout the tenure and sukuk holders have recourse to the originator if there is a shortfall in payments. The returns for the investor are based on the performance of the asset.  Examples of such are musharakah, mudarabah and ijarah sukuk.

In an asset-backed sukuk the asset does not remain with the originator during the tenure. The originator transfers the underlying asset to a special purpose vehicle (SPV) in a true sale that holds the asset and issues the sukuk. The returns for the investor are the asset’s cash flow and redemption. Examples of this are murabahah, istisna and salam sukuk. A salam sukuk is based on an underlying forward financing transaction where the financial institution pays in advance for buying specified assets, which the seller will supply on a pre-agreed date.

One of the factors holding back the growth of Islamic investment is the absence of standardisation in product structures, said Gupta. “But we are seeing a phase of rapid evolution in this, with major Islamic centres like Malaysia and the UAE leading the way. This is expected to help deepen the market,” he said.

(Reporting by Yazad Darasha, Editing by Michael Fahy)

(michael.fahy@refinitiv.com)

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© ZAWYA 2019