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Home > Asset Management Checklists > An Overview of Shariah-Compliant Funds

Asset Management Checklists

An Overview of Shariah-Compliant Funds


Checklist Description

This checklist looks at leasing, equity, development, and commodity funds that are compliant with shariah law, outlining what they are and how they operate.

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Definition

Shariah-compliant funds are investment vehicles which are fully compliant with the principles of Islam. The funds are prohibited from making investments in industries categorized as morally deficient, such as those related to gambling or alcohol. Because Islam does not permit any form of exploitation, any kind of investment in conventional banking is outlawed. With the concept of debt also contrary to the principles of Islam, investment in highly leveraged companies is also not permitted for shariah-compliant funds. The exclusions extend to potential investments in other funds which offer guaranteed returns. Any use of futures and options, either by the fund managers or by companies in which the funds invest, is also likely to attract close scrutiny by the funds’ supervisory shariah boards.

Due to the rapid growth in Islamic finance over recent years, the available range of shariah-compliant funds has expanded as financial services providers seek to tap into the increasing demand for investment products that respect the principles of Islam. The most common forms of shariah-compliant funds are described below.

Ijarah

Ijarah (also transliterated ijara) is a leasing-type fund that acquires assets such as real estate or equipment and then leases them out to another party in return for a regular rental payment. In all cases the fund retains ownership of the asset and must ensure that usage of the asset is at all times in accordance with Islamic principles.

Murabahah

Murabahah (or murabaha) is a kind of development fund that acquires assets and then sells them to a client at a predetermined price which reflects the fund’s cost of acquiring the asset plus a profit margin. Sometimes described as “cost-plus” funds, murabahah investment vehicles do not hold long-term ownership of the assets, but instead generate a financial return from the payment obligations taken on by clients for a pre-agreed period.

Equity

Equity funds invest directly in companies through the purchase of shares. Given the difficulties involved in scrutinizing every aspect of how a company operates to verify shariah-compliance, this new, more progressive attitude allows investment in companies that operate in permitted industries, with the proviso that a proportion of the returns generated for the fund from any interest-bearing deposits held by the company must be donated to charity.

Commodity

Commodity funds invest in physical commodities, although speculative activities such as short selling are not permitted. However, the fund manager may make use of istisna’a contracts, pre-agreeing the price of goods to be manufactured and delivered at a specified future date, with the manufacturer benefiting from advance receipt of the agreed sale price. Commodity fund managers can also use bai salam contracts. These can be compared to conventional forward contracts, though the key shariah-compliant differentiator is that the seller’s position is protected because payment is passed to the seller on agreement of the contract rather than on its completion. However, in return for the effective transfer of contract risk, the buyer is compensated by the fact that the agreed delivery price is set at a discount to the physical spot price.

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Advantages

  • Shariah-compliant investment funds provide a means of investing while still honoring the high morals and principles of Islam.

  • Shariah-compliant funds promote large-scale investment along lines similar to the niche ethical funds available to Western consumers.

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Disadvantages

  • The funds can be more expensive to develop and administer than mainstream funds due to the need for greater verification of compliance with shariah principles.

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Action Checklist

  • Assess the full range of available shariah-compliant investment products before selecting the type you wish to use.

  • Consider how much risk you are prepared to assume before investing.

  • Mainstream investors may wish to consider potential investments in shariah-compliant funds.

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Dos and Don’ts

Do

Don’t

  • Don’t feel you have to verify the compliance of a fund yourself—contact a fund provider for advice.

  • Don’t expect guaranteed attractive returns, even from the most ethical forms of investment.

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Further reading

Books:

  • Anwar, Habiba, and Roderick Millar (eds). Islamic Finance: A Guide for International Business and Investment. London: GMB Publishing, 2008.
  • Jaffer, Sohail (ed). Islamic Asset Management: Forming the Future for Shari’a-Compliant Investment Strategies. London: Euromoney Books, 2004.
  • Vogel, Frank E., and Samuel L. Hayes, III. Islamic Law and Finance: Religion, Risk, and Return. The Hague: Kluwer Law International, 1998.

Articles:

  • Feinberg, Phyllis. “Seeking pension money: Mutual fund family follows Islamic law.” Pensions and Investments (October 30, 2000). Online at: tinyurl.com/6zugr7a
  • Siddiqi, Moin A. “Growing appeal of Islamic investment funds.” Middle East (July–August 1997).

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