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Home > Capital Markets Checklists > Islamic Equity Funds

Capital Markets Checklists

Islamic Equity Funds

“Economics, as it has been practised in the last three decades, has been positively harmful for most people.” Ha-Joon Chang


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Checklist Description

This checklist describes Islamic equity funds, where investors earn halal profits in strict conformity with the precepts of shariah.

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Definition

Islamic equity funds (IEFs) are similar to traditional equity funds in that investors pool their funds to invest in shares. However, the main difference between IEFs and standard equity funds is that investors in IEFs earn halal profits in strict conformity with the precepts of Islamic shariah.

Returns are achieved largely through the capital gains earned by purchasing shares and selling them when their price increases. Profits are also achieved from the dividends distributed by the relevant companies.

Of course, these funds are not allowed to invest in certain areas. They cannot, for example, invest in companies involved in areas that are not lawful in terms of shariah, such as alcohol, gambling, or pornography. They also have a restricted ability to invest in areas such as financial companies and fixed-income securities, due to the shariah ban on usury. These funds generally avoid bonds and other interest-bearing securities, while seeking protection against inflation by making long-term equity investments.

The first IEF was the Amana Income Fund, established in June 1986 by members of the North American Islamic Trust, the historical Islamic equivalent of an American trust or endowment, serving Muslims in the United States and their institutions. The fund is still in existence today. Prior to the growth of IEFs, few investment alternatives were available to Muslim investors.

A wide variety of investment managers, including major financial institutions, now offer these funds. Examples include Citibank, Deutsche Bank, HSBC, Merrill Lynch, and UBS. Following the growth of IEFs, credible equity benchmarks have been established, including the Dow Jones Islamic Market (DJIM) index and the FTSE Global Islamic Index Series.

Fund managers can use indices such as the DJIM index to screen stocks. The DJIM tracks shariah-compliant stocks from around the world. It eliminates those that fail to meet shariah guidelines, including financial ratio filters.

The Islamic equity funds industry had grown to around US$20 billion in assets under management by February 2008, according to Failaka Advisors, a fund-monitoring company. Failaka Advisors said that the IEFs had grown rapidly, tripling over the previous five years, driven by Gulf Cooperation Council investors. Saudi Arabian funds and fund managers dominate the industry, accounting for nearly 75 funds out of around 300 IEFs worldwide. Bahrain has become the favored center for fund registrations in the Gulf.

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Advantages

  • These funds have obvious advantages to Muslims, who can invest their money safe in the knowledge that the fund will not compromise any of their religious beliefs.

  • Many funds have been around for a long time and have a good track record of generating healthy returns for their investors.

  • It can be argued that, over the long term, IEFs will tend to perform better than conventional funds, since the former avoid investing in heavily leveraged companies.

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Disadvantages

  • The restricted ability of IEFs to invest in certain market sectors limits opportunities and may increase the risk of losses during economic downturns.

  • Since Islamic principles preclude the use of interest-paying instruments, the IEFs do not maximize current income because reserves remain in cash.

  • Most of the funds target high net-worth individuals and corporate institutions, rather than the small investor. Minimum investments range from US$50,000 to as high as US$1 million.

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Action Checklist

  • As with traditional equity funds, the value of an IEF rises and falls as the value of the stocks in which the fund invests goes up and down. Therefore, only consider investing in an IEF if you are willing to accept the risk that you may lose money.

  • Research sites that monitor the performance of IEFs to ascertain which fund is most likely to suit your needs and which have performed the best over a number of years. However, remember that past performance does not necessarily provide a guide to how well the fund will perform in the future.

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Dos and Don’ts

Do

  • Analyze these funds in the same way as you would any other equity investment. Ask yourself whether you are looking for income or capital gain and whether you are prepared to tie up your money for a long period—most investment managers believe that anyone investing in an equity fund should be prepared to commit for at least five years.

  • Ask yourself whether you are prepared to accept the risk involved in investing in equities—stocks go down as well as up.

Don’t

  • Don’t invest without exploring the wide range of funds on the market to find out which is best suited to your needs.

  • Don’t invest without consulting an independent financial adviser. However, make sure that they are truly independent and do not earn a commission by recommending clients to a certain fund.

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Further reading

Books:

  • Ayub, Muhammad. Understanding Islamic Finance. Chichester, UK: Wiley, 2007.
  • Siddiqi, Adnan, and Peter Hrubi. Islamic Investments Funds Versus Hedge Funds. Munich, Germany: Grin Verlag, 2008.

Website:

  • Failaka Advisors monitor the performance of Islamic equity funds and provide a comprehensive list of Islamic funds worldwide: www.failaka.com

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