Shari'a compliant funds

Date: Friday, May 1, 2009
Author: Hedgeweek.com

Introduction
The rapid growth in the Islamic financial markets, both in terms of institutions and products available over the past 10 years has prompted increasing interest from conventional managers to develop products to serve this market. It is estimated that over 20% of the world population are Muslims and there is increasing demand from Muslims to conduct their financial affairs in accordance with the principles of Islamic Finance as espoused by the Shari'a. The UK now has five fully fledged Islamic Banks and several conventional banks are offering Islamic products. This brief introductory article will seek to identify what differentiates a Shari'a compliant (or Islamic) fund from a conventional fund and address some of the practical issues that Volaw has come across during the past fifteen years.

Principles of Islamic finance
The underlying concept of a Islamic fund is very similar to any other form of Ethical fund, such that the underlying investment parameters are restricted by reference to certain defined criteria, in the case of an Islamic fund, adherence to the precepts of Shari'a law. The basic principles of Islamic finance as espoused by Shari'a law are:

  • The prohibition of riba - i.e. the earning (or payment) of interest;
  • The avoidance of gharrar - i.e. excessive uncertainty or deceit in contracts;
  • The prohibition of maisir - i.e. gambling and speculative transactions;
  • The application of Al-Bay in all transactions - i.e. trading or commerce, such that parties share profits and losses on the basis of their capital share and effort; and
  • A prohibition in dealing in haram items, see below.
The first Islamic investment fund was established during the late 1980s, but the real catalyst to the development of these funds was a ruling by the Fiqh Academy of the Organisation of Islamic Countries, whereby 'shares' in a company were defined as an 'undivided portion of the company assets'. Prior to this there had been much debate about whether investing in shares (or equities) was allowable under Shari'a law. The ruling, however, opened up the sector to the millions of Muslims throughout the world who wanted to invest their surplus earning or savings in accordance with Shari'a law.

Investment funds have been defined by the Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI) as follows:

Funds take the form of equal participating shares/units, which represent the shareholders'/unitholders' share of the assets, and entitlement to profits or losses. The funds are managed on the basis of either mudaraba or agency contract.

Whilst the most common vehicle used in Islamic fund structures is a limited liability company, many Islamic funds are structured as Limited Partnerships. The Limited Partnership is generally regarded as being the preferred vehicle to structure a fund within Shari'a principles as the role and responsibilities of the General Partner as Manager and Limited Partners as Investors are similar to participants in a mudaraba contract.

Investment selection
Probably the most important function of the fund manager will be the selec¬tion of fund investments so as to ensure that the fund does not invest in haram (disallowed or harmful) items. First a manager will select investments from an overall universe that would meet the fund's investment objectives, and then, they will further refine their investment universe by screening for stocks of companies that are haram. In determining which stocks are haram, the manager will be guided by the Fund's Shari'a Supervisory Board ("SSB") who will set the criteria for which the manager will then screen so as to determine a Shari'a compliant universe.

The criteria that the manager will be required to work within can be split into two distinct categories. First are the qualitative criteria that will consider the actual business activities of the target company, and secondly certain quantitative measures that will consider cer¬tain financial ratios derived from the target company's accounts.

Disallowed activities under the qualitative criteria will include such items as:
  • Companies that produce, sell, distil or distribute alcoholic beverages and products.
  • Companies that produce, sell, distribute or slaughter pork and pork-related products.
  • Companies engaged in gambling, casinos, lotteries and related games.
  • Conventional (non-Islamic) banks, financial institutions and insurance companies.
This list is only a few of the more common haram activities and many funds will have a slightly different set of criteria although as we will see below some continuity is being seen across the rulings of different SSB's. A further difficulty arises from the actual nature of many of the institutions that make up any investment universe. In these days of multinational conglomerates it can be very difficult to find a company that does not participate in some form of an impure activity. The common solution is to purify the income and profits arising from this invest¬ment by making an equivalent gift to a charitable account that will be distributed in accor¬dance with the directions of the SSB.

Having established an initial investment universe by eliminating companies with unacceptable primary business activities, it is then necessary to further refine the universe to ensure that any target investment has not been financed through inappropriate financial resources. To do this, the manager will undertake a quantitative analysis of the accounts of the underlying investment to ensure that the company is managing its affairs in accordance with certain Shari'a principles. This is an area over which there was significant debate in the early days of Islamic investment funds and the actual ratios to be applied varied widely from fund to fund. However, the advent of the Dow Jones Islamic Market Indexes in 1999 effectively codified best practice in this area and while circumstances may dictate that some of these ratios do not apply to a particular category of investment, the Dow Jones financial measures are now widely adopted by the managers of Islamic equity-based products. In 2004, these quantitative criteria were included in AAOIFI's Shari'a Standard number 21.

It follows that in addition to the performance of their normal roles in managing the fund, and supervising the investment process, in the case of an Islamic investment fund, the manager is required to perform additional roles to ensure that the underlying investments are Shari'a compliant, both at the time the initial investment is made, and also for the period that the investment continues to be owned by the fund.

Conclusion
This article has concentrated on the application of Shari'a principles to a fund investing in equities. The same principles will apply whether the fund is investing in shares, real estate, commodities, leasing contracts or any of the other specialist forms of fund. Perhaps the most important lesson we at Volaw have learnt over the years in developing and struc¬turing funds and other Islamic financial products is that an early discussion with the Schol¬ars representing the SSB is of immense value and can save numerous hours in having to rework documentation, particularly where the investment objectives or structure of the fund are different from other funds that have already been established.

by Trevor Norman
Director - Islamic and Middle East Group
Volaw Trust & Corporate Services Limited
Trevor is an acknowledged industry specialist in Islamic finance work. Since 1995, he has worked on a wide variety of Shari'a-compliant transactions, including collective investment funds and Sukuk issuance SPV's.

This article originally appeared in the Spring 2009 edition of the Channel Islands Stock Exchange Bulletin Board.