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Saturday, 1 November 2008

Identifying Shariah-compliant equities a challenging task

The demand for Shariah complaint investment products has risen extremely in the last decades. In a recent research conducted by Booz & Company the total volume of Islamic assets in 2008 is estimated to be US$ 500 billion. Additionally, in 2000 the total number of Islamic funds worldwide has been 102 funds growing annually with a CAGR of 28% and is expected to reach 925 funds in 2009.
Similar to ethical and social responsible investments that have to adhere to specific ethical requirements, Islamic financial instruments have to comply with the religious belief and the Shariah laws governing business interactions and investments conducted by Muslims.
Experienced Shariah scholars deduce from these Shariah sources a number of quantifiable guidelines which have to be adhered to when Shariah compliant investment instruments are structured. Generally, Shariah compliant investments have to avoid investment in non-compliant activities such as riba (conventional interest-based instruments), gharar and maysir (highly uncertain and speculative activities such as derivatives) and non-compliant business activities related to pork or alcoholic product, gambling facilities or pornography for instance.
Companies are analyzed by Shariah-compliant fund screening to identify their involvement in Shariah non-compliant business and financial activities. Business activity screening eliminates companies whose primary business activity does not comply with the Shariah, such as conventional banks, bars and casinos. Financial screens, on the other hand, measure businesses involvement in Shariah non-compliant financing activities, such as interest earnings and debt financing.
Since it is almost impossible to find companies which are not dealing with conventional banks and either earn or pay interest, the Shariah scholars identified specific threshold levels limiting the extent to which companies can be involved in such practices. Some Shariah service providers employ a financial screen in which the cumulated revenue from non-compliant activities (alcohol, pork, pornography) for any company considered may not exceed 5% of their gross profit. The use of such a threshold level is a relaxation of the Islamic ban to get involved in non-compliant business activities and practices and is revised through purification.
The real challenge of Shariah screening is to identify for the companies considered the proportion of revenue generated from non-compliant activities. This is not an easy task especially in the case of companies whose core or primary business is compliant but due to the wide range of products and services they are engaged in a proportion of revenue might be generated from activities deemed non-compliant under Shariah. Examples of businesses whose core business in compliant but generate a proportion from non-compliant activities include:
  • General Motors which generates a large proportion of its revenue from financial services based on conventional interest.
  • McDonalds that sells some products including pork (bacon) and in some European countries sell beer or other alcoholic beverages.
  • Wal-Mart which in its product palette offers also pork products.
  • Honeywell which generates a proportion of revenue from defense and military.
  • Airlines that serve and sell alcoholic beverages and pork.
(International Business Times)

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