July 2009

INSIDE VIEW: Islamic finance

Screening companies for Haram, or forbidden, activities is becoming more and more sophisticated, says Zaineb Sefiani at BMB Islamic burj.jpgSharia-compliant investment management is concerned with investments in assets that are in compliance with Islamic law. An Islamic investor is not allowed to invest in companies that derive most of their revenue from non-Sharia-compliant business activities, or that use interest in operating or financing their business. In the context of investing in equities, screening for Sharia compliance is ensured using two main screens: business activities and financial ratios.

The first level is business activity screening, or sectoral screening, in which companies are filtered out if they derive more than a certain percentage (usually 5%) of their business activities from one of the sectors forbidden by Islamic law. The outright forbidden (Haram) trading sectors include pork, alcohol, gambling, interest-based banking and finance, tobacco, pornography and similar unethical activities.

The process of implementing de facto Haram is not straightforward, as we need to look at all the business activities involved in the value chain. In the case of an industry sector, this would mean from the production of a raw material, to the delivery of the final product.

It would be interesting to take one non-Sharia-compliant business activity, and analyse the entire value chain. If we take the example of alcoholic beverages, a company whose core activity includes producing wine, spirits and beer, such as Diageo, would naturally be screened out of any Sharia-compliant investment universe. Large pub-owning companies such as Scottish and Newcastle will also automatically be classified as Haram. At the logistics stage such as a company that delivers barrels to pubs and bars, there is a strict Sharia requirement to exclude these companies as well. In general, Sharia rules against any business activity that is directly or indirectly involved in Haram businesses. The 5% threshold is applied at any stage of the value chain. If for example, there is sufficient information to believe that a company produces aluminium cans solely for beer canning, this company should be screened out. The same rule applies to aluminium producers themselves.

Ethical investing
On the other hand, the screening process for companies operating in weaponry, advertising and media is less straightforward. While not overtly forbidden under Sharia law, these sectors are in effect filtered out on a moral and ethical basis. Investment in weaponry is permissible in Sharia law if the underlying motive is defensive in nature, and as long as there is no potential collateral damage. However, due to the subjectivity of differentiating what constitutes legitimate defence, contemporary Sharia opinion has opted to exclude this sector all together.

More recently, a top European ethical fund manager, in collaboration with BMB Islamic, has worked on a new investment approach that genuinely integrates ethical and faith-based investment strategies. This is an interesting example that adds a new layer to the traditional sectoral screening process. In addition to the traditional filters mentioned earlier, there is a positive screening process whereby companies are selected if they make a positive contribution to society and encourage good management practice of sustainable issues.

It is easy to see that this approach makes the stock selection process much more complex. Equally, in terms of negative screening, companies that have, for example, a high involvement in animal exploitation, nuclear power generation, poor relations with employees, customers or suppliers would come at the top of the Sharia screen list. The positive screening seeks out investment in companies that are involved in providing basic necessities to life, such as offering customers ethical and environmentally friendly product choice, or actively addressing climate change. The universe of investment stock might be considerably reduced once ethical filters are applied. This revolutionised investment approach has been endorsed by some of the most prominent scholars in the Islamic finance industry, four of which sit on the board of the Accounting and Auditing Organisation for Islamic Financial Institutions.

To accommodate the demand from Islamic fund managers, index providers were the first to introduce Sharia indices as early as 1998. The FTSE, DJIM, MSCI, S&P all offer a selection of Sharia indices that allow the end users like fund managers to pick stocks for their investment portfolios.

Many funds have composite portfolios that rely on one or several index providers. These Sharia indices, however, may give a fairly limited choice in terms of the investable universe. In addition, some of these indices do not delve deep enough into any given company’s financials so as to determine the exact percentage of revenue which is generated from prohibited activities. This has serious implications on other services related to Sharia compliance, such as dividend purification, where fund managers are required to purify dividends earned by companies in their investment portfolio that derive a percentage of their revenue from non-Sharia-compliant business activity.

In short, the indices’ sectoral screening is purely based on the primary business activity of the company. Those businesses whose primary activity is Sharia compliant, but derive a portion of their revenue from Haram activities are not excluded. The real challenge in Sharia stock screening application is to specifically capture the latter companies that still generate more than 5% of their revenues from prohibited activities.

For example, a company such as Sainsbury’s is categorized under the ICB sector ‘food and drug retailer’, but sells pork and alcohol and might be generating more than 5% from these business activities. Another example is Louis Vuitton Moët Hennessy, categorised as ‘clothing and accessories’, but that still earns revenues from the sale of wines and spirits.

In order to determine the exact percentage of revenue from non-Sharia activities within companies operating in multiple business segments and those that pass the generic industry filters, Islamic fund managers need to conduct a thorough analysis of the firms’ accounts and reports, which may not be readily available. A company like Sainsbury’s might not be segregating between its sources of revenues (from pork sales vs non-prohibited products).

New generation screening
A new generation of Sharia stock screening processes has now emerged, creating a sophisticated but viable stock screening system which identifies the exact portion of prohibited activity within a company.

A United States-based provider of Sharia fund management solutions offers its clients a global equity screening service which is considered a powerful filtering engine, composed of 40,000 stocks globally in 95 different countries. The service provider lists the investments that need purification, and also has the capability to calculate dividend purification. The screening system does not as of yet have a Fatwa from the scholars, but it can be programmed to accommodate any financial ratio at the discretion of the Sharia scholars of a fund management company. In terms of sectoral screening, the system has the ability to remove companies that are indirectly involved in Haram businesses, such as a software company that produces software for casinos. However, when the data information is not available, such as in the case of Sainsbury’s, which does not provide a breakdown of its revenues, this company is then considered Sharia-compliant unless there is sufficient evidence to prove otherwise. 

A UK-based hedge fund manager that has spent two years on developing one of the most sophisticated and rigorous Sharia screening systems considers such companies as non-Sharia-compliant. This screening system looks at 38,000 stocks representing more than 95% of the stocks worldwide. Another interesting feature is that it has both a web-based interface where clients can search by name, sedol, and various tickers, as well as by geography and industry sector. In addition, the Sharia screening system has an Excel add-on whereby a client can screen a complete portfolio from within the Excel software, that takes daily downloads from global financial information providers.

The filtering system is achieved in two steps. The first step consists of removing companies whose core activity is prohibited. The second stage involves a manual in-depth research on the financial and business activities of those companies that pass the first step. This Sharia screening system also provides daily updates on the compliance status of a company. For example, the system takes into account daily corporate actions, which means that a fund manager holding a position on a stock that becomes non Sharia-compliant, will be notified on the same day, and in theory, can take immediate action.

The number of Sharia-compliant equity funds now exceeds 400, of which a large number are Middle East and North Africa focused, or targeting individual countries within that region. At the same time, there is a rising demand from fund managers seeking to outsource these labour-intensive tasks to an external specialist. Conventional fund managers looking to launch Sharia-compliant equity funds will find off-the-shelf Sharia-compliant stock screening systems a simple and practical solution. The move from the traditional approach of using in-house resources for stock screening to a new generation of screening and monitoring tools can be achieved by using specialist Sharia advisory and structuring firms.

Zaineb Sefiani is associate client relationship manager at BMB Islamic

©2009 funds europe

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