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Magazine Issues » April 2021

Sharia: When Muslim principles meet ESG

Muslim_investorsHow are the worlds of Sharia and sustainable investing converging –and to what extent can this trend continue? Tanya Ashreena reports.

When Schroders announced the launch of its Islamic Global Equity Fund in December, it said the fund would include a diversified investment strategy that combined Sharia law compliance with multi-factor investing and ESG principles.

The fund’s launch was in line with the Schroder Global Investor Study published in 2019, which found that many investors in the Islamic world are putting an increased emphasis on sustainability while deciding how to allocate their portfolios – and that there is an opportunity for the Sharia investment industry to capitalise on this.

The past couple of years have seen many Islamic funds integrating ESG.

“There is a convergence between ESG and Islamic investing as, fundamentally, they both consider their impact on society and the welfare of people and the environment,” says James Grist, head of group distribution for the Mena region at HSBC Global Asset Management.

“As ESG investing has become more mainstream, due in part to the increasing awareness of the effects investments can have on our planet, there has been rising demand from investors for investment solutions that address ESG considerations.

“Therefore it is not surprising that there is also demand from investors who are seeking Sharia-compliant investment versions of the same solutions, enabling them to align two important principles – Islamic and ESG – together.”

The opportunities are significant, he adds, when you consider a global population of around 1.8 billion Muslims, many of whom live in emerging markets. With growing personal wealth, there is a need and opportunity for products that meet the values of Islamic finance and provide access to a wide range of investment themes and asset classes, ESG being one of them – and this market is underserved.

“We have seen the assets under management in our Islamic Global Equity Index [launched in 2014] increase significantly in recent years to now over US$1.8 billion (€1.5 billion),” Grist says.

Najmuddin Lutfi, chief executive of Malaysia-based BIMB Investment Management, agrees, drawing parallels with socially responsible investing (SRI): “There is alignment between Islamic capital markets and sustainable and responsible investments, as both are values-based and strong on risk management,” he says.

“For example, some Islamic finance products include purification – a donation to charity of the proportion of an investment’s return through prohibited activities, such as the sale of tobacco or alcohol products. In parallel, some SRI investors, by maintaining their stake in poor ESG-performing companies, use their shareholding as a tool to nudge industry laggards.”

Lutfi adds: “In Islamic finance, risk must be shared between investors and companies. The prohibition of riba, commonly translated as ‘excess’, is one of the cornerstones of Islamic finance. Often interpreted as a prohibition on interest, debt can be a controversial investment vehicle under Islamic finance, and this has favoured risk-sharing structures, such as equity investments.

“Meanwhile, in SRI, a company’s management of ESG topics offers a view on the company’s management of a broader set of risks, so both focus on risk management.”

BIMB Investment started out in Sharia-ESG investment in Malaysia in 2015. Today these funds contribute to more than 60% of the firm’s assets under management. “In the past two years, we have seen more fund houses offering Sharia ESG funds,” Lutfi says.

Certification demand
While various Sharia ESG funds have sprung up, the question of certification remains a growing issue. A growing number of investors will invest in a product only if it is certified. However, despite ample demand, no one body certifies products that are both Sharia and-ESG compliant.

“I have spoken to market participants in Luxembourg, where they have told me if you do a product that is Sharia and ESG-compliant, there will be more Christians than Muslims buying it because the demand is so high in Europe for ESG,” says Saudi Arabia-based John Sandwick, general manager of Safa Investment Services. “You need to certify to call your Islamic fund ESG and currently no adviser gives you a Sharia ESG certificate.”

However, Yasser Dahlawi, chief executive of the Bahrain-based Shariyah Review Bureau, says his organisation is developing a standard. “We are conducting a detailed study trying to examine the criteria of ESG, its requirements and reporting framework,” he adds. “We are also discussing the adaptation of ESG with select clients. Upon completion of our study, we may consider becoming a Principles for Responsible Investing (PRI) signatory ourselves.”

The Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) also has a set of norms-based standards for corporate and social responsibility. These specifically set out mandated and recommended actions for Islamic financial institutions to follow with regards to ESG factors.

‘Regulatory challenge’
The structure of an Islamic ESG fund varies according to the jurisdiction.

“Sharia standards in Gulf Cooperation Council (GCC) are stricter than standards elsewhere,” says Doug Bitcon, head of credit strategies at Rasmala. “There is also less of a focus on the environment aspect, as most economies in the region are based on fossil fuels.”

While there is no regulatory requirement in the US or major Western countries for Sharia certification and ongoing Sharia audit, in some jurisdictions in the GCC and Asia, certification by an authorised Sharia board is a legal or regulatory requirement.

Ashley Lester, lead manager of the Schroders Islamic Global Equity Fund, admits the primary challenge of setting up the fund was regulatory. “It is a very process-driven market and dividend purification are not standard processes in the UK market,” he says. “There was quite a lot of discussion and consultation with the regulators and it took more than a year from generating the concept of this fund to getting the Financial Conduct Authority’s (FCA) approval for the launch.”

Another hurdle was getting the investment universe right and making sure that the fund could adequately implement the recommendations of Amanie Advisors, an external consultant on Sharia compliance appointed by Schroders to provide advice and approve investment guidance.

Schroders’ Islamic Global Equity Fund invests in a range of equities within the Dow Jones Islamic Market World Index. Meanwhile, the HSBC Islamic Global Equity Index is a passively managed fund that tracks the Dow Jones Islamic Market Titans 100 Index, a Sharia-compliant index that follows a two-stage exclusionary screening process as part of its Sharia standards.

“The first stage is to exclude companies based on non-Sharia-compliant sectors, which includes conventional financial services, weapons and defence, pork-related products, alcohol, tobacco and entertainment,” explains HSBC’s Grist.

“The second stage is to exclude companies which are holding excessive levels of interest income, using three different financial ratio criteria.”

Sharia outperformance
While there is always going to be some performance deviation between Sharia-compliant and conventional versions of the same fund due to the Islamic screening process and resulting investment universe, Islamic funds absolutely hold their own, according to Grist.

“The Sharia-compliant version of the S&P Global Broad Market index has outperformed the conventional variant by more than 10% over the last 12 months,” he says.

Conventional equity funds, with a large weightage of stocks in the banking and financial sectors, tend to perform well in the early and middle stages of a market upcycle and during periods of strong economic growth, given that these sectors are more sensitive to market and economic cycles, says Lum Ming Jang, chief investment officer at Malaysia-based Public Mutual.

“In comparison, Islamic equity funds tend to outperform conventional equity funds during periods of market downturns as they do not invest in conventional banking and financial stocks or companies with high gearing ratios, which tend to underperform the broader markets during these periods,” he adds.

“They focus on sectors that are considered to be more defensive and resilient, such as consumer, healthcare, industrial and manufacturing, as well as growth sectors such as technology and e-commerce.

“With financial and highly geared companies removed from the Sharia-compliant investment universe, Islamic equity funds are generally geared towards companies with low leverage, healthy balance sheets and relatively lower volatility of earnings.”

A long way to go
Judging from the BIMB funds’ performance record, Lutfi says that Islamic equity funds can definitely match or outperform their more conventional peers. For example, the BIMB Malaysia Shariah ESG Equity Fund returned 19.14% in 2020, whereas the average equity fund in Malaysia returned 17.05%.

Nevertheless, there is still a long way to go before such products go mainstream, says Stephanie Sotiriou, investment manager at TAM Asset Management. “If you’re an Islamic investor, ESG will be an added layer for you, but if you’re an ESG investor, you won’t specifically be looking for these products.”

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