Principles of Islamic Investment

As investors become more aware of the benefits of investing in socially responsible funds, the interest in Islamic investing is also increasing. What does it entail and how are Shari'ah compliant funds assessed?

Socially-responsible investment is a growing global phenomenon whereby investors select stocks based upon the issuing companies' moral and ethical behavior. This typically includes avoiding involvement in certain businesses, as well as maintaining ethical environmental and employment practices.

In Islam, these issues are governed elegantly by the Shari'ah, or divine guiding principles revealed in the Qur'an, which Muslims worldwide are expected to follow to the extent possible given their circumstances. Corporate treasurers and institutional investors representing Muslim clients increasingly need to concern themselves with these Islamic investing guidelines. Several services now offer ratings, reports, and indexes that provide guidance in this area.

What is Islamic Investing?

Islamic investing is investing with a commitment to the Shari'ah, the divine guiding principles revealed by God to humankind in the Qur'an and demonstrated by the Prophet Muhammad (peace be upon him). Most of these principles are common to most religions and morality systems, including the three Abrahamic religions - Islam, Christianity, and Judaism.

The Islamic investor considering owning stock in a company must consider the level of Shari'ah compliance in the company's business practices, because as a stockholder he becomes a minority owner of the company and shares some ethical responsibility for the company's activities. Islamic business practices encourage cooperation in producing and distributing goods and services that enhance human prosperity and dignity.

The Shari'ah prohibits all business activities that produce significant harm or undignified moral behavior. Business activities involving gambling, pornography, alcohol, money-lending, harmful substances and pork are prohibited in Islam. The Shari'ah also requires avoidance of revenues derived from any direct or intentional support of such activities.

It clearly calls for avoiding the payment or receipt of interest on money-lending (riba in Arabic, see below), avoiding hazardous or excessive ambiguity in transactions (gharar in Arabic), and obeying the laws of the land (government laws). Additional Islamic business principles include respect for the environment and human welfare, fair and transparent dealing, and fair and just employment and R&D policies.

Is Stock Investment Allowed Under Shari'ah?

Equity investing is strongly encouraged in Islam. Most Islamic scholars agree that owning common stock in modern corporations is allowed, within certain guidelines, and is analogous to the equity partnerships practiced by the Prophet Muhammad and encouraged in his traditions (the Sunnah).

"In fact, buying stocks can be one of the most Shari'ah-conscious investments available to many individual Muslims today," says Dr. Monzer Kahf, a leading scholar of Islamic finance and economics, "provided the following

guidelines are met for the issuing company:"*

The company's main line of business must be allowed.
Riba and other prohibited activities must not generate more than a small percentage of the company's income.

Financial assets (liquidity in banks and account receivables) that may generate interest must not be too large a percentage of company value.

Leverage or dependence on borrowing must not be high.
The company must have honest and transparent business practices and not be involved in cheating, fraud, etc.

The Islamic investor must estimate the percentage of their profits that may have come from riba and other prohibited activities and donate it to general charitable causes so that their investment and profit remain pure. This is called "purification" of investment gains.

What is Riba?

Riba is an Arabic word meaning increment or increase. In the context of business, it means an unearned increase in an exchange contract without offering anything in return that is recognizable in Shari'ah.

Interest on money-lending is the most common kind of riba; it's strongly condemned in the Qur'an in several verses. Examples of riba include interest on bank loans and credit cards, gains from trading bonds or other debts, and interest earned on saving and other deposit accounts.

On the other hand, charging rent for the use of a physical asset, such as a car, a machine or a house, is permissible and is not riba. Therefore leases in which the lessor retains ownership and responsibility for the usability of the asset ("operating leases" generally qualify) do not involve riba. Trade on credit, where a higher-than-spot price is charged in deferred payment for goods or services, is also allowed and is not riba. Gains from trading ownership shares in physical assets or business enterprises are not riba.

And growth in the value of equity or other assets resulting from human effort or market conditions is certainly not riba. All of these allowed forms of earning a return on capital are encouraged in Islam: "...God has permitted trade, and forbidden riba." (Qur'an 2:275).

What is the Rationale for the Prohibition of riba?
Microeconomic Rationale
On the micro level, the prohibition of riba aims at maintaining justice in transactions.

Charging interest is inherently unjust and unbalanced as it gives the lender an assured and secured return and puts all the burden of risk and unknown future outcome on the borrower. Additionally, by limiting lending to a zero-return personal benevolent practice, the avoidance of riba places a healthy, natural limit on the amount of debt that a person or business can accumulate.

In Islam, a loan is a benevolent act, and has little place in business or commerce. A person may loan someone her car, $100, or a cup of sugar, but she cannot take interest on the loan and can only demand return of the item loaned (or its like-kind equivalent in the case of money or consumables), although she may take and hold something as security for repayment of the loan.

In commerce on the other hand, we engage not in benevolent acts but in commutative contracts, i.e., agreements where two parties trade things of value with the hope of financial gain. Therefore loans are generally unsuitable for the realm of commerce in Islam.

However, it is perfectly acceptable to buy, sell, and rent goods, assets and services. Payment may be on the spot, advanced, or deferred, and a higher price may be charged for an item if payment is deferred. Similarly, a lower than spot price may be associated with advanced payment.

Profit in trade, whether in sale for cash or credit, accrues only once and is based on the price agreed upon at the time of sale. Debts may be created, but they are only created in exchange for real goods or service of equal value. Debts do not grow merely with the passage of time. This puts a limit on the amount of debt a party can accumulate, equal to the value of goods or services she/he has purchased.

For example, a person may rent a refrigerator or buy it on extended payment terms, but if he does not make the scheduled payments, the seller may take back the refrigerator and/or refuse to offer future credit to the buyer, but he cannot add to his debt other than to cover the cost caused by delinquency.

On the other hand, riba borrowing allows getting funds for vague or non-specific use, such as getting a cash advance on a credit card for speculating in the market; it just encourages wasteful spending and growing debt.

Therefore, according to Islam, by prohibiting interest-bearing loans but allowing trade, God has allowed commerce to flourish while naturally limiting the amount and duration of debt each person or business can accumulate.

Without riba, this accumulation is limited to the value of real products or services useful to the debtor, which are normally available to secure the corresponding debts. The potential for general bankruptcy is greatly reduced. Creditors' claims are straightforward and normally secured by the financed assets.

Families and businesses avoid the temptation to borrow money to buy things they don't really need or can't afford. And because each debt is normally secured primarily by the acquired asset, each creditor has a strong incentive to ensure the asset he is offering is affordable and will substantively improve the debtor's life or business. The whole system is fairer to both debtor and creditor.

Macroeconomic Rationale

There are other, macroeconomic rationales for the prohibition of riba**. In a riba-free financial system, capital providers and capital users are brought closer together psychologically.

Whether providing equity capital or riba-free debt capital (trade credit or leasing), capital providers must remain engaged to some extent and share commercial risk with the users of their capital. This tends to improve capital allocation, smooth economic cycles and soothe the tension between social classes by tying the fortunes of capital and labor more closely.

The overall economy can become more stable and self-regulating and less dependent on the economic pronouncements and predictions of money movers and central bankers.

The economy is also more efficient because it allocates capital primarily on the basis of profit-making potential, rather than primarily on the basis of the creditworthiness of the borrower.

Further, by encouraging equity-based finance, a riba-free system encourages more innovation and results in higher economic growth rates. Finally, the system is more just because profit-sharing finance rules out net transfer of pre-existing wealth from those without capital to those who already have it, thereby avoiding antagonism between classes and the associated social and political problems.

What is Gharar?

Gharar is ambiguity in transactions. The Prophet Muhammad prohibited it at levels large enough to be hazardous to their definitiveness and/or ability to be fully executed.

An example is selling anything that is indefinable such as the "fish catch of tomorrow," or selling anything without actually owning it first (such as short-selling of stock where the cost of acquiring stock to meet future obligations is unknowable).

Gharar is not fraud or deception. Fraud and deception are prohibited under Shari'ah and the laws of the land, but gharar is more subtle. Deception is selling an old car without telling the buyer it has a major engine problem.

Gharar is both parties agreeing to the purchase knowing there is a major engine problem but without first having it assessed by a mechanic to determine its approximate cost of repair.

Any transaction agreed to by the parties without describing its major defining specifications generally involves an unacceptable level of gharar. However, a small amount of gharar is allowable and unavoidable in most transactions.

For example, if the above problem involved a tear in the seat upholstery, the sale could occur without the parties determining its cost of repair.

A general rule of thumb for avoiding a prohibited level of gharar is to avoid any transactions where, due to absence of knowledge or uncertainty of delivery, one or more parties risk the majority of their consideration (even if they agree to it).

Ratings and Index Services

There is a very small but growing industry developing to provide independent guidance to investors on the Shari'ah-compliance of stocks. Dow Jones in 1997 launched the first of its Dow Jones Islamic Market Indexes.

The company, in consultation with a board of Shari'ah scholars, applies Islamic screens to the universe of publicly-traded stocks to arrive at the companies making up its indexes.

It now has a family of over 60 indexes covering stocks meeting its screening criteria, with a combined market capitalization of over $9 trillion. This market-comprehensive, stable benchmarking is a critical piece of the developing Islamic stock investing industry.

Another critical piece is more in-depth coverage and Shari'ah-compliance ratings of individual stocks, analogous to Morningstar or Lipper. Several efforts have been pursued in this area over the past few years. AIF Investor Services started rating companies' Shari'ah compliance on an A through F scale in 2004. The company now rates over 100 US Large Cap stocks and is adding coverage of about 10 stocks per week.

As the industry grows, these existing participants are likely to be joined by others, and corporate treasurers and institutional investors representing Muslim clients or constituencies will have a growing body of information available to help guide them in making Islamic investment decisions.

* For more on this subject, see N. Yaquby, "Trading in Equities: A Shari'ah Perspective," Proc. 4th Harvard Univ. Forum on Islamic Finance. Harvard CEMS: 2000, p. 119

**Siddiqi, Mohammad Nejatullah, "Riba, Bank Interest, and the Rationale of its Prohibition," Islamic Development Bank Islamic Research and Training Institute (Jeddah: 2004).

Authors Note: Some material used by permission of AIF Investor Services, LLC.