Mutual fund: The Islamic way

By Faraz Ali Ansari.

Islam is a religion that unites both spiritual and worldly aspects of life. It regulates not only an individual’s relationship with God but also human relationships in social and financial settings. Thus, the shariah or the Islamic Law is part of every Muslim’s cultural, social, and behavioural identity. We as Muslims are prohibited by religion to deal in interest (riba) in any way — giving and receiving as well as witnessing are all prohibited. But conventional investment overlooks this perspective and offers investments based on interest. Thus, in case of an Islamic investment, there is no interest payable to its investors. They can neither demand nor receive any interest from the borrowers.

The application of shariah to investment choices and management is not a new concept for an Islamic Republic. Earlier, Muslims were able to establish an interest-free financial system to mobilise resources in order to finance productive activities and consumer needs, which worked effectively for centuries and are practised to date. Until the 21st century, for most devout Muslims, stock market investments were perceived as grey and controversial areas. Traditionally, the bulk of Islamic funds has been channeled into low-risk and modest return instruments, such as murabaha (short-term, secured commodity and trade finance) and structured medium-term investments in ijara (leased assets such as aircraft-shipping operations and equipment or machinery).

However, since the mid-1990s, interest in Islamic mutual funds has grown largely due to a fatwa on investment banking issued by the Islamic Jurisprudence Academy in Saudi Arabia. The decree ruled that within certain parameters equity investment was acceptable under sharia. Muslims prefer to invest in accordance with their religious beliefs and Islamic funds offer scope for joint cooperation between Western and Eastern financial cultures. These dedicated funds, which are developed and marketed mostly in strategic alliances between Islamic and local banks, are beneficial for both parties. They bring together portfolio management expertise and the global distributional networks of major investment houses with the Sharia Board’s approval.

Islamic Investment Fund (IIF) is a joint pool wherein the investors contribute their surplus money for the purpose of investment to earn halal, (riba-free) profits in strict conformity with the precepts of Islamic shariah. The return on the subscription is tied up with the actual profit earned or loss suffered by the fund. If the fund earns profits, the return in the subscription will increase to that proportion; and, in case the fund suffers losses, investors are bound by law to accept that loss. Islamic law prohibits investments in stocks, such as conventional financial services, i.e. banks and insurance companies because Quran forbids riba (paying or charging interest on money). Hence, the collective amount from investors is appropriately invested into a business or company that has undergone a process, termed screening or cleansing, which is conducted by a board of shariah advisors, during which the board must approve every potential investment.

In case of equities, investments in distillers, gambling, tobacco, pork, and non-halal meat products, hotel and leisure (who serve liquor), casinos and night clubs stocks is prohibited. Trading in government and corporate bonds, and derivatives (stock options and future contracts) are also prohibited. The latter entails gharar (i.e., uncertainty and speculation) as well as the interest element inherent in such transactions. Dealing in preference shares is also prohibited since they entitle the holders to preferential dividend rights and carry a fixed rate of return. The main objectives of Islamic fund managers are to select low-leveraged and efficient companies with proven records of stable earnings.

There is a strong desire to participate in Islamic equity funds among private investors and institutions in Muslim countries. Islamic mutual funds have high correlations with the Islamic Law principles of equity participation and the sharing of risks. The growth of Islamic funds is improving the market’ liquidity and provides risk-diversification opportunities for medium and long-term maturity structure, a feature that is still lacking in the Islamic capital market.

Investment in Islamic Funds provides attractive returns to investors through investing in Shariah Compliant Income Instruments while taking into account capital security and liquidity considerations. The fund strives to take advantage of available opportunities in Shariah Compliant Income Instruments in order to realise a high-level of total return from a diversified portfolio. Islamic investment provides investors with a safe and stable stream of halal income on their investments and generates long-term risk adjusted returns.

There is an increasing trend towards exposures to the developed stock markets among high net worth Muslim investors seeking higher returns from diverse stocks that also comply with the sharia’s guidelines. Islamic mutual funds have a global market appeal and Islamic asset management businesses offer attractive opportunities for joint ventures between local and foreign banks.