Shari ah compliant funds Written by: Shamier Khan, Portfolio Manager at Element Investment Managers

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1 FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h 24 A u g u s t V o l u m e 9 72 Shari ah compliant funds Written by: Shamier Khan, Portfolio Manager at Element Investment Managers In this article we look at the requirements a share has to meet in order to qualify as an investment for our suite of Shari ah-compliant funds. Shari ah is also commonly referred to as Islamic law. What makes a share Shari ah-compliant? When determining if a share is Shari ah-compliant one has to assess both the qualitative factors as well as the quantitative factors. A share has to meet both the qualitative and the quantitative requirements before it is approved as a Shari ah-compliant investment. Note that this is not a once-off compliance assessment, but rather an on-going assessment throughout the life of the investment. Who performs the Shari ah-compliant assessments? This assessment is performed by an independent Shari ah Committee. This Committee is typically comprised of senior Islamic scholars. Our Shari ah Supervisory Committee ( SSC ) consists of Mufti Mohammed Ali (Chairman), Mufti Ashraf Qureshi, Mufti Ahmed Suliman and Mufti Yusuf Suliman. When performing this assessment (both qualitative and quantitative), the scholars adhere to rules and standards that they consistently apply. These rules and standards are broadly based on those of the Accounting and Auditing Organization for Islamic Finance Institutions ( AAOIFI ). The assessment is performed throughout the year as and when companies report their results. Thus, the list is always current. Page 1

2 Qualitative assessment The qualitative assessment is performed on the type of security and the business of the company. Type of securities A Shari ah-compliant fund should acquire only the ordinary shares of investee companies or shares that have the same rights and obligations as ordinary shares. Therefore, the fund may not purchase or acquire preferred shares or convertible notes, i.e. shares that have preferred treatment. However, the fund is permitted to employ Shari ah-complaint financial instruments. Business activity The business activity must be investigated to ensure that it is halaal (permissible under Shari'ah law). No investments will be made in companies that are involved primarily in prohibited or industries not compatible with Shari ah as determined by the relevant SSC. Such or industries include: Conventional financial institutions, which are interest based, including banks, insurance companies, brokerage and finance houses, or leasing companies; Gambling, gaming or casinos; The manufacturing, packing and distribution or sale of non-halaal food and beverages, particularly pork and alcoholic or other intoxicating products; Entertainment, including cinemas, hotels, pornography, publications and music, and the production or distribution or sale of such entertainment, such as television channels and radio stations; The manufacturing and sale of weapons or military equipment; The manufacturing, packing and distribution or sale of tobacco products; Trading of gold and silver on deferred basis; Other immoral or unethical. The table below details the sectors that we at Element, as well as the four major Islamic indices providers, and AAOIFI consider impermissible. Page 2

3 Non-compliant sectors per Element and the major index providers Sector AAOIFI Element Dow FTSE S&P MSCI Jones Alcoholic x X x x x X Beverages Broadcasting X x x x X and Entertainment Conventional x X x x x X Financial Services Gambling x X x x x X Hotels x X x x x X Insurance x X x x x X Media X x x Agencies (except newspapers) Pork-related x X x x x x products Restaurants x X x x x x and Bars Tobacco x X x x x x Trading of gold x x x and Silver on deferred basis Weapons and Defense X x x x X = denotes non-compliant sector = denotes no specific mention of sector as a non-compliant sector Source: Official Indices website - Dow Jones (June 2018), FTSE (June 2018), S&P (June 2018) and MSCI (May 2016), AAOIFI (October 2017) and Element Investment Managers (June 2018) The table above shows that there is largely consensus amongst the various SSC. Based on the table it could be argued that our SSC adopts a relatively conservative approach. Page 3

4 Quantitative assessment The quantitative assessment is determined by financial ratios. These ratios cover four areas, namely, interest bearing debt, interest earning assets, liquidity and non-permissible income. These financial ratios are broadly based on AAOIFI standards. AAOIFI is a Bahrain based not-for-profit organisation whose stated purpose is the standardisation and harmonisation of international Islamic finance practices and financial reporting in accordance with Shari ah. The AAOIFI standards are not laws and thus competent authorities in Australia, Indonesia, Malaysia, Pakistan, Saudi Arabia and South Africa have issued guidelines derived from the standards and publications. Objective of financial screening ratios Level of interest-bearing liabilities: This filter is necessary to ensure that the company is not overly reliant on interest-based financing and to ensure that the financial leverage risk of the company is low in order to mitigate the risk of bankruptcy and liquidation. Securities: This filter is necessary to ensure that the company is not overly reliant on interest based investments and that the tainted returns from fixed income sources (interest-bearing bank accounts, certificates of deposit, bonds, etc.) is kept to a minimum. Liquidity: This filter is necessary to avoid interest on the sale of cash or debts. Impermissible income: This filter is necessary to ensure that the company s exposure to interest income and other non-compliant is not excessive. Per the table below it becomes clear that there is a greater discrepancy amongst the various Shari ah boards with respect to what constitutes an acceptable ratio within the financial screening process than when considering the qualitative factors that make a business impermissible. Page 4

5 Level of based debt Securities Liquidity Liquidity Impermis sible Income AAOIFI Element Dow Jones FTSE S&P MSCI Debt/Market Debt/ Debt/Market Debt/ Debt/Market Debt/ Cap less Assets Cap (avg. 24 Assets less Cap (avg. 36 Assets less than 30% months) 33% months) 33% 33% Securities/M arket Cap 30% market value of illiquid assets, benefits and rights/ Assets greater than 30% interest and noncompliant income Securities/ Assets 33% Net liquid assets (cash plus current assets less current liabilities) have to be 70% of total assets Net liquid assets have to be the market capitalisati on of the company interest and noncompliant Securities/M arket Cap (avg. 24 months) less Account Receivable/ Market Cap (avg. 24 months) less Noncompliant (other than interest income) Securities/T otal Assets 33% Account Receivable/ Assets less than 50% interest and noncompliant Securities/M arket Cap (avg. 36 months) less Account Receivable/ Market Cap (avg. 36 months) less than 49% Noncompliant (other than interest income) Securities/T otal Assets 33% Account Receivable/ Assets less interest and noncompliant = denotes no specific mention of this ratio Source: Official Indices website - Dow Jones (June 2018), FTSE (June 2018), S&P (June 2018) and MSCI (May 2016), AAOIFI (October 2017) and Element Investment Managers (June 2018) Page 5

6 Assets vs. Market Capitalisation Certain authorities including Element Investment Managers have opted to use total assets as opposed to market capitalisation when determining the screening ratios. We consider total assets as a true representation of the wealth owned by the company. The ratios are used to determine the size of certain financial aspects (e.g. interest-based transactions) of the company. The balance sheet is generally used to determine the size of the company with regards to its components. A true reflection of the size of interest-bearing is also taken from the balance sheet; therefore its comparison should also be taken from the balance sheet. The market capitalisation approach compares historical debt values (per the balance sheet) with a market determined asset value (per the stock market). Consequently, one is not comparing two like-determined items (i.e. apples with apples). assets fluctuate because of business decisions taken by the company whereas market capitalisation fluctuates with market influences. Thus, the level of debt may not have any direct relationship to market capitalisation. Therefore, companies might qualify for inclusion as Shari ahcompliant due to a change in its share price even though there has been no change in its debt and asset levels. Share prices are also subject to speculators and irrational investor decisions with no discernible link to the actual business of the company. Utilising the market capitalisation approach introduces more volatility into the portfolio which could result in unnecessary trading cost being incurred due to increased turnover in the portfolio. A criticism of the total asset approach is that it is based on historical values and does not capture the value attributable to internally generated intangible assets (goodwill) whereas the market capitalisation approach intrinsically captures these values. Another criticism is that the total assets approach is not based on timeous data, that is, the data is based on the last reported/audited figures whereas market capitalisation is a current value. However, as mentioned above, the main criticism of the use of the market capitalisation approach means that the numerator and the denominator are determined on different methodologies. Non-permissible income and income purification Subject to an investee company satisfying the above financial filters and qualitative factors, the share may be bought regardless of the origination or source of the non-compliant income. However, the fund is to purify its investment by quantifying this tainted income and donating it to charities approved by the SSC. Page 6

7 Conclusion A share has to meet both the qualitative and the quantitative requirements before it is approved as a Shari ah-compliant investment. Note that this is not a once-off compliance assessment, but rather an ongoing assessment throughout the life of the investment, that is performed by an independent Shari ah Committee. This Committee is typically comprised of senior Islamic scholars. At Element Investment Managers, we would consider our screening process as relatively conservative when compared to the four major index providers and the AAOIFI standards. However, we believe our approach best captures both the rule and spirit of the Shari ah law. Page 7

8 Glacier Research would like to thank Shamier Khan for his contribution to this week s Funds on Friday. Shamier Khan BCom, CA (SA), CFA Shamier has worked in the investments industry since 1999 starting at HSBC. He was also part of JP Morgan, where he was a top-rated analyst in the telecommunication, media and food sectors. In 2009, Khan was an Investment Analyst and a Portfolio Manager at Sanlam Investment Managers. He joined Element Investment Managers in October 2013 as an Investment Analyst and a Portfolio Manager. He is responsible for Shari ah Investment Management and products. Page 8