Chapter 3: Permissible Investment Vehicles
The previous chapter dealt with permissible vehicles that would allow Muslims to
acquire capital to finance purchases of equipment, homes, automobiles, etc. We
now turn to the other side of the coin: what permissible investment vehicles are
available for Muslims? Of course, there are many direct investment vehicles. A
Muslim can invest directly in any legitimate business, possibly earning some
profits. However, it is useful to focus oil relatively passive investment
vehicles such as equities, mutual funds, etc., as well as "fixed income"
alternatives to forbidden interest based instruments such as bonds and money
market funds.
Common shares in a listed company are as the name suggests "shares" in the
assets of the company. Thus, if the company's business is legitimate, and its
conduct is in compliance with the rules of Shari`a, Muslims are allowed to own
such common shares (stock). Common stock may thus be bought and sold, as the
potential owner sees fit. While the common stock is held, it earns a portion of
the total profits of the firm, part of which may be distributed to the
shareholders in the form of dividends, and the other part may be reinvested in
the company. Thus, the first part of the profit share is given directly to the
shareholder, while the second part is given back implicitly by the increase in
the company's capital, a fixed proportion of which is claimed by the held share.
Other common means of investing in claims on companies' capital are not allowed:
bonds are explicitly a claim on a portion of the company's interest bearing
debt, and preferred stock are a hybrid stock/bond.
Since common stocks of Islamically appropriate companies may thus be bought and
sold; it is also possible to create mutual funds in such stocks. A mutual fund
would group the funds of a number of investors, and "manage" those funds by
investing in a portfolio of permitted stocks, buying and selling them as they
see fit. The mutual fund managers collect a fee for their efforts in studying
the market conditions as well as the prospects of each given company. In some
Islamic countries, some "Islamic mutual funds" also calculate and pay the
appropriate Zakah on shares on behalf of their investors, in addition to
screening the various stocks and choosing the portfolio weights according to
their best judgment. Within the Islamically permitted pool of companies approved
for trading by the Shari`ah, boards of such fund managing companies, a variety
of funds may be created (technology, high growth, blue chip, regional, etc.).
Most "Islamic funds" of this sort have had a consistent record of outperforming
"the market" in most categories. This guide is intended to give general
information on trends in Islamic banking and finance, and therefore, I refrain
from giving any specific information on fund management firms.
One point which should be understood by the reader of this primer, however, is
that a number of compromises were made by jurists to make it possible for
"Islamic stock indices"' and "Islamic mutual funds"' to exist. If the strict
Shari`a rules were applied, the pool of permitted stocks will be too small for
any reasonable diversification to be possible. Here's a particular dilemma: the
strict rules of Shari`a will dictate that the individuals (and hence the company
in which they are shareholders) should neither borrow nor lend with interest.
However, most listed companies fall in one of two categories: either they tend
to face occasional liquidity shortages, in which case they borrow (with interest
of course), or they are cash rich, in which case they tend to put their excess
liquidity in interest bearing instruments (e.g. government bonds, etc.). This,
together with legal structures in the U.S. and elsewhere favoring debt financing
(e.g. due to tax deductions on interest payments), make it very difficult to
find companies which neither pay nor receive interest. This difficulty motivated
the jurists' compromises discussed below.
Shari`ah boards are employed by "Islamic fund management" firms as well as
"Islamic index" generating companies. The jurists serving on those boards
determine a set of rules for selecting the eligible pool of companies whose
stocks may be held by Muslims. Some of those rules are clear cut, while others
require each investor to search his own conscience for answers. While the
opinions of prominent jurists on "Shari `ah boards" add a significant measure of
respectability and credibility to the enterprise, Muslims are ultimately
responsible for their own decisions. If the reader finds some of those rules
unconvincing, he or she should attempt to learn more by contacting the various
firms and information sources. No matter how prominent the issuers of a fatwa
may be, they are human. We ask Allah to reward them for their best efforts, but
we cannot absolve ourselves of our most basic religious responsibilities by
following their opinions if we are convinced otherwise.
The first set of filters is straight forward: exclude all companies whose
primary business involves forbidden products (e.g. alcohol, pork, tobacco,
financial services, weapon production, and "entertainment''). A typical screen
given by the Dow Jones Islamic Index (DJII) Shri`a board can be found on the web
at:
http://www.dowjones.com/corp/index_products.htm
(pp. 810). The second set of
filters, based on "financial ratios", is significantly more dubious. The rules
recently adopted by the DJII board are virtually identical with those adopted in
earlier years by other fund management company Shari'a boards in Islamic
countries. Those rules relate to the above mentioned compromises on three
prohibitions due to the inherent Riba and other impurities:
- Carrying interest bearing debt.
- Receiving interest or other impure income.
- Trading in debts at, a. price other than their face values.
The Shari`a boards of most Islamic fund managers and equity indices have reached
very similar compromises. The following is the list of rules/compromises (ibid,
p.10) used by DJII:
- Exclude companies with a debt to total asset ratio of 33% or more.
- Exclude companies with “impure plus non operating interest income” to revenue
ratio of 5% or more.
- Exclude companies with accounts receivable to total assets ratio of 45% or
more.
Those rules are virtually identical to those used by other indices, e.g. the
FTSE Global Islamic Index Series, http://www.ftse.com/ebox/TII.html. The first
compromise is based rather loosely on a famous Hadith where Abu Bark (mAbpwh)
asked the Prophet (pbuh) how much of his wealth to give in charity, and the
Prophet (pbuh) said: "one third, and one third is plenty". This is clearly an
out of context use of the Hadith, and jurists do not claim that it is used as a
legal proof, but rather as a comforting rule of thumb. The third compromise is
based on the view that if the majority of the company's assets are illiquid;
then the total assets may inherit the status of that majority (c.f. M. Taqi
Usmani (1998, pp.208 210)). The second compromise assumes that 5% is a
negligible amount. I have not been able to find any source which would mention
the origin of that rule.
I do not have the pre requisite religious knowledge to debate whether or not
compromises on issues related to Riba can be justified in this manner. However,
I can point out that the cutoff rules on financial ratios used in this area seem
extremely arbitrary, and potentially rigid. In this regard, even if they are
indeed justified, it is very unlikely that fixed cutoff ratios will be
appropriate for all circumstances and all pools of equities? The reader will
simply have to make his or her own mind. I cannot afford to bear any
responsibility for others' decisions, and hope that the reader will recognize
that I am only providing information on recent developments in this area to help
him or her become better educated.
Many retirees and others need to invest in income generating vehicles with
minimal risk. Obviously, investing in common stocks carries significantly more
risk than most such people can tolerate. At the very least, a component of their
investment needs to be earmarked for so called "fixed income" vehicles.
Unfortunately, the vast majority of conventional fixed income investments (e.g.
CDs, government bonds, money market accounts, etc.) include forbidden Riba. How
then can retirees and those nearing retirement be able to get a lower risk
source of income from their investments?
Consider a simple example first: the individual seeking the lower risk
investment vehicle may use his money to buy some real estate (e.g. an apartment
building, or a warehouse) that generate income in the form of rent. This rent
will naturally go up with inflation, as will the value of the real estate, thus
providing a reasonable inflation hedge and helping the investor keep the real
value of his or her wealth, while generating an income on which to live.
Of course, any specific piece of real estate may still carry risks which the
more sophisticated investor can diversify without affecting the average income
stream. For instance, the particular area in which you buy an apartment building
may become less fashionable, and the value of the building as well as the rent
income may decline significantly. Also, any given building may require
substantial repair costs due to unforeseen damages, etc. Therefore, it may be
better for the investor to team up with a group of similar-minded investors and
jointly own a collection of buildings in different areas. Each individual's
share of the total rent income will be equal to his share in the total value of
the portfolio. This simple diversification can allow hire to have the same
average rent income he could get on his own, but with much lower risk (the
chances that all the buildings will be adversely affected at the same time is
very small).
This is the concept behind an "'ijarah fund". Recall that an Islamic financial
institution engaged in a number of lease contracts continues to own the assets
throughout the life of the leases. While some jurists restricted the lessor's
ability to sell the leased asset or parts thereof during the lease period, most
others permitted such a sale as long as the lease continues. Therefore, the
Islamic financial institution can treat its portfolio of leased assets as a
company or fund, shares of which may be sold to investors. The investors then
earn a fixed income according to their shares in the fund. Like the forbidden
conventional fixed income investments (e.g. money market funds, bonds, etc.),
the fixed income from a lease fund will move up with inflation, and the risks
borne are minimal (default in the conventional contract vs. default and repairs
or losses of assets in the lease fund).
[Note: It is becoming popular nowadays
to propose also having "uturabaha funds" along similar lines. However, in a
murdbaha, the asset is no longer owned by the Islamic financial institution, and
what they can "securitize" and sell is therefore the cash flow generated by the
liability on the buyer. Such debts/liabilities may only be sold at par value,
and therefore cannot provide a source of income for the "investors". Compromises
along the lines discussed above are constantly cropping up, with a higher
percentage of physical assets being combined with some murabaha accounts
receivables in a single portfolio.]
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