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.

Investing in equities

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: (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:

  1. Carrying interest bearing debt.
  2. Receiving interest or other impure income.
  3. 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:

  1. Exclude companies with a debt to total asset ratio of 33% or more.
  2. Exclude companies with “impure plus non operating interest income” to revenue ratio of 5% or more.
  3. 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, 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.

"Fixed income" funds

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.]