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The paradox of Islamic finance

Islamic finance introduced investors to the ideas of ethical investment centuries ago. Now, its adherents say that it needs to embrace the present
March 22, 2019

Since its foundation in the seventh century, the Islamic faith has spread across the globe, with more than 1.8bn adherents today. In 2018, there were 3.4m Muslims in the UK, making up 5 per cent of the population. The Pew Research Center, an American think-tank, predicts that by 2050 this figure will have climbed to just over 13m, or 16.7 per cent of the UK population. They will need access to financial products that adhere to Islamic standards.

Islamic finance is not fiendishly complicated to grasp, but it does require knowledge of the principles that underpin the religion. Those who follow Islam observe “peace and submission to Allah”, as the word translates. The religion sits upon three legal foundations: aqidah (beliefs), akhlaq (morals) and shariah (duties).

This third pillar governs a person’s interactions with God (ibadah), and his/her interactions with others (muamalat ammah), which includes finance. Non-Muslims may be familiar with a handful of rules from this last sub-category, with regards to food, marriage and family. Less familiar, however, is the notion of shariah-compliant finance.

According to clerics and Islamic finance experts, this lack of familiarity even extends to followers of the faith. “Muslims believe that Islam gave them a financial system to operate and to apply it to their financial matters,” says Qari Asim, an imam at Leeds’ Makkah mosque. But that doesn’t always equate to deed, or even much discussion. “There isn’t a huge emphasis in this country to talk about sharia compliance in financial matters,” adds Mr Asim.

In fact, in the UK, shariah-compliant product provision is scarce, demand is low and understanding is meagre among the general Muslim population, according to Islamic finance experts and religious leaders alike. It falls upon Islamic scholars to interpret the scriptures, and finance professionals are expected to follow. This can create tension, and at times Islamic finance amounts to a theological battle between religious experts. As such, it is hard not to sympathise with rank-and-file believers who want to observe these rules with ease, much as they do when they consume halal food.

Shifting sands

Over half of the UK’s Muslims are under the age of 25, and therefore not a significant investor base, yet. But this demographic is familiar with trends that have permeated other aspects of business and finance, namely financial technology and indexing. Environmental, social and governance (ESG), also popular with the younger generation, has been increasingly built in to investment strategies over the past few years – it has run at the core of Islamic finance for centuries.

Divestment from sin stocks such as tobacco and alcohol, a dominant theme of ESG investment, is increasingly viewed as a route to consistent and ethical returns, rather than an unnecessary, self-imposed restraint. If the ethical investors are right, then the ancient rules of shariah-compliant finance, which might seem draconian at first, could indeed provide a path to good investment performance – the Dow Jones Islamic Market Titans 100 Index, which has delivered annual returns over the past decade of 12.5 per cent, would support this hypothesis. And if the Pew Research Center is right, demand for shariah finance is set to rocket, and participants across financial services will have to sit up and take notice.

 

What is Islamic finance?

There is no one neat definition of Islamic finance. Experts agree that the principles of risk-sharing and ethical investment are paramount, and that while different rules set by a number of organisations exist, those who strive to invest in this spirit will be spared any “grievous punishment”.

That said, there are some fairly straightforward proscriptions. For one, alcohol, gambling, certain forms of music and entertainment, pornography and tobacco are prohibited for investment, as they are for consumption. Businesses that generate a significant proportion of their revenues from these goods are also forbidden. Conventional financial services, such as insurance and lending, are also off limits. Bans on speculative investments rule out instruments such as conventional derivatives and a ban on earning interest, known as riba, rules out conventional bonds. There is a replacement for fixed income, called sukuk, which we’ll come to.

These rules are fairly simple to grasp for the shariah investor. But it gets a bit more difficult from here.

When it comes to equities, Islamic finance favours well-capitalised companies. So, once investments have been screened by indices, such as the Dow Jones Islamic Markets (DJIM) indices, for undesirable characteristics they are then put through a series of riba-type filters in order to remove businesses with excessive levels of debt or interest income.

The DJIM Index Shariah Supervisory Body lists the following three filters, and failure to match any one of the three results in disqualification from indexation:

1. Total debt divided by trailing 24-month average market capitalisation must be less than 33 per cent.

2. The sum of a company’s cash and interest-bearing securities divided by trailing 24-month average market capitalisation must be less than 33 per cent.

3. Accounts receivable divided by trailing 24-month average market capitalisation must be less than 33 per cent (note: under shariah investment principles, accounts receivable are viewed as loans to distributors).

It’s worth bearing in mind that there are a number of other screens for shariah compliance, including rules set by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Securities Commission Malaysia (SCM).

But to get a flavour of the challenges that come with picking stocks this way, let’s apply the DJIM rules to the Investors Chronicle’s very own Mr Bearbull Income Portfolio as it stood at 31 August 2018 and see what happens.

How does it work in practice?

Mr Bearbull has been running his income portfolio at the Investors Chronicle since 1999. In that time, he has outperformed the FTSE All-Share Index by 60 per cent, with the portfolio currently up 181 per cent since inception. By way of comparison, the Dow Jones Islamic Titans 100 Index, which measures the largest 100 shariah-compliant stocks globally, has grown by 531 per cent since launching in 1995. While it’s unfair to compare an income portfolio with a growth portfolio on this basis, Dow Jones proves that shariah principles needn’t be a barrier to returns.

But back to the Bearbull Income Portfolio, and let’s start by removing the obvious candidates. Pub retailer Greene King (GNK) is straight out. As conventional financial services companies are also proscribed, currency management provider Record (REC), insurance industry player Randall & Quilter (RQIH) and NatWest 9% Prefs are off the list.

Next, we divide our remaining companies’ total debt by their trailing 24-month average market capitalisation. GlaxoSmithKline (GSK) fails on this basis, because it comes in at 36 per cent. Chemicals specialist Elementis (ELM) and US gas distributor The Williams Company (US:WMB) are also out – blasting past the 33 per cent threshold at 37 per cent and 88 per cent, respectively.

We move on to the second filter. No companies on the portfolio fail on this basis – aviation services company Air Partner (AIR) has the highest percentage of cash and interest-bearing securities divided by its trailing 24-month average market cap, coming in at 12 per cent.

Air Partner, however, fails on the third measure, as dividing its accounts receivable by the same denominator yields a figure of 44 per cent. The next highest level on the list is held by industrial engineer Vesuvius (VSVS), which yields 28 per cent.

Of Mr Bearbull’s 13 holdings, only Manx Telecom (MANX), electronics engineer Zytronic (ZYT), Empiric Student Property (ESP), Topps Tiles (TPT) and Vesuvius make the cut.

 

Standardisation is needed

The above is intended to give an impression of how shariah principles might influence a portfolio, and is by no means prescriptive. Beyond the rules and intricacies of financial markets, individual circumstances also have a big role to play when it comes to shariah investing. Qari Asim suggests that for some, “it’s just people’s economics that don’t allow them to go for Islamic finance products”. He also calls for a greater standardisation of Islamic products, in order to facilitate better access for Muslims.

Muhammed-Shahid Ebrahim, professor of Islamic finance at Durham University Business School, believes the application of ESG principles should alone be sufficient for Islamic investors. He argues that the influence of scholars on the rules of finance can be unhelpful, and that scholars should pay greater attention to the views of finance professionals. “Sometimes, the religious scholars just do things which may not make sense from a finance perspective,” he says, observing that scholars are prone to an overly literal observation of Islamic standards that emanate from the medieval era, when economies were dominated by agriculture.

“The Koran [teaches that] you’ve got to consult people of knowledge,” he adds. “The shariah scholars are supposed to consult with us. We are the people of knowledge, but they don’t recognise us as being people of knowledge.”

Mohamed Damak, global head of Islamic finance at Standard & Poor’s, agrees with the need for more standardisation in Islamic finance. Progress is being made here – in October, AAOIFI and the Islamic Financial Services Board (IFSB), another leading shariah finance body, signed a memorandum of understanding to strengthen standards in shariah finance.

“It’s happening,” Mr Damak says. “Slowly, but it’s happening. If we were to be in a situation where, for example, the process of issuing the sukuk is as smooth as doing the conventional bond, that would create some avenues of growth for the industry,” he adds.

Conventional bonds are haram (forbidden) because they yield riba (unjust gains). So instead of ‘normal’ bonds, Muslims may purchase sukuk. First issued in Malaysia in 2000, sukuk represent undivided shares in the ownership of tangible assets relating to a specific project or investment activity.

A sukuk investor holds a common share in the ownership of the assets connected to the investment, but this does not amount to a debt owed to the issuer of the bond. Instead of receiving payments from an issuer on fixed dates, as with a regular bond, a sukuk holder receives a proportionate share in revenue or cash generated by the sukuk assets. There’s no interest, but this way investors can still gain exposure to fixed income.

Along with standardisation, Mohamed Damak eyes fintech as another catalyst for growth in the Islamic finance industry. “Fintech could help the industry to grow its reach, to tap new customer segments that are currently excluded from the banking system,” he says.

 

A more transparent future

Over in Seattle, Saad Malik has set out to realise Mohamed Damak’s vision. His Zoya app, which is currently available in its beta stage on mobile app stores, screens US-listed stocks for shariah-compliance with the AAOIFI standards. It sits alongside the Wahed app, which covers stocks on multiple exchanges and offers users the opportunity to review equities against a number of different standards. Users may also pay for professionally-verified research, which provides official halal certification.

Malik was influenced by his own difficulties of shariah investing. “I came across one article that said, do it this way, then I came across another article that said, do it this way,” he recalls. “All of a sudden I ended up with Dow Jones, versus S&P, versus AAOIFI... I was just overwhelmed by what all that meant.” Screening products have existed for several years, but they lacked transparency, and often carried exorbitant minimum spending limits.

Together with a friend, and later with Islamic scholar and finance expert Sheikh Joe Bradford, Malik’s company, Investroo, identified a market that is clamouring for clarity on investment dos and don’ts. The app does not claim unequivocally that a stock is compliant or not, but is nevertheless informative. In February, there were 130 people using Zoya.

Malik is honest about the current state of Islamic finance. “The Islamic finance industry, up until now, has had a very closed-off culture,” he told us. “It’s been very difficult to get transparency [and] information.”

Fintech offers a solution for all of finance, he argues. “It’s been able to speed up innovation,” he says. “It’s been able to produce a lot more innovative products that have made the financial lives of people much more simple.” Islamic finance, which he believes is “10 or 20 years behind”, is no exception.

Islamic finance is, in many ways, baffling. It appears to enshrine a progressive set of values, steeped in centuries of history, seemingly prescient and alive to the investment and societal risks of sin stocks and poorly capitalised companies. It also appears resistant to necessary reform. It is a sort of Zeno’s paradox – progress seems impossible to achieve, yet we must have gotten to this point, somehow.

This may be a blessing in disguise for entrepreneurs like Saad Malik. “We’re far behind,” he says. “And that means more opportunity”.