SOUTH AFRICA IS NO STRANGER to the principal of ethical investing, with socially responsible investments (SRIs) assuming greater importance in the overall strategy of retirement funds. Since Shari'ah compliant funds are based on the ethical screening of shares to exclude specific stocks, those funds can definitely be categorised as SRI.
In the past, due to a lack of feasible Islamic products, Muslim investors were forced to forgo investment returns as conventional investment portfolios didn't conform to Islamic law. Today, due to the continuous advancements in financial markets, increasing knowledge and demand for Islamic investments, the development of Shari'ah compliant funds has become the market niche. Investors' appetites for Shari'ah products are increasing, with the current Shari'ah investment market estimated at US$500bn globally, with an expected growth rate of 10% to 15%/year1.
In SA there are an estimated 350 000 to 400 000 Muslim households, creating a potential savings and investment market worth R1,8bn/year2.
What is Shari'ah?
Shari'ah is the body of Islamic law within which public and some private aspects of life are guided. Shari'ah encompasses all aspects of a Muslim's life, including politics, economics, business law, family and social issues.
Investing according to the Shari'ah involves a complex set of laws that aim to provide each party of a transaction an equal footing while simultaneously developing a sound work ethic. The fundamental principle of Shari'ah investments is that the return must be commensurate with the risk taken.
Criteria of Shari'ah Compliant Funds
Although the Shari'ah has specific laws regarding investments and finance the interpretation of the laws is subjective and different scholars may have conflicting opinions. That's led to the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) developing a number of guidelines and principles to ensure that all Shari'ah compliant funds are managed according to a standard set of principles.
That certainly doesn't eradicate the challenge of personal interpretations and opinions but does assist in ensuring that a guideline exists to ensure accountability. In SA, the Association of Collective Investments (ACI) and the Financial Services Board have adopted AAOIFI's standards as the benchmark to evaluate a fund's Shari'ah compliancy. Those principles are explained below.
Interest: Shari'ah prohibits the trading of short-term debt instruments at other than face value, or from drawing upon the established intrabank market, as those transactions involve interest and excessive uncertainty (Gharar).
That means Islamic financial institutions tend to have highly liquid balance sheets with limited investment opportunities for their current assets. Thus Sukuk have, over the past few years, created opportunities for the short- and medium-term placement of such funds.
The Sukuk (Islamic bond) for the most part fulfils the Islamic financial industry's need for a debt instrument. In its simplest form it's a certificate evidencing ownership of an asset. The development of Sukuk was in response to Shari'ah's prohibition on earning returns from loan contracts where returns are based on interest. Conventional bonds and other derivative instruments that rely on profiting holders by providing returns based on interest are therefore unavailable to Muslims who want to invest in Shari'ah compliant investments.
The AAOIFI - which issues standards on accounting, auditing, governance, ethical and Shari'ah standards - has defined 14 different types of Sukuk. The Sukuk structures rely on the creation of a special purpose vehicle that issues certificates that represent, for example, ownership of the asset, entitlement to a debt or to rental incomes or even accumulation from various Sukuk (a hybrid Sukuk).
The return provided to Sukuk holders therefore comes in the form of profit from a sale, rental or a combination of both.
A distinguishing feature of a Sukuk is that in instances where the certificate represents debt to the holder the certificate won't be tradeable in the secondary market and should be held until maturity.
Business category: Certain business categories don't meet the criteria of the Shari'ah. Therefore, specific stocks are excluded from the stock universe from the outset. The categories that are prohibited include, among others:
* Weapons and military equipment.
* Conventional financial institutions that are interest-based.
* Entertainment, including cinemas, hotels, pornography publications and music.
* Non-halaal food and beverages, particularly pork and alcohol or other intoxicating products.
That leads to a Shari'ah compliant equity portfolio in SA displaying a bias to resource stocks and potentially sector concentration, leading to a less well-diversified portfolio. Also, different asset managers' portfolio holdings are similar due to the limited universe of stocks.
Financial ratios: Once a listed company has been identified as an appropriate stock by screening the business category, certain financial ratios are calculated. The financial ratios include:
* Debt/Average 12-month trailing market cap or total assets.
* Cash plus interest-bearing securities.
* Accounts receivable/average 12-month trailing market cap or total assets.
The first two financial ratios may not exceed 30%; the third ratio may not exceed 70%.
Non-permissible income: If a listed company complies with all three principles above it's still possible that minor components of its profits are derived from sources that aren't permissible under Shari'ah. Investments will not be made in companies where the interest and other non-permissible sources of income are more than 5% of the company's total income.
Interest income from interest-bearing accounts and investments yielding income that's considered impure by Shari'ah standards must be purified. After being audited and computed, dividends will be cleansed of that non-permissible income before being distributed to the investor. The proceeds from that income are then distributed to charitable organisations.
The distribution of non-permissible income is an important aspect of Shari'ah investing, as it assists in the upliftment of communities and ensures that the investment is socially responsible. Specific areas of focus include disaster relief, education and healthcare.
The Shari'ah Supervisory Board
All funds that claim to be Shari'ah compliant require a Shari'ah Supervisory Board to direct, monitor and supervise the investments and activities of the fund to ensure compliance with Shari'ah principles. The purpose of supervision is to certify for Muslim consumers that the financial product is acceptable to them from an Islamic legal perspective and is therefore lawful to them.
The board is an independent body of specialist jurists in Islamic commercial jurisprudence.
It must consist of at least three members, one of whom can be an expert in general Islamic finance and business principles.
There are currently five Shari'ah boards in SA, namely: Absa, FirstRand, Futuregrowth, Oasis and Stanlib. All five boards are well represented with members not only qualified in Islamic jurisprudence but who also have relevant business and investment experience.
There are currently no Islamic indices available in the SA market. The majority of the current Shari'ah compliant funds in the SA market benchmark against the FTSE/JSE all share index. The lack of appropriate SA indices may require the construction of a tailor-made benchmark.
In the international market, Dow Jones and FTSE have constructed Islamic indices. Currently, the Dow has 31 different equity indices and has also implemented the first Sukuk index. FTSE currently has three different Islamic indices. More recently S&P and MSCI Barra have also introduced Islamic indices.
Shari'ah Compliant Funds in the South African Market
The majority of Shari'ah compliant funds are in the form of unit trusts and invest wholly in equity, which exceeds current prudential guidelines that allow for a 75% equity allocation as stipulated in Regulation 28 of SA's Pension Funds Act. That represents a concern for the retirement fund industry, as members could potentially be invested 100% in equities, exposing them to the volatility of the stock market.
Shari'ah investing is a viable alternative of ethical investment that's expected to grow in future as products are developed to meet the requirements of Regulation 28 and Shari'ah law.
However, legislation also needs to take into account the unique characteristics of those products.
Asset consultants must educate and equip themselves with the relevant knowledge to ensure that boards of trustees of retirement funds are sufficiently informed of the options available. As the demand for Shari'ah compliant products increases and those products are demystified the market will be forced to respond with more product choices, appropriate benchmarks and suitable legislation.
2. Stanlib - The Asset Test September 2007
Shari'ah fund brochures and correspondence with: Futuregrowth Asset Management; Fraters Asset Management; Oasis Asset Management; Stanlib.
* Articles: Centuries-old religious law incorporate modern investment theory? A new generation is exploring the possibilities, by Susan Trammell, CFA, CFA Magazine March-April 2005.
SULIMAN graduated with a BCom (Honours) in Finance from the University of Witwatersrand in 2004. She started at Alexander Forbes as a performance analyst in the Asset Consulting Division in October 2005. She's currently an Assistant Consultant on a number of funds and medical schemes.