Sharia-compliant discretionary solutions

02 June 2015

Fraser Donaldson – Insight Analyst (Investments)


Of the 80 or so discretionary firms that Defaqto covers, there are only two that currently offer Sharia-compliant solutions – perhaps a little surprising with a quarter of the world’s population being Muslims. 

Internationally, Sukuk, which is a kind of ‘Islamic bond’ that is asset-backed rather than based on interest, has gone from strength to strength over a relatively short period of time, with the first one launched in 2002 in Malaysia.

Why Sharia-compliant solutions are so complex

There's clearly an appetite for Sharia investment, so why has the discretionary industry appeared to be slow on the take-up? There are three fundamental challenges for any investment firm that is looking to provide Sharia-compliant solutions:

  1. Where deep-rooted beliefs are concerned, there is a good chance that the investor, in most cases, is likely to have a better understanding of Sharia law than non-specialist investment managers
  2. Although there are some very specific rules, some aspects of Sharia Law are open to interpretation. For instance, every Islamic bank has its own Sharia board which produces its own regulations. The concept is that every Islamic scholar can have their own view on anything (called a fatwa or religious pronouncement). This means there are no completely consistent standards to abide by
  3. The cost of governance, ensuring that the ruling interpretation of Sharia Law is abided by

In some respects, Sharia looks a little like ethical investing. The difference is that ethical investors are approaching investment from a moral standpoint. This means they can make a judgement based on the greater good and can allow themselves some compromises. Sharia investors are approaching from a religious point of view and quite understandably should not be expected to compromise on their beliefs.

Exclusions

There are some fundamental areas that Sharia investment cannot be involved in, including:

  • Alcohol
  • Tobacco
  • Adult entertainment
  • Pork
  • Gambling
  • Weapons
  • Conventional banks and building societies
  • Interest-bearing securities
  • Conventional derivatives
  • Short-selling

This means that advisers looking to add a Sharia-compliant solution to their armoury should be looking for certain elements of governance. For these elements we have looked at the governance structure behind the Sukuk for guidance:

  • A Sharia board, that includes Islamic scholars that are there to guide the investment managers on Sharia Law and provide interpretation where there is doubt
  • An annual audit of adherence to Sharia principles either by the board or, preferably, by a third party (avoiding conflicts of interest issues). This is in additional to standard accounting and reporting requirements
  • ‘Purifying’ of any income received. Essentially this means identifying any non-halal income such as interest payments that have been inadvertently or unavoidably received. This interest needs to be paid to an Islamic charity that has been chosen by the investment manager and approved by the Sharia board
  • In terms of the research required, the starting point is that all companies are considered non-compliant until proven otherwise. It is likely that company analysis that is normally available will not give sufficient data to judge on Sharia compliance. There will therefore be additional costs in analysing companies from a Sharia point of view
  • Custodians must hold assets on Sharia principles, avoiding activities that they would normally enter into when making held assets work for them. There are other administrative technicalities where an interest charge may apply – here this should be converted to a fee

While this is the approach of the Sukuk, potentially issuing hundreds of millions of dollars at a time, where these additional costs can be borne, advisers should still be looking for elements of this kind of governance and specialism from any discretionary manager that claims that it can provide Sharia solutions.

In our opinion, this is not an area of investment that individual investment managers can ‘have a go at’ on a bespoke basis. There does need to be some specialist guidance and infrastructure in place, and it is the job of the adviser to identify this.

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