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Accentuating the positive:governance of Islamic

investment fundsMervyn K. Lewis

University of South Australia, Adelaide, Australia

Abstract

Purpose The purpose of this paper is to examine the nature and structure of Islamic investmentfunds and evaluate their governance.

Design/methodology/approach The methodology employed is the conceptual framework ofIslamic economics.

Findings It is found that Islamic investment funds have grown rapidlythis decade: in Malaysia alone,

thenumberofsharia-compliant funds has grown from 17 in 2000 to 149 in 2008, and at a global level thereare 650 funds in operation. However, the industry has developed in a particular way, by focusing onnegative screens, and removing from investments those activities deemed to be unacceptable to Islamicprecepts, rather than pursuing as well the implementation of other aspects of the Islamic ethos.

Originality/value The conclusion reached is that, if the Islamic investment fund industry is toprovide more completely for the religious and financial aspirations of investors, it needs to go beyondthe negatives and to also accentuate the positive and, drawing upon Islamic governance guidelines,actively seek out investments that have a positive impact on society and the environment and promotethe welfare of the community. These issues hitherto have been largely unexplored.

Keywords Investment funds, Globalization, Ethical investment, Governance, Islam

Paper type Conceptual paper

1. IntroductionThe title of this paper borrows from the 1944 song Accentuate the Positive with lyricsby Johnny Mercer, which goes:

Youve got to accentuate the positiveEliminate the negativeAnd latch on to the affirmativeDont mess with Mister In-Between.

Obviously, while not wanting to eliminate the negative, the theme of the paper is toaccentuate the positive and latch on to the affirmative aspects of Islamic economic,financial and governance principles.

Ask the man in the street what Islamic banking and finance is about and they are

likely to respond (if at all) by talking about the negatives Islam bans interest,prohibits gambling and speculative activities and does not allow involvement in, or thefinancing of, alcohol and the production of pork. That is, the answer received is morelikely to revolve around what Islam is against, rather than what it is for. This paperargues that if Islamic investment funds are to reach their full potential as an avenue

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1759-0817.htm

Sections of the paper have benefited considerably from working with Nurul Aini bt Muhamed(Muhamed, 2009).

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Journal of Islamic Accounting andBusiness ResearchVol. 1 No. 1, 2010pp. 42-59q Emerald Group Publishing Limited1759-0817DOI 10.1108/17590811011033406


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for investment in a globalized setting, there needs to be a greater emphasis on thepositives, what Islam stands for.

In financial services, as in other fields, globalization should be seen as a processopening up national economies and markets, enabling knowledge, technology, ideas,

services and capital to move more easily and quickly from country to country andwidening the extent and form of cross-border activities. Home bias (the preference forgeographically proximate investment opportunities) has been on the decline for thepast two decades, and the increase in investment rates and cross-border activity incapital market investments is consistent with a diminishing risk compensation onoverseas investments (Greenspan, 2005). This process was spurred, and continues to bepropelled, by liberalisation and deregulation of capital markets, underpinned bytechnological change which is lowering communication and information costs,reducing geographical isolation and financial autarky and enhancing the internationaltradeability of goods and services (Lewis, 1999, 2003).

One manifestation of globalization is an intensification of international trade and anincrease in the scope and significance of all kinds of cross-border transactions.In Islamic financial services, this process is exemplified by the growth of cross-bordertransactions due to the expansion of Islamic investment funds, which operate at aglobal level. Fund management of this form has become a growth segment for theIslamic financial sector over the last decade; all the more so because Islamic investmentbanks, unlike their Western counterparts, do little Merger and Acquisition business ortrading activity and have made wealth management and mutual funds a principalfocus (Wilson, 2006).

In exploring this trend, the paper begins by examining the nature of the Islamicfunds, the principles of sharia-compliant finance (i.e. the positives and thenegatives), and the global implications of the funds in stimulating Islamic investmentsworld-wide. It concludes by comparing the Islamic funds with the Western models of

socially responsible investments (SRI), which provide a template (although withimportant differences) for how Islamic investment funds may develop in future.

2. Islamic investment fundsIslamic investment funds, like any investment pooling system, collect individualsavings for investment and the sharing of benefits. Those subscribing capital to thepool receive documentation evidencing their subscription (certificates, units or shares),entitling them to a pro-rata share of the profits (or losses) of the fund. Each fundconsequently has its own idiosyncratic structure, capital, subscription, maturity andexpected returns and risks.

However, there is some commonality, at least among the Islamic investment funds,for in order to be described as Islamic, thepurpose of the investment must be to earn halal

profits in conformity with the precepts of sharia, as interpreted by fiqh (Islamicjurisprudence). While the funds may take many different forms, two essential conditionsmust be met. First, neither the principal amount nor the rate of return can be guaranteed.Instead, the units must carry a pro-rata share of the actual profits earned by the fund andnot a fixed return tied to the face value of the certificates. Second, the funds gathered inthe pool must be invested in business and activities acceptable to Islamic principles.To this end the funds have a team of sharia scholars, either internal or external(outsourced via specialised consultancy firms), to advise on sharia-compliance.

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2.1 The global positionThere are no accurate figures of the size of the Islamic financial industry or its rate ofgrowth (although the 15 per cent per annum growth rate number has been repeated sooften that it has passed into the folklore). The latest estimate (made by Mahmoud

El-Gamal) puts the world-wide assets that comply with Islamic law in a range betweenUS$700-1,000 billion (as reported in the New Straits Times, 2009, p. B13). Broadlyconsistent with this estimate, Eurekahedge (2008) estimated the total size of the Islamicfinancial industry in June 2008 at US$800 billion. Their figure is an all-encompassingone and, in addition to Islamic investment funds, incorporates all forms of Islamicassets such as bank deposits and investment accounts, takaful (Islamic insurance),securities, and direct investments. If we focus more narrowly on the Islamic investmentfund sector alone, assets under management in Islamic funds at June 2008 wereestimated by Eurekahedge as US$44 billion for the 608 funds that report to it. Allowingfor another 40 or so non-reporting funds would likely see the figure for overall fundsunder management in Islamic investment funds rise to around US$60 billion.Nevertheless, this figure is still well under 10 per cent of total Islamic assets.

While small by global and industry standards, the number of sharia-compliantfunds has been growing rapidly. In the early 1990s, there were only a few fundsscattered around the world; Failaka International put the number of funds in 1994 at 13(Smyth, 2006). Since then, numbers have increased strongly from 2002, when 22 newfunds were launched, to 2007, when 158 new funds were issued. With an attrition rateof less than five funds per year, the total number of funds more than doubled in thethree years 2005-2007. Over 25 new funds were launched in the first quarter of 2008,although some slowing down since then due to the global financial crisis can beexpected. Following the Tech wreck of 2001 and the bursting of the dot.com bubble,the number of new funds issued from the Middle East declined sharply, but theirnumbers were more than made up by new funds from Malaysia.

Some details of the Islamic investment funds launched in 2007, can be summarized asfollows based on the Eurekahedge Islamic Funds Database (Eurekahedge, 2008).Overall, Saudi Arabia and Malaysia are the two largest markets for Islamic investmentfunds in terms of location of the fund management company and client base, althoughother areas have a market presence. In terms of head office location of funds issued, themarket shares (in per cent) are Saudi Arabia (25), Malaysia (23), followed by Kuwait (12),UAE (5), Bahrain (4), Singapore (4) and others. For the domicile of the client base (againexpressed in per cent), a similar pattern holds with Malaysia (24) and Saudi Arabia (23)dominant, followed by offshore clients (18), Kuwait (8), Bahrain (5), Indonesia (5), andothers. Finally, when it comes to the distribution of assets by geographic mandate, thereis a greater concentration and less regional diversity. Approximately, 63 per cent ofassets are held in the Middle East mandates, with global mandates and the Asia Pacific a

long way behind with 13 and 12 per cent, respectively. This pattern is thought to reflectthe legacy of past investments, a continued preference for Gulf (GCC) economies,and well-developed marketing channels (Eurekahedge, 2008).

Considering the two key markets of Saudi Arabia and Malaysia, there are importantdifferences between them. Malaysia has been described as a Shariah-ConsistentInvesting Incubator (Hassan and Girard, 2008), and sharia-based investment fundshave grown strongly in Malaysia since 1999. This year was a significant one, indeeda turning point, in the development of Islamic investment funds in Malaysia and

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elsewhere when Dow Jones, Financial Times-Stock Exchange (FTSE) and BursaMalaysia launched Islamic indices. Not only was credibility given to the Islamic fundmanagement industry, but it also created a new investment category in the form ofindex funds. In the case of Malaysia, both the number of sharia-based funds and the

net asset value of Malaysian Islamic funds have exhibited stronger growth than that ofthe conventional funds, so that at the beginning of 2009 over one-quarter of all funds(149 out of a total of 579 funds) and 17 per cent of assets were sharia-based (SecuritiesCommission Malaysia, www.sc.com.my).

A study by Ernst & Young (2008) compared the investment strategies ofthe Islamic investment funds in Malaysia and Saudi Arabia with those of globalconventional mutual funds. As well as highlighting the vast discrepancy in the numberof funds at that time (134, 120, and 61,000, respectively), the analysis suggests thatSaudi Arabian funds differ from the other two. Of the 252 registered funds inSaudi Arabia, 219 are mutual funds and the 120 Islamic mutual funds constitute55 per cent of the total. In terms of the portfolio composition, there is a much strongeremphasis in Saudi Arabia on equity investments (62 per cent of the total) than is the casein Malaysia (46 per cent) and also for the conventional funds (42 per cent). Indeed,the investment strategies in Malaysia appear to be closer to those found in theconventional fund industry[1].

2.2 Type of fundsThere are several types of Islamic investment funds including equity, ijara,commodity, real estate, murabaha, money market and mixed funds. These variousfunds embody very different patterns of returns. Ijara and murabaha funds offervirtually fixed returns being based on fixed leasing charges on capital equipment onhire purchase and cost-plus profit rates, respectively, while equities necessarily areexposed to greater market volatility in the short run and need to be seen as an

investment for the long-term. Funds which are specialized in real estate development(many structured as private equity) offer a different balance between risks and returnsagain. Hedge funds are becoming one prospective fund category in the industry,though there are disagreements on their permissibility and structure among the shariascholars (Morais, 2007).

Of the different types of Islamic investment funds, those involving equityinvestment comprise more than 50 per cent of the total funds (Eurekahedge, 2008). Thecurrent market trend shows there is expansion of these types of financial vehicles sincetheir development in the 1980s. They take a variety of forms such as global, regional,sector, country, hedge and index funds, e.g. the Dow Jones Islamic Market (DJIM) indexfund. Other funds may specialize in particular investments such as leasing ijara,murabaha, commodities or real estate in the form of Real Estate Investment Trusts

(REITs). Special funds may be launched for industry trading or to finance a specificproject for a specified period. There may also be open funds that are open to invest inall kinds of mixed Islamic portfolios such as murabaha, mudaraba, istisnaand Islamicdeposits (e.g. Al Baraka General Fund, Al-Amin)[2].

The Ernst & Young study cited above compared the target asset classes of issuedIslamic funds in 2002 and 2006. Equity fund issuance, although still dominant,has been joined by liquid instruments, including money market and commodity funds,while private equity and real estate have also expanded. Islamic money market funds


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comprise deposits and Islamic repurchase agreements (Repos with less than one yearmaturity). The Islamic-based instruments classified as fixed income are sukuk(Islamic bonds), which in the funds typically have a maturity more than one, and lessthan two, years. Clearly, then, there is now a considerable diversity of asset classes issued.

2.3 Attractions of Islamic investment fundsLike conventional investment funds, the Islamic investment funds bring a number ofpotential general benefits to investors (Al Tayar, 2006). These revolve aroundspecialized administration, gaining geographic and sectoral distribution of funds,a variety of maturities from short- to long-term, flexible withdrawal options, clear legalterms, conditions and responsibilities placed upon the sponsor, a balance between risksand returns, and specified investment objectives for the particular fund.

There are also some specific advantages gained by investors accessing Islamicinvestment funds as a market category. First, there is diversification across Islamicinvestments. The benefits of diversification are well known, and investment funds canachieve this for modest-sized portfolios. Islamic investment funds have the potential to

generate capital for different Islamic markets, with different growth performance andfinancial instruments, despite the apparent concentration at present in GCC economies.Second, Islamic funds can promote ethical and moral values in investment in the globalcapital markets and in Muslim countries world-wide. Third, there is the provisionof sharia supervision. Since each fund has its panel or board of sharia scholars,the funds serve as a vehicle for organizing and harnessing religious supervision toguide investment decisions and portfolio offerings.

2.4 Fundamental requirements for Islamic acceptabilityIslamic scholars advising the Islamic investment industry have generally followed thesharia principle ofmuamalat(the field of pecuniary transactions), dealing with humanrelationships and contractual arrangements as opposed to ibadat which define therelationship between God and his creatures. In simple terms, the principle treatseverything as permitted unless it is explicitly prohibited. If followed through,transactions such as private equity and venture capital may be considered as perfectlyacceptable modes of transacting so long as they meet certain Islamic principles(Yunis, 2006).

Essentially, two fundamental conditions must be adhered to by Islamic investmentfunds. First, the underlying or ultimate asset, which is the subject of the investment,must be acceptable and halal. For instance, in a real-estate investment fund, theoccupiers of the real estate must conduct sharia-compliant business or something thatis not inherently haram. Also, rules must be followed as to the proportion of incomefrom a real estate asset that can be haram and that will not taint the underlyinginvestment. Second, the proposed structure itself needs to be acceptable from asharia-compliant viewpoint, in a number of respects:

. Funds must be invested in a vehicle that has been structured in a sharia-compliantmanner based on tangible assets and not speculative in nature (gharar).

. The constitution of the investment vehicle must prohibit haram activities.

. The activities of the directors and officers need to be acceptable and theiractivities conducted in a sharia-compliant manner. This requirement, however,is much broader than is generally interpreted, as is now explained.

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3. Principles of sharia-compliance3.1 Positive and negative aspectsThere are positive and negative injunctions to be followed. The negative injunctionsrelate to the things that must be excluded from Islamic investment funds (in fact, from

all forms of Islamic finance). General prohibitions on immoral activities such asdishonesty, bukhl(miserliness), israf(extravagance), hirs (greed) and iktinaz (hoarding)coalesce with specific provisions that are clearly specified in the Holy Quran andSunnah. Four well known prohibitions apply to Islamic financing. These relate to:

(1) elements of interest (riba);

(2) uncertainty (gharar);

(3) gambling (maysir); and

(4) prohibition of certain goods (such as alcohol and pork).

Less well-publicized are the positive principles that ought to (and desirably, should)

feature in Islamic economic and commercial activities. These are obligations both tohumanity and society and also to humanity and the environment, along withdecision-making rules. The first grouping refers to doctrines that must be incorporatedinto business activities by the participants, for example, buyers, sellers, suppliers anddistributors. Ethics, according to Beekun (1997), are a set of moral principles thatdifferentiate between what is right and what is wrong, and thus guide Muslims intheir daily activities. Most Islamic concepts and precepts in the Holy Quran and theSunnah of the Prophet Muhammad carry positive connotations for Muslims lives andshape their relationships with society and the environment. Justice, honesty, prudenceand moderation are among elements that must be embedded in a Muslims character,and thus be reflected in an individuals activities. Maintaining life in balance and

moderation is encouraged in Islam. Having wealth is permitted so long as it does notbecome all-consuming and deflect Muslims from their responsibilities towards theIslamic community (ummah). The God-given resources and wealth in this world are tobe shared, to ensure that all brothers can at least have the basic necessities. Chapra(1992, 1993, 2000), for example, emphasized the motivation of Muslims to strive foral-falah in the hereafter, evidenced in their moderate lifestyle, and so help the needy.Such broader social and communal objectives, it may be recalled, were prominentamongst those providing the intellectual basis for Islamic banking and finance in theformative years (Ahmad, 1980). Certainly, the encouragement of justice, an equitabledistribution of wealth and brotherhood, can be seen in the obligations of Muslimstowards their brothers and sisters. Several methods are employed in promoting justiceand a fair distribution of wealth in society, and these include zakat (tax levy to purify

wealth) and sadaqah (voluntary almsgiving) as mechanisms of wealth distribution andsocial welfare.

Environmental concerns and the priority of conservation activities are recognisedtoo in Islamic teachings. Humans are considered an integral part of the environment,and this feature is exemplified in the requirement that people maintain a jointrelationship with members of the community and the environment to serve the DivineWill. That there is a special relationship between humans and their environment isclearly articulated in the Holy Quran:


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There is not an animal (that lives) on earth, nor a being that flies on its wings, but (forms partof) communities like you. Nothing have we omitted from the Book, and they (all) shall begathered to their Lord in the end (Al Anam 6:38)[3].

Islam holds that all resources and wealth are owned by God, and merely held in trustby people. In parallel, the environment is presented to humans so that they can learnfrom its creation, and utilise it for their own life and society in such a way as to realizethe blessings from God (Al-Qaradawi, 1998). Further, the environment serves as avaluable test of worship towards God, as elaborated by Khalid (2002, p. 337) in thefollowing terms:

The Quranic view holds that everything on the earth was created for humankind. It wasGods gift (nimah) to us, but a gift with conditions nevertheless and it is decidedly notsomething that one runs and plays with. The earth then is a testing ground of the humanspecies. The tests are a measure of our acts of worship (ihsan) in its broadest sense. That isliving in a way that is pleasing to Allah; striving in everything we do to maintain theharmony of inner and outer environments.

As a corollary, given amanah (trusteeship), humans as viceregents (khalifah) are expectedto take care of the environment and preserve it for future generations. Construction andmanufacturing, agriculture and the production of goods must be conducted in aresponsible way that does not exploit and degrade the environment (Hamed, 1993).

Thus, the concept of trusteeship underpins the inter-relationships betweenhumanity, society and the environment. Economic, financial and natural resources areheld in trust from God, and mankind is accountable to God and the community for theuse that is made of them. A further consideration is that decision making about howresources are to be employed is also an important trust from God, and the Holy Quranmandates that this process be undertaken on the basis of mutual consultation (shura)with all involved parties (Iqbal and Lewis, 2009). Shura describes a decision making

process with the involvement of many parties to achieve consensus and agreement,and as such is seen in the Holy Quran as the ideal way in which a good person shouldundertake affairs:

Those who hearken to their Lord, and establish regular prayer; who conduct their affairs bymutual Consultation (Al Shura, 42:38).

As a means of governance and management, shura should be adopted and adaptedwith the guidance of Islamic sources for investment practices. A necessary counterpartis supervision, follow-up and monitoring as embodied in the concept of hisba (Lewis,2005). There are in all, three levels of monitoring and supervision in Islam. The first isimposed by God, the second is self-controlling, and the third is externally controlled.Muslims believe that they are monitored and controlled by God in every aspect, and

thus the first level of control directs Muslims to behave in a manner consistent withIslamic teachings (Hamed, 1993). In contrast to internal control, external control by thecommunity is to ensure that those given authority do not depart from Islamicprinciples. In this case, hisba plays a significant role as an external controllingmechanism, empowering Muslims individually to act as private prosecutors orenforcers of Islamic standards (Schacht, 1964, p. 52). In effect, hisba as a supervisoryconcept seeks to prevent people in whom trust is vested from deviating from Islamicguidelines and encourages them to follow Islamic precepts (Muhamed, 2009).

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In summary, the positive principles guiding Islamic investment are:. Promotion of justice (adl) and honesty and trust (amanah).. Involvement in decision-making and governance (shura)..

Supervision, follow-up and monitoring (hisba).. Purification of wealth (zakat) and voluntary almsgiving (sadaqah).. Brotherhood and the advancement of the Islamic community (ummah).. Protection of nature and the environment.

The upshot of these positive elements is that Muslims cannot be disinterestedinvestors, buying and selling shares and making investments without knowledge ofthe underlying business activities. By implication, since many individuals invest theirsavings through institutional investment vehicles, the fund managers must performthese roles on behalf of the capital providers by monitoring activities, engaging withinvestee companies, and contributing to the enhancement of social welfare and the

environment. Some do, but most do not. Instead, they simply observe the negativestipulations regarding riba, gharar, maysir and haram activities. The reasons can betraced in part to a lack of appreciation and understanding of the positive aspects inthe Islamic agenda, but are mainly due to the practicalities of the investment universe.

3.2 Screening and cleansing for equitiesOver 50 per cent of Islamic investment funds are equities mutual funds or unit trusts(Eurekahedge, 2008). If such funds were confined to listed Islamic corporations thenumber of funds would be a small fraction of those on offer. In order to gain a widerange of investments, necessary for diversification and liquidity, most investmentneeds to take place through the major global and regional exchanges. However, thereality is that almost all the companies quoted on current stock markets are in some

way engaged in an activity which violates the injunctions of sharia. Accordingly, amajor question from the Islamic point of view is whether investments in internationalequity markets are acceptable under sharia (Hasan, 1995). There is no doubt thatdealing in the supply, manufacture or service of things prohibited by Islam (haram),such as riba, pork meat, alcohol, gambling and so on cannot be acceptable.Nevertheless, companies that are not involved in such haram activities could beconsidered acceptable. The main objection against them is that in their own internalaccounting and financial dealings they lend and borrow from riba banks and otherinstitutions, but the fact remains that their main business operations do not involveprohibited activities. Essentially, non-Muslim entities cannot be expected to workunder the Islamic code of conduct, and in any case only a negligible amount of interestmay be involved. Can such activities ever be considered Islamic?

This question has led to an extensive debate amongst sharia experts (Usmani, 2001).Some argue that it is not allowable for a Muslim to deal in the shares of such a company,even if its main business is halal. Their basic argument is that every shareholder of acompany is a sharik (partner) of the company, and every sharik, according to Islamicjurisprudence, is an agent for the other partners in the matters of the joint business, andby implication would be giving consent to non-Islamic transactions. Other shariascholars, who are nowin the majority, do not endorse this view. They contend that a jointstock company is basically different from a simple partnership. Being composed of


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a large number of shareholders, a company cannot give veto power to each shareholder,as would occur in a partnership. Consequently, if a company is engaged in a halalbusiness, but also keeps its surplus money in an interest-bearing account, from which asmall incidental interest income is received, this fact does not render all of the business of

the company unlawful. In this case, where income from the interest-bearing activitiesand accounts is incorporated, the proportion of such income in the dividend paid to theIslamic shareholders must be given by them to charity. For example, if 5 per cent ofthe whole income of a company has come out of interest-bearing returns, 5 per cent of thedividend must be given in charity. This process is known as purification. However,it must be preceded by screening of the relevant companys business activities.

Quite clearly, ascertaining such information could be costly for an individual fund,but has been made less so by the creation in February 1999 of the DJIM, launched inBahrain, the Kuala Lumpur Stock Exchange Syariah Index introduced on 17 April1999 to coincide with the new Hijrah year 1420, and of the FTSE Global Islamic IndexSeries in November, 1999. In the case of the DJIM, for example, the screening proceedsbroadly as follows in two stages. First, the primary business of the company must behalal (permissible), therefore business involving, among other forbidden practices,conventional banking, alcohol, tobacco, weapons, pork, gambling and providers ofentertainment services (hotels, casinos and cinema) are not acceptable. Second,financial screens are then applied to screen out companies with unacceptable financialratios:

. companies for which total debt divided by trailing 12 month average marketcapitalization is 33 per cent or more;

. companies for which cash plus interest-bearing securities divided by trailing12 month average market capitalization is 33 per cent or more; and

. companies for which accounts receivables divided by 12 month average marketcapitalization is 33 per cent or more.

Then, there is reported a dividend cleansing/impure income figure. Here, tainteddividend receipts relate to the portion, if any, of a dividend paid by a constituentcompany that has been determined to be attributable to activities that are not inaccordance with sharia principles and therefore should be donated to a proper charityor charities. Such cleansing cannot be counted as part ofzakatobligations. In this andother matters, the index compilers are advised by sharia scholars.

Nevertheless, significant differences remain amongst the sharia scholars in twomain respects. First, there are differences of opinion about purification, in particularthe scholars differ about whether the purification is necessary where the profits aremade through capital gains (i.e. by purchasing the shares at a lower price and sellingthem at a higher price). Some scholars are of the view that even in the case of capitalgains, the process of purification is necessary, because the market price of the sharemay reflect an element of interest included in the assets of the company. The otherview is that no purification is required if the share is sold, even if it results in a capitalgain. The reason is that no specific amount of the price can be allocated for the interestreceived by the company (Usmani, 2001).

Second, there are differences in the screening procedures between the three majorindices, as set out in Table I. In general, in terms of the screening of equity, SecuritiesCommission Malaysia has been seen as utilising the most lenient approach in the case

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DJI

FTSE

SEC

Dimension

Criteria

Excluded

%

Excluded

%E

xcluded

%

Industry

Alcohol

p

p

p

screen

Tobacco

p

p

p

Pork-relatedproducts

p

p

p

Conventionalfinancialservices

Financialservicesbasedonriba/

interest

p

p

p

a

Levelof

tolerence

Conventionalinsurance

p

p

Lifeinsura

nce

p

Stockbrok

ingorsharetradingin

Syariah:non-compliantsecurities

p

a

Levelof

tolerence

Weaponsanddefense

p

p

Entertainm

ent:non-permissible

entertainm

entactivities

Hotel

p

p

a

Levelof

tolerence

Casino/gam

bling

p

p

p

Gaming

p

p

Cinema

p

Pornograp

hy

p

Music

p

Companiessignificantlyaffectedby

above

p

Otheractivitiesdeemednon-

permissiblebySyariah

p

Financialratio

screen

Totaldebt

Interestbearingdebtfinancial

instrument

p p

Ratio:(.33%)from

mrktcap.

Ratio:(.33%)from

mrktcap

p

p

Contributionofinterestincome

receivedb

ycompanyfrom

conventionalfixeddeposit

p

Ratio:(.33%)from

mrktcap.

p

Dividendreceivedfrominvestmentin

Syariahnon-compliantsecurities

p

Note:

a

TherearethreedifferenttolerancebenchmarksthathavebeenusedbySecuritiesCommission,Ma

laysia,suchas5,10and25percent

Source:Muhamed(2009)

Table I.Screening criteriaadopted by three

organisations as the basisfor the selection of the

sharia compliance equity


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of companies with mixed business, as compared to the Dow Jones indices that use amore strict approach. Securities Commission Malaysia, for example, provides threedifferent tolerance benchmarks: 5, 10 and 25 per cent on mixed activities of investeecompanies, depending on the companies image. According to Securities Commission

Malaysia, the hotel industry when part of a mixed business is permissible based ontheir 25 per cent benchmark, for the reason that it provides maslahah (good deeds) tothe public. Despite what may seem to some such anomalies, it does seem more likelythat a higher proportion of Malaysian companies operating in the Malaysian contextwill be sharia-compliant relative to companies that operate in Western markets. Thisexpectation is supported by the numbers. As at the end of 2008, 855 stocks in Malaysia(87 per cent of total listed stocks), accounting for 64 per cent of market capitalisation),were classified as sharia-compliant (Securities Commission Malaysia, 2009a).

In terms of the selection and screening procedures for stocks, there are some obviousparallels between the methods used to ensure compliance with sharia principlesand the procedures undertaken in the socially responsible Western investment funds.A comparison is now made of Islamic and Western ethical investment models.

4. Islamic and Western ethical investment comparedWhen considering the nature of the principles to be applied for screening forsharia-compliance, a distinction was drawn between negative and positive criteria. Thesame distinction holds for Western investment funds, although the Western funds havemoved much further than Islamic funds from an emphasis on the negative to focusing onthe positive elements (Bivell, 2008). This development took place in three stages.

When SRI began in the West, it too, like the Islamic funds, focused on the negative.Some origins of ethical investment can be traced to the nineteenth century with Quakerand Methodist religious investors seeking to avoid investing in weapons production,and alcohol, tobacco or gambling, but the movement took shape in a formal sense in the

1970s and 1980s (Knowles, 2000). Essentially, ethical investment revolves aroundnegative screening, and the filtering out of investments seen to be harmful andinconsistent with the investors or fund managers values. Those activities mostcommonly screened out are tobacco, alcohol, armaments, human rights abuses, animalcruelty and pollution.

Next to emerge was the concept of environmental investment, based on identifyingactivities and practices that are beneficial to the environment. In Australia, forexample, the Environmental Investment Directory was initially published in 1992 andprovided the first publicly released listing of environmentally positive investments(Bivell, 2008). Based on positive screening, the environmental investment movementactively seeks out investment opportunities in sectors that have a positive impact onthe economy, the environment and other relevant areas of society by investing in

activities such as clean technology and clean energy.Sustainability investment was the third development and it arose in the late 1990s

and early 2000s, coinciding with the growing use of sustainability reporting.Sometimes called best-of-breed or best-of-class investing, sustainability investmentendeavours to identify and select those enterprises that are the most sustainable intheir industry. Quantitative and qualitative measures are employed to determinethe organizations environmental, social governance (ESG) or ethical performance,using criteria such as adherence to good corporate governance principles, use of

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resources, treatment of staff, approach to customers and suppliers and engagementwith and contribution to the community. These factors are often summarized by theacronyms ESG and corporate social responsibility, although all three approaches(ethical, environmental and sustainability) embody a concern for environmental

outcomes, albeit with different emphases.A comparison of the Islamic equity funds and the SRI funds reveals a vast canvas of

fund categories and types. Nevertheless, in broad terms, some differences are discerniblein terms of portfolios, performance, client base and governance principles (De Anca, 2010).

PortfoliosIf the FTSE Shariah All World Index and the FTSE 4GOOD Global Index are used,respectively, as representative of the Islamic and SRI equity fund portfolios, a numberof differences emerge. Since the Islamic funds tend to avoid those institutions andenterprises for which interest-based finance is the principal or main activity, the weightof the financials in the Islamic funds is low relative to SRI funds (although some ofthese exclude banks because of concerns about third world debt). On the other hand,

SRI funds give a low weight to oil and gas, basic and industrial materials andthese sectors are screened out of many SRI funds. Where the Islamic and SRI fundsoverlap is that both invest extensively in consumer services, technologies andtelecommunications on the grounds that these are not heavily polluting (SRI) and haveonly a minor involvement in interest or haram activities (Islamic).

PerformanceFigure 1 compares the two FTSE indices, representing Islamic and SRI funds, from2003 to 2008. In general, the two indices perform similarly over the 2003-2006 periodbut begin to diverge considerably in 2007 and 2008 when the different compositionstarts to exert an influence. In particular, the Islamic index benefited from thehigh weighting given to the oil and gas sector, with the rise in oil prices to a peak of$145.29 per barrel in July 2008, and also from the low weighting of financials in view ofthe collapse of banking stocks that began in 2007 and gathered pace in 2008.

Figure 1.A comparison of the

performance of FTSEIslamic and SRI funds,

2003-2008

240

220

200

180

160

140

120

100

80

30-Se

p-03

27-Fe

b-04

30-Ju

l-04

31-D

ec-04

31-M

ay-05

31-O

ct-05

31-M

ar-06

31-A

ug-06

31-Ja

n-07

29-Ju

n-07

30-N

ov-07

30-A

pr-08

FTSE Shariah all-world index

FTSE4 Good global index

Source: Based on DeAnca (2010)


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Client profileEarlier, the distribution of clients of Islamic investment funds was reported. Notably,Saudi Arabia and offshore locations provided over 40 per cent of the clientele. Many ofthese are thought to be large-scale investments (IFSL, 2008). By contrast, the SRI funds

attract monies from NGOs, charities and public institutions (many of which are smallscale), and also rely on small investments from a retail base, with some funds acceptingminimum investments of around $1,000 (www.uksif.org/).

GovernanceIslamic investment funds must be advised by a sharia authority to determine thelegitimacy of investments in accordance withsharia. In Malaysia, for example, an Islamicunit trust requires a sharia adviser to certify that the fund complies with shariarequirements. Sharia advisersmust be registered with the SecuritiesCommission, andaresubject to oversight by the Shariah Advisory Council of the Securities Commission, whichadvises on sharia compliance and screens listed companies for sharia-compliance(Securities Commission Malaysia, 2009b). SRIs have less formal arrangements. They relyon professional SRI organizations for external advice (Statman, 2007) and have a boardcomprising professionals, academics, NGO activists and business people determining SRIprinciples according to the client base of the fund.

5. Future directions for the governance of Islamic fundsThe major challenge facing the Islamic investment fund industry comes from its size.Earlier, it was estimated that the industry accounts for less than 10 per cent of theIslamic financial industry. In the two major markets of Saudi Arabia and Malaysia,Islamic funds account for 55 and 26 per cent, respectively, of the fund market.However, elsewhere the 650 global Islamic investment funds are dwarfed by the61,000 conventional mutual funds that have a substantial market presence and have

well-established marketing channels. How can the Islamic funds raise their profile andenhance their global reach?

Writing in 2006, Smyth (2006) of Failaka International saw the need to improveinvestor education and address issues of transparency. He recommended theassignment of ratings to funds in order to enable professional advisors to recommendfunds based on a recognized and consistent standard. To this end, Failaka has sincedeveloped and offers to its subscribers the following range of subscription-only services:

. an online database of sharia-compliant investment funds;

. research-based advisory services including fund manager due diligence;

. sharia advisory services offering fund managers and institutional investorsaccess to its sharia board;

. a guide to sharia scholars; and

. Annual International Islamic fund awards, giving recognition to the bestperforming funds and fund managers.

Muhamed and Lewis (2008) argued that the funds themselves can do much to gain theconfidence of investors by improving disclosure of fund information, providinginvestors with information as to how investments are selected and how the fund ismanaged, setting out clearly the remuneration and fee structure, and by making

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information readily accessible through, for example, well-designed, informative websites. Each fund should have a clear statement of investment objectives, information onasset allocation, the degree of geographic and sector representation, investmentopportunities and give regular reports on fund financial performance.

A different suggestion is added here and that is to follow down the route taken bythe SRI funds. Islamic investment funds can borrow from their conventional SRIcounterparts and move away from reliance on the negatives (the prohibitions) andemphasize the positive elements in investment selection. Nowadays, SRI boards focusincreasingly on positive criteria and how to foster certain companies to becomebest-of-breed performers in the sector. Notably, those funds that signed up to the UNPrinciples of Responsible Investment have undertaken to incorporate ESG investingissues into analysis and decision-making processes, be active owners and seekappropriate disclosure from entities in which they invest (Negline, 2009).

Such an emphasis amongst Islamic funds would be consistent with the requirementsin the Holy Quran and Sunnah regarding mutual consultation (shura) and concerns forprotection of nature and the environment. Of course, one would not expect the Islamicfunds slavishly to follow their Western counterparts. Islamic investment has its ownvalues and objectives following Islamic teachings, and has different foundations to theconventional Western investment style. Islam brings its own principles that promoteequity, justice, social welfare and brotherhood, which should find reflection ininvestment activities. In particular, wealth and property do not belong absolutely tohumans, since they are gifts from God, and thus must be held in trust and sharedand preserved. The ummah and the environment become important parties thatshould be taken care of by these investors. Benevolence, altruism and a sense ofbrotherhood are important elements that should exist in every individual Muslim.This strong foundation shapes Muslims behaviour across all activities, includinginvestment.

Nevertheless, if this distinctive set of values is to be put in place, significant changesare needed in the Islamic investment fund industry. An investment selection processbased only on the negative elements is not sufficient, as it does not encompass all of theIslamic principles. Prohibitions ofriba, gharar, maysirand certain goods such as alcoholand pork must remain in place, but need to be extended to other aspects. Inclusion ofenvironmental as well as social elements as integral components of the assessmentcriteria can be seen as the best way to preserve the benefit of all relevant stakeholders.Indeed, from this perspective the environment ought to be regarded as a stakeholder(representing the interests of future generations), and the preservation of its rights anobligation of Muslims to rank alongside those commitments to the present community.Neglecting such a responsibility suggests thanklessness of Gods bequest to humans(Kamla et al., 2006). Although Islam accepts (in fact encourages) private property and

ownership, owners of property in their roles as vice-regents must use the resources withresponsibility towards others in society and the environment (Zinkin and Williams,2006). For example, it is unacceptable if investments by Islamic investment funds andother institutional investors are made in companies that are involved in environmentalpollution or that bring damage to society.

Individual investors, however, can only do so much. One suggestion is thatfund managers and institutional investors strengthen their roles in relation toinvestee companies on behalf of their investors (fund holders), stakeholders and other


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minority investors of investee companies (Muhamed, 2009). The institution ofhisba canin this guise be revived and extended to the context of supervising and monitoringinvestee companies by the Islamic investment funds on behalf of their investorsand stakeholders. Rather than exercising the exit strategy as widely practised in

the mainstream approach, in which the holding of shares is deemed as buyingtransactions, these funds might be expected instead to monitor and supervise theinvestee companies continually to ensure that these companies are following Islamicprinciples. As such, monitoring and supervising of the investee companies needs to beconducted not only with respect to the performance of the share values and strictlyfinancial benefits, but also expanded to embrace features of the governance structuresand compliance with Islamic principles.

There are already some developments underway. In 2006, the family of 70 regional,country and industry indices derived from the DJIM World Index was expanded toinclude the DJIM Sustainability Index, which combines Islamic investing principleswith sustainability criteria. In May 2009, an Islamic green fund was launched by the

UK Islamic Bank Gatehouse (owned by the Kuwait investment company SecuritiesHouse) and the Swiss Fund Management Company Sustainable Asset Management(SAM), following in the footsteps of the first ever fund combining ethical and Islamicprinciples issued in April 2009 by F&C Asset Management and BMB Islamic. The newfund is described as the first sharia-compliant water-focused investment strategyfund. In the remit, SAM identifies companies that meet the investment criteria forsustainability and have an exposure to water in terms of technologies, products andservices throughout the value chain of the water industry. Gatehouse then screensthose companies for sharia-compliance in terms of the usual interest income andfinancial ratios (Islamic Finance News, 2009, p. 16).

There seems every likelihood that such initiatives will herald a new direction forIslamic funds. Gatehouse argues as follows:

Successful Islamic investment products will be those that not only meet the financial andactivity-based screens for Shariah investments, but also whose entire approach to investing isbased on adhering to wider principles of Islam such as concern for the environment, access tobasic resources and sustainability in general (Islamic Finance News, 2009).

Going down the environmental path is an obvious direction for Islamic funds to take towiden their global appeal. It is also completely in accord with Islamic principles.However, the real challenge will be to extend this list to embrace other positives in theIslamic agenda, such as the promotion of justice, active supervision and monitoring,involvement in decision making, and brotherhood and the advancement of Muslimcommunities, areas that so far remain unexplored.

Notes

1. More complete details of Islamic investment funds summarized here are given in Lewis (2010).

2. The various Islamic financing instruments including ijara, murabaha, mudaraba andistisnaa are described in Lewis and Algaoud (2001).

3. The verses from the Holy Quran are drawn from The Holy Quran (1998).

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About the authorMervyn K. Lewis is a Professor of Banking and Finance, in the School of Commerce of theUniversity of South Australia, at the City West Campus, Adelaide, Australia. Before joining theUniversity of South Australia in 1996, he was for 12 years, Midland Bank Professor of Money

and Banking at the University of Nottingham. In 1986, he was elected a Fellow of the Academy ofthe Social Sciences in Australia. As well as being Visiting Professor at a number of universities,in April 2009, he was inaugural Securities Commission Malaysia-University of Malaya VisitingScholar in Islamic finance. He has published 21 books, 65 articles and 76 book chapters. His lastvolume is An Islamic Perspective on Governance, co-authored with Z. Iqbal (Edward Elgar, 2009).Mervyn K. Lewis can be contacted at: [email protected]


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