CHAPTER 6
Mitigating the Myths
The Benefits of Islamic Funds for the Broader Investor Base
And We have not sent thee save as a bringer of good tidings and a warner unto all mankind.
(Saba: 28)10
INTRODUCTION
When I was a speaker at an Islamic finance conference in Vienna, Austria, in February 2012, a middle-aged European participant provoked me with the following view: “I am not comfortable with all the exclusionary screening in Islamic investing and I believe that the smaller investible universe will result in performance drag on my investment portfolio.”
My response to him was to pose a choice. “You have two portfolio that exhibits higher stability, although it is, both granting the same performance return. One is constructed from a smaller investment universe that exhibits higher stability, and the other is constructed from a larger universe that exhibits less stability. Which one would you choose?”
He paused and answered, “I would choose the portfolio that exhibits higher stability, although it is constructed from the smaller investment universe.”
This is an example of the types of misconceptions about Islamic investing that need to be debunked in order for Islamic investment funds to be accepted by everyone.
Now that investors are aware of the wide choice of Shariah investment products available in the market, they should learn to appreciate the benefits that come along with Shariah investing. Making decision to invest in Shariah investment products can be challenging if investors are unaware of the ancillary benefits. Considering most of these investors have only had the experience of investing conventionally, myths and misconceptions exist about the Islamic investment proposition that need to be clarified.
Naturally, education efforts and creating awareness on the benefits of investing in these products is a necessity. In this chapter, we are sharing with you not only the benefits of Shariah funds but also the truth regarding most of the misconceptions about the Shariah investing approach. Helping to increase the level of awareness for the past eight years, active industry leaders have organized international events to ensure consistent understanding by market players. Some notable events are the Global Islamic Funds Forum in Malaysia, the World Islamic Funds Conference in Bahrain, the International Takaful Summit in the United Kingdom, and the Islamic Finance News Issuers & Investors Forum in Europe, Southeast Asia, Australia, and the GCC.
Islamic investing results in a portfolio that grants value and stability with comparable returns to those of conventional investing. Due to the securities screening process, the Islamic investing approach results in a smaller investible universe that exhibits lower volatility. The conventional investing approach results in a larger investible universe but can still exhibit higher volatility. The key difference is the risk-return characteristics where the Islamic equity portfolio exhibits a more stable performance despite its smaller investible universe. This is compared to the conventional portfolio whose performance may be less stable, despite its larger investible universe. In a situation where the same return on investment can be achieved, which investment approach is preferable?
There has also been articulation by investors that the asset classes made available to the investors are not as broad and deep as what is made available to them in the conventional investment space. This concern could be the result of lack of visibility of the track record of these investment products by virtue that the various asset classes are structured using home-based currencies for their domestic sandbox.
ISLAMIC PRINCIPLES COME WITH BUILT-IN FINANCIAL ETHICS
Islamic investing is based on an ethical investing approach. Islamic securities incorporate financial ethics to create an investment alternative that is a manifestation of the shift from a free market to a fair market. This shift came about as a result of the 2008 global financial crisis, which was caused by an element of greed among market players who distributed complex and opaque investment products that investors found hard to understand.
Islamic investing practices fair distribution of wealth through the sharing of profit and loss among contracting parties. This sharing inhibits profiteering and mitigates overly greedy behavior, which is deemed unacceptable by the Judeo-Christian-Islamic value system, which highlights the importance of dealing with justice to all contracting parties in a transaction. This is in line with the guidance of Mahatma Gandhi, who said, “Earth provides enough to satisfy every man’s need but not for every man’s greed.”1
Islamic securities are structured based on tangible and asset-based transactions. This ensures that Islamic investing derives from real economic activities. This makes good investment sense for those who demand built-in financial ethics in their investment solutions.
THE MYTHS OF SHARIAH INVESTING
It makes sense to first clarify and dispel the various misconceptions of Shariah investing before discussing the inherent benefits. The misconceptions fall into two categories: the broader, more encompassing level of Shariah principles and the more specific portfolio characteristics of this investment approach.
Myth 1: Shariah Investment Is for Muslims Only
Shariah-compliant investment products are not only for Muslims, as evidenced by examples in Asia and the United States. In Malaysia, the CIMB Islamic Commodities Structured Funds 1 and 2 garnered 57 percent non-Muslim investors during its initial offer period. In the United States, Saturna Asset Management, a Shariah investment manager based in Bellingham, Washington, disclosed that most of its AUM for its Amana Global Equity Fund is from non-Muslim investors.2
It is also a matter of shifting perception. For example, if a person walks into any McDonald’s restaurant anywhere in Malaysia, the first thing that comes to mind is that this is a fast-food restaurant. It does not occur to a non-Muslim customer that he should not eat there because this is a halal (permissible under Islam) restaurant and therefore is only meant for Muslim customers. It serves burgers just like any other fast-food restaurant, only the burgers happen to be halal.
Similarly, when it comes to investing, non-Muslim investors should view Islamic investment products the same way: investment solutions that just happen to be Shariah compliant. At the same time, Muslim investors can invest in these solutions because they can be assured that they are meeting the requirements of Shariah principles. Therefore the correct perception should be that Shariah investing is available to everyone, Muslim or not.
Myth 2: Shariah Investing Is More Costly
The requirement to have a Shariah adviser leads to the misconception that Shariah investment products are more costly to produce and invest in. This cost is usually absorbed by the investment manager at its discretion in order to successfully compete with conventional investment products.
The concern by investors that they have to also pay for the additional cost of structuring the underlying securities (i.e., Sukuk) is untrue. The costs for structuring the underlying securities are absorbed by the issuer at the origination level, similar to how it works for conventional investment products and their underlying securities. As such, from the investor perspective, they do not have to pay for this additional cost. They are paying the market price for Shariah investment products, which is offered based on market demand and supply, the same as conventional investment products.
There is also the impression that the ancillary costs that come with managing a Shariah investment product will make it expensive for the investor. This includes the Shariah adviser, lawyers with Shariah expertise, as well as qualified professionals with Islamic investment expertise, all of which are in limited supply. This is untrue because the investment managers have demonstrated their commitment to absorb these expenses as the cost of doing business. This is measured by the total expense ratio (TER) of the fund, which measures the total costs associated with managing and operating an investment fund. These costs are not passed down to the investors, in order to offer competitive pricing. In terms of investment management fees, an analysis of the 26 Islamic funds on the UCITS platform in both Dublin and Luxembourg shows that management fees chargeable to these funds range from 150 basis points to 225 basis points, just like those of conventional funds available on the UCITS platform.
Therefore, the fees charged are comparable to those of conventional investment products. There is no premium charged for Shariah governance.
Myth 3: Limited Number of Investment Managers and Expertise
The limited number of investment managers has instilled the perception that Islamic investment products are unable to offer a spectrum of asset classes that will meet the asset allocation strategy of investors. The Amanie-Failaka Symposium 2010 & 5th Annual Failaka Islamic Fund Awards in Dubai showcased investment managers from Canada, Australia, Russia, Switzerland, South Africa, the United States, Southeast Asia, and the Middle East who offered Islamic products that invest in equity, Sukuk, commodity, and real estate asset classes both via traditional and alternative strategies like hedge funds.3
Case in point: in 2008 Barclays Capital developed and launched Al Safi in partnership with Shariah Capital and the Dubai Multi Commodities Centre Authority (DMCC), an agency of the Dubai government. At the time of the launch the DMCC committed to seed the first commodity hedge fund managers on Al Safi with USD50 million each, a total of USD200 million.4
While the numbers of Islamic investment managers are few compared to the conventional investment industry, there is a broad enough variety of Islamic investment products and asset classes available in the market.
Myth 4: Lack of Standardization of Shariah Interpretation
In the sphere of translating Shariah principles into practice, standardization occurs on two levels: Shariah interpretation and Shariah policies and procedures.
Islam is derived from one divine source, which is the Qur’an and Sunnah. However, the application of Shariah principles that relate to doing business and commerce differ due to the variation in interpretation. There are four different schools of thought, or mazhabs, which were introduced by different imams, or scholars, in four different time periods in different regions. As a result, the practice of Shariah principles naturally varies across different jurisdictions. Therefore, the aim should be for harmonization of the Shariah interpretations, as opposed to standardizing to one mazhab internationally.
It is quite straightforward to standardize processes and put them into practice when it comes to policies and procedures for Shariah-compliant securities and investment solutions. As a result, there is a higher level of standardization for Shariah-compliant investment processes versus those of other ethical investment solutions—that is, socially responsible investment (SRI). The Shariah investment process is standardized and institutionalized, and its ultimate intention is aligned with SRI, whereas in general, SRI guidelines can vary greatly. For example, an SRI investment process could weigh environmental, social, ethical, and governance factors differently according to the individual mandate. Therefore, the Shariah investment process can provide a welcome standardized approach to ethical investing.
Myth 5: Sukuk Investing Means Legal Ownership
Similar to the conventional bond structure, a Sukuk can be structured with underlying assets as collateral. In such a situation, the investors will then have actual legal ownership of the asset. In the event of a default, these investors can claim on their respective rights and interests.
There has been a mistaken assumption that Shariah investing always results in the legal ownership of assets. However, Sukuk structures are predominantly structured such that the investor has a beneficial ownership of the underlying assets, not legal ownership. Beneficial ownership means the investor has rights to the potential income derived from the usage of the asset without actual legal ownership of the asset.
Myth 6: Islamic Products Are Too Complicated
Many investors carry a misconception that the products are too complicated. The thoroughness of Shariah investing is misunderstood as a complexity. The equity screening and the asset-backing with profit and loss sharing substitutes to debt financing are the virtues of Shariah investing. The equity screening is done in two stages, the business screening and the financial screening. The former ensures that the investments in goods and services that are prohibited by Shariah are excluded. The next stage further excludes the stocks with high debt, high receivables, and idle cash reserves. This ensures stability of investments with a moral dimension. Similarly, the profit-and-loss-sharing nature of Sukuk eliminates the rigidity of debt contracts, which provides no flexibility to the borrowers. Sukuk proceeds are used for real economic activities that, again, confer social benefits and productive use of money. Nevertheless, the screening ensures that the investments are stable and prohibit excessive risk taking.
“Truth is by nature self-evident. As soon as you remove the cobwebs of ignorance that surround it, it shines clear.”—Mahatma Gandhi5
Myth 7: Investment Performance Drag Due to a Smaller Investment Universe
Now that the broader myths have been addressed, let us examine the specific myths pertaining to the different characteristics of this investment approach. When it comes to Shariah investing, the overarching misconception is that the many restrictions in the investing process will result in a drag in performance. First, the assumption that there are many restrictions is untrue. Second, the restrictions are more prescriptive of an alternative investment approach and process that results in a more stable portfolio. The individual aspects that result in this myth will now be addressed.
One of the assumptions is that Shariah screening results in a smaller investible universe. This limits the selection pool. What investors do not realize is that the qualitative and quantitative screening aspects are there to produce a more stable portfolio.
The qualitative and quantitative screening process for permissible securities still results in a large enough pool from which one can construct a sound and diversified portfolio, which averages 150 to 200 constituents. In addition, quantitative screening provides an embedded risk management overlay at the portfolio level. This screening, via the application of three financial ratios based on debt, receivables, and cash, results in a more financially sound pool of constituents to select from.
If one were to construct a global Islamic equity portfolio from components of the Dow Jones Islamic World Index, one can select from a broad universe of 2,413 components with an impressive market capitalization value of USD18.35 trillion.6 The Dow Jones Islamic Market Asia/Pacific Index has 1,146 components and a substantial market capitalization of USD4.37 trillion.7 Similarly, the amount of Sukuk outstanding during the first half of 2012 has grown impressively to USD210.8 billion.8
Subsequently, the investment manager’s construction of a sound diversified portfolio should refute the pervasive misconception that Shariah investing will result in a performance drag. In actual fact, what is produced is a more resilient investment portfolio in two respects. First, over a minimum longer-term period of five years, a Shariah-compliant portfolio has comparable risk-return performance to a conventional portfolio. Second, a less volatile portfolio with more stable characteristics in a down-trending market is produced. Therefore, over a complete market cycle, there is no significant performance drag.
There are those who are of the view that Shariah investing lacks a convincing investment track record. If this were posed six years ago it would have been a valid critique. However, as at the end of 2012, we have sufficient empirical evidence to demonstrate that Shariah investing is resilient and can outperform the conventional investing over the last five years. See Table 6.1.
Table 6.1 Index Performance
The most challenging periods for any given portfolio is either during (i) a market downturn or (ii) in the midst of extreme market volatility. In hindsight, the period between May 2006 and December 2011, provided an unprecedented and historic period of time that served as a crucible for the Islamic investment approach.
Over the longer period from end December 2008 to 2012, comparing the Dow Jones Islamic Market World Index to the conventional Dow Jones World Index, the cumulative total return demonstrated an outperformance of 9.91% over the conventional index.
In addition, during the 18-month bear market from October 2007 until March 2009, the annualized volatility of the Dow Jones Islamic Market World Index (DJIM) was lower at 32.47 percent, 1.62 percent less volatile than the Dow Jones World Index (W1DOW) at 34.08 percent. For the five-year period from July 2007 until end July 2012, the annualized volatility of the DJIM was also lower at 17.04 percent, 1.44 percent less volatile than the W1DOW at 15.60 percent.9
Limited Hedging Capabilities
Using derivatives is allowed in Shariah investing as long as it is for purposes of hedging and not speculation. Shariah principles discourage excessive loss in any transaction and as such hedging activities are encouraged if they can reduce this excessive loss. Shariah concepts such as wa’ad (promise) and salam (forward sales) are used to transact hedging initiatives.
For example, the salam (forward sales) contract can be used for derivative transactions since it allows the selling of a commodity that is not owned by the seller to facilitate transactions that can avoid excessive loss. However, this contract must fulfill essential pillars: contracting parties, the object/commodity that will be given in return, price to be paid, date of delivery, location, and specifications of that object/commodity.
The fact is that the Shariah investment approach permits the use of derivatives for purposes of hedging with proven Shariah-compliant underlying assets. Derivatives used for hedging are restricted only if there are significant elements of speculation or uncertainty (gharar) and gambling (maysir) and can be subjected to exploitation, which is prohibited (haram) in Islam.
BENEFITS OF SHARIAH INVESTING
Having comprehensively reviewed the misconceptions and the broad range of Shariah investment solutions available currently, which were detailed in Chapter 5, here is a summation of the benefits that will serve to reassure investors in considering this as a credible investment alternative.
Credible Alternative
- Provides a choice. Non-Muslim investors should view Islamic investment products as valid additional investment options. They just happen to be Shariah compliant so that Muslim investors can be assured that they are meeting the requirements of Shariah principles. Therefore, Shariah investing is available to everyone.
- Diversification and alternative investment. Shariah investment guidelines are prescriptive of an alternative investment approach and process that results in a more stable portfolio and yields diversification benefits to an investor’s overall asset allocation.
- Comparable risk/return performance over the long term. Over a minimum longer-term period of five years, a Shariah-compliant portfolio has comparable risk-return performance to a conventional portfolio. Therefore, over a complete market cycle, there is no significant performance drag.
- Smaller investment universe not a hindrance to portfolio performance. Due to the securities screening process, the Islamic investible universe has fewer component stocks to invest in but with lower volatility. This is compared to the conventional investment universe whose performance may be less stable, despite a larger investible universe.
- Higher resilience in a down-trending market. At the initial stages of a market downturn, the stock prices of financial services and highly leveraged companies tend to be among the first to decline. Given that the Islamic investing process excludes both types of companies from the portfolio via qualitative and quantitative screening, the portfolio will be somewhat less prone to erosion in value.
Exercises Prudence
The Shariah-compliant investment process exercises prudence because approved portfolio constituents are companies whose finances are not highly leveraged. The screening process enforces the principle that acceptable Shariah-compliant stocks should not be involved in excessive risk taking, high borrowing, and exploitations of contracts.
Focus on Fundamentals
Investors’ appetite has shifted from sophisticated and complex products to a desire for simplicity and clarity with regard to their investment solutions as an outcome of the 2008 economic crisis. There is a higher demand today for investment solutions that are structured with certainty, fairness, ethics, and without speculation. For example, any Sukuk structure must be fundamentally based on tangible underlying assets.
Capacity to Manage Risk
Far from being a hindrance, the institutionalized investment screening process produces an investible universe of companies with a stronger financial position and limited financial risk exposure in a financial crisis. These companies will also be in a better position to take advantage of the improving economy and to better weather any adverse financial impact.
The Islamic investment process comes with the structured capability to manage risk as the screening provides an embedded risk management overlay at the portfolio level. This screening, via the application of three financial ratios based on debt, receivables, and cash, results in a more financially sound pool of constituents to select from.
Responsible Investment
Islamic investing is rooted in real economic activities and productive uses of money. Islamic investment products focus on businesses founded on real and productive activities that generate fair and legitimate profit. Exotic instruments like derivatives unrelated to underlying assets are shunned; as are excessively leveraged and speculative activities.
As an example, the Sukuk structure by definition requires that funds raised from the issuance of Sukuk must be utilized for real economic activities. Hypothetically, a gambling enterprise, which is nonpermissible under Shariah principles, can actually issue a Sukuk to raise funds so long as the proceeds are utilized for the benefit of mankind (i.e., building infrastructure like bridges, schools, and hospitals).
Islamic investing also complements socially responsible investing (SRI). Shariah guidelines, when compared with traditional socially responsible investment, are consistent with ethical financial practices and sharing, both in approach and objective, but they do not preclude compatibility with other SRI approaches. As long as these approaches do not conflict, they are not only compatible but also complementary, with the integration of SRI and ESG criteria offering both ethical and financially prudent guidelines as an added value. This alternative investment approach has demonstrated comparable risk-returns and can be developed jointly. Therefore, SRI and ESG investors can demand the integration of the complementary potential of Shariah investing into their portfolio to further enhance the ethical robustness in line with their specified values.
Moves from free market to fair market (greed to fair and ethical) contribute to responsible investing. While there is suboptimal sharing of profit and loss and unfair distribution of wealth in the “free market,” Shariah practices ensure the opposite and encourages a “fair market” where principles are provided to ensure that contracting parties operate fairly in free markets. The origin of this view is rooted in the Judeo-Christian-Islamic value system that highlights the importance of dealing with justice to all contracting parties in a transaction.
With the benefits conferred through the Shariah investment process, it is easy to see why Shariah investing has high potential to break through to the mainstream in the next decade. The wider trend reveals that investors are looking for decent returns within a value-for-money fee structure in line with other competitive products on the shelf. The fact that Shariah investment products can deliver this within a values-based investing framework is icing on the cake.
Investors have now come to the understanding that Shariah investments are not restricted to investors of the Islamic faith, nor limited to Islamic companies. Instead, this transparent investment process focuses on identifying companies that are established, well-capitalized, well-managed, and not highly leveraged.
Investors of all stripes are drawn to a values-based approach that filters out undesirable businesses. Finally, Muslim investors are able to ensure their investments are aligned with their own faith.
CONCLUSION
Misconceptions on Shariah investing exist due to basic lack of knowledge and understanding of the underlying philosophy and the investment process. However, these perceived shortcomings are simply not true. Far from being overly complex and expensive, Islamic investing is actually transparent and competitively priced.
The truth is that a broad range of investment products are based on high disclosure standards, which are managed by qualified investment professionals with international expertise. In fact, harmonization and institutionalization of Shariah policies and procedures internationally is achievable, even if it is not possible to standardize Shariah interpretation across the board, given the legacy of four different schools of thought.
The management and long-term performance of a Shariah investment portfolio is not hampered by the screening process, which results in a smaller investment universe. The screening process embeds a risk management overlay in order to discover established, well-capitalized, well-managed companies that are not highly leveraged. The resulting investible universe is more stable and provides stronger building blocks from which an investment manager can construct a portfolio that has similar risk-return over the long term. Furthermore, hedging is allowed, in line with Shariah principles, to ensure there are no excessive losses.
With these myths demystified, the benefits of Shariah investing become apparent. This investment approach exercises prudence and focuses on fundamentals. It offers higher resilience in a down-trending market. Invested monies must be invested in real economic activities and grant a respectable return in line with specified ethics. The last decade has shown an emerging trend of interest in ESG and SRI investing. Shariah investing has demonstrated comparable risk-returns and can be developed in an integrated fashion to further enhance the ethical robustness of ESG and SRI in line with their specified values.
Whatever its name, Shariah investing can clearly satisfy the demand of investors who want their monies invested responsibly. The truth is that both Muslims and non-Muslims can invest in broad range of cost-effective investment products that can be transparently and flexibly managed to achieve similar investment returns to mainstream investment products.
NOTES
1. Thomas Weber. Gandhi as Disciple and Mentor (Cambridge University Press, 2004).
2. “Amana Income Fund 2nd Largest US Islamic Equity Mutual Fund,” Global Islamic Finance Magazine. www.globalislamicfinancemagazine.com/index.php?com=news_list&nid=1886
3. Opalesque [username], “Islamic Fund Managers Rise to the Challenge.” Amanie Islamic Finance Consultancy and Education LLC Web site (2010). www.amaniedubai.com/ver2/publications/amanie-in-the-news/26-islamic-fund-managers-rise-to-the-challenge
4. Shariah Capital, Inc. “DMCC Seeds Al Safi Trust,” Bloomberg.com (2008). www.bloomberg.com/apps/news?pid=newsarchive&sid=aVktRYDBqu_w
5. “Gandhi’s Views on God.” Mahatma Gandhi Information Website. www.gandhi-manibhavan.org/gandhiphilosophy/philosophy_god_god.htm.
6. S&P Dow Jones Indices, LLC. “Dow Jones Islamic MarketTM World Index Factsheet.” (December 2012).
7. Ibid.
8. KFH Research Ltd. and the Global Islamic Finance Forum (GIFF). “Global Islamic Finance Forum (GIFF).” Kuala Lumpur, Malaysia: September 18–20, 2012.
9. CIMB Principal Islamic Asset Management, “Case for Islamic Asset Management,” (July 31, 2012).
10. The verse is calling everyone to take part in a Shariah investment portfolio, because Shariah is meant for everyone on this earth; it is not restricted to Muslims only. This is to show the globalization of the Islamic investment portfolio.
General Reading
Brown, Ellen Hodgson, The Web of Debt: The Shocking Truth About Our Money System And How We Can Break Free. Revised and Expanded with 2008 Update. Third Millennium Press Baton, 2008.
Dar, Humayon, and Mufti Talha Ahmad Azami, “Global Islamic Finance Report (GIFR).” BMB Islamic Publication, 2010.
Vicary Abdullah, Daud, and Keon Chee, Islamic Finance: Why It Makes Sense. Understanding Its Principles and Practices. Marshal Cavendish Business, 2012.