The definition of a Sharia-compliant stock is ambiguous. At best, it suggests that a stock is Sharia-compliant if it fulfils both sectoral and financial screening filters. Sharia-compliant investment management is concerned with investments in assets that are in compliance with Islamic law. An Islamic investor is not allowed to invest in companies that derive most of their revenue from non Sharia-compliant business activities, or that use interest in operating or financing their business. In the context of investing in equities, screening for Sharia compliance is ensured using two main screens: business activities and financial ratios.
The first level is business activity screening, or sectoral screening, in which those stocks are filtered out from the investable universe which derive more than a certain percentage (usually five per cent) of their business activities from one of the sectors forbidden by Islamic law. The outright forbidden trading sectors include pork, alcohol, gambling, interest-based banking and finance, tobacco, pornography and similar unethical activities. The process of implementing de facto Haram is not straightforward, as we need to look at all the business activities involved in the value chain. In the case of the industry sector, this would mean from the production of a raw material, to the delivery of the final product.
It would be interesting to take one non Sharia-compliant business activity, and analyse the entire value chain. If we take the example of alcoholic beverages, a company whose core activity includes producing wine, spirits and beer, such as Diageo, would naturally be screened out of any Sharia-compliant investment universe.
Large pub-owning companies such as Scottish and Newcastle will also automatically be classified as Haram, because it is involved in the selling of alcoholic beverages. At the logistics stage such as a company that delivers barrels to pubs and bars, there is a strict Sharia requirement to exclude these companies as well. In general, the Sharia rules against any business activity which is directly or indirectly involved in the Haram business.
The five per cent threshold is applied at any stage of the value chain. If for example, there is sufficient information to believe that a company produces aluminium cans solely for beer canning; this company should be screened out. The same rule applies to aluminium producers themselves and so on.
The screening process for companies operating in weaponry, advertising and media industries, on the other hand, is less straight forward. While not overtly forbidden under Sharia law, these sectors are in effect filtered out on a moral and ethical basis. Investment in weaponry is permissible in Sharia law if the underlying motive is defensive in nature, and as long as there is no potential collateral damage. However, due to the subjectivity of differentiating what constitutes legitimate defence, contemporary Sharia opinion have opted to exclude this sector.
More recently, a European top ethical fund manager, in collaboration with BMB Islamic, a London-based Sharia advisory and structuring firm, has worked on a new investment approach that genuinely integrates ethical and faith-based investment strategies. This is an interesting example that adds a new layer to the traditional sectoral screening process. In addition to the traditional filters mentioned earlier, there is a positive screening process whereby companies are selected if they make a positive contribution to society and encourage good management practice of sustainable issues.
It is easy to see that this approach makes the stock selection process much more complex. In terms of negative screening, companies that have high involvement in animal exploitation, nuclear power generation, poor relations with employees' and/or customers and/or suppliers come at the top of the Sharia screen list.
The positive screening seeks out investment in companies that are involved in providing basic necessities to life, offering customers ethical and environmentally friendly product choice, actively addressing climate change, promoting protection of human rights, having positive impact on local communities, with effective anti-corruption control, and transparent communication. This list is not comprehensive but illustrates how the universe of investment stock might be considerably reduced once all these filters are applied. This investment approach has been endorsed by some of the most prominent scholars in the Islamic finance industry, four of which sit on the board of Accounting and Auditing Organisation for Islamic Financial Institutions.
To accommodate the demand of Islamic fund managers, index providers were the first to introduce Sharia indices as early as 1998. FTSE, DJIM, MSCI and S&P offer a selection of Sharia indices that allow the end-users (i.e. fund managers) to pick stocks for their investment portfolio.
This is the reason why many funds have composite portfolios that rely on one or several index providers. These Sharia indices, however, may give the investment fund manager a fairly limited choice in terms of investable universe. In addition, some of these indices do not delve deep enough into a company's financials so as to determine the exact percentage of revenue which is generated from the prohibited activities. This has serious implications on other services related to Sharia compliance such as dividend purification, where fund managers are required to purify dividends earned by companies in their investment portfolio, that derive a percentage of their revenue from non Sharia-compliant business activity.
In short, the indices' sectoral screening is purely based on the primary business activity of the company. What this entails is that Sharia indices perform an automated industry screening using classifications codes that define only the companies whose core business activities are not Sharia-compliant. Those businesses whose primary activity is Sharia-compliant but derive a portion of their revenue from Haram activities are hence not excluded. The real challenge in Sharia stock screening application is to specifically 'capture' the latter companies, that still generate more than five per cent of their revenues from prohibited activities.
For example, a company such as Sainsbury's is categorised under the ICB sector "food and drug retailer", but sells pork and alcohol and might be generating more than the five per cent revenues threshold from these business activities. Another example is Louis Vuitton Moet Hennessy, categorised as "clothing and accessories", but that still earns revenues from the sale of wines and spirits.
In order to determine the exact percentage of revenue from non-Sharia activities within companies operating in multiple business segments, and that pass the generic industry filters; Islamic fund managers need to conduct a thorough analysis of the firms' accounts and reports, which may not be readily available. A company like Sainsbury's might not be segregating between its sources of revenues (from pork sales vs non-prohibited products).
A new generation of Sharia stock screening process has now emerged, creating a sophisticated but viable stock screening system which identifies the exact portion of prohibited activity within a company. A US-based provider of Sharia fund management solutions, offers its clients a global equity screening service which is considered a powerful filtering engine, composed of 40,000 stocks globally in 95 different countries. The service features daily market data feeds provided by the top three market data providers – Thomson Financial, Reuters and Interactive Data Corp.
All data feeds once received, are subsequently screened using proprietary software and manual researchers to accurately classify company' activities. Finally, the filtered data is securely delivered using state-of-the-art web technology that allows for in-depth research, analysis and purification tasks to effectively screen for Sharia-compliant funds. The service provider lists the investments that need purification, and also has the capability to calculate dividend purification.
The screening system as of yet does not have a Fatwa from the scholars, but it can be programmed to accommodate any financial ratio at the discretion of the Sharia scholars of a fund management company. In terms of sectoral screening, the system has the ability to remove companies that are indirectly involved in 'Haram' businesses, such as a software company that produces software for casinos.
However, when the data information is not available such as in the case of Sainsbury's – which does not provide a breakdown of its revenues – this company is considered Sharia-compliant unless there is sufficient evidence to prove otherwise.
By Zaineb Sefiani
- The writer is Associate Client Relationship Manager at BMB Islamic
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