The example provided by Islamic finance has gained notice from communities quite outside the Muslim world not least of all from the center of an entirely different faith-based community. Earlier this year, Bloomberg News reported a statement by the Vatican through its official newspaper Osservatore Romano that banks should look at the rules of Islamic finance to restore confidence among their clients at a time of global economic crisis. These rules, in other words, are not particular to Islam nor to the Roman Catholic Church nor to any other individual faith or belief system but to the ethics and values that should support the financial dealings of any and all communities in any and all marketplaces.
Islamic Screening Criteria
In Islamic investing, Shari'ah law allows investment in company shares (common stock) as long as those companies do not engage in lending, gambling or the production of alcohol, tobacco, weaponry, pornography and environment pollution. Investment in companies may be in shares or by direct investment (private equity). Islamic scholars have made some concessions on permissible companies, as most use debt either to address liquidity shortages (they borrow) or to invest excess cash (interest-bearing instruments). One set of filters excludes companies that hold interest-bearing debt, receive interest or other impure income or trade debts for more than their face values. A further distillation of these screens would exclude companies whose debt/total asset ratio equals or exceeds 33%; companies with "impure plus non-operating interest income" revenue equal to or greater than 5%; or companies whose accounts receivable/total assets equal or exceed 45% or more.
SRI Investment Screening Criteria
SRI uses negative criteria to avoid investing in companies that are involved in specific areas. This screening is largely subjective, often depending on individual consciousness, but a general look at those screenings shows a similarity to the screens used by the Islamic world when selecting suitable investments with riba (interest) probably being the major difference between the two sets.
Ethical screenings in the conventional banking world rule out many of the same kinds of firms as are screened out of the Islamic finance world, such as those involved in gambling, alcohol, arms manufacture, tobacco, pornography and the like. Ethical investments tend to use negative criteria to avoid investing in companies involved in areas such as:
Trading with oppressive regimes and countries with poor humanrights records.
Environmentally damaging practices.
Pornography and offensive advertising.
Gambling.
Tobacco and alcohol production.
Unnecessary exploitation of animals.
Unsafe products and services.
Genetic engineering, abortion and embryonic research.
Armaments.
Something in Common
One can see that in ethical and Islamic screening criteria, there are some things in common. The difference, of course, is the Islamic prohibition on interest-based transactions and interestbased finance. As far as conventional ethical schemes are concerned, this does not even register.
In order for Islamic finance to play a greater role in the investment field, there is a need to stress what the Islamic model has in common with the socially responsible investment community of the conventional world and to point out that the industry is already pre-screened so that it inherently meets the needs of the ethically conscious market.
Islamic finance has the potential, and appeal, to be used outside of the Muslim community. In serving the Muslim community, the differentiation of Islamic financing from conventional financing must be stressed, showing the faith-oriented differences between Islamic modes and conventional ones. But to the non-Muslim market, similarities should be stressed because to that market, financing is just a commodity item.
Ethical Factors in Investment
Investment managers stand a good chance of improving their portfolio performance and reducing their risks if they pay closer attention to the social and environmental performance of the companies in which they plan to invest. Ethicsrelated factors which may serve to depress investment returns include the cost and availability of capital; increased liability claims; expanded rules on disclosure; greater emphasis on social and environmental factors in credit risk ratings; corporate governance; the emergence of environmental taxes; and the increasing use of economic arguments by ecological pressure groups. Ethics-related factors that could benefit companies include increases in resource productivity and market share growth and new business development due to companies recognising the potential offered by ethical investment.
There are many ways in which company strategies perceived as ethical or Shari'ah compliant can impact share price both at the company and at the portfolio level. Let us examine the different ethical influences through two descriptive models in order to understand how risk and return can be affected in financial performance. Both ethical and Islamic investors can learn from these two models.
The Effects of Ethical Behaviour On Company Share Price
First, let us examine which company strategies perceived as ethical can impact on share price. The model shows the main links between the company, shareholders, employees, customers and government and how ethics can impact a companys cash flow in terms of costs, sales and the cost of capital.
Company Policies
Improved social and environmental performance can lead to cost savings by preventing environmental liabilities and reducing materials and energy consumption. At the same time, it should be recognised that some of the behaviour that ethical investors favour is very unlikely to be more profitable for a company, at least in the short term. A good example is a company decision to turn down a lucrative military contract with an oppressive regime; that is not likely to increase profits unless the company can find an equally profitable contract elsewhere or the long-term effects on reputation prove more beneficial. Similarly, not all efforts to reduce impact on the environment may save money or earn a reward in the marketplace.
Reputation
It may be mentioned that ethical or unethical behaviour can have an impact on reputation and share price. A good example is how an oil-exploring company such as Shell can be hampered by wider social issues. The boycott of Shell in 1995 resulting from the companys attempt to dump its Brent Spar oil platform in the North Sea showed a willingness by the consumer to favour companies which have a policy to respect the environment. Later Shell found itself at the centre of international controversy for its operations in Nigeria in relation to that countrys poor humanrights record. Shareholder and consumer pressure forced Shell to recognise that separation of business from the wider society is not healthy for business.
Consumers
In the business world, companies are increasingly recognising that they have to pay attention to all their stakeholders. In 1996, MORI conducted a poll that found that three out of 10 people had chosen or boycotted a product or company for ethical reasons. Campaigning organisations are increasingly targeting their campaigns against large multinationals and using the power of consumers and investors whose awareness of ethical issues is growing to persuade companies to change.
Regulation
Government regulation plays an important role in promoting ethics in business. Managers of environmentally ethical funds, for example, say that because of the environmentally proactive stance of the companies they select for investment - whether that means using the latest environmental technology, minimising damage to the environment or employing best practices - these companies will benefit from future regulation by being ahead of the game.
Employee Motivational Training
Human resources development, or the motivational training of employees, can create a pleasant working environment and sound work practices which have a positive effect on productivity and efficiency. Motivational training can provide profitability within the company. A 1996 MORI survey found that 41% of the employees satisfied with their jobs will recommend their employers products or services without being asked. On the other hand, not all attempts to invest in better stakeholder relations can be expected automatically to yield a greater return.
Effects of Islamic Ethical Investment On a Portfolio
The Islamic ethical criteria of Islamic equity funds, along with their managers, are the key influences on portfolio performance. The Shari'ah supervisory board defines the ethical universe from which the fund manager can invest. In the case of a passively managed fund, it is only the Islamic ethical criteria and the index construction rules that are the key influences, though very few passively managed Islamic ethical tracker funds exist. A model (Figure 2) depicts the ways in which Islamic ethical investment criteria can impact portfolio performance.
Diversification
The use of Shari'ah principles to define the investible universe at the portfolio level may lead market players to assume that there may be some degree of lesser diversification. However, portfolio variability does not reflect the average variability of its components because diversification reduces variability. In finance, even a little diversification can provide a substantial reduction in variability, and the investor can get most of the benefit with relatively few stocks.Therefore the negative diversification effects of selecting stocks from an Islamically constrained universe are likely to be very tiny.
Sector and Stock Effects
Islamic ethical restrictions will have an impact on the size and structure of the resulting investible universe. It is often said that Islamic investment funds exhibit a smaller-companies effect since they tend to invest in smaller or medium-size companies. Larger companies may be more likely to be ruled out by Islamic ethical screening as they tend to be involved in a larger number of areas of which investors might disapprove. Smaller companies may be more volatile than larger companies, which matters in the short term, although a portfolio of smaller companies will diversify away the specific risk of individual stocks.
Furthermore, Islamic ethical funds are often overweight in some sectors such as technology and construction, etc. The Islamic ethical universe completely avoids sectors such as tobacco, conventional banks, pornography, alcohol, gambling, polluting industries and so on which are against Islamic ethical criteria. In the short term, these sector-related effects will come into play as some sectors do better than others. This can have a positive or negative effect depending on the balance of sectors in the portfolio compared with the unconstrained universe. Nevertheless, sometimes sectors viewed as unethical will have inherent long-term liabilities, for example, the tobacco sector. Overall, the likelihood is that individual sector effects will balance out, at least in the long term.
Tracking Error
The tracking error of an Islamic ethical fund against unrestricted (conventional) indices (such as MSCI, FTSE or CRSP, etc.) compared with that of an unconstrained fund is also likely to be higher. Shorter-term performance may diverge widely from that of funds using more conventional approaches and from unrestricted (conventional) indices. But the tracking error may not matter to the investor concerned about the balance of return and risk measured by the volatility of a fund.
Concentration
Like mainstream ethical funds, a few Islamic ethical funds claim that because they have fewer companies to invest in, they know those companies better and are more focused on their activities and, as they are often long-term investors, this pays off over time. If Islamic ethical funds have fewer companies to invest in and a tendency to invest in them for longer, there will be less churn in the portfolio and lower trading costs.
The style of fund manager and experience may or may not fit with a particular Islamic ethical approach. A particular style may suit restrictions better than others, or Islamic ethical criteria may interfere with some fund managers strategies. For example, suppose a fund managers strategy calls for an overweighting of chemical stocks: In this case, Islamic screening may interfere with implementation because of environmental considerations. A possible source of underperformance could therefore be a mismatch between the skill and style of the fund manager and the requirements of the particular Islamic ethical approach adopted.
The research cost into company activities may be passed on by fund managers to the investor because increased management costs may impinge on the financial performance of some Islamic ethical funds. However, while Islamic screening may represent an extra layer of cost, this is more than compensated for by the high level of customer retention that Islamic ethical funds appear to have.
Management of Funds
The Islamic ethical investment industry claims that while assessing a companys social and environmental record, a better insight into an organisations financial performance can be gained. Some behaviour also positively viewed from an ethical standpoint (such as the implementation of an environmental management system or good employee relations) can be a proxy for a generally well-managed company.
Many Possibilities
There is a wide range of ways in which ethical or unethical behaviour could influence a companys commercial success and its share price. The two models above demonstrate that the use of Islamic ethical criteria in the selection of a portfolio of shares could also have a variety of positive and negative effects upon investment performance. The combination of all these factors may have the overall effect of broadly similar financial performance to conventional funds. It is not true that Islamic ethical criteria will always lead to a good performance, nor will it always lead to a bad one.
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