Chapter 12

Managing Assets in Islamic Investments

In This Chapter

arrow Discovering the contract structures of investment products

arrow Screening equities for sharia compliance

arrow Maintaining fund purity

arrow Monitoring fund performance with Islamic indexes

arrow Getting a grip on Islamic market risk

In Chapter 11, I introduce you to the Islamic capital market and its components, which include investment products such as Islamic mutual funds, bonds, and exchange-traded funds. My goal in this chapter is to help you understand what makes an Islamic product truly Islamic. The word Islamicin this context means that a product is sharia-compliant: It adheres to the principles of Islamic law and avoids all industries and activities that this law prohibits.

A fund management company doesn’t get to arbitrarily label a product “Islamic” and start marketing it to the public. This label carries a certain weight, and it must be earned. Therefore, in addition to doing most of the same types of work that a conventional investment fund management company does, the manager of an Islamic fund assumes the additional responsibility of getting that fund screened or filtered for sharia compliance and purifying the fund if it includes any prohibited investments. (As if eking out investment profits in a roller-coaster economy isn’t hard enough by itself!)

Stay tuned for all the details on what exactly the screening and purification processes entail. I also tell you how fund management companies are monitoring fund performance with Islamic market indexes and describe new products available for managing risk in the Islamic market. First up, I explain the Islamic contracts that provide the foundation for the majority of Islamic investment products.

Considering the Contracts That Support Sharia-Compliant Funds

As I note throughout this book, starting in Chapter 1, sharia compliance requires adherence to Islamic principles. Among the key principles are the prohibition of interest, speculation, gambling, and involvement with certain activities and industries. Later in this chapter, I note how the prohibition of specific activities and industries affects Islamic fund management. But how can you create and promote an investment fund that doesn’t involve speculation or gambling and doesn’t offer to pay investors interest?

In this section, I describe three types of Islamic contracts that fund management companies use as the basis for establishing investment funds. As you discover, the return on capital from an Islamic fund isn’t guaranteed or fixed. Instead, the return is based on the sharing of profit and loss among investors on a preestablished and pro-rated basis. (The profits of the fund are distributed among investors after deducting administrative and fund management fees.)

tip.epsIf you’ve read Chapter 10 about the types of income-generating products offered by Islamic banks, you may notice that the three types of contracts I highlight here overlap with some contracts I describe in that chapter. That’s because these contracts allow various types of partners (banks, fund management companies, investors, people and businesses in need of funds, and so on) to work together on a profit and loss sharing basis that avoids interest-based transactions.

Mudaraba funds

A mudaraba contract is based on a financial partnership in which one party (an investor, called a rab al mal in Arabic) gives money to another (a fund manager, called a mudarib) for the purpose of investing it in a business or economic activity. The investor puts up all the capital, and the fund manager provides expertise and knowledge to help the activity succeed. Both parties share the profits based on an agreed-upon ratio, but only the investor can lose the initial capital if the activity flops. (That’s because, when a flop occurs, the manager loses the value of the time and effort he devoted to the investment.)

remember.epsMost Islamic equity funds are based completely on the mudaraba contract: The fund management companies invest in sharia-compliant stocks, and after they sell those stocks, any profit (gain) is distributed to the investors. In addition, all non-equity Islamic investment funds use the mudaraba contract as the basis of distributing profits (or losses) among investors and the fund managers. However, the means by which a non-equity fund may seek to earn profits can be based on another type of contract, such as the ijara and murabaha contracts, which I describe in the following sections.

Note: An Islamic equity fund may also be based on a wakala contract, in which a principal (the investor) gives money to an agent (the fund manager) to manage. The fund manager charges a management fee and pays any additional return to the investors. This type of fund is not often used; most Islamic equity funds are based on the mudaraba contract.

Ijara (leasing) funds

The leasing concept has become one of the most preferred contracts for Islamic investment funds. Here’s how it works: The fund purchases real estate, motor vehicles, or machinery, and then users lease the assets. Ownership of each asset remains with the fund, and the rental income is distributed among investors according to the size of each person’s ownership in the investment pool. The very basic condition applied is that the utilization of the asset is sharia-compliant; for example, construction equipment purchased by an Islamic investment fund can’t be leased to a company for the building of a casino.

Ijara funds are issued to investors with a unit price and minimum subscription (investment amount) indicated, and the term (the length of investment) is specified in the contract. The fund management company charges a management fee, which is specified in the contract so the investor knows exactly how much money the company receives.

realworldexample.epsOne example of an ijara fund is the Islamic Ijara Fund VIII offered by the National Bank of Kuwait (NBK). According to the bank’s website (, the objective of the fund is a familiar one: to give investors “reliable and attractive monthly returns” and to repay capital investments at the end of the contract period. When defining the strategy it uses to accomplish this objective, NBK explains its sharia-compliant approach this way:

The Fund seeks to invest all of its assets in the purchase of equipment or portfolios of equipment which will in turn, be leased to diversified lessees. The Fund will select high quality lessees, with a particular focus on “Fortune 1000” companies and companies that are found to be of high credit quality.

A key risk related with an ijara fund is that it may not be able to diversify its portfolio enough. If the fund lacks sufficient diversification, it may yield less income than a more-diversified portfolio. An ijara fund also faces payment default risk as well as currency risks if it’s invested in an international market.

Murabaha (cost plus) funds

In a murabaha type of contract, an asset is sold to a party at the cost of the asset plus a profit margin. (Hence, the shorthand term cost plus to refer to murabaha contracts.) The buyer knows the asset’s cost and the profit margin included; the seller must not disguise this information (and therefore hide the true amount of profit she stands to make). Both parties agree to the payment terms, and generally the payment is deferred (meaning it isn’t made in full on the date of sale).

In cost plus investment funds, the investors’ money is pooled by the fund management company and allocated to several cost plus trade investments. The profit generated from these investments is distributed among the investors after deducting the fund management company’s predetermined (and agreed upon) share of profits. The profit specifically refers to the markup made when selling assets to third parties.

Murabaha funds are relatively low risk, but that doesn’t mean they’re free of risk altogether. A murabaha fund has trade risk that relates to the buyer’s ability to pay its obligations, and it may face currency risk if it participates in international transactions. Overall, however, this investment approach helps to reduce investors’ risk by distributing cash among multiple and diversified murabaha investments.

realworldexample.epsFollowing are two examples of murabaha funds:

check.png SHUAA Capital of Saudi Arabia has offered a Murabaha Fund since 2010. The fund is invested mainly in murabaha investment transactions. (Visit for details.)

check.png Al Bilad Investment Company ( offers the Al Murabih Fund (BILAMUR), which makes investments in cost plus contracts that transact commodities — with the exception of gold and silver, which are treated as currency.

Seeing Commodity and Equity Funds in Action

To offer a clearer picture of how Islamic investment funds function, here’s a snapshot of two common types of funds: those that invest in commodities and those that invest in equities. If you’re looking to build a sharia-compliant investment portfolio with the potential for significant growth (as opposed to a portfolio focused mostly on safeguarding your funds), chances are good you want to include one or both of these types of funds. As with conventional funds of this type, the Islamic variety of commodity and equity funds present some risk to the investor because you can’t know with certainty that the price of a certain commodity or a company stock is going to increase. No way around it: You can’t hope for returns without facing some associated risks. That’s just the nature of investing, Islamic and otherwise!

Commodity funds

Commodity funds may invest in purchases or projects based either on the cost plus (murabaha) contract or, in the case of construction projects (or other projects to be completed in the future), the leasing (ijara) contract. (The earlier section “Considering the Contracts That Support Sharia-Compliant Funds” gives you the lowdown on these Islamic contracts.)

In the conventional market, many types of commodity funds are available that allow you to invest in oil, wheat, pork bellies, orange juice, and so on. Conventional investors (who don’t necessarily want to see and touch the commodities in question) look to fund management companies to make savvy trades — often using derivative products (which I explain in Chapter 11) — to garner profits from the commodity’s price changes.

Islamic commodity funds also invest in physical commodities but must avoid short selling as well as investment products of a speculative nature, such as commodity futures. In an Islamic commodity fund, the commodities are actually purchased for resale. (The fund management company doesn’t try to short sell a commodity security, for example.) The profit from the sale is distributed among the investors according to the investment contract.

In order to be accepted as sharia-compliant, the commodity fund must meet the following basic criteria:

check.png The commodities involved can’t be prohibited in Islam. In other words, no pork, alcohol, or other forbidden items.

check.png Short selling isn’t allowed. The seller must actually have possession of the commodities in question.

check.png All parties involved must know the price of the commodities to be traded.

check.png Forward sales aren’t allowed, except under salam and istisna contracts (which I describe in Chapter 10).

realworldexample.epsHere are just two examples of existing Islamic commodity funds:

check.png Riyad Capital Bank ( in Saudi Arabia has two Commodity Trading Funds available to investors. One fund deals in U.S. dollars, and the other deals in Saudi Riyals; both are sharia-compliant.

check.png Al Rajhi Capital (, also in Saudi Arabia, offers three commodity fund products: a U.S. dollar commodity fund, a Saudi Riyal commodity fund, and a Euro commodity fund.

Equity funds

Equity funds — conventional and Islamic — primarily invest in company stocks. Islamic equity funds are based on mudaraba or wakala contracts.

An equity fund gains profit by buying and selling stocks to achieve capital gains and by receiving corporate dividends. The capital gains and dividends are distributed among investors proportionally according to the size of each person’s investment. The key difference between an Islamic and conventional equity fund is the requirement for an Islamic equity fund to invest in sharia-compliant assets. (The next section covers how fund management companies screen stocks to determine which are sharia-compliant and therefore fair game for Islamic equity funds.)

remember.epsIslamic equity funds really opened the door to investing for people seeking to purchase sharia-compliant stocks and to make socially responsible investments. And because these funds avoid investing in companies that are highly leveraged with debt (as I explain in the next section), Islamic equity funds may have a performance advantage over some of their conventional counterparts. The drawback is that the investment criteria for inclusion in an Islamic fund are strict enough to eliminate certain industries altogether, which can negatively affect such funds during economic downturns. (As with all things in the investment world, Islamic equity funds have their pros and cons!)

realworldexample.epsHere are just three examples of the hundreds of Islamic equity funds currently available:

check.png Malaysia’s AmIslamic Funds Management launched the AmASEAN Equity Fund (AMASEQY) in 2011. The fund’s investments focus on the nations of Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam.

check.png HSBC Amanah GCC Equity Fund (SAMGCCE), launched in 2006 and managed by HSBC Saudia Arabia, strives for medium- and long-term capital growth by making investments in sharia-compliant stocks of the Gulf Cooperation Council (GCC) area: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates. For more information, visit

check.png Launched in 2003, the Meezan Islamic Fund (MEZISLM) is a product of Al Meezan Investment Management Limited ( The management company’s website states that this fund is “not only the largest Shariah compliant equity fund but also the largest Equity Fund in [the] private sector in Pakistan.”

Screening Stocks for Islamic Investments

Islamic fund management companies must invest in the stocks of companies that are sharia-compliant. A fund management company must use a screening (or filtering) process to determine (with the guidance of sharia scholars) whether a company qualifies as sharia-compliant.

remember.epsMost sharia scholars agree that the following two-step screening process best determines sharia compliance:

1. The company’s actual business goes under the microscope first. Scholars and fund managers look for any indication that the company engages in transactions or other activities that are prohibited by Islamic law. This screening step is qualitative, meaning that it isn’t based strictly on numbers but rather on the quality (the nature) of what the company does as its business.

2. If the company passes the first screening, the next consideration is its financial ratios. To be sharia-compliant, the company must meet certain financial criteria. (It can’t carry too much debt, for example.) The financial test is quantitative, meaning that (unlike in the first screening step) the company must meet specific financial metrics.

In the sections that follow, I explain these two steps in more detail.

tip.epsKeep in mind that few companies can truly comply 100 percent with sharia law. Therefore, a company doesn’t need to get a grade of 100 in order to pass the sharia test. Instead, scholars and fund managers allow for a certain percentage of non-sharia-compliant activity (which is almost impossible to avoid) without booting the company from the approved list of possible investments.

Avoiding prohibited industries

The first test a sharia scholar or fund manager applies when considering whether a company is sharia-compliant focuses on the company’s core business. If the company’s business centers on prohibited activities, the company is out — period; it doesn’t even make it to the financial round.

Prohibited industries and activities per sharia include the following:

check.png Conventional financial services that feature transactions based on interest, speculation, and/or gambling: This criterion means that conventional banks, investment companies, insurance companies, and other financial institutions are considered noncompliant.

check.png Certain food and beverage industry sectors: Companies whose core businesses involve alcohol, pork products, or other meat that’s not slaughtered according to sharia law aren’t considered compliant.

check.png The tobacco industry and activity related to illegal drugs: In the past, tobacco use was a source of some controversy and confusion in the Muslim community. Now, however, most sharia scholars agree that the use of tobacco and investing in the tobacco industry are prohibited. And of course, illegal drugs (and any illegal activities, for that matter) are off limits.

check.png Gambling: This prohibition means that an Islamic fund can’t invest in casinos, online lotteries, lotto draws, and betting transactions.

check.png The production of weapons of mass destruction (WMDs): What the West refers to as collateral damage is considered the killing of innocents per Islam, and it’s forbidden. Therefore, sharia forbids the production of WMDs.

check.png Certain sectors of the entertainment industry: Sharia prohibitions apply to adult entertainment products, including magazines, videos, audio recordings, websites, and all methods of distributing pornography. The same prohibition applies to erotic arts. In addition, certain types of non-Islamic music and cinema are prohibited.

remember.epscheck.png Cloning: This example demonstrates a crucial point: Islamic scholars must continually make decisions about the compliance status of new technologies and industries. Obviously, the prohibition against cloning activity is a fairly recent decision, and the prohibition of cloning could possibly change depending on future circumstances.

Groups of companies with subsidiaries that engage in activities prohibited by sharia also are excluded from Islamic investment funds. For example, consider a hotel (owned by a large corporation) that derives a substantial amount of its income from a nightclub or casino that is prohibited per sharia. Because the profits from this nightclub or casino impact the overall profit of the corporate group, an Islamic fund can’t invest in the group as a whole.

As I note earlier, few companies pass the screening process related to the industry of their core business with a perfect score. In the case of a corporate group with scores of subsidiaries, you can bet that somewhere along the line, one or more of those subsidiaries engages in prohibited activities. For this reason, sharia scholars and fund managers must establish and use benchmarks for determining whether a specific corporation or group crosses the line into noncompliance.

realworldexample.epsThe Sharia Advisory Council of Malaysia has established such a benchmark. For example, under the council’s system

check.png A company must receive less than 5 percent of its profits from a prohibited industry.

check.png For a company that derives profits from an industry that affects many people and is difficult to avoid (such as tobacco), the threshold increases to 10 percent.

check.png For a company that earns rental payments, up to 20 percent of its profits can come from rentals to non-sharia-compliant activities (such as renting properties for gambling).

Passing the financial test

If a company survives the first step of screening — the industry test — it moves on to a test that focuses on its financial ratios. If a company passes this second step of the screening process, it earns the label of sharia compliance, and its stocks can be included in Islamic funds.

The objective of the financial test is to ensure that the company’s non-sharia-compliant financial facts don’t have a significant influence on the company’s stock price and the company’s overall performance. For example, the Islamic investment fund wants to avoid investing in companies that carry too much debt. The financial ratios are prepared based on financial statements such as the income statement and the company’s balance sheet. Evaluators then compare the results of these ratios with certain benchmarks.

remember.epsKeep in mind that the benchmarks used for financial screening can vary from fund to fund. The sharia boards of Islamic financial institutions or Islamic indexes are the ones who establish the benchmarks, and different boards (adhering to different schools of thought) may establish different thresholds.

The following three separate financial tests are commonly applied during this screening step.

Debt-to-equity ratio

The company’s debt-to-equity ratio is determined by dividing its total debt by its total market capitalization. For sharia compliance, the accepted debt level is generally between 30 and 33 percent.

Why is this test important? Companies fund their assets by using equity and debt. Most of the time, debt is interest-bearing; the company needs to pay interest to its lenders, which are often conventional banks and other financial institutions. Sharia doesn’t accept interest-based transactions. Therefore, in theory, investing in companies that pay interest on debt isn’t allowed. But in reality, finding a company that is 100 percent free from interest-bearing debt is difficult. So sharia scholars have determined a benchmark — a tolerance level for the acceptability of debt. At the same time, scholars encourage companies to avoid interest-based debt, especially as Islamic financing becomes more readily available.

remember.epsAlthough the general tolerance for the debt-to-equity ratio is between 30 and 33 percent, the tolerance level may change according to the sharia board and its decision based on a fund’s current requirements.

Interest income ratio

The second financial test looks at a company’s interest income ratio, which is its interest income divided by total revenues. Generally, the benchmark is less than 5 percent.

When a company has surplus working capital or funds, it deposits that money in financial instruments, most of which give the company interest income. Interest income is generally shown in the company’s income statement as “other income.” Because sharia doesn’t allow interest-based transactions, interest income is prohibited. However, sharia scholars agree that if this interest income is negligible, investing in the company is still acceptable. However, scholars encourage stockholders to raise their voices against future interest income and to donate the interest income portion of their dividends to charity.


The liquidity test can take various forms. The big-picture goal is to ensure that the company is achieving a certain balance between liquid and illiquid assets. Certainly, desiring such a balance makes financial sense: A company needs to have enough liquid assets on hand to cover its short-term expenses, but it also needs to invest in illiquid assets to sustain and grow its operations.

remember.epsFrom the perspective of sharia compliance, the issue is that current (liquid) assets are considered to be the same as cash. Sharia forbids the trading of cash for cash and restricts how much profit a company can earn from cash-based (rather than asset-, product-, or service-based) activities. So a company that has too many liquid assets is considered noncompliant, and its assets can’t be part of a sharia investment fund.

realworldexample.epsSharia scholars use various benchmarks for handling the third financial test of the sharia-compliance screening process. Here are three examples of how that plays out in the real world:

check.png One sharia scholar says that if a company is a pass-through entity and its core business is sharia-compliant (and involved in installment-basis business activities), the company’s accounts receivable should be no more than 45 percent of its total assets. If the percentage is higher, the majority of the company’s dealings are based on money rather than goods, services, or assets.

check.png Other sharia scholars say that a company can make income from illiquid assets only — that cash and cash equivalents can’t be used to make income. The acceptable range of liquid assets in this case can span from 33 percent to 80 percent depending on the fund and its scholars. (A company may have 80 percent liquid assets, but as long as it uses only the other 20 percent — the illiquid assets — to generate income, it may still be compliant.)

check.png A third viewpoint is that a company should have cash and cash equivalents (including accounts receivable) — liquid assets, in other words — that total less than 70 percent of its total assets. The company’s stocks are represented by the total assets, so if the company has 100 percent liquid assets (or close to it), that means its stocks are equal to money. Sharia prohibits money being exchanged for money, so a company whose stocks are equal to money is ineligible for trading.

Purifying a Fund of Noncompliance

An Islamic fund must be diligent about maintaining its sharia compliance. After all, the companies it invests in are constantly changing; few businesses conduct exactly the kinds of transactions and have exactly the same financial ratios every single year. In this section, I explain how funds strive to ensure ongoing sharia compliance and how they purify their holdings when they discover noncompliance.

Conducting screening reviews

Because a business doesn’t remain static year after year, the screening processes that I describe in “Screening Stocks for Islamic Investments” must be ongoing. For example, mergers and acquisitions can significantly alter a company’s core business. Suppose a company acquires a group that is involved in the meat-processing industry (including pork). Because pork-based products aren’t allowed per sharia, the company may no longer pass the industry screening process. Likewise, if a construction company starts a new project that is financed through conventional investments by raising debt equity, the project will have an impact on the company’s financial tests.

The right frequency of checks on a company’s sharia compliance depends on the fund, and most funds review their current investments against their sharia compliance screens at least once every year. Some funds may opt to do monthly or quarterly screenings instead. Many funds review their equities’ financial ratios when each company’s latest financial data becomes available in the market, when the company releases its interim financial reports. (Until new financial data or news items are available to the public, the fund’s sharia board or managers may not have any practical reason to perform a screening review.)

remember.epsIf a fund is based on an Islamic index, such as those I profile later in “Benchmarking the Performance of Islamic Funds: Islamic Indexes,” the fund manager’s job is easier because the index itself conducts ongoing compliance screening and sends out alerts when problems are detected.

Taking action on noncompliance

What happens if a fund manager discovers that an investment has become non-sharia-compliant? And what if the fund has accepted dividends or profited from capital gains before realizing the compliance problem?

remember.epsAs soon as a fund manager discovers noncompliance, he must take immediate action to purify the fund’s holdings. But sharia boards have generally given funds some flexibility when dealing with this situation to accommodate the realities of working with the corporate sector. Following are some protocols that most funds observe:

check.png When a corporation fails one or more of the financial tests I describe earlier, a short period (such as a few weeks or a month) is allowed to determine whether the corporation can come back into compliance and pass the tests again or whether its noncompliance is ongoing.

check.png When a stock becomes non-sharia-compliant for a long period (such as a few months) but the company is trying to regain compliance, the fund manager must assess the impact of the noncompliant activities on the company’s dividends. This assessment is typically given in the form of a percentage so the fund can calculate the portion of noncompliance and deduct the amount from the total dividend derived from that company. The deducted portion for noncompliance must be given to charity.

check.png When a stock becomes permanently non-sharia-compliant — a company totally changes its core business activities, for example — the stocks need to be removed from the fund. Here’s how capital gains are handled in this situation:

• If the stock is liquidated immediately when the company announces a change to its core business, the capital gains from the liquidation are kept by the fund and distributed to investors.

• If the stock is liquidated sometime after the company announcement is made, the capital gains are given to charity.

• If the stock in question has fallen below the original cost of the fund’s investment, the sharia board likely allows the fund to keep the stocks until the dividends and market price match the original investment cost. As soon as that match occurs, the investment is liquidated. If the fund receives any gains above the original investment cost, the extra money goes to charity.

Benchmarking the Performance of Islamic Funds: Islamic Indexes

To manage any investment fund effectively, you need to understand your fund performance. The best way to examine performance is to compare it to industry benchmarks and performance indicators. In the financial industry, indexes serve as such benchmarks and indicators. Everyone knows what a fund means when it claims to have “beaten the S&P every year for the past decade.” Investors cheer.

When Islamic investment funds were first being developed (a process I outline in Chapter 11), the funds were benchmarked against the well-known conventional indexes. But that yardstick was flawed because Islamic funds can’t invest in so many of the industries represented by those indexes.

As a result, Islamic indexes were created and now serve as more-appropriate benchmarks for examining an Islamic investment fund’s performance. The Dow Jones Islamic Market (DJIM) indexes, created in 1999, were the first successful Islamic indexes developed, and they have been joined by many others, such as

check.png The FTSE Global Islamic indexes

check.png Global GCC Islamic Index

check.png Global Islamic Index

check.png The Kuala Lumpur Sharia Index (KLSI)

check.png MSCI Global Islamic Indices

check.png The S&P Shariah indexes

Most of these indexes use a similar set of criteria to screen companies for inclusion.

remember.epsIslamic indexes provide invaluable services to investment fund managers. As you probably realize based on the fund screening information earlier in the chapter, the process of selecting companies for inclusion in a sharia-compliant equity fund is technical and time-consuming (and requires supervision from a sharia board; see Chapter 16). Because Islamic indexes conduct their own initial compliance screening research under the guidance of a sharia board or committee, Islamic fund managers can trust that any stock included in such an index is fair game for investment. Thus, Islamic indexes reduce the costs associated with an Islamic fund’s screening process and help funds tap into a wider diversity of stocks.

realworldexample.epsJust as individual funds must strive to maintain sharia compliance by conducting ongoing screening and purifying when necessary (as I discuss in “Purifying a Fund of Noncompliance”), indexes must do the same. Here are just three examples:

check.png The Dow Jones Islamic Market (DJIM) indexes review the sharia compliance of their equities quarterly: on the third Friday of March, June, September, and December. Therefore, any fund based on one of these indexes should review its sharia compliance at least quarterly as well.

check.png The BSE TASIS Shariah 50 Index, an index based in Bombay, India, reviews its stock for compliance monthly. Therefore, any fund based on this index should review its compliance monthly.

check.png (, a sharia screening and compliance management service that works with fund and index managers, has introduced an iPhone application that provides instant access to information about the sharia compliance of a stock, reasons for a stock’s noncompliance, and alerts regarding changes to the compliance status of a stock.

In the following sections, I profile four Islamic indexes to point out the benchmarks and screening processes they establish and use.

Dow Jones Islamic Market (DJIM) indexes

The DJIM is a whole family of broad-market, blue-chip, fixed income, and other indexes. According to its website (, the DJIM screens companies to remove those that engage in the prohibited industries I outline earlier in this chapter (see the section “Avoiding prohibited industries”). These arenas include alcohol, pork-related products, conventional financial services, and tobacco. The website also lists the broad terms “entertainment” and “weapons and defense” as industry screens.

The DJIM conducts three financial tests, which are similar to those I outline in this chapter (see “Passing the financial test”). Specifically, the index expects each of the following financial ratios to be less than 33 percent:

check.png A company’s total debt divided by its “trailing 24-month average market capitalization”

check.png “The sum of a company’s cash and interest-bearing securities divided by [its] trailing 24-month average market capitalization”

check.png The company’s “Accounts receivables divided by [its] trailing 24-month average market capitalization”

A supervisory board of five sharia scholars guides the DJIM. This board currently has members from Bahrain, Malaysia, Saudi Arabia, Syria, and the United States. Per the Dow Jones Indexes website, “The geographic diversity of the scholars helps to ensure that diverse interpretations of Shari’ah law are represented.”

Industry insights from Dow Jones Indexes

Why did Dow Jones Indexes branch out to Islamic finance?

Islamic indexes started as a niche market when Dow Jones Indexes pioneered the space in 1999. The Dow Jones Islamic Market indexes catered to family trusts, discretionary accounts, and mutual funds. Although development was initially slow, growth led to the creation of exchange-traded funds based on Islamic indexes, which have been essential to broadening the appeal of Islamic finance ever since.

What are the recent developments in the Islamic indexing space?

Recently, Dow Jones Indexes launched innovative sharia-compliant indexes covering natural resources, dividends (high-yield stocks), takaful (insurance), and Islamic banking.

How do Islamic indexes perform compared to conventional indexes?

Sharia-compliant screens remove highly leveraged stocks and tend to be overweight in industries such as healthcare, technology, and oil and gas and underweight in others such as financial services. This filtering can help or hinder the performance of Islamic indexes when compared to their conventional counterparts. Over the past few years, for example, financial services have underperformed, while oil and gas and technology have outperformed, leading Islamic indexes to fare better than their conventional counterparts.

What are the challenges Islamic indexing is facing?

The main challenges are perception and lack of education. Two common misconceptions are that Islamic products are expensive and difficult to structure and that they create more work because they must conform to sharia principles. In reality, Islamic indexing is simply a faith-based, ethical investment style.

How do indexes measure the sukuk market?

In 2006, Dow Jones Indexes launched the first sukuk, or Islamic bond, index. The index was primarily created to be used as the benchmark for investors seeking exposure to sharia-compliant fixed-income investments.

This information was provided by Dow Jones Indexes.

© CME Group Index Services LLC 2011. Source: “Dow Jones Indexes” is the marketing name and a licensed trademark of CME Group Index Services LLC (“CME Indexes”). “Dow Jones” and “Dow Jones Indexes” are services marks of Dow Jones Trademark Holdings LLC and have been licensed for use by CME Indexes.

S&P Shariah indexes

Standard & Poor’s introduced its first sharia indexes in 2006. Initially, three indexes were screened for sharia compliance, creating the S&P 500 Shariah, the S&P Europe 350 Shariah, and the S&P Japan 500 Shariah. Since that time, S&P has developed significantly in this market. It now has three index series — the S&P Global Benchmark Shariah Index Series, the S&P Global Investable Shariah Index Series, and the S&P Global Strategy Shariah Index Series — with a total of 27 indexes as of this writing.

In conducting its industry screening, the S&P excludes companies in the traditional list of prohibited industries: alcohol, gambling, pornography, tobacco, pork products, conventional finance, and cloning. It also excludes advertising and media companies, with some exceptions: Newspapers, news channels, and sports channels, as well as advertising and media companies that derive more than 65 percent of their total income from Gulf Cooperation Council (GCC) countries, are accepted. The S&P also screens out any companies that deal in the “Trading of gold and silver as cash on [a] deferred basis” (according to the Standard & Poor’s website:

FTSE Bursa Malaysia Hijrah Shariah Index

The website for this index (which you can access from; click on “Global Equity Indices”) indicates that the index operates with direction from the Malaysia Securities Commission’s Shariah Advisory Council. Launched in 2007, the index screens to exclude companies whose core business activities relate to conventional banking and other interest-related activities, life insurance, alcohol, tobacco, arms manufacturing, gaming, and pork and other prohibited food products.

The index also excludes the following:

check.png Companies carrying a level of debt that indicates “an inappropriate use of leverage relative to their assets”

check.png “Companies that have income from cash or near cash equivalents or inappropriate levels of receivables to assets . . .”

check.png Companies with an unacceptably high percentage of “liquid assets to illiquid assets”

check.png “Companies whose cash and cash equivalent to total assets exceeds the percentage permitted under Shariah principles and commonly accepted philosophies”

MSCI Global Islamic Indices

Per its website (accessed at; go to “Indices” and click on “Faith-Based”), this family of indexes excludes businesses that “derive more than 5% of their revenue (cumulatively) from” alcohol, tobacco, pork-related products, conventional financial services, defense and weapons, gambling, music, hotels, cinema, and adult entertainment. (Note that the 5-percent allowance jibes with my note earlier in the chapter about how difficult it can be for any company to achieve 100 percent sharia compliance.)

The MSCI indexes publicly provide more detail than most other indexes regarding what, exactly, they look for during the industry screening process. Visit the website for details on each prohibited industry.

As well, the MSCI indexes examine three financial ratios for each company when determining sharia compliance, reflecting the screening process I describe in the earlier section “Passing the financial test”:

check.png Total debt divided by total assets

check.png The sum of the company’s cash and interest-bearing securities divided by its total assets

check.png The sum of the company’s accounts receivable and cash divided by its total assets

Each of these ratios should be less than 33.33 percent.

Developing New Methods for Managing Market Risk

Managing risk is a crucial aspect of investment management. As I explain in Chapter 11, the Islamic capital market is developing rapidly. As its exposure to market risk (the very real possibility that the value of a security or group of securities can drop on any given day) increases, the market’s inability to tap into certain conventional risk management instruments becomes more problematic. In this section, I offer a quick overview of the concerns related to Islamic market risk and some products being developed to try to curb it.

Identifying the issues

Conventional investment funds have quite a few options for managing market risk, including futures, forward contracts, options, and swap markets. (See Chapter 11 for a rundown of these derivative products.) But the Islamic derivatives market is very small and very young. And in many cases, it faces restrictions from sharia boards that are wary of the speculation involved in derivative products as a whole.

Adding to the concern is that Islamic funds can’t diversify as much as conventional funds. Their screening processes remove entire industries from investment consideration, narrowing the field of equity selection. Although diversification can’t, by itself, eliminate market risk, it certainly can soften the blow when one large company — or even one entire industry — faces a sudden decline in equity value.

Creating products that mitigate market risk

Two groups of products are currently being developed to help hedge risk in the Islamic market: derivatives (specifically futures and forward contracts) and capital protected equity funds. Both types of products are familiar to conventional investors.

Futures and forward contracts

Futures and forward contracts are familiar derivatives in conventional finance. Both products are used to hedge risk, and both allow a buyer and a seller to agree today on the price of a future asset sale/purchase. (That asset may be a financial asset or commodity, for example.) A difference is that futures are traded on exchanges but forward contracts aren’t.

I note in Chapter 11 that many sharia scholars have concerns about the compliance of derivatives in general. In fact, some scholars don’t permit futures under any circumstances because these contracts involve goods that don’t yet exist and therefore involve too much uncertainty. However, some scholars accept futures and forward contracts as sharia-compliant if the following conditions are met:

check.png The delivery of the underlying asset is compulsory.

check.png The delivery date of the asset can’t be adjusted.

In Islamic finance, a salam (purchase with deferred delivery) contract is used to support futures and forward contracts. In a salam contract, the price of the goods to be received in the future is paid in full at the time of purchase. Therefore, this type of contract can be used to protect the value of assets in Islamic funds and Islamic bonds. This product differs from conventional futures and forward contracts, in which both the payment and the asset exchange take place in the future.

Capital protected equity funds

Capital protected equity funds require that the majority of assets in the funds be allocated to fixed-term cost plus (murabaha) transactions that are supported by third-party guarantees issued by A1/P1-rated financial institutions. (The financial institutions providing the guarantees have the highest short-term ratings from S&P and Moody’s.) This product was introduced to help investors feel safer about their investments.

In the murabaha contract, as I explain earlier in this chapter, the cost plus profit is deferred. When a fund is invested with such a contract, the investor receives profit plus capital in installments. Therefore, the fund is better able to return all the capital it invested.

realworldexample.epsAl Meezan Investment Limited of Pakistan offers the Meezan Capital Protected Fund, which (per the website “aims to ensure 100% capital protection upon maturity.”

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