Warren Mcleod | Saliegh Salaam | Grant Watson
Shari'ah compliant investment funds have grown significantly
globally over the last decade. In addition to catering for the
requirements of Muslim investors, these funds also meet the
increasing demand for ethical investments. Not everyone is familiar
with how Shari’ah compliant investing is conducted and the
investment implications of this ethical-religious approach for South
WHAT IS SHARI’AH COMPLIANT
Investing in a Shari’ah compliant manner essentially means
investing in accordance with the religious and ethical framework of
the Muslim faith, which is interpreted by a Shari’ah board. In terms
of this framework, investors cannot earn:
- Interest income, however derived.
- Income from businesses that are morally questionable or
damage wellbeing, such as defence, tobacco, alcohol,
gambling companies etc.
- Income earned from sources where there is excessive
uncertainty, such as gambling and speculative investments.
All South African collective investment schemes that are Shari’ah
compliant have to have a Shari’ah board and adhere to a global
set of Shari’ah standards of the Accounting Auditing Organisation
for Islamic Financial Institutions (AAOIFI). These standards require
- A qualitative test is done to determine the nature and sources of
- A quantitative test must also be performed which looks at a
number financial ratios. These ratios are as per the following
One of the most critical elements of Shari’ah compliant investing
is the processes in place to ensure compliance. Given that one of
the primary requirements of investors in Shari’ah compliant funds
is to achieve a return within an ethical and a religious framework,
it’s important for investors to understand the compliance processes,
specifically who the Shari’ah board is, what the governance
processes are and whether a Shari’ah audit is performed.
However, differences of interpretation do crop up across Shari’ah
boards. AAOIFI standards are open to interpretation and these
differences of interpretation can create variances in investable
universes across various Shari’ah funds. These in turn can impact the
opportunities to generate relative performance.
Potentially less diversification
- Interest income exclusions mean that Shari’ah compliant funds
are precluded from investing in interest instruments such as
money market instruments and bonds (government and corporate
bonds). As a result, the range of asset classes may be narrower
than those available to conventional balanced funds. Shari’ah
compliant balanced funds typically invest in Sukuks, which may
be viewed as “Islamic bonds”. In the shorter-term maturities,
these instruments are akin to promissory notes. However, these
instruments are typically less liquid than conventional fixed
income assets, due to set-up costs relating to these structures,
and they have early redemption costs.
- Derivatives may not be used as they are deemed speculative.
In addition, derivative pricing also incorporates an implicit
interest rate component. Given this exclusion, the potential return
generation and risk management opportunities that derivatives
offer investors are not available to Shari’ah compliant funds.
- “Nature of business” criteria mean that companies including
tobacco, alcohol, financial and insurance are not eligible for
investment. Consequently, when these sectors or companies
outperform or underperform, Shari’ah compliant funds may
underperform or outperform.
Further, potentially higher share concentration risk may arise due to
the various “nature of business” exclusions that are driven by ethical
or religious criteria.
As can be seen from the above table, the JSE Shari’ah Index is
about 55% smaller than the SWIX, based on number of shares. This
significantly smaller universe could potentially impact risk and return
Investing in well-capitalised
The Quantitative test (ratio 1 and ratio 2) measures a company’s
gearing, as well as its investment in non-passive income-generating
assets. Companies with debt above 30% compared to market value
and passive income-generating assets above 30% are excluded.
Well-capitalised companies have a lower probability of bankruptcy
or default and are better able to navigate the shifting economic
landscape and rising interest rates. In addition, by ensuring that
interest-bearing investments are below 30%, management are
incentivised to either pay excess cash to shareholders or invest them
in productive investments. If an investor believes that well-capitalised
companies are more likely to outperform over time due to perceptions
around the quality of the company, then Shari’ah compliant funds,
by definition, should benefit from its bias towards quality companies
and are a “hedge” against leverage.
Performance variation relative to
As a result of the application of Shari’ah criteria to the SWIX, the
resultant Shari’ah compliant universe will be materially different to
the SWIX. This difference is best illustrated by looking at the tracking
error and volatility of the JSE Shari’ah Index and the proprietary Old
Mutual Customised Shari’ah Index relative to the SWIX. Tracking
error measures the higher volatility of the difference in returns
between a given fund and its benchmark, which in this example is
the SWIX. The risk ratio measures the volatility of a given Shari’ah
index to the SWIX:
It’s evident that the Shari’ah compliant criteria result in a high tracking
error as well as higher volatility relative to the SWIX. These statistics
highlight the importance of managing risk systematically to mitigate
the effects of the Shari'ah criteria on absolute and relative risk.
Another way to view the differences between the two indices is to
compare the top 10 weights in the respective indices. A review of the
top 10 shares in the JSE Shari’ah Index and the JSE SWIX highlights
dramatic differences, with only three shares, namely MTN, Sasol and
Steinhoff, being found in the top 10 of both indices. All this highlights
that investors in Shari’ah compliant funds are likely to have a different
return experience to conventional funds at a point in time.
Impermissible income donated to
All companies that are Shari’ah approved may derive incidental
impermissible income. This income has to be less than 5% of total
revenue. Impermissible income is all income including interest income
and income from sources that may be morally questionable. This
income is donated to charities at least once a year. Questions that
may arise regarding impermissible income are:
- What is the calculation methodology for impermissible
- What is the impact on the fund net asset value or performance
when impermissible income is removed from the fund?
- Are investors treated equally?
- What governance processes are in place with respect to the
A long-term track record
Due to the nature of the ethical and religious constraints of Shari’ah
compliant funds, it is important to consider whether the manager has
at least a five-year track record of managing these mandates.
Given the implications we have highlighted above, it is good to
know that Shari'ah compliant funds, constrained by ethical and
religious requirements, are able to outperform conventional funds that
have no ethical and religious constraints. The Shari’ah fund with the
earliest inception date (June 1992), namely the Old Mutual Albaraka
Equity Fund, has been a top-quartile performing fund since inception
and has outperformed inflation by 8.4% per annum over this period
to the end of September 2015.
The returns are even more impressive when you consider that
these include the impact of impermissible income on performance.
Impermissible income effectively reduces the Shari’ah fund’s
performance. This data provides evidence that ethically-minded
investors can invest in a manner consistent with their ethical or
religious beliefs and still generate attractive long-term wealth.