Investment Implications of Shari’Ah compliant investing

26 Jan 2016

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 African investors.


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:

  1. Interest income, however derived.
  2. Income from businesses that are morally questionable or damage wellbeing, such as defence, tobacco, alcohol, gambling companies etc.
  3. 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 that:

  1. A qualitative test is done to determine the nature and sources of income.
  2. A quantitative test must also be performed which looks at a number financial ratios. These ratios are as per the following table:
         Interest bearing

Ensuring compliance

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

  1. 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.sukuk rate
  2. 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.
  3. “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.

 Qualitative Test

sector exposure

Further, potentially higher share concentration risk may arise due to the various “nature of business” exclusions that are driven by ethical or religious criteria.

exposure 1

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 opportunities.

Investing in well-capitalised companies

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 conventional funds

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:
exposure 2

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 charities

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:

  1. What is the calculation methodology for impermissible income?
  2. What is the impact on the fund net asset value or performance when impermissible income is removed from the fund?
  3. Are investors treated equally?
  4. What governance processes are in place with respect to the charitable donations?

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.

  • Warren McLeod
  • Saliegh Salaam
  • Grant Watson
  • Fundamentals