Financial Screens for the Islamic Finance and Lesson from the Ethical Investment Industry

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Shari’ah Scholars and Harmony in Short Supply
December 19, 2008
A Shariah Compliant Alternative to Selling Short with Borrowed Securities by Shaiykh Yusuf Talal De Lorenzo
December 29, 2008
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Financial Screens for the Islamic Finance and Lesson from the Ethical Investment Industry

Quoted from the Islamic Business and Finance by Professor Rodney Wilson available at: (

The criteria for selection outlined in the first part of the article are essentially qualitative, in the sense that they involve judgement rather than precise measurement. Quantitative criteria are however also used when screening equities to ensure that they are Shari’ah compliant. These involve calculation of ratios, such as the proportion of interest bearing debt to assets or the ratio of total debt to the average market capitalisation of a company over a period of 12 months. The issue of leverage is complicated. Avoidance of investments in companies which have any involvement with Riba-based banks is ideal, but this would mean the exclusion of virtually all quoted companies, including those whose stocks are traded in the equity markets of Muslim countries.

In practice, fund management groups seeking to comply with Shari’ah adopt several criteria, and there is disagreement and debate about what approach is most appropriate. Firstly, they examine the extent to which a company’s income is derived from interest, and any proportion in excess of 15 per cent is deemed unacceptable. The second criterion is to consider the extent of debt to equity finance, where a proportion in excess of one-third is considered unacceptable. Rushdi Siddiqui of Dow Jones Islamic Indices advocated tighter criteria in the 1990s, with a limit of 25 per cent for the debt to capitalisation ratio, but there was no consensus on this. The TII-FTSE Islamic index adopts only one financial screen, excluding companies whose interest bearing debt divided by assets is equal or greater than one-third, or 33.33 per cent. The Dow Jones Islamic Indexes have three financial screens to exclude companies:

1. No Islamic investment if total debt divided by the trailing twelve-month average market capitalisation is greater than or equal to 33 per cent
2. Omit companies if the sum of cash and interest bearing securities divided by the trailing twelve-month average market capitalisation is greater than or equal to 33 per cent of revenues
3. Exclude companies if the accounts receivable divided by total assets are greater than or equal to 45 per cent of revenues.

Problems and potential injustices with financial screening
Although those who advocate financial screening have good intentions, it can have unfortunate consequences both for the companies included in an Islamic equity portfolio, and the Muslim investors in the fund themselves. In bear markets such as that experienced from 2001 until early 2003 in most Western countries, market capitalisation can fall significantly while debt remains constant or rises. This results in many additional companies being excluded under the first financial screening criteria, and in the case of the post 2001 slump, high technology companies, that had been much favoured by the Islamic fund management industry, were soon excluded. Having a trailing twelve-month average for market capitalisation delays exclusion, but when bear markets persist, the inevitable occurs.

It is debatable if excluding companies because of cyclical developments affecting the entire market is justified, or indeed whether it is really legitimate to include debt laden companies simply because there has been a bull market with a very positive impact on their market capitalisation. These matters deserve further consideration from Shari’ah scholars, as companies cannot be blamed or excused because of developments in the market in general, although admittedly it can be argued that prudent companies with low or moderate debt are less likely to be affected by market downturns than those with high debt. Nevertheless, Islamic disinvestments during a slump may make matters worse for a struggling company, and bring bankruptcy and redundancy for employees, including those who are Muslims. Investors in the Islamic equity fund may also suffer, as selling shares when prices are falling may not be the best exit strategy.

The TII-FTSE Islamic Index does not screen out companies with more than one third of their revenues deriving from interest on cash and securities, but the Dow Jones Islamic Indexes, as already indicated, specifically exclude such companies. This exclusion of course applies to most conventional banks, but there is no need to use a financial screen to exclude these institutions, as they are already excluded because of the sector screen. Investment companies may be excluded if they have excessive cash holdings under this financial screen, as in practice their liquidity is likely to be invested in interest earning bank accounts or conventional bonds. For Islamic investment companies, the answer to the liquidity dilemma will be ultimately to hold sovereign and corporate Sukuk when they become more widely issued and traded. For conventional investment companies, such securities are likely to remain marginal for their liquidity management.

The concern of the Shari’ah advisors to the Dow Jones Islamic Indexes over receivables arises because there is often interest charged on deferred payments and accounts overdue. The stipulation that companies should be excluded if the ratio of accounts receivable to total assets exceeds 45 per cent is designed to ensure that companies selected for Islamic portfolios are not dependent on interest income for most of their earnings. However, this is exactly what has happened to many multinational industrial companies, that might otherwise be suitable for inclusion in Islamic fund portfolios. For instance, due to the global competition in the vehicle industry, car manufacturers such as Ford, General Motors and Daimler Chrysler have become in effect banks, with most of their profits derived from financing vehicle sales through extended payments terms. None of these manufacturers now qualify for inclusion in the Dow Jones Islamic Indexes, even though they are the world’s largest car manufacturing companies.

Rather than specifying a fixed proportion for income from cash and interest bearing securities, or a limit on receivables, the TII-FTSE Islamic Index suggests that Muslim investors can purify their income through dividend cleansing. This implies giving away any income derived from Haram sources to charitable causes, and hence making the residual income Halal. The so-called tainted dividend receipts relate to the portion, if any, of a dividend paid by a constituent company in an Islamic equity portfolio that is attributable to activities that are not in accordance with Shari’ah. Once this is calculated, Muslim investors have the opportunity to legitimise their earnings, and deserving charities benefit.

Lessons from the ethical investment industry
As already indicated, there are parallels between the concerns of investors involved with the ethical investment industry in the West, and those who entrust their money to Islamic equity funds. As with Islamic equity fund management, the ethical industry uses both positive and negative screens for stock selection. The major difference is that the screens are socially determined rather than through religious teaching. Often the ethical industry is described as socially responsible investing, the main concerns being matters of social conscience and environmental issues. Although the ethical investment industry is primarily driven by secular concerns, and does not promote an overtly religious message, some of the leading participants such as Friends Provident and Clerical Medical in the United Kingdom have Christian origins, the former being associated with the Society of Friends.

The Friends Provident Stewardship fund is the leading UK ethical fund with more than $2.5 billion under management, compared to $3.6 billion managed by the entire Islamic equity fund management industry. Friends Provident Stewardship fund aims to avoid companies that cause environmental damage and pollution, or are involved in the manufacture and sale of weapons, trade with or have operations in oppressive regimes, exploitation of developing countries, unnecessary exploitation of animals, nuclear power, tobacco or alcohol production, gambling, pornography or offensive or misleading advertising. As most Muslim economies are developing, and some have oppressive regimes, the negative list of the Friends Provident Stewardship fund may be of particular interest to Islamic equity fund managers and their Shari’ah advisors.

Islamic equity funds should arguably put stress on the positive criteria for selecting companies rather than simply listing prohibitions. The Friends Provident Stewardship fund looks to support companies that supply the basic necessities of life and provide high quality products and services that are of long-term benefit to the community. As Muslims share these objectives that are stressed in Islamic teaching, it may be appropriate for Islamic equity funds to include such positive statements in their prospectuses. At present the Islamic equity funds industry is largely reactive, disinvesting when companies breach its financial screens or change the nature of their business, hence being excluded by the sector screens. The ethical investment industry is more proactive than reactive, seeking to engage with companies in order to change their policies, so that they can conform to their social and environmental agendas.

In practice, most of the engagement with companies by the Friends Provident Stewardship fund has involved encouraging international pharmaceutical companies to supply patented medicines to the developing world at lower prices and improve working conditions and employment practices. Unlike many fund management groups, the Friends Provident Stewardship fund is actively engaged in corporate governance by voting in around 1,500 companies each year. Where they vote against a company proposal, reasons are given in writing, and the fund attempts to start a discussion with the company over its concerns. The complete voting record is made available on the website and updated every month.

Ethical investment encompasses stock broking and portfolio management as well as equity fund management, Charcol Holden Meehan, being the largest specialist firm in the sector in the United Kingdom. Individuals with more than $178,000 to invest can have a personal ethical screening service, and Charcol Holden Meehen also offer ethical pensions and investment opportunities for venture capital. The standard of information disclosure to clients is extremely high, and in many ways could be regarded as a benchmark for the Islamic fund management industry.

Charcol Holden Meehen offers clients three different levels of ethical compliance, designated light green, medium weighting and dark green. Even for the light green designation, companies involved in tobacco production or distribution, the armaments trade, animal testing or environmental exploitation are excluded. However, much of the emphasis is on positive screening. Portfolios are designed to have market sector weightings, so that performance can be compared with major indices, but companies for inclusion are selected according to a best of sector approach, this being defined in ethical rather than financial terms. Companies are selected that exemplify the best environmental and social policy in each sector. For Charcol Holden Meehan, the medium ethical category implies some exposure in oil, pharmaceuticals and banks, but below market weight for each of these sectors. Companies that are included in the dark green portfolio are expected to contribute significantly to the ethical objectives adopted, for example waste management companies making a major contribution to recycling.

Although many may view Shari’ah compliance in binary terms of Haram and Halal, there are often ethical trade-offs when adopting screening, and choices are by no means clear cut. It is not simply a matter of sacrificing material gain in order to be certain that Islamic principles are being upheld, but of recognising that a step-by-step approach may be the best means of attaining religious objectives. Hence, those who are at the light green stage may be regarded as being at the start of the journey, and those at the dark green stage further down the road. There are philosophical as well as practical lessons for the Islamic screening process to be learnt from the ethical screening experience. Yusuf Talal DeLorenzo, a leading Shari’ah advisor to numerous equity fund managers, has stressed the benefits of building bridges between the ethical and Islamic investment industries.

Widening the remit for Shari’ah screening
Developing sound and acceptable screens is crucial for both Islamic and ethical finance. It reduces the workload of the Shari’ah board, as once the criteria are agreed, fund managers can simply apply the rules and exclude Haram stock. Many institutions offer a wide range of Islamic equity funds as clients have different time horizons and risk preferences, and it would be impossible for Shari’ah board members to advise on every single stock purchase by fund managers. The availability of standardised screens can therefore facilitate the development of the industry. For instance, the National Commercial Bank of Saudi Arabia could introduce new products such as the Islamic Equity Builder Certificates without increasing the workload on their Shari’ah advisors, as fund managers simply apply the screening software supplied by the Dow Jones Islamic Indexes.

Satisfying the Shari’ah advisors regarding screening is a necessary but not a sufficient condition for the success of Islamic equity funds. Having a Shari’ah committee composed of eminent and respected scholars is a source of comfort for most clients, and is a major factor in ensuring a sound reputation for the fund. However, knowledgeable clients in the future may want direct assurance of Shari’ah compliance rather than indirect assurance through the Shari’ah committee as intermediaries. As with ethical funds, clients may wish to make their own judgements in the light of full information on the screens, and an explanation of why they are relevant to Shari’ah compliance. This will not necessarily reduce the role of the Shari’ah advisors, but rather they may become more communicators and educators as well-informed clients ask ever more questions about the rationale for investing according to conscience, and not simply on the basis of financial returns.

Best Regard

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    With Mr. Zhe Li from Shanghai, Dr. Irfan Kaygalak from Turkey and Mr. Mohamad El-Saiti from Libya


    1. Ron Robins says:

      For anyone interested in Shari’ah investing, I frequently carry the latest news and research on my popular ethical investing site at

      Best wishes, Ron Robins

    2. Stephanie says:

      Out of curiosity, I have a question. Let’s say the stock become permanently tainted despite passing the initial screening tests (e.g. it was a leisure group stock at first but diversified to include alcohol/adult entertainment related sales – which is now the crux of the group’s profits)? I am assuming that the particular stock would have to be sold as it is now non-Sharia’a compliant.
      What about the profit made (if any) from the sale? Would it get distributed to the investors (bearing in mind it is now haram stocks) or donated to charity?

      • ZULKIFLI HASAN says:

        There are few methods of screening. Dow Jones screens for acceptable business activities by stating that activities of the companies should not be inconsistent with Shari’ah precepts. Securities and Exchange Commission Malaysia screens mainly on activity of income -based. If one particular stock is found to be suspiciously non-halal or its activities are diversified in which represent the core business of the company then it will be delisted from halal counters. From my personal opinion, the issue of non-halal profit derived from such activities should be declared unlawful and be donated to charitable organisation. There are shortcomings on the current screening method and I personally view that it needs some modification.

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