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Shariah Guidelines For Shariah Guidelines For ISLAMIC FUNDSISLAMIC FUNDS

April 24, 2012April 24, 2012Alhuda-CIBE TrainingsAlhuda-CIBE TrainingsAvari Towers, KarachiAvari Towers, Karachi

By By

Muhammad Najeeb Khan Muhammad Najeeb Khan

Sharia AdvisorSharia AdvisorHabib Mertropolatin Bank

Sharia Board Member Sharia Board Member UBL Islamic Fund

Islamic InvestmentIslamic Investment

• The term 'Islamic Investment Fund" The term 'Islamic Investment Fund" in this chapter means a joint pool in this chapter means a joint pool wherein the investors contribute wherein the investors contribute their surplus money for the purpose their surplus money for the purpose of its investment to earn halal profits of its investment to earn halal profits in strict conformity with the precepts in strict conformity with the precepts of Islamic Shari‘ahof Islamic Shari‘ah



• FirstlyFirstly, instead of a fixed return tied , instead of a fixed return tied up with their face value, they must up with their face value, they must carry a pro-rata profit actually carry a pro-rata profit actually earned by the Fund. Therefore, earned by the Fund. Therefore, neither the principal nor a rate of neither the principal nor a rate of profit (tied up with the principal) can profit (tied up with the principal) can be guaranteed.be guaranteed.



• SecondlySecondly, the amounts so pooled , the amounts so pooled together must be invested in a together must be invested in a business acceptable to Shari‘ah. It business acceptable to Shari‘ah. It means that not only the channels of means that not only the channels of investment, but also the terms investment, but also the terms agreed with them must conform to agreed with them must conform to the Islamic principles. the Islamic principles.


Equity FundEquity Fund

•In an equity fund the amounts are In an equity fund the amounts are invested in the shares of joint stock invested in the shares of joint stock companies. The profits are mainly companies. The profits are mainly derived through the capital gains by derived through the capital gains by purchasing the shares and selling them purchasing the shares and selling them when their prices are increased. Profits when their prices are increased. Profits are also earned through dividends are also earned through dividends distributed by the relevant companies. distributed by the relevant companies.


Equity Fund Equity Fund

•It is obvious that if the main business of a It is obvious that if the main business of a company is not lawful in terms of Shari‘ah, company is not lawful in terms of Shari‘ah, it is not allowed for an Islamic Fund to it is not allowed for an Islamic Fund to purchase, hold or sell its shares, because purchase, hold or sell its shares, because it will entail the direct involvement of the it will entail the direct involvement of the share holder in that prohibited business. share holder in that prohibited business.


Conditions Conditions

• Conditions for investment in Conditions for investment in SharesShares In the light of the foregoing In the light of the foregoing discussion, dealing in equity shares discussion, dealing in equity shares can be acceptable in Shari‘ah subject can be acceptable in Shari‘ah subject to the following conditions: to the following conditions:


ConditionsConditions

• 1.1. The main business of the company The main business of the company is not violative of Shari‘ah. Therefore, it is not violative of Shari‘ah. Therefore, it is not permissible to acquire the shares is not permissible to acquire the shares of the companies providing financial of the companies providing financial services on interest, like conventional services on interest, like conventional banks, insurance companies, or the banks, insurance companies, or the companies involved in some other companies involved in some other business not approved by the Shari‘ah.business not approved by the Shari‘ah.



• 2.2. If the main business of the companies is If the main business of the companies is halâl, like automobiles, textile, etc. but they halâl, like automobiles, textile, etc. but they deposit their surplus amounts in an interest-deposit their surplus amounts in an interest-bearing account or borrow money on interest, bearing account or borrow money on interest, the share holder must express his the share holder must express his disapproval against such dealings, preferably disapproval against such dealings, preferably by raising his voice against such activities in by raising his voice against such activities in the annual general meeting of the company. the annual general meeting of the company.



• 3.3. If some income from interest-bearing If some income from interest-bearing accounts is included in the income of the accounts is included in the income of the company, the proportion of such income in the company, the proportion of such income in the dividend paid to the share-holder must be given dividend paid to the share-holder must be given in charity, and must not be retained by him. For in charity, and must not be retained by him. For example, if 5% of the whole income of a example, if 5% of the whole income of a company has come out of interest-bearing company has come out of interest-bearing deposits, 5% of the dividend must be given in deposits, 5% of the dividend must be given in charity. charity.



• 4.4. The shares of a company are negotiable The shares of a company are negotiable only if the company owns some illiquid only if the company owns some illiquid assets. If all the assets of a company are in assets. If all the assets of a company are in liquid form, i.e. in the form of money they liquid form, i.e. in the form of money they cannot be purchased or sold except at par cannot be purchased or sold except at par value, because in this case the share value, because in this case the share represents money only and the money represents money only and the money cannot be traded in except at par. cannot be traded in except at par.



• What should be the exact proportion of illquid What should be the exact proportion of illquid assets of a company for warranting the assets of a company for warranting the negotiability of its shares? The contemporary negotiability of its shares? The contemporary scholars have different views about this scholars have different views about this question. Some scholars are of the view that the question. Some scholars are of the view that the ratio of illiquid assets must be 51% in the least. ratio of illiquid assets must be 51% in the least. They argue that if such assets are less than They argue that if such assets are less than 50%, then most of the assets are in liquid form, 50%, then most of the assets are in liquid form, and therefore, all its assets should be treated as and therefore, all its assets should be treated as liquid on the basis of the juristic principle: liquid on the basis of the juristic principle:



• Some other scholars have opined that even if the Some other scholars have opined that even if the illiquid asset of a company are 33%, its shares can illiquid asset of a company are 33%, its shares can be treated as negotiable. be treated as negotiable. The third view is based on the Hanafi The third view is based on the Hanafi jurisprudence. The principle of the hanafi school is jurisprudence. The principle of the hanafi school is that whenever an asset is a combination of liquid that whenever an asset is a combination of liquid and illiquid assets, it can be negotiable irrespective and illiquid assets, it can be negotiable irrespective of the proportion of its liquid part. However, this of the proportion of its liquid part. However, this principle is subject to two conditions: principle is subject to two conditions:



According to Shariah Standards of Accounting and According to Shariah Standards of Accounting and Auditing Organization for Islamic Financial Auditing Organization for Islamic Financial Institutions (AAOIFI) a Stock Company has been Institutions (AAOIFI) a Stock Company has been defined as:defined as:

““A stock company is a company of which the capital is A stock company is a company of which the capital is

partitioned into equal units of tradable shares and partitioned into equal units of tradable shares and

each shareholder’s liability is limited to his shares in each shareholder’s liability is limited to his shares in

the capital. It is a form of financing partnership. The the capital. It is a form of financing partnership. The

rules of rules of Sharikat al-InanSharikat al-Inan apply to this company apply to this company

except on the issue of the limited liability of the except on the issue of the limited liability of the

shareholders and the fact that this type of company shareholders and the fact that this type of company

cannot be unilaterally terminated by one party or a cannot be unilaterally terminated by one party or a

minority of its shareholders”minority of its shareholders”


ScopeScope

Transactions in an Islamic Capital Market should be

free from the involvement of prohibited activities

by Islam as well as free from the elements such

as usury (riba), gambling (maisir) and ambiguity

(gharar)


Shariah Compliant StocksShariah Compliant Stocks

• Shariah Guide lines:Shariah Guide lines:• Shariah based principle of equity Shariah based principle of equity

participation is Shirkahparticipation is Shirkah• Stocks are classified as Shariah Stocks are classified as Shariah

compliant if their business activities compliant if their business activities do not fall in the prohibited list do not fall in the prohibited list prescribed by Shariah Scholars prescribed by Shariah Scholars

• Certain financial ratios are also Certain financial ratios are also applied for screening.applied for screening.


Shariah Compliant StocksShariah Compliant Stocks

Prohibited activities:Prohibited activities:• AlcoholAlcohol

• GamblingGambling

• Pork related productsPork related products

• PornographyPornography

• Conventional financial Conventional financial servicesservices

• Conventional insuranceConventional insurance

• Tobacco, Tobacco,

• Indecent EntertainmentIndecent Entertainment

Financial Ratios:Financial Ratios:• Main ratios applied areMain ratios applied are

– Debt to equity ratioDebt to equity ratio– Cash and interest bearing Cash and interest bearing

securities to equity ratiosecurities to equity ratio– Cash to asset ratioCash to asset ratio

• In Malaysia, the screening of In Malaysia, the screening of listed stocks is undertaken by listed stocks is undertaken by a centralised body- Shariah a centralised body- Shariah Advisory Council of SECAdvisory Council of SEC

• In other jurisdictions, In other jurisdictions, screening services are screening services are performed by individual performed by individual institutionsinstitutions


Stock Market BusinessStock Market Business

• The stock exchange provides a market place The stock exchange provides a market place where investors can buy and sell shares. The where investors can buy and sell shares. The exchange’s role is to monitor the market to exchange’s role is to monitor the market to ensure that it is working efficiently, fairly and ensure that it is working efficiently, fairly and transparently.transparently.

• The trading system comprises four distinct The trading system comprises four distinct segments:segments:

• T+ (2) settlementT+ (2) settlement

• Spot transactions Spot transactions

• Provisionally listed counter Provisionally listed counter

• Futures contractFutures contract


Key components of Islamic Capital Markets

Shariah Compliant Stocks

Islamic Funds

Islamic Bonds

Islamic Capital Market


Shariah Related Issues in Stocks Shariah Related Issues in Stocks TradingTrading• Not permitted to purchase shares by Not permitted to purchase shares by

raising interest bearing loans through raising interest bearing loans through a broker or someone else.a broker or someone else.

• Not permitted to pledge the shares for Not permitted to pledge the shares for the interest bearing loan.the interest bearing loan.

• It is not permitted to sell the shares It is not permitted to sell the shares that the seller does not own which is that the seller does not own which is called short sale. The promise by the called short sale. The promise by the broker to lend these shares at the time broker to lend these shares at the time of delivery is of no consequence.of delivery is of no consequence.


Issues in Stocks Trading (Contd)Issues in Stocks Trading (Contd)

• Not permitted to conclude futures Not permitted to conclude futures contract for shares because according contract for shares because according to Shariah only one thing either to Shariah only one thing either payment or delivery can be deferred.payment or delivery can be deferred.

• Not permitted to conclude the Not permitted to conclude the contracts of options for shares or to contracts of options for shares or to conclude swap contracts with respect conclude swap contracts with respect to shares and their returns.to shares and their returns.

• The contract of Salam is not The contract of Salam is not permissible in shares – identified permissible in shares – identified itemsitems..

Stock Screening Criteria

Various Criterion have been developed by the Scholars to screen any scrip’s eligibility for investment. The major stock screening criterion followed are:

• Dow Jones Islamic Market Indices Criteria (DJIMI)

• Meezan Islamic Market Index Criteria (KMI 30 Index Criteria)

Business of the Investee Company: The basic business of the investee company should be Halal.

Debt to Market Capitalization: Total debt divided by 12-month average market capitalization should be less than 33%.

Cash and Interest Bearing Securities: The sum of company’s cash and interest-bearing securities divided by trailing 12-month average market capitalization should be less than 33%.

Accounts Receivables: Accounts receivables divided trailing 12-month average market capitalization should be less than 33%.

Dow Jones Islamic Market Index Criteria

Business of the Investee Company: The basic business of the investee company should be Halal.

Debt to Total Assets: The interest bearing debt of the investee company should not exceed 37% of total assets.

Illiquid Assets to Total Assets: Total illiquid assets of the Investee company as a percentage of total assets should be at least 25%.

Investment in Shariah Non-Compliant Activities: Total investment of the investee company in Shariah non-compliant business should not exceed 33% of total assets.

Income from Shariah Non-Compliant Investments: The income from Shariah non-compliant investments should not exceed 5% of gross revenues of the investee company.

Net Liquid Assets vs. Share Price: The net liquid assets per share should be less than the market price of the share.

Meezan Islamic Market Index Criteria

It is necessary to purify the earnings by deducting from the returns on the investments those earnings emanating from an unacceptable source from a Shariah point of view.

In context of equity investment according to Shariah standards it is obligatory to eliminate prohibited income that is mixed up with the earnings of the company and this obligation is on the one who is the owner of the shares.

Purification Requirement

Elimination is not obligatory for the intermediary, agent or manager out of part of their commission or wages because this is their right in lieu of the work they have undertaken.

In case of Fund Management it is responsibility of the Management Company to eliminate the prohibited income.

According to Shariah Standards for the determination of the percentage of prohibited income the recourse should be the last verified financials position.


we calculate the percentage of non-compliant income to the gross revenue (sales + other income) for each investee company and this percentage is called as charity rate.

Charity rate for each investee company is multiplied with the dividend income from respective companies to get the charitable amount. This charitable amount is then transferred to a separate account.

Shariah advisor verifies the whole process of elimination of prohibited income and issues a certificate to be included in the annual accounts of the fund.



Quantitative Screening Criteria

• The basic business of the investee company should not be non-Shariah compliant like conventional banks and insurance companies

• Total non-Shriah compliant debt of the Investee Company should not exceed 40% of the total assets.

• Total illiquid assets (which are not cash or cash equivalent) of the Investee Company as a percentage of the total assets should be at least 20%


Quantitative Screening Criteria

• Total investment of the investee company in Shariah non-compliant business (as a secondary source of income) should not exceed 33% of the total assets

• Investee Company’s interest income or any other non- Shariah compliant income should not exceed 5% of its gross revenues

• All the essential Shariah trading rules would be applied in case of trading; hence short sale or sale before settlement date would not be allowed


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Documents

main business

equity shares

business acceptable

islamic fundsapril

precepts of islamic

islamic principles

insurance companies

relevant companies