Investing by the Book: Shariah Compliant Mutual Funds

The concept of Shariah-compliant mutual funds can be daunting for the average Muslim, so in this post we will explore its principles, benefits, and strategies, to see if more Muslims can unlock the potential offered by this type of investment.

Introduction to Shariah Compliant Mutual Funds

Shariah compliant mutual funds are investment funds that adhere to Islamic principles of investing. Some key features include:

• Avoiding investments in prohibited sectors like alcohol, tobacco, gambling, etc. as per shariah law
• Avoiding interest (riba) and leveraged investments
• Ensuring underlying business practices align with Islamic values

As per shariah investing principles and practices, shariah funds screen potential investments to filter out non-compliant stocks and sectors. Fund managers also actively monitor portfolios to purify any non-compliant income.

“Shariah-compliant funds facilitate ethical investing in a way that adheres to the principles of Islamic finance.”

The objective is to provide Muslim investors a means to participate in financial markets in a halal manner that aligns with their values.

Some key screening criteria used as per screening for halal stocks include:

• Sector-based screening – Exclude companies involved in prohibited activities like alcohol, tobacco, pork products, gambling, adult entertainment, etc.
• Financial ratio screening – Exclude companies with excessive leverage or interest income above tolerated thresholds. Common thresholds are:
  • Debt less than 33% of market capitalization
  • Cash + interest bearing items less than 33% of market capitalization
• Qualitative screening – Assess underlying business practices and ethics of company management

Shariah funds are an growing segment within the broader halal investing landscape that caters to faith-based investors looking to participate in capital markets in a compliant manner.

Here is a draft outline for Section II on principles of shariah investing:

Key Principles of Shariah Investing

Shariah investing is guided by certain Islamic principles derived from Quranic injunctions and the hadith (sayings and traditions of Prophet Muhammad PBUH). Some core principles include:

• Prohibition of riba (interest) – Charging or paying interest is prohibited under shariah law. Shariah funds avoid interest-bearing investments.
• Avoidance of gharar (uncertainty) – Excessive speculation and uncertain transactions are discouraged. Derivatives and highly leveraged investments are typically avoided.
• Avoidance of maysir (gambling) – Investments that rely heavily on chance or gambling are prohibited. This restricts investment in casinos, lotteries, etc.
• Investment in halal sectors – Companies involved in prohibited activities like alcohol, pork, adult entertainment, gambling, etc. are filtered out.
• Ethical and governance factors – Qualitative assessment of underlying business practices beyond financial screening.

As per halal investment criteria, these principles aim to avoid exploitation and align investments with Islamic ethics. Shariah scholars actively provide guidance and oversight on criteria.

“The intention behind Islamic investment principles is to promote economic activities that are ethical, socially responsible, and environmentally sustainable.”

Common shariah compliant investment structures like sukuk bonds and ijara contracts are designed to avoid riba and comply with halal investment objectives.

Overall, shariah investing provides Muslim investors a means to participate in modern financial markets in a halal manner that adheres to Quranic principles and traditions.

Key Screening Criteria for Shariah Compliant Investments

Shariah advisors use various screening criteria to filter out non-compliant stocks and sectors for shariah mutual funds as per screening for halal stocks:

Sector-Based Screening

Companies involved in prohibited activities as per shariah law are excluded:

• Alcohol
• Tobacco
• Gambling
• Adult entertainment
• Conventional financial services (riba-based banks)
• Pork products
• Weapons and defense

Financial Ratio Screening

Companies are filtered based on financial ratios like:

• Debt to market capitalization – Typically should be <33%
• Cash + interest bearing items to market capitalization – Typically should be <33%

This avoids companies with excessive leverage or interest income.

Qualitative Screening

This evaluates the underlying business practices of a company beyond just financial factors. Criteria assessed include:

• Business ethics
• Corporate governance
• Environmental impact
• Treatment of employees
• Compliance with shariah in overall operations

The halal investment criteria aims to invest in businesses that align with Islamic principles holistically.

“Shariah screening combines both quantitative filters and qualitative factors to construct Islamic portfolios”

Ongoing monitoring by scholars also ensures compliance is maintained within shariah fund portfolios.

Shariah Compliant Mutual Funds in India

The shariah funds segment in India is small but growing, as more fund houses launch Islamic plans to tap demand.

Some leading providers of shariah funds in India include:

• Tata Mutual Fund
• HDFC Mutual Fund
• Aditya Birla Sun Life Mutual Fund
• Navi Mutual Fund
• IDFC Mutual Fund

They offer a range of shariah compliant equity funds and debt funds.

Major Shariah Equity Funds

These funds invest in shariah compliant stocks across sectors. Returns are comparable to non-shariah indices.

Shariah Debt Funds

Debt funds invest in shariah compliant instruments like sukuk bonds, trade finance, and P2P lending. Returns tend to be moderate given lack of interest-bearing debt.

While limited, shariah funds offer Indian Muslims an avenue to invest as per faith-based principles of halal investing.

Key Advantages of Shariah Investing

Shariah compliant investing offers some unique benefits:

• Values alignment – Allows investors to align investments with their faith-based principles as per halal investing.

• Exposure to new sectors – Shariah screening results in exposure to some underrepresented sectors with growth potential.

• Portfolio diversification – Low correlation to conventional stocks provides diversification benefits.

• Stable performance – The screening criteria tends to exclude high-risk and speculative stocks, resulting in more stable returns.

• Ethical investing – Shariah funds enable investors to create portfolios that reflect their values beyond just returns.

“Shariah investing facilitates participation in financial markets in a manner that adheres to Islamic ethics.”

As per screening for halal stocks, the screening process allows constructing halal portfolios aligned with principles of Islamic finance.

While shariah funds have limitations like narrowed universe and potentially higher expense ratios, they provide an avenue for faith-based investing per religious injunctions for Muslims.

Limitations and Risks of Shariah Investing

While shariah funds have benefits, they also come with some limitations:

• Narrower universe – The screening criteria significantly narrows the pool of compliant stocks. This can restrict diversification and growth opportunities.

• Potentially higher expense ratios – Additional screening and oversight results in higher fund operating costs in some cases.

• Limitations on fixed income – Lack of shariah-compliant fixed income instruments restricts options for low-risk investments.

• Benchmarking challenges – Lack of well-defined shariah-compliant benchmarks makes assessing performance difficult.

• Compliance risk – Potential for human error in screening or investments going out of compliance over time. Requires robust monitoring.

As per halal investment criteria, shariah investing inherently has a more limited universe given the faith-based screens. Investors have to balance compliance with performance.

“Shariah funds may lag conventional counterparts during rallies in prohibited sectors like financial services or alcohol.”

Overall, shariah funds require specialized expertise and due diligence. But they provide an avenue for Islamic investors to participate in markets in a halal manner.

Final Thoughts

In summary, shariah compliant mutual funds offer Muslim investors an avenue to participate in financial markets in a manner aligned with Islamic principles.

Key points:

• Shariah funds adhere to guidelines like avoiding riba, investing in halal sectors, and screening for compliant stocks.

• Criteria like sector, financial, and qualitative screens aim to construct Islamic portfolios.

• Benefits include values alignment and potential diversification, while limitations include narrower universe and compliance risks.

• In India, shariah plans are a niche but growing segment to tap demand from faith-based investors.

As per halal investing principles and practices, shariah investments integrate Islamic ethics with modern finance. While adoption is currently limited, they have potential for growth.

“Shariah funds enable participation in equities and debt in a halal manner in line with the Quran and teachings of Prophet Muhammad (PBUH).”

For Muslim investors looking to align faith with finance, shariah mutual funds provide a compliant investing solution.