Social investing has been around for a long time and is generally acknowledged to generate effective returns. Shariah compliant investing is a newer form of social investing that is less widely understood.
While new, the approach is rapidly gaining followers. According to a 2006 report by Moody's Investors Services, there are about US$750 billion invested in Islamic banks and mutual funds as well as the Islamic arms of conventional banks worldwide. The amount is expected to grow at an annual rate of 10% to 15%.
This article looks at Shariah compliant investing based on Standard & Poor’s 500 index (NYSEARCA:SPY) and its Shariah cousin.
At the highest level, we see that 295 companies of the 500 in the S&P large cap U.S. index pass the Islamic filter (see filter details at end of article). We also see that the total market cap of the Shariah 500 index is $7.8 Trillion versus $12.9 Trillion for the entire S&P 500.
The general principles of Shariah investing are: (1) no interest, and (2) social responsibility, in the form of prohibited businesses (see list at end of article). Those principles cause the sector weights to vary considerably as shown in the table below. The “no interest” principle appears to have the greatest overall significance when we note the massive reductions in Utilities and Financials. The prohibited business types are morally important, but apparently not all that significant in shifting industrial sector weights when compared to the “no interest” rule.
Different sector weights notwithstanding, the return, volatility and Sharpe ratios for the S&P 500 and its Shariah derivative over 3 and 5 years for are similar, as shown in the table below.
Overall, we conclude that observant Muslims can invest in a Shariah compliant index (at least the S&P index and probably the others) with relative confidence that their financial future will not be compromised as a result of following their moral or religious principles.
For U.S. investors, the choices are limited. IMANX and AMAGX are the principle choices.
Standard and Poor’s Islamic Index Rules:
There are three S&P Islamic indices (based on the S&P 500, S&P Europe 350 and S&P Japan 500). To be eligible for consideration, a stock must first be in an underlying index.
Sector-Based Screens Business activities related to the following are excluded:
• advertising and media (newspapers are allowed, sub-industries are analyzed individually)
• trading of gold and silver as cash on deferred basis
During the selection process, each company’s audited annual report is reviewed to ensure that the company is not involved in any non-Shariah compliant activities. Those that are found to be non-compliant are screened out. The above industries are not considered Islamic and would not be appropriate for investment for observant Muslims.
Accounting-Based Screens - After removing companies with non-compliant business activities, the rest of the companies are examined for compliance in financial ratios, as certain ratios may violate compliance measurements. Three areas of focus are (1) leverage, (2) cash, and (3) the share of revenues derived from non-compliant activities. All of these are subject to evaluation on an ongoing basis.
Leverage Compliance –
• Debt / Market Value of Equity (12 Month average) < 33 %;
Cash Compliance –
• Accounts Receivables / Market value of Equity (12 Month average) < 49 %;
• (Cash + Interest Bearing Securities) / Market value of Equity (12 Month average) <33%;
Revenue from Non-Compliant Activities -
In certain cases, revenues from non-compliant activities are permissible, if they comply with the following threshold:
• (Non-Permissible Income other than Interest Income) / Revenue < 5%
Dividend Purification Ratio - This ratio is provided to investors for purification purposes, it is calculated as:
• Dividend x (Non Permissible Revenue / Total Revenue)
Where ancillary non-compliant revenue cannot be avoided, “purification” of the investment can be achieved by donating the portion of income from non-compliant activities to charity.
Disclosure: The author does not own any fund mentioned in this article.