by Said M. Elfakhani, M. Kabir Hassan and Yusuf M. Sidani
Muslims represent around one-ﬁfth of the world population with more than $800 billion to invest. This amount is growing by 15 per cent annually. Only a small portion of the available funds are invested in Islamic products, which is indicative that this market is, for the most part, unexploited (Hassan, 2002). The Islamic mutual funds market is one of the fastest rising segments within the Islamic ﬁnancial system, yet, when compared to the mutual fund industry at large, Islamic mutual funds are still in their infancy stage of growth and development, most being around for less than a decade. Islamic funds are fairly diverse for a young industry. While the majority of the funds are equity funds (84 per cent of the total 126 funds), balanced (or secured) funds (14 per cent) as well as Islamic bond (sukuk) funds (2 per cent) have recently been launched. Moreover, among the equity funds, several sectors and geographical investment areas are featured. Out of the total 126 available Islamic funds, 35 are global equity funds (28 per cent), 10 are American equity funds (8 per cent), 5 are European equity funds (4 per cent), 5 are Asian equity funds (4 per cent), 29 are Malaysian equity funds (23 per cent), 13 are country funds – mostly Saudi Arabian, Egyptian and South African (10 per cent) – and 8 are technology and small capitalization equity funds (6 per cent). Most Islamic funds do not aim at high net-worth people; minimum investment subscription ranges from $2000 to $5000 (Hussein and Omran, 2005).
Islamic equity funds witnessed strong expansion during the late 1990s as they beneﬁted from the technology boom, most of them demonstrating high positive returns,even higher than their benchmarks. Their number increased from eight funds prior to 1992, to 95 funds with about US$5 billion in assets in 2000, then dropped to about US$4 billion by the end of 2001. Nevertheless, more funds have been launched since 2002, on the back of rising market expectations and with more lessons having being learned.
The drop in the industry’s total assets that occurred in 2000–2001 is related to the downslide of world equity markets generally and investors’ inclination to move funds into safer instruments. Islamic-based equity fund managers reacted consequently by reshuﬄing the makeup of their portfolios, with those overweight in technology shifted to the healthcare and energy sectors. In addition, the new funds had a propensity to be more capital-protected or balanced funds. Of the 23 funds initiated in 2000, nine were global equity funds and ﬁve were capital protected or balanced funds; whereas, of the 20 funds initiated in 2001, ﬁve were capital protected or balanced and only three were global equity funds (Failaka International, 2002).
Usmani (2002) explored the principles of shari’a governing Islamic funds. He explained several types of investment funds which may be accommodated – with some conditions – under Islamic precepts. For that matter he explained the principles underlying equity, ijara, commodity, murabaha and mixed funds, as follows.
Usmani explained the diﬀerences in opinion among Muslim scholars pertaining to
the permissibility of investment in companies which are involved in a halal business but nevertheless have a portion of their transactions involving incidental haram (shari’anon-compliant) activities such as interest. He concluded that a large number of presentday scholars argue that such incidental business activities do not render the whole business unlawful. Nevertheless a list of conditions has to be met before investment in such funds can be ruled as shari’a-compliant. Accordingly Muslims can invest their funds in such businesses that meet some speciﬁc conditions, as follows:
1. The investment has to be made in businesses that do not violate shari’a.In that respect
no investment can be made in companies that engage in unlawful activities such as
liquor, gambling and pornography.
2. In the case where the main line of business is lawful but the company is involved in
interest-related activities, shareholders have to express their disapproval for such dealings wherever possible.
3. The income generated from dividends has consequently to be puriﬁed from such
activities by allocating a percentage of that dividend to designated charities in proportion to the income generated from interest-related activities.
4. The shares of the company can only be negotiable if the business owns some illiquid
assets. Shares for companies whose assets are all in liquid form can only be traded at
The above conditions require a strict ﬁltering process to determine which companies
might be included in the fund and which companies should be excluded. The ﬁltering
process will ﬁrst exclude all companies involving forbidden items. The second ﬁltering mechanism involves a set of ﬁnancial ratios which have to be met by any company before it can be included. These ratios are used in order to safeguard against earning proﬁts resulting from interest. El-Gamal (2000) indicated that most Islamic funds have reached similar compromises pertaining to the ratios acceptable in companies that could belong to the fund. For example, the Dow Jones Islamic Market Turkey Index (DJI, 2005) indicates that the stocks excluded represent companies involved in any of the following activities: alcohol, tobacco, pork-related products, ﬁnancial services, defence/weapons, entertainment. In addition the ﬁnancial ratio screens exclude all companies for which any of the following ratios are 33 per cent or more:
1. ‘Total debt divided by trailing 12-month average market capitalization
2. The sum of a company’s cash and interest-bearing securities divided by trailing 12-
month average market capitalization
3. Accounts receivables divided by trailing 12-month average market capitalization.’
Ijara means leasing whereby funds are used to purchase assets and lease them out to thirdparty users. Ijara is increasing in popularity and is the most popular method of Islamic house ﬁnance in the United Kingdom (Matthews et al., 2002). Leasing is an increasingly acceptable instrument from the perspective of many Muslims scholars (Warde, 2000). Rentals are collected from the users and the investors in the fund own a proportionate share of the leased assets. Ownership is authenticated in certiﬁcates or sukuk which are negotiable in the secondary markets. Ijara is permissible according to shari’a but also subject to certain conditions (Usmani, 2002). The assets themselves have to be halal; that is assets used in gambling casinos or manufacturing alcoholic products do not qualify. The rental charges should be set at the outset and known to the parties involved in the transaction and should cover the whole period of the lease. The lessor assumes all the responsibilities subsequent to ownership so that the lessor has the duty to manage the assets including repairing the assets in case of malfunction (Warde, 2000; Usmani, 2002).
In addition, the leasing agency must own the leased object for the duration of the lease (El-Gamal, 2000). Ijara is considered a useful tool leading to economic development and is increasingly used in retail ﬁnance such as home mortgages and cars (Warde, 2000). In the ijara fund, the fund management acts as an agent of the subscribers and thus can charge a fee for the service it renders. Such fees can be ﬁxed or a percentage of the rentals received (Usmani, 2002).
Islamic jurisprudence also allows commodity funds which entail the purchase and subsequent sale, by the fund, of commodities for a proﬁt. These proﬁts are distributed among the investors in the fund in proportion to their investment. Some conditions also apply in this case. The commodities themselves have to be halal. In addition, the price of the commodities has to be known to the parties at the time of the transaction. If the price is unknown or attached to another eventuality, this is not allowed. Moreover the seller has to have physical or constructive control over the commodity to be sold. Constructive possession refers to any activity which indicates that the risk of the commodity is transferred to the purchaser (Usmani, 2002). Accordingly forward sales are not allowed in most cases as they involve dealing in commodities which a person does not own or possess at the time of the transaction. Two exceptions are istisnaa and salam (Usmani, 2002). Istisnaa means commissioning a manufacturer to manufacture commodities for later delivery to the purchaser. Salam refers to a sale contract in which the purchaser pays fully against the deferred delivery of the goods involved. These two types of forward contracts can be used lawfully by Islamic investment funds.
As an example of the increasing interest in commodities funds, Sedco, a company that pursues public and private equity Islamic investment opportunities, collaborated with Goldman Sachs to establish the AlFanar Goldman Sachs Commodity Fund. Company oﬃcials asserted that there will be an extensive array of commodities in the fund, with a particular stress on energy and precious metals (The International Islamic Finance Forum, 2005a).
This is a speciﬁc case of a commodity sale in which the buyer knows the price and agrees to pay a premium over the initial price (El-Gamal, 2000). Such commodities are said to be sold on a cost-plus basis. While murabaha is essentially a sale agreement and not a ﬁnancing agreement, it can be used as a ﬁnancing vehicle through adopting speciﬁed procedures (Usmani, 2002). Murabaha typically involves a client approaching an institution and they together come to an agreement that the institution makes the purchase from a third party. The transaction could also be realized through the client purchasing the commodity as an agent of the institution and then the institution sells the commodity to the client for a deferred price. It is important to note that the institution immediately sells the items purchased to the clients after their purchase. Accordingly, the portfolio of murabaha – and the units of a murabaha fund – would not include any commodities; it would just include cash
and receivables that would be paid by the client at a later date. The fund has to be a closedend fund and its units cannot be negotiated in a secondary market (Usmani, 2002). Despite its wide acceptance and popularity, murabaha is sometimes controversial as it seems to emulate the features of a traditional ﬁnancing arrangement.Murabaha represents the most Islamic mutual funds 259popular scheme of Islamic ﬁnancing, accounting for over 70 per cent of Islamic ﬁnancing
transactions (Curtis Davis Garrard, 2000). The National Commercial Bank located in
Saudi Arabia manages the largest murabaha fund in the world, over $3billion (Banker
Middle East, 2005).
These funds represent cases where the transactions are made in diﬀerent types of investments including equities, leasing, commodities and so on. Usmani (2002) indicates that, if the tangible assets of the fund are more than 51 per cent, then the units of the fund become negotiable. If the liquid assets and debts exceed 50 per cent then the units of the fund cannot be traded and the fund must be a closed-end fund.