Islamic ESG funds have emerged as a beacon for ethical investors in recent years. But what exactly are they?
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What are Islamic ESG Funds?
Islamic ESG funds combine the principles of Islamic finance with the criteria of Environmental, Social, and Governance (ESG) investing. These funds have seen a surge in popularity, with their value reaching USD 756 million in the first quarter of 2021, as reported by Standard Chartered.
The Principles of Islamic Finance
Islamic finance strictly adheres to the teachings of the Quran. It prohibits activities like charging interest (Riba) and investing in haram (forbidden) industries such as alcohol, gambling, and pork. Islamic ESG funds ensure that all investments align with these principles.
Furthermore, Islamic finance shares some similarities with certain approaches to ESG screening in using screens to reflect an underlying set of values or principles.
Understanding ESG (Environmental, Social, Governance) Criteria
ESG criteria focus on a company’s environmental impact, its relationships with employees and the community, and its governance structures. Islamic ESG funds integrate these criteria into their investment decisions, ensuring that they invest in companies that prioritize sustainability, ethical practices, and good governance.
For instance, the PRI defines responsible investment as a strategy and practice to incorporate environmental, social, and governance (ESG) factors in investment decisions and active ownership.
Why are Islamic ESG Funds Gaining Popularity?
Islamic ESG funds resonate with investors who want to align their faith with their financial goals. The global shift towards responsible investment has further propelled their growth.
Aligning Faith with Financial Goals
For many, investing in Islamic ESG funds means they’re not compromising their beliefs for financial gains. They can confidently say their money supports only ethical and Shariah-compliant ventures. This alignment is evident in the way Islamic finance and ESG investing practices overlap, with both focusing on ethical considerations in investment decisions.
The Rise of Ethical Investing
The global shift towards ethical investing has boosted the popularity of Islamic ESG funds. Investors now actively seek opportunities that promise not just financial returns but also positive societal impact. The use of screening for ESG issues when constructing a portfolio has a long history in responsible investment.
This can be traced back to faith-based approaches to avoiding or divesting from companies involved in activities seen as incompatible with a set of beliefs or values. In fact, negative screening represented US$19.8 trillion in assets under management globally in 2018, with positive screening deployed across US$1.8 trillion in assets.
Key Features of Islamic ESG Funds
Islamic ESG funds have carved a niche for themselves in the investment world thanks to their unique features that cater to both ethical and Shariah-compliant investors.
Shariah-Compliant Screening Process
Islamic ESG funds employ a meticulous screening process before making any investment decisions. This ensures that the funds remain in line with both Islamic principles and ESG criteria.
Prohibition of Interest (Riba)
Islamic ESG funds strictly avoid ventures that deal with interest. By adhering to the prohibition of Riba, these funds ensure they remain Shariah-compliant. In Islamic finance, interest-backed transactions get viewed as unethical because the risk and reward of a transaction should be shared between parties rather than creating a disparity.
Avoidance of Haram Industries
Islamic ESG funds take extra caution to avoid industries considered haram or forbidden in Islam. This commitment ensures that investors’ capital never inadvertently supports businesses that contradict Islamic teachings.
For instance, any form of speculation or gambling deemed Maisir in Islamic terms, is prohibited. Similarly, Gharar, which represents excessive risks or uncertainty, is also avoided, making short selling and certain derivative transactions forbidden.
ESG Integration in Investment Decisions
Islamic ESG funds place a significant emphasis on companies that adhere to ESG criteria, ensuring that investments are not only profitable but also ethical and sustainable.
Islamic ESG funds actively seek out companies that are champions of environmental causes. These companies work towards reducing their carbon footprint, promoting sustainability, and contributing positively to the environment.
The recent surge in green sukuk, a combination of traditional Islamic sukuk financing with green project finance requirements, exemplifies this commitment. Countries like Saudi Arabia and the UAE have ambitious plans to boost clean energy production, and green sukuk might be the ideal financing solution for such initiatives.
Companies that prioritize the well-being of their employees, engage constructively with their communities, and uphold human rights are particularly attractive to Islamic ESG funds. The emphasis on societal benefit in Islamic finance aligns well with the social aspect of ESG.
For instance, the Islamic Development Bank (IsDB) has issued sukuk that focus on projects under the United Nations Sustainable Development Goals, specifically targeting “Good Health and Well-Being” and “Decent Work and Economic Growth.
Governance and Ethical Business Practices
Good governance is the backbone of any successful company. Islamic ESG funds give preference to businesses that maintain transparent governance structures and uphold ethical business practices. The strict use-of-proceeds disclosures in Islamic finance, regulated by boards of Islamic law scholars, ensure that these funds are genuine in their claims.
Moreover, the integration of ESG advisers and oversight committees in the decision-making process ensures that both Islamic and ESG principles are consistently upheld.
5 Leading Islamic ESG Funds to Watch in 2023
The market offers a plethora of Islamic ESG funds, but certain ones truly stand out. Here are five Islamic ESG funds that have garnered significant attention and are worth considering for your investment portfolio in 2023.
1. Kuwait Finance House’s (KFH) ESG Fund
Kuwait Finance House (KFH) has made a notable commitment to sustainability, aligning its goals with Kuwait’s Vision 2035 plan. This bank has been a frontrunner in embedding sustainability into its operations, even surpassing the nation’s schedule.
KFH’s Achievements and Initiatives
KFH’s Role in Sustainable Development: Back in 2015, when Kuwait embraced the United Nations global sustainable development agenda, KFH was at the forefront, financing numerous low-carbon construction projects. This proactive approach has solidified KFH’s reputation as a sustainability pioneer in the Middle East.
Global Aspirations: KFH plays a pivotal role in driving Kuwait’s global aspirations, aiming to transform the nation into a significant financial and trade hub by 2035. The bank’s expansive network, linking continents and key economies like Saudi Arabia, Turkey, Malaysia, Bahrain, and Germany, underscores its influence.
KFH Trade System: This new system, developed in collaboration with Boursa Kuwait, aims to expand KFH’s international customer base. It facilitates electronic trade in line with Islamic Shariah principles and is available via apps for both Apple and Google Play users.
Partnership with UN Development Programme: KFH’s recent collaboration aims to expand sukuk issuance, promoting Islamic green finance and mitigating carbon emissions. This initiative exemplifies the bank’s commitment to increasing investments in green sukuk and supporting the Gulf’s embrace of the SDG trends driving global markets.
2. Al Rayan ESG Growth Fund
This fund, based out of Qatar, has been a frontrunner in promoting sustainable investments in the Gulf region. With a focus on renewable energy and sustainable infrastructure, Al Rayan has been a preferred choice for investors looking for Shariah-compliant ESG options.
Sustainable Infrastructure: Al Rayan has financed several green infrastructure projects across the Middle East, promoting sustainable urban development.
Renewable Energy: The fund has made significant investments in solar and wind energy projects, aligning with global sustainability goals.
3. Noor Ethical ESG Fund
Originating from the UAE, Noor Ethical ESG Fund has made significant strides in promoting ethical investments in the region. The fund’s portfolio boasts companies that have strong ESG practices and are Shariah-compliant.
Diverse Portfolio: From healthcare to technology, the fund invests in various sectors, ensuring a balanced and diversified portfolio for its investors.
Community Initiatives: Noor Ethical actively supports community development projects, ensuring that their investments have a positive societal impact.
4. Bank Rakyat ESG Equity Fund
Malaysia’s Bank Rakyat has been a pioneer in Islamic finance. Their ESG Equity Fund focuses on companies in the ASEAN region that adhere to both Islamic principles and strong ESG practices.
ASEAN Focus: The fund provides investors with exposure to the rapidly growing ASEAN market through investments in companies that have a strong ESG track record.
Tech Investments: Bank Rakyat’s fund has a keen interest in technology companies that are driving sustainable innovations in the region.
5. Faisal Islamic ESG Global Fund
Operating out of Egypt, Faisal Islamic Bank’s ESG Global Fund offers investors a chance to invest in global companies that are Shariah-compliant and have robust ESG practices.
Global Exposure: The fund provides investors with exposure to companies across North America, Europe, and Asia.
Strong Screening Process: Faisal Islamic ensures that all companies in their portfolio undergo a rigorous screening process to ensure they adhere to both Shariah and ESG principles.
Benefits of Investing in Islamic ESG Funds
Investing in Islamic ESG funds offers numerous benefits that cater to both the financial aspirations and ethical values of investors.
Ethical and Sustainable Growth
Islamic ESG funds don’t just promise financial growth; they ensure your investments support ethical causes.
Positive Impact on Society and Environment
When you invest in Islamic ESG funds, you’re actively contributing to a better world. These funds channel investments into companies that prioritize societal welfare and environmental conservation.
For instance, recent examples include the sustainability-linked sukuk issued in 2022 by Saudi National Bank and Riyad Bank. Additionally, the ‘Green Sukuk’ bonds issued by the First Abu Dhabi Bank in 2021 further emphasize the commitment of Islamic ESG funds to environmental causes.
Long-Term Financial Stability
Islamic ESG funds emphasize long-term growth. By investing in companies with sustainable business models, these funds ensure steady returns for investors. The focus on sustainability through continuous investor-company engagement sets them apart.
Moreover, the rules-based avoidance of harm in Islamic Finance ensures that investments remain ethical and sustainable.
Diversification and Risk Management
Islamic ESG funds provide a diversified portfolio, significantly reducing investment risks.
Portfolio Diversification Benefits
Islamic ESG funds diversify across sectors and regions. This diversification ensures that risks spread out, offering more stable returns. For instance, while some funds might focus on tech companies, others might prioritize renewable energy or healthcare, ensuring a balanced portfolio that can weather market fluctuations.
Reduced Exposure to Volatile Industries
By strictly avoiding haram industries, Islamic ESG funds inherently reduce exposure to volatile markets. This commitment ensures more consistent growth. The certification of Sharia compliance, overseen by recognized Shariah Boards and scholars, further strengthens trust in these funds.
As Islamic Finance and ESG investing converge, there’s a growing emphasis on certification, making these two forms of responsible investing mutually recognizable and trusted.
Challenges and Solutions in Islamic ESG Investing
Islamic ESG funds have gained significant traction in recent years, offering a unique blend of ethical and sustainable investment opportunities that align with Islamic principles. However, like any investment avenue, they come with their set of challenges. Let’s delve deeper into these challenges and the solutions that have emerged.
Navigating the Complexities of Shariah-Compliance
Islamic ESG funds, by their very nature, must adhere to the principles of Shariah law. This means they avoid investments in businesses that deal with alcohol, pork, gambling, and interest-based financial services, among others.
The Challenge of Limited Investment Avenues
Given the strict criteria, Islamic ESG funds often find their investment avenues limited. Many mainstream opportunities might not align with both Islamic and ESG principles. This limitation can sometimes lead to missed high-return opportunities that other conventional funds might capitalize on.
Solution: Diversified Global Portfolios
To navigate this challenge, many Islamic ESG funds have actively diversified their portfolios across global markets. By doing so, they can tap into a broader range of opportunities that align with their stringent criteria, ensuring both Shariah-compliance and adherence to ESG principles.
Balancing Ethical Considerations with Profit Motives
While profitability is a primary goal for any investment fund, Islamic ESG funds have the added responsibility of ensuring they don’t compromise on their ethical standards.
The Challenge of Competitive Returns
Striking a balance between ethical considerations and profit motives can be challenging. With the dual criteria of Shariah-compliance and ESG adherence, these funds might sometimes miss out on high-return opportunities available to conventional funds.
Solution: Long-Term Value Creation
However, Islamic ESG funds have a distinct advantage. They focus on long-term value creation. By investing in sustainable and ethical businesses, they ensure steady growth. Over time, these investments often outperform volatile high-return opportunities, ensuring competitive returns for investors.
Ensuring Authentic ESG Adherence
The rise in popularity of ESG investing has led to many companies claiming adherence to ESG principles. However, not all these claims are genuine.
The Challenge of Greenwashing
Greenwashing, where companies exaggerate or falsely claim their ESG initiatives to attract investments, is a growing concern. Islamic ESG funds, in their pursuit of genuine ethical investments, need to be wary of such misleading practices.
Solution: Rigorous Due Diligence
To ensure they’re investing in genuinely sustainable and ethical businesses, Islamic ESG funds conduct rigorous due diligence. They delve deep into a company’s practices, ensuring that their ESG claims are authentic. This meticulous approach ensures that investors’ money truly supports genuine ethical initiatives.
The Data Challenge in ESG Investing
A significant challenge highlighted by the EY article is the disconnect between the ESG data asset managers need and what’s available. The lack of standardized criteria, real-time data, and the prevalence of conflicting ESG taxonomies make it challenging for Islamic ESG funds to make informed decisions.
Solution: Collaborative Efforts and Technological Integration
To address these data challenges, Islamic ESG funds are collaborating with various stakeholders, including regulators, data providers, and other financial institutions. Additionally, the integration of advanced data analytics tools, artificial intelligence, and machine learning is helping these funds derive actionable insights from diverse data sources.
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