Guide to shariah compliant ETFs – what are your options?

This article was updated on January 24, 2021

I have been asked to speak about ethical and religious funds by some of my readers.

So this article will review your options, when it comes to Shariah-compliant ETFs.

If you are looking to invest, you can email me at advice@adamfayed.com or contact me on the WhatsApp function.

Exchange-Traded Funds:

‘ETF Definition’ –ETFs or ‘Exchange-Traded Funds’ were first introduced in the year 1993. An Exchange-Traded Fund (ETF) is similar to stocks and can be traded with the help of Stock Exchanges.

ETF is generally composed of different assets such as Bonds, Stocks, Equities and Commodities which exist in order to keep the trading somewhat nearer to the Net Asset Value. However, there might be a possibility of having slight deviations while composing to the value equivalent to that of the net value.

Each ETF individually consists of various assets within it. For example, The ETF which tracks the index ‘S&P 500’, generally consists of 500 equities. Some of the most popular ETFs are those that track the indexes ‘NASDAQ 100’ and ‘S&P 500’

Most of the Asset Management Companies like Vanguard or BlackRock issue ETFs and each asset management company might individually be able to issue more ETFs. In most cases, ETFs are known to track an Index which can either be a Stock Index or a Bond Index. It is estimated that during the time period between 1993 and 2015, an amount equivalent to 2 trillion US dollars was invested in ETFs only from the United States of America. 

‘Benefits of trading with ETFs’ – The major benefits offered by the ETFs which make them an attractive investment option available to the investors are:

Lower costs – ETFs are generally considered to have lower costs than other types of investment products because most ETFs are not actively managed.

Due to this reason, ETFs are insulated from the costs of having to buy and sell securities on a regular basis to accommodate shareholder purchases and redemptions.

ETFs typically have lower marketing, distribution and accounting expenses when compared to most other types of investment assets. Most of the ETFs are not subjected to 12b-1 fees.

Buying and selling flexibility – ETFs can be bought and sold by the trader at current market prices during any time of the trading day as per their requirements, unlike mutual funds and unit investment trusts, which can only be traded by the investor at the end of the trading day.

As ETFs are the publicly traded securities, their shares can be purchased on margin and can be sold short enabling the effective use of hedging strategies, stop orders and limit orders, etc. which allow investors to precisely specify the price points at which they are willing to make a trade.

Tax efficiency – ETFs basically generate relatively low capital gains, because of the low turnover of their portfolio securities. However, this can be considered as an advantage that they share with other index funds.

The advantage is that the tax efficiency of ETFs is enhanced because they don’t have to sell securities in order to meet with the investor’s redemptions.

Shariah Compliant Investing:

‘Definition’ – Shariah Compliant Investing, which is also known by the names ‘Islamic banking’, ‘Islamic finance’, ‘sharia-compliant finance’ etc., is type of banking or financing activity that abides with sharia (which is the Islamic law) and it is practically applied in the procedure of Finance or Banking through the development of Islamic economical standards. 

A few examples of the types of Islamic banking/finance are:

  • Mudarabah (which is profit-sharing and loss-bearing)
  • Wadiah (which is safekeeping)
  • Musharaka (which is a joint venture)
  • Murabahah (which is cost-plus financing)
  • Ijara (which is leasing)

These types of financing or banking methods were introduced as the ‘Quran’ (holy book of Islam) prohibits its followers from making trades which bring exploitative gains to them (This process of obtaining gains, which is prohibited in Islam is also known as ‘Riba’). Riba stops the Muslims from investing in any type of assets that are traded at a subsequently more price than their original value. 

Investments or trades in the goods and services that are contrary to the principles of Islam are also considered to be ‘Haraam’ (a sinful thing that should be prohibited). Some of the examples for such types of goods and services are trades related to pork, alcohol, etc. Trades that involve interests in the net amount to obtain profits for the individuals are also known to be Haraam by many Muslim people. 

‘Shariah Principles’ – Islamic banking and finance prohibits a variety of activities to be consistent with the principles of Islamic law. With the help of this, they at least try to achieve an orthodox interpretation of the law and can be guided by Islamic economic standards. Some activities mentioned here might not be considered to be illegal in some secular states.

  • Interest – All forms of interest are considered to be riba and hence prohibited to the Islamic individuals either to give or take interest for money. Islamic rules on transactions have been created in order to prevent Muslims from interest.
  • Investing in businesses involved in Haraam activities (activities that are forbidden). These types of activities include things such as selling alcohol, pork, etc. or producing media such as gossips, music or movie related services or pornography.
  • Charging fines for payments that have been made late than usual. This is applicable to murâbaḥah or other types of fixed payment financing transactions.
    However, some authors believe there is an exception for the cases where late fees can be charged. It can be charged if the amount collected is donated to a charity, or if a person has intentionally refused to make a payment.
  • Maisir. This is usually known to be activities involved in gambling but often used to describe speculation in Islamic finance. Involvement in contracts where the ownership of a good depends on the occurrence of a predetermined, uncertain event that leads to profits in the future is considered to be maisir and is forbidden.
  • Gharar. Gharar is usually referred to as “uncertainty” or “ambiguity”. The prohibition of both maisir and gharar tends to remove the scope of investing in derivatives, options, and futures. Islamic finance supporters believe that these types of activities involve excessive risk and may foster uncertainty and hence, fraudulent behavior such as this is found to be in derivative instruments used by conventional banking as well.
  • Engaging in transactions that involve products and services that are lacking material finality. All transactions must be directly linked to a real underlying economic transaction, and therefore activities such as trading options and most other derivatives are excluded.

Money on the most common type of Islamic financing and it should be made only from a tangible asset that is owned by a person who has the right to sell them. When it comes to financial transactions, it demands that risk must be shared. A quote in Islam that supports this is “Money cannot be made from money”. Another statement that supports the Islamic banking theory of finance is that “Money has no intrinsic utility, it should only be used as a medium of exchange”

Some other types of restrictions and regulations according to the Islamic laws of Banking and Finance are:

  • Islamic banks are to collect zakat from customers’ accounts according to some sources.
  • A board of Shariah experts is appointed and they have to supervise and advise each Islamic bank individually on the propriety of transactions to make sure that all the banking and finance activities carried out by them are following the Islamic principles. 

By following banking or finance that is abiding by the rules of Islam is done in order to stop Muslims from following non-Islamic practices. Starting with only a few banks and financial institutions, the number of banks that are shariah compliant became 300 by the year 2009 and by 2014, it was estimated that assets with a value equivalent to $2 trillion were shariah compliant.

This gave more chances for Muslim investors to make trades without having to disobey the rules set by Islam. Today, Shariah-compliant financial institutions in the world are more than 1% of the total world. These are considered to be mainly from the countries of GCC (Gulf Cooperation Council), Iran, Malaysia, etc. 

Although most people might think that the Islamic banking contributes only to a part of the assets that are owned by the Muslims in the world, the most important that might not consider is that since the beginning, the shariah-compliant banking/financing has been growing way faster than anybody could expect.

Popular categories of Shariah-compliant investment options available to an investor include real estate and exchange-traded funds (ETFs). Private equity is also a considerable option for a good investment asset abiding by the Shariah principles but carried interest is considered a problem within Shariah law.

There are many types of financial instruments available to the Islamic investors which follow the Shariah investing principles. They are:

‘Islamic Bonds (Sukuk)’ – ‘Sukuk’, which is also known by the names of “Islamic Bonds” or “sharia-compliant Bonds”, are the types of financial certificates created as an alternative option to conventional bonds. The types of Sukuk differ based on the various structures of Islamic contracts (such as ‘murabaha’, ‘ijara’, ‘wakala’, ‘istisna’, ‘musharaka’, ‘istithmar’, etc.). The financing of Sukuk depends on the project.

Similar to a traditional bond, a Sukuk comes with an expiration date. But rather than receiving interest payments on money lent as bonds do, a Sukuk holder is given a part-ownership of an asset with the help of which they receive income either from profits generated by the respective asset or payments made by the issuer in the form of rent. 

The part ownership element and the lack of a guaranteed repayment of initial investment resembles equity instruments. However, in practice, Sukuk is based on an asset rather than being backed by an asset, which means the assets are not completely owned by the investors with the help of their investment vehicle. The investors would also have to recourse to the originator if there is a shortfall in the payments.

There are some other types of financial instruments such as ‘Islamic Bonds’, ‘Islamic Funds’, etc., that are abiding by the rules and regulations of the Shariah principles. But today, we are going to have a deeper look at ‘Shariah-compliant ETFs’.

‘Shariah Compliant ETFs’ – The ETFs that follow the Shariah-compliant investing rules and principles are known as ‘Shariah-Compliant ETFs’. Shariah compliant ETFs come under category of socially responsible investments that come under ‘ESG (Environmental, Social, and Governance)’

ESG investing is the category of investment options available to the investors that are based on the environmental, social, and governance factors. ESG investments are often used for describing investment types such as ‘socially responsible investing’ and ‘sustainable investing’.

Investment choices that are eligible for the Environmental, social, and governance (ESG) criteria are becoming very popular as they might be helpful for the investors to choose the right type of companies in which they might want to invest.

For example, if we take our current topic of Shariah-compliant investing, it can be clear to us that investors might want to choose the assets that are based on certain rules and guidelines set forth by their religion.

Shariah-compliant ETFs are the best available investment options as they follow the sharia rules and can be an efficient way of gaining profits for the Muslim investors without having to disobey their religious rules while trading in order to gain profits.

Shariah-compliant funds are based on many requirements that they must follow. Some of the major requirements for an ETF in order to become a Shariah-compliant ETF is that it should exclude investments which derive a majority of their income from the trading of alcohol, products related to pork meat, products, and services related to pornography, gambling, military equipment or weapons. 

Another major rule of a Shariah-compliant ETF includes an appointed Shariah board, who will conduct an annual Shariah audit and purifying certain types of prohibited income such as interest, by donating the profits generated by interest to a charity.

In order to check whether an ETF is in compliance with the Shariah principles, we would have to check for the following factors:

‘Shariah-compliant constituents’ – The constituents that are consisted of an ETF must be Shariah-compliant. This refers to the shares that an ETF consists of and any other type of asset that is held by the ETF.

‘Compliance with Shariah screening’ – Every ETF must be screened in a while in order to make sure of the on-going Shariah compliance. The screening criteria that should be satisfied by an ETF in order to be compliant with Shariah principles are:

  • It’s Business Activity Screening
  • It’s Financial Screening

‘Business Activity Screening’ – Companies which involve in any of the following mentioned activities will be filtered out as non-Shariah compliant:

  1. Conventional financial services such as traditional banking and investments.
  2. Trading in risk and Gharar. 
  3. Activities that involve in Gambling, Qimar, and Maysir. 
  4. Activities that are related to Alcohol and prohibited beverages
  5. Activities involved in Pork related products and non-halal food production, packaging, processing or any direct activity that is linked to unlawful consumables. 
  6. Goods and services that are involved in Tobacco related products. 
  7. Illegal adult industry (pornography) related activities.
  8. Entertainment activities such as music, movies, etc.

A company that satisfies all the criteria for business activity screening will be subjected to a financial ratio screening process.

‘Financial Ratio Screening’ – 

  1. Income from the activities that are non-compliant with the Shariah principles and are involved with interest should not exceed 5% of total revenue.
  2. Deposits that are related to interests must not exceed 30% of the market capitalization. 
  3. The interest-bearing debt must not exceed 30% of the market capitalization
  4. Overall market value of assets that are related to cash directly and are debt-free should be at least 30% of the total value of all the assets.

‘Tracking a Shariah-compliant index’ – Conventional ETFs track the common traditional indices. Although it is not mandatory for an ETF to track an Islamic index in order to be in compliance with Shariah principles, it is highly suggested and recommendable. An Islamic ETF should only track the indices which are in compliance with the Shariah principles.

‘Compliance with Shariah principles for gold, silver and currencies’ – Any ETF which has gold, silver or currency as its constituents should be able to comply with the Shariah principles oftrading gold, silver and currencies.

Selling gold for silver is permitted regardless of differences in the weight of the counter-values and sale of gold for currencies is permitted at any mutually agreed price. 

In both cases, the counter-values for the trade must be exchanged as required by Shariah.

Selling gold for anything other than gold, silver or currencies such as selling gold for commodities, services, etc., is also permitted at any price without having the requirement of immediate exchange of the counter-values.

In case of selling gold for gold, silver or currencies, the two counter-values must be delivered during the session, physically or constructively. If gold is sold for anything other than the above, deferment of one of the counter-values is permitted. However, it is not permitted to stipulate the deferment of both the counter-values when selling gold, as in the case of forwards and futures.

When trading with the ETFs that are in compliance with the Shariah principles, it is required to make sure that the principles of Shariah are satisfied accurately. The general set of principles include:

  • The thing/object of sale should have to be existing at the time of sale. If a non-existent thing has been sold, even though the sale was done on mutual consent, the sale is not considered to be a sale according to the rules of Shariah.
  • The seller should be the original owner of the sale object during the time of the sale.
  • The sale object should be in the physical possession of the owner during the sale. 
  • The sale should have to be done within the same time and cannot be postponed to a future date. Even if both the seller and buyer are willing to make the sale event in the future, it would be considered to be against the principles.
  • Any sale object that is being sold by the seller should have to possess some value. Any sale of an object or a thing that is of no value should not be sold.
  • Only usable objects can be sold during the time of sale and haram objects cannot be sold.
  • The object should be familiar to the seller.
  • Any type of sold commodity should not be bought by an individual and the buyer should not take any chances in that.
  • The price of the object should be certain and any sale involving in uncertain prices will not be considered as a sale.
  • The sale should be regardless of any disparities and discrimination. The sale should be unconditional such that any person who is willing to buy the object can be able to purchase it for the same price as others. 

By following the above-mentioned set of guidelines, an ETF can become a Shariah-compliant ETF and can be traded by any Islamic investor without any hesitation. 

‘Examples of Shariah-compliant ETFs’ – There are a vast number of ETFs, that are in compliance with the Shariah principles and are available to the investors. Although it is not possible to mention all the ETFs that are in compliance with the Shariah principles, some of famous Shariah-compliant ETFs that are maintained by S&P Dow Jones are S&P Global Healthcare Shariah, S&P Global Infrastructure Shariah, S&P Developed Large and Mid-Cap Shariah, S&P Developed Small Cap Shariah and the S&P Developed BMI Shariah Index.

Conclusion:

Investments that are in compliance with the Shariah principles often require a lot of attention from the investors. It is not an easy task and cannot be done by investors without any experience or investors having very low knowledge regarding this. 

It is often suggested as the best advice for the investor to make a perfect strategy of their investment and discuss their strategy with a financial advisor having a good reputation (like us).

By having a management strategy as well as expert advice from a financial expert any person can be able to achieve a lot of profits from their investments and are able to have a successful trading career.

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