Understanding basics of Shariah investing

We all have different reasons to invest our hard-earned money. It might be for a short-term purpose like the purchase of a car or a house, or a long-term goal such as funding our children's education or ensuring a more comfortable retirement.

Investing can take on a religious significance, too. For a growing Muslim audience, investments must not only be able to achieve their goals, but also be compliant with the Islamic law.

The principles of Shariah investing dictate that to be considered acceptable, companies must pass a certain set of criteria. Among them, the balance sheet structure should contain neither too many liquid assets nor debt, and the company should not engage in "haram" (forbidden) industries such as alcohol, tobacco, gambling as well as specific foods considered non-halal or impure.

Advisers who are considered experts in Islamic law are integral to the investment selection and review process. At Franklin Templeton Investments, for instance, portfolios are independently reviewed and endorsed by the Amanie International Shariah Supervisory Board, which is highly regarded for its extensive Shariah and technical expertise.

The Amanie scholars provide initial approval on investment objectives and strategy, as well as ongoing supervisory and monitoring services to ensure continuous adherence to internationally accepted Shariah principles and standards.

Implementation of these standards can be subjective at times, as it depends on the interpretation of different Shariah boards - a challenge to portfolio managers. In addition, this can lead to a lack of homogenized investment approach as well as confuse potential investors.

Shariah Investing 101

Generally, a company that holds too many liquid assets may have Shariah restriction on eligibility. So one would think, this will result to the elimination of the company.

However, this is not always straightforward. It can depend upon the Shariah screening methodology applied by the fund adviser in the review process in which one calculates the company's financial ratio.

If a company classifies a large portion of its liquid assets as long-term, certain Shariah benchmarks will not include it as part of their liquid asset calculations. In addition, some benchmarks will use market capitalization as the denominator while others will use total assets - both of which could provide different results.

Using market capitalization as the denominator is particularly difficult for value investors (like us) because as a stock gets cheaper and hence provides more long-term value, it could suddenly become ineligible as the market capitalization falls relative to the liquid assets or debt.

Stocks that were compliant at one time but then later deemed non-compliant must be disposed of, but once again it's all about details. For example, the frequency at which the company pays its dividends (once a year, semi-annually or annually) could make a difference to eligibility.

Depending on the Shariah screening methodology, a company that accumulates large amounts of cash throughout the year before paying it out in the form of dividends runs the risk of becoming non-compliant. Once it pays the dividend, it may become compliant and hence an eligible investment once again.

The grace period given to dispose a stock (once it becomes non-compliant) is also different from one benchmark or adviser to another. For instance in as far as dividend is concerned, if the grace period to sell non-compliant stocks is short, one may be forced to sell it before it pays the dividend. Conversely, if the grace period is long, the stock could remain compliant by paying the dividend and reducing cash on the balance sheet.

Opportunities abound

Such are the challenges of Shariah investing. But despite the constraints, we are able to find plenty of potential opportunities.

In managing Shariah portfolios, we leverage the same investment team and research process. So Muslim investors essentially get a subset of our broader portfolio, which is compatible with specific Shariah principles.

Overall, our team is finding potential opportunities in the healthcare, energy, and telecommunications sectors. European financials represent a sector our Shariah portfolios cannot invest in, but we've been finding a lot of value over the past year there in our other portfolios.

By country, Malaysia represents one of the biggest markets right now for Shariah investing, and is growing because of its advanced national pension scheme. There is a mandatory monthly contribution into the national pension fund that grows with population and income levels.

Other emerging centers include Middle East financial hubs like Dubai and Abu Dhabi. I think the natural interest in Shariah investing is likely to be confined to Muslim nations, but it would not be surprising to find other countries that are also keen to offer an Islamic investment vehicle. This is due in part to a large and growing Muslim diaspora globally.

Our potential investment opportunities could likewise continue to expand, and we think it's an exciting time to be an investor in this growing space.

Alan Chua is a Singapore-based EVP and portfolio manager at Templeton Global Equity Group.

(Zawya / 15 April 2013)

---
Alfalah Consulting - Kuala Lumpur: www.alfalahconsulting.com
Islamic Investment Malaysia: www.islamic-invest-malaysia.com