A Hamilton credit union is the first financial outfit in Steeltown to join a global banking trend that’s slowly making its way to Canada.

McMaster Savings and Credit Union (MSCU) has begun offering Shariah-friendly mortgages, financial arrangements that comply with the prohibition under Islamic law on the payment or collection of interest.

Working in partnership with UM Financial, a Muslim financial services company based in Scarborough, MSCU has ventured into the world of trade partnerships that generate profit rather than interest.

“We’re a credit union, we need to serve the community we’re in and we identified this as a community that wasn’t being served,” said Paul Mauthe, CEO of MSCU.

Without a wealthy relative or friend to act as a financial partner, many Muslims had a hard time purchasing homes. That changed when the Mississauga-based Islamic Society of North America (Canada) set up the Islamic Co-operative Housing Corporation (ICHC).

The ICHC became so popular, it spun off into Ansar Co-operative Housing when a capital limit on ICHC shares had been reached. The two companies together have financed more than 600 homes, 200 of which are now fully owned by their Muslim purchasers.

Community leader Javid Mirza said most of the Muslim homebuyers he knows bought with the help of ICHC. But UM Financial, short for United Muslims Financial, is giving them competition.

“We’re different from ICHC,” says Shuja Qureshi, manager of the UM Financial branch on the Mountain. “The property is registered in the purchaser’s name, not ours, and if you sell the property, you don’t have to share the profit with UM Financial.”

Making a home was tricky for many Muslims, especially newcomers struggling to get established, Qureshi says. Going to regular banks, which charge interest on loans, just wasn’t an option.

UM Financial founder Omar Kalair approached 17 financial institutions before Credit Union Central of Ontario (CUCO), governing body for the province’s credit unions, decided to back his Shariah-friendly mortgages.

With CUCO as financier, UM Financial buys the home but the purchaser’s name goes on the title to the property. The purchaser kicks in a down payment and pays a rental fee similar to a monthly mortgage payment.

UM Financial charges one-half to three-quarters of a percentage above the going mortgage rate to cover the costs of the arrangement.

Financing comes in part from Shariah-compliant credit union deposit accounts that pay dividends rather than interest. Mauthe says the deposit accounts have proved to be a tough sell.

“We have a cultural issue,” Mauthe says. “It’s based on trust. Potential customers want to know why we’re offering this and what’s in it for them. They’re very cautious. They really dig and want all the ins and outs of the whole thing.”

Even Qureshi, a congregant and former board member at Hamilton Mosque, says potential clients have a long list of questions before they’ll consider doing business with him.

In order to be Shariah-compliant, a mortgage must be financed interest-free from start to finish. Islamic law calls this Musharakah, which translates to partnership and is used for Islamic financing throughout the Middle East and parts of Asia.

Published: September 22 2006 12:43 | Last updated: September 22 2006 12:43

The man about to arrive in a restaurant next to the Bank of England in the City of London is coming to talk about religion. Not the Christian creed that has shaped the City of London over the centuries, but the religion that currently begets unease in many westerners – Islam. More specifically, why, at a time when parts of the Muslim world appear to be at war with the west, some of the world’s biggest investment banks are pouring resources into “Islamic finance”.

He has been described as one of Deutsche Bank’s leading figures in its quest to win Islamic business. His colleagues say he is a genius at creating schemes that enable rich Muslims to use their money in accordance with their beliefs. When he arrives, not only does he not look like a Muslim; he doesn’t even look like a hotshot banker. With a sober shirt and understated manner, he looks more akin to an accountant. (In fact, he is a qualified actuary.) Wearily, he introduces himself as Geert Bossuyt – and rubs tired eyes. He has come off a flight from Dubai, where Deutsche Bank is building up a business on the back of the Middle Eastern oil boom.

“It is not so comfortable flying overnight, but it is efficient, so I do it,” he explains in a flat tone of voice which partly reflects the fact that Bossuyt hails from the Flemish part of Belgium. At the same time, unlike many bankers, Bossuyt is not a man who exudes testosterone-fuelled aggression or enjoys the sound of his own voice; instead, he makes his points in a scrupulously polite manner.

Though so-called Islamic banks have been operating in places such as Malaysia and Dubai for some time, global bankers have traditionally viewed the sector as a small, exotic niche, focused on household investors. But in the past five years – since the attack on the World Trade Center in 2001 – something extraordinary has occurred: behind the scenes, some western investment banks have increasingly started working with Muslim clerics to create a new range of financial products designed for devout Muslims. Under sharia law, Muslims are not allowed to receive interest on their accounts, or go into debt. The new Islamic banking products range from simple savings schemes or mortgages, to the type of complex capital market products that large corporations use to raise billions of dollars.

Some devout Muslims view this trend with dismay, claiming it perverts the true spirit of their religion. However, many more appear to welcome it. Estimates of the size of the Islamic finance industry currently vary wildly from $250bn to $750bn (the sector is as murky and as fragmented as much of the Islamic political world). However, everyone agrees that the business is expanding rapidly – partly because of the involvement of western banks.

“These days Islamic finance is probably the only area where you could say that western institutions are actually helping the Islamic world to develop,” says Humayon Dar, managing director of a sharia consultancy, in which Deutsche Bank is the majority shareholder. “I think [the industry] provides a bridge between the Islamic world and western worlds today.”

But, beneficial or not (and not everyone believes it is), this link between western banks and Islamic clerics has come as a surprise. Investment banks are frequently perceived as financial predators, not cultural bridges. And a group such as Deutsche Bank has its historical roots in German, Christian tradition. In fact, I later discover that Bossuyt is a practising Catholic.

So how, I wonder, does a man – and a bank – like this get involved in this game? As I pursued this story in the following weeks, some of Deutsche Bank’s rivals tried to dissuade me from focusing too much on the German bank. “They’re not that special,” one banker said, pointing out that Deutsche Bank entered the Islamic finance business far later than groups such as HSBC or Citigroup – and its business is consequently less established than others. Yet it is this very “ordinariness” that is intriguing: how Deutsche Bank is carving out a frontier in Islamic finance is better seen as a fable for our times, rather than the story of just one bank.

For Bossuyt, the tale started in Belgium, where he grew up in a humble, rural village where his siblings still live, clustered around the Catholic church. He studied engineering and in the early 1990s joined a small Belgian insurance and banking group. Bossuyt dabbled in different banking fields and later qualified as an actuary. But – like many financiers with engineering skills – he discovered a talent for what bankers call “structured finance”. This is the art of creating complex financial schemes to meet particular client needs. (In the case of Belgium, for example, which has a punitive fiscal regime, these schemes typically enable investors to save on tax.)

Bossuyt’s work caught the eye of Deutsche Bank. In August 2001 – a month before the attack on the World Trade Center – he moved to London, where the once parochial and traditional European institution dominated by Germans had reinvented itself during the 1990s as a global investment bank.

Bossuyt was soon approached by Deutsche Bank’s private wealth management department, which had been handling money from the Middle East ever since the 1970s oil boom. During the 1980s and 1990s, this money had typically gone into mainstream investments, such as real estate, equities or US treasury bonds. But as the world reeled from 9/11, the private banking salesmen noticed a new trend: Middle Eastern investors were increasingly requesting financial instruments that complied with Islamic law, or sharia. So, they asked Bossuyt if anyone in his team could produce sharia-compliant products.

Bossuyt was stumped: nothing in his Flemish-Catholic background or engineering degree had prepared him for this. So he approached Yassine Bouhara, then head of the equity derivatives group (but now head of global markets equity). A suave man, with one of the largest watches I have ever seen, Bouhara epitomises the newly cosmopolitan character of Deutsche Bank: born in Algeria, he holds Swiss nationality and grew up in Madagascar, Ethiopia and France. As a Muslim, Bouhara quickly spotted the significance of this demand for sharia products; but unlike some of his European colleagues, he did not approach Islam with an exaggerated sense of fear, disdain or politically-correct respect. Thus, while many other banks have assumed that the best way to build an Islamic finance business is to teach financial skills to Muslims, Bouhara decided to find some structured finance experts and teach them about Islam.

“We look on sharia-compliant products in much the same way that we look at any other ethical product, or just like we deal with different tax laws or regulatory issues,” says Bouhara. Or as Bossuyt recalls: “I went to Yassine and asked ‘who should do sharia finance?’ and, to my surprise, he said ‘You!’”

A few months later, on a bitterly cold November evening, two dozen of Deutsche Bank’s smartest young financiers gathered at the bank’s offices on London Wall. An Egyptian-born professor called Mahmoud El-Gamal had come to explain to them, for a consultancy fee, how Islamic finance worked. El-Gamal seemed perfect for the task. He comes from a centuries-old family line of Islamic scholars and describes himself as a “deeply committed Muslim”. However, he chose to forge his career not by studying religious law, but by doing a PhD in economics in the US, where he now teaches.

In recent years, as we now know, the experience of dealing with the west has prompted some of El-Gamal’s countrymen to embrace a fundamentalist vision of Islam. However, El-Gamal adheres to a reformist and reflective line of Islamic thought that has earned less publicity. His website publishes poetry he has written in both Arabic and English, and his hero is Imam Muhammad Abduh, a 19th-century cleric who led an abortive Muslim reform movement. Meanwhile, his academic research focuses on Islamic finance, placing the Koranic principles within modern, global capitalism.

That evening, in his PowerPoint presentation, El-Gamal explained that, as many people already think they know, the Koran bans some financial practices, such as riba – a word translated as “interest” or “usury”. This is not unique to Islam: Jewish tradition also frowns on usury, as did the Christian Church until five centuries ago. In 1140, for example, the Church declared that anybody charging interest would be excommunicated (a move which prompted Christians to use Jews as money lenders, since they were presumed to be already excommunicated).

However, Islam’s attitude towards finance is arguably more subtle than Christianity. Or, as El-Gamal says, “It is too simplistic to just talk about riba.” For the ban on riba reflects a much bigger vision of finance, in which money is supposed to be used as a store of value for business activities, not as a commodity in itself. While money can be used for trade, say, it should not be used by itself simply to create more money. Hence, gambling is banned within Islam, along with most forms of debt and activities that trade risk; instead, the ideal form of finance is one where the providers and users of money share risks and rewards. Or as Sheikh Mufti Taqi Usmani, a leading Islamic cleric, recently told a banking conference in London: “The basic principle of Islamic finance is that money is always backed by assets… it is equity financing… not debt.”

El-Gamal’s students quickly grasped the message. “The Deutsche Bank guys were extremely bright,” he recalls, with a chuckle. So the presentation moved to the crucial question: could you mix Islamic laws with modern finance?

For at least 30 years or more, financiers in the Muslim world have been trying to do just that. The endeavour started with the creation of so-called Islamic banks in places such as Malaysia, Pakistan and Dubai. These differentiate themselves from normal banks since they do not pay interest on accounts; instead, they pool depositors’ funds, invest it in acceptable projects such as real estate, then share out the profits.

At first these Islamic banks were small and parochial. But they gradually expanded and started to create more complex financing schemes. Some of these, such as musharaka (joint venture) financing, look similar to modern American-style venture capital. However, the practice most widely used by Islamic banks is murabaha, the “cost plus profit” scheme. In essence, this involves a bank, at the request of a client, purchasing specified goods (such as a commodity) for a third party, and then selling the goods to the client at the purchase price – plus an agreed fixed profit that compensates the bank that provided the funds.

In the eyes of some Muslims, practices such as this look more like financial smoke and mirrors, which might meet the “letter” of Islamic law but do not match its spirit. “[Murabaha] is clearly interest, but concealed in Islamic garb,” argues Muhammad Saleem, a western-trained banker (and committed Muslim) who used to advise Islamic banks before he became disillusioned and wrote his book Islamic Banking – A $300 Billion Deception (Xlibris Corporation, 2006).

El-Gamal himself, in the years since he taught at Deutsche Bank, has also become disenchanted with the industry. “There is much that is depressing in the house of Islam today. [But] as an economist I find little that is more depressing than what is falsely called Islamic finance,” he wrote in a recent blog. More specifically, he claims that many modern Islamic practices are simply “legal arbitrage”, which echo the hypocritical schemes that Christians used in Europe eight centuries ago to circumvent the Church’s ban on usury.

However, such public criticism is unpopular in many parts of the Muslim world, and consequently very rare. (”Since I started saying these things, I don’t get invited to many conferences anymore,” El-Gamal admits.) Instead, most Muslims appear to regard the industry with a sense of religious and cultural pride – a sentiment that has swelled in recent years. “Most Muslims don’t want to live in an Islamic state,” explains Farmida Bi, a Pakistani-born British lawyer. “But if you offer them ways to assert their Islamic identity today that are not too arduous, like with Islamic finance, there is a lot of demand.”

Or as Jawad Ali, a Palestinian-born lawyer who helps to produce sharia-compliant products for some of the Middle East’s wealthiest dynasties, adds: “After the first Gulf war a lot of people took money out of the [Middle East] region, to put it in the US… but after the second Gulf war, people shifted out of the US and started looking for sharia products. These days even a Muslim who is not very devout will choose a sharia-compliant product because it enhances his status in the community.”

And this trend has touched non-Muslim countries as well: in the past couple of years, Islamic banks have mushroomed in the UK, serving local Muslims, men such as Qudeer Latif, a British Pakistani lawyer. As a committed Muslim, Latif says he used to put his money in “ordinary” banks (but always donated any interest he received to charity). These days he uses Islamic banks, and he now works for Clifford Chance, the UK law group, creating sharia-compliant products. “Recently many Muslim professionals have looked for ways to express their identity,” he explains, in a strong Birmingham accent. “Choosing sharia-compliant products is one way to do that.”

In the months after El-Gamal’s tutorials, the financiers at Deutsche Bank had much to reflect on. The events of 9/11 had left some American bankers, particularly in New York, vehemently hostile to the Muslim world. But though Bossuyt was relatively ignorant about Islam, he says he tried to approach it with an open mind. “People say that Belgians lack personality,” he says, in a deadpan voice. “But I think we are extremely adaptive – we borrow from everyone else; we do not try to dominate.”

More practically, Bossuyt spotted some intriguing opportunities for innovation. The first generation of Islamic finance generally approached the discipline from a narrowly religious background. However, Bossuyt’s experience was different – and he could see some unexpected parallels, not so much with early Christendom, but with other branches of modern finance. In countries such as Belgium and Germany, for example, retail investors were often also keen to avoid interest payments, but for tax, not religious reasons. So, Bossuyt asked, why not use the lessons learned from, for example, international tax planning to create sharia products?

One obvious obstacle to this scheme was that Deutsche Bank appeared to lack Islamic credentials. But this was not as much of an impediment as it might seem. For a product to be deemed “Islamically compliant” in the eyes of investors, qualified sharia scholars must issue a fatwa (religious ruling) declaring that it meets Koranic laws. The credibility of a product, in other words, rests on the scholars and fatwa – not on the bank.

This means that even a non-Islamic bank can produce Islamic products – as long as there is a fatwa. But it also means the reputation of the scholars is crucial: famous scholars command far more respect than neophytes. Or, as El-Gamal says: “Islamic scholars are essentially brands.”

But how could Deutsche Bank acquire the necessary Islamic “brand”? Some western banks that had entered this field back in the 1990s, such as HSBC and Citigroup, had created so-called sharia boards: groups of scholars employed on a retainer, to offer sharia advice and fatwa. However, because Deutsche Bank was entering after its rivals, most of the top scholars were already working for the competition. And with scholars often sitting on more than one sharia board, it was easy for innovations to leak.

So Deutsche Bank took a different route. In the course of arranging the original Islamic training course, Bouhara and Bossuyt made contact with an Islamic research centre at Oxford University. Some of its academics were keen to create their own “sharia consultancy”, so in the autumn of 2004, Deutsche Bank co-founded Dar al Istithmar. Both sides emphasised that it was an arms-length arrangement, but Bossuyt agreed to serve as a director. And the academics at Dar al Istithmar used their impressive network of contacts in the Muslim world to attract the all-important “brand name” to the institute’s sharia board: Sheikh Hussein Hamid Hassan, 73, a man sometimes dubbed the “grandfather” of Islamic finance.

I met the formidable Sheikh Hussein in an anodyne conference room at Deutsche Bank’s London headquarters. Though the surroundings were bland – and Sheikh Hussein arrived wearing a suit and tie – it was a memorable interview. The Sheikh is a charismatic figure, with a greying beard and magnetic eyes, and he discussed every issue as if delivering a fiery sermon. Indeed, when I posed questions he disliked (such as how much he was paid) he slammed his fist so hard on the table that my notebook jumped. With passion, he explained how his path had crossed with Deutsche Bank. He was raised in Egypt and studied Islamic law at the famous Al-Azhar University (an institute equivalent to Harvard in Islamic religious circles). However – unusually – the Sheikh also studied law and economics in the US, and in 1975 he helped to create Dubai Islamic Bank, the world’s first Islamic bank. He then became its leading sharia adviser, and as the bank subsequently expanded, his career took off.

These days, he dispenses sharia advice to more than a dozen large financial institutions across the Muslim world. He spends much of his life on aircraft, or in conference rooms with bankers, reviewing financial documents to determine whether they meet Koranic law. “The main issue is the concept – how to get a structure [that is sharia compliant]. Sometimes it takes two minutes to work this out, sometimes two years,” he explained. “Every day a new banker comes, wanting to do Islamic finance. But there is a real shortage of scholars – we are incredibly busy.”

So why, I asked, had he decided to work with a western group, such as Deutsche Bank, rather than stick with institutions that hail from the Muslim world?

Some western bankers suspect that the Islamic clerics are partly driven by fear and ambition: most local Islamic banks, this argument goes, are so immature in financial terms that the clerics believe that they need western banks to build a sustainable, large-scale Islamic finance industry. However, Sheikh Hussein had a different explanation. “Before, people said the world was divided into the capitalist system and the communist system. But now we have conventional finance and Islamic finance,” he declared in a booming voice.

“But Islam is not just for Muslims, but for the whole world. And Islamic finance is a wonderful thing. So we want to make this gift available to all of civilisation. It is good for everybody!”

Warily, I observed that it was also good for some scholars’ personal finances. The fees paid to Islamic clerics are a closely guarded secret, but $300,000 for a deal is apparently not unusual. This inspires criticism from some observers: El-Gamal, for example, dubs the industry “a cartel”. However, clerics insist that the fees simply reflect a shortage of Islamic scholars who understand modern finance. And – as Sheikh Hussein’s aides emphasised to me – the fees are not paid for the fatwa per se, but for the time needed to analyse financial documentation, which sometimes runs to hundreds of pages. “If you are ill, you see a doctor and you pay. So if you want to do Islamic finance, you need an expert,” the Sheikh declared. “Those [western] lawyers are getting millions of dollars for deals. So if you are a sharia scholar, should you have to beg in front of the mosque door? There is nothing in the Koran saying that sharia scholars should be excluded from being compensated.”

By early 2005, Deutsche Bank had finally assembled all the ingredients needed for a sharia business. It had a team of financial experts who understood the issues. It also had access to Islamic scholars. “The great thing about Sheikh Hussein is that he loves to debate,” says Bossuyt. “We can call him and say ‘We need to meet you tomorrow’ – and he will. He works day and night.”

Better still, Deutsche Bank could see a vast pool of potential clients. A few months earlier, McKinsey, the management consultants, had conducted a private survey showing that 20 per cent of investors were already buying Islamic products, and another 60 per cent were willing to consider them – if the products were attractive enough. Bouhara decreed that this “60 per cent” was the crucial target. “Our aim is to make sharia-compliant products as good as conventional products.”

So Bossuyt and his colleagues set to work. Initially, most of their sharia-compliant business was kept strictly under wraps, since Middle Eastern investors tend to be obsessively secretive about their finance. “The majority of deals done in this industry are private placements,” explained Bossuyt. However, as 2005 wore on, some structures emerged into public view. Deutsche Bank was appointed, for example, to organise sharia-compliant financing for a real-estate project in Mecca, Islam’s holiest city, organised by the Saudi Binladen Group, a construction company. The Islamic Development Bank asked Deutsche Bank to raise $500m with a sukuk. This is a relatively new financing instrument that allows companies to raise funds from a large pool of investors, in a manner similar to bonds (without, of course, paying “interest”).

Then Deutsche Bank publicly launched a product called HFRX global hedge fund certificates. This purported to be the industry’s first sharia-compliant product that tracks the performance of hedge funds. The precise mechanisms of how this worked were – like so much else – not public knowledge. However, a key ingredient was that in the autumn of 2005 the bank created a so-called “Islamic window” – or a dedicated pool of money for its Islamic business, headquartered in London but strictly ring-fenced from the rest of the bank. “Essentially what we have now is two Deutsche Banks – one Islamic and one not,” Bossuyt said.

Soon after, Bossuyt and his colleagues received their biggest accolade to date: early this year, Euromoney magazine named Deutsche Bank the “Most Improved” and “Most Innovative” in Islamic finance. Dar al Istithmar was also named best Islamic adviser. The awards were collected by the Deutsche Bank team – and Sheikh Hussein – at a glitzy dinner in London.

Shortly after I started tracking Deutsche Bank’s Islamic adventures, I attended an Islamic finance conference in a London hotel. The audience was a blend of western, Asian and Middle Eastern financiers. The keynote speaker was Gordon Brown, the chancellor.

Brown started with the traditional Arabic Muslim greeting “Asalaam aleikum”, enunciated very slowly, as if he feared offending with a mispronunciation. Then he delivered a speech that dizzily mixed development statistics, political rhetoric and quotes from the Koran. (”As one hadith from the Prophet Muhammad says, seek knowledge from cradle to grave… so let me discuss our education goals.”) The central theme, however, was that Brown wanted to promote London as the future “global centre for Islamic finance”.

On the same day, British police were conducting an anti-terrorist raid in the Muslim neighbourhood of Forest Gate, just a few miles away in east London. You could understand that Brown might be keen to highlight something positive about relations between Islam and the west. More fundamentally, every dollar or pound now being placed into a sharia-compliant structure on a London dealing floor by Deustche Bank – or any other group – is another boost to the City. “London is the global centre of structured finance so it is no surprise that so much Islamic finance is happening there,” says Jawad Ali, the Palestinian lawyer. But this may not last for much longer. Places such as Bahrain, Singapore, Malaysia and Dubai are now furiously fighting to establish themselves as Islamic financial centres too, and in time it seems likely that the financial centre of gravity will shift east. Indeed, shortly after I met Bossuyt, he took his young family to live in Dubai.

So I went to see him there, in the brand new offices that Deutsche Bank is opening on the third floor of The Gate, a landmark building in Dubai. By any standards, it is a bizarre setting: The Gate is a futuristic, barely finished building, which mimics Paris’s Arc de Triomphe and is intended to house Dubai’s financial community. When I arrived for the interview, I found western, Asian and Middle Eastern bankers huddled around the front doors in 44C heat, puffing on cigarettes to observe the building’s smoking ban. Some wore billowing white Arab robes; others suits or jeans. Meanwhile, around them the air vibrated with the sound of construction work: dozens of skyscrapers are springing up from the desert. It is just one small sign of the oil-fuelled construction frenzy across the Middle East that has bankers salivating.

“Two years ago, if you told clients in the Middle East that you had come to see them from London, they would be impressed you had made the effort,” Bossuyt said, in Deutsche Bank’s offices. “But now it has completely changed. You have to be here.”

Cheerfully, he listed some of his team’s recent deals: a new Islam-compliant investment product had been listed on the Dubai International Financial Exchange; another would be launched soon. Meanwhile, a $460m sukuk had just been issued by Aabar, Abu Dhabi’s mighty petroleum group.

That last deal was particularly interesting because it was very innovative, Bossuyt explained, effortlessly mingling Koranic terms with banking jargon: “It’s the first time a mudaraba structure has been combined with a real convertible [security].” The Aabar deal was significant for another reason. Until now, the company had always used conventional financing tools. But, as Mohamed Badawy, chief financial officer of Aabar, later told me, it had switched to sharia finance not because the company’s own officials were feeling religious, but because it thought investors were moving that way. “People who only invest in sukuk will not buy conventional bonds, but people who buy bonds will buy sukuk,” says Badawy. “We felt a sukuk would provide more liquidity… for us, this was about economics.”

That sentiment has potentially important implications for the future. Until now, Islamic products have tended to cost consumers more than conventional products, and their range has been restricted. But as the market matures and expands, this gap could close. And that could then prompt more non-Muslims to use sharia-compliant structures as well – simply because it lets them reach more investors.

“I think in the future Islamic finance won’t be seen as an exotic niche any more, but will move into the mainstream of banking,” Bossuyt said. Or as his boss, Bouhara, echoed: “Eventually I think sharia products will be so widely accepted that people won’t even notice or know – it will be like going to buy a kebab in London, or a McDonald’s burger in Riyadh, which happens to be halal.”

Was that a good thing? I asked. Bossuyt paused – and then, when he spoke, he chose his words carefully. Before entering the world of Islamic finance, he said, he had viewed Islam with some wariness; but when he looked back on the past years, he now realised that many western stereotypes about Islam were wrong. “I have much more respect for Islamic culture now.”

But he had also made a second discovery. “The investment banks who got involved in this business are doing this because they want to make money. And, of course, chasing money has some negative aspects. But the thing about money is that it has no view on religion – it is blind. So chasing money can also bring people together, it can unite.”

Then his mobile phone rang. With an apologetic grimace, he explained he needed to go to another meeting. Somewhere, perhaps, there was yet another Muslim client who was seeking advice on Islamic products from a Flemish-Catholic banker. And somewhere, I reflected, as I stepped out into the scorching heat of a Gulf summer, another tiny, hidden thread was about to be woven into a complex, unseen financial tapestry covering parts of the western and Muslim worlds – even as fractures in our geopolitical landscape grow wider and deeper.

Copyright The Financial Times Limited 2007

Introduction

Today’s investment environment is a challenging one for all of its participants. Things have come a long way since the turn of the past century, and a deeper analysis of the investment industry is required to understand how it will change in the future. The following memorandum aims to discuss the various issues, opportunities and challenges facing portfolio managers of large balanced mutual funds over the next decade. We will begin with a brief description of portfolio management and some historical background on the industry. We will then continue the discussion around the underlying issues. Some of the issues we will put forward are arguably as old as the profession itself, including the fiduciary duty a manager has to her clients. Other issues, on the other hand are expected to gain some light in the upcoming decade, especially issues such as ethical and environmentally friendly investing. We will also address some of the upcoming challenges in this business including the various management and research fees charged to clients by their fund managers, and the degree of transparency of those fees, or lack thereof. Our discourse will also highlight the future investment environment which is expected to continue to be constrained by growing regulation, and compliance burdens. The memorandum will aim to be comprehensive, however much of the discourse will be focused on the major issues expected to gain prominence over the upcoming years.

Portfolio Management

Portfolio management deals with the construction and maintenance of a collection of investments. Portfolio managers are the professionals who are entrusted with the responsibility of creating the best possible collection of investments for each customer’s needs and circumstances. Guided by a statement of investment policy, which outlines the return requirements, the investors’ risk tolerance, and the constraints under which the portfolio must operate, the portfolio manager aims to maxims her customers’ expected return while taking on the least amount of risk.

The funds management business began in 1924 when three Boston security executives pooled their money ($50,000) together to create the first official mutual fund in the United States, the Massachusetts Investors Trust. Today, mutual fund companies have evolved into becoming financial intermediaries that invest the money received from unit holders in accordance with a specific mandate known to all investors before they subscribe. Since the early 1920s, the funds management industry has changed quite a bit. As of last year there were more than 1,800 mutual funds in Canada representing over 50 million unit holder accounts and assets under administration worth $608.6 billion (US$16.06 trillion globally). Despite the evolution of the industry, many of the issues that the early managers had to deal with are still applicable today, and will likely continue to persist in future years to come. New issues, opportunities, and challenges have also come about making this industry as exciting as ever.

Fiduciary Duties and Responsibilities

Fiduciary duties and responsibilities have been, and continue to be one of the main issues that concern investment and fund managers both in Canada as well as around the world. Fiduciary duties are in fact at the center of all the other issues, challenges, and opportunities that we will outline below, including the recent industry scandals and their regulatory repercussions, management fees, and environmentally friendly investments.

A fiduciary is a person or an institution that manages money and/or business affairs for another person or institution. Fiduciary duties are those that common law jurisdictions impose upon a person who undertakes to exercise discretionary powers in the interests of another person in circumstances that give rise to a relationship of trust and confidence. This underscores the fact that all fund managers carry fiduciary duties that they must adhere to. The prudent man (investor) rule is at the heart of modern fiduciary standards, and centers around fiduciaries’ responsibility to use good judgment and make long-term decisions for the benefit of their clients in a manner consistent with how reasonable people manage their own money. Fund managers are responsible for taking decisions that are free from conflict of interest issues, and are intended on maximizing the client’s value, and not that of the manager herself.

Fund managers must be aware of the trust relationship between them and their clients (whether implicit or explicit), and must never be complacent about holding their customers’ interest in high regard. Disregarding such a duty can have severe consequences and result in severe financial repercussions, as we will highlight below. This will continue to be an issue that fund managers must be aware of, and have to adhere to in many years to come.

Mutual Fund Scandals

Unfortunately, the fund management business is as susceptible to scandals as any other business. Scandals arise when the fund manager disregards her fiduciary duties outlined above and neglects to act in the best interest of the fund unit holders. The most recent example of this is the case of the late trading and market timing transactions that took place at Bank of America. Bank of America permitted the Canary fund to engage in market timing transactions in its Nations Funds, allowing it to buy and sell fund shares after the market closed while still getting that day’s price. It, in affect, allowed the fund to profit from late news that was expected to move the price on the following trading day. In this example, the management company allowed the exploitation of stale securities prices at the expense of the fund’s other investors.

A 1999 study by Roger M. Edelen, former finance professor at Wharton, concluded that traders could make sizable profits by exploiting stale prices. Eric Zitzewitz, professor of strategic management at Stanford Graduate School of Business, concludes in a recent study that late trading is widespread, occurring in one out of six fund families and costing investors $400 million a year since 2001. He concluded that market timing costs investors about $4 billion a year. While the actual dollar figure associated with costs to investors is up for debate, the fact that mutual fund scandals are taking place, and hurt investors, is not.

In January of last year, another lawsuit was brought against over 40 mutual fund managers by shareholders in the U.S. due to another investment scandal. The lawsuit cited the managers’ failure to collect more than US$2 billion in settlement pay-outs to which the funds’ shareholders would have been entitled. The lawsuit alleged that the failure to claim this money during the three-year class period dating back to January 2002 was a breach of the fund managers’ fiduciary duty.

Such scandals tarnish the reputation of the mutual funds industry, along with its professionals and managers. The challenge to fund managers is to always focus on the interests of the individual unit holders no matter how much pressure she is under not to do so. Once again, strict adherence to fiduciary responsibilities is essential for managers in the upcoming decade.

Regulatory Burden

The recent scandals above have shaken the confidence in the governance of mutual funds, and resulted in increased scrutiny by the U.S. regulators. Prior to September 2003, the Securities and Exchange Commission (SEC) did not examine mutual fund companies for trading abuses such as market timing violations. This was because the agency viewed other activities as representing higher risks and believed that companies had financial incentives to establish effective controls. This has since changed. New regulations recently introduced require that the Chairman of a fund be independent of the fund manager and that 75 percent of its board of directors must be independent of the company’s investment adviser. The SEC also adopted rules that require mutual fund companies and investment advisers to appoint chief compliance officers (CCO) who are responsible for monitoring compliance with laws and regulations. The SEC also requires mutual fund company CCOs to prepare annual reports on company policies and violations.

Fund managers are likely to experience a lot more regulatory changes in the coming decade, as governance standards are raised as a response to some of the large corporate scandals that have recently occurred. These changes are the regulator’s attempts to protect investors and ensure that their interests are paramount in the eyes of their fund managers. Regulation will further push mangers towards more transparency and to establish stronger elements of independence. These changes should not be taken lightly as they will invariably introduce additional compliance costs and add to the already growing regulatory burden placed on fund managers (and others in the business). This will constitute added challenges to the fund manager, but are imperative to restore investor confidence in the fund management business.

Management Fees

This is one of the most important issues that fund managers must be cognisant of and will have to contend with in the coming years. Managers have to deal with conflicting pressures, trying to properly serve fund investors meanwhile having to also serve their management companies. There is an obvious and direct relationship between the management companies’ profits, and the amount of fees they are able to pass through to the fund holders. The investors on the other hand realize higher returns when fees are kept to a minimum. Therein lays the problem.

One could argue that management companies do best when their funds attract as many investors as possible and hence such competitive pressures limit their urge to maximize fees as much as possible. Recent research however contends this, and suggests that managers do exploit opportunities to maximize fees, often using techniques that make fees virtually invisible to investor, and therefore clearly violate their fiduciary responsibilities to their clients.

Prior to 1980, fund companies were required to absorb costs associated with the funds’ marketing and distribution, typically expensing them out of their own revenue, the management expense ratio (MER). The SEC later adopted Rule 12b-1, allowing for such fees to be passed on to investors. The rational for such a rule was that it actually helps investors since it would lead to a reduction in other expenses due to economies of scale, since marketing would draw more investors to the funds. What ended up happening however was that funds that passed through the marketing and distribution costs did not compensate by lowering the other expenses, irrespective of how many new investors were drawn to the fund. By 1983, about 24% of funds charged 12b-1 fees, and the figure climbed to 61% by the end of 2002 however no compensating lowering of the other expenses took place. One must note those retail investors are the ones most susceptible to this, since institutional investors are better informed, carry more clout, and are able to better protect themselves. Institutional investors typically are better able to resist such pass through fees.

Research costs have also been slowly and discretely passed on to investors. The same research suggests that fund companies pay for such research through “soft dollars”, where brokerage companies (those supplying the research) execute trades for fund managers in exchange for higher commissions. Since those commissions are paid from fund assets and not from the manager’s MER, the research costs are in all intents and purposes being paid for by the investors. Most retail investors are probably unaware of such added costs that in affect lower their overall returns.

Managers are tempted to maximize their short-term profits by shifting expenses to investors, but this practise may not be profit maximizing in the long-run. Given the current increased sensitivity of investors with respect to governance, accountability and disclosure, the practice of shifting expenses, either via soft dollars or 12b-1 fees, especially if it raises expenses to investors without their knowledge, could develop into a serious problem for mutual fund providers. The voice of criticism against management fees has been getting louder, especially when such opinions are held by the most prominent in the investment industry. Fund mangers must pay close attention to their fee structures, and not forget that their fiduciary duty requires them to maximize their clients’ returns, and not their own.

Performance Measurement

Fund performance is, and will continue to be one of the challenges that fund managers have to address. The issue lays in the fact that the typical horizon of a fund manager is longer term, which is usually based on the investors’ time horizon. Fund managers however are assessed on a more frequent basis, that being quarterly or semi-annually. The problem with this is that this indirectly impacts the fund managers’ behaviour, making them focus more on short term results, at the expense of the long term performance. The problem becomes even bigger when the investors themselves are looking for longer term portfolios, yet insist on closer scrutiny and more frequent assessments of their managers. Long term portfolios should ignore short term price fluctuations, and hence allow managers more breathing space.

Fund managers should tackle the issue of performance measurement directly, and turn it into an opportunity. They should do their utmost to persuade their clients to asses them over a longer period (e.g. 1 to 2 years) instead of the current assessment frequency. Doing so would go a long way in smoothing out the inevitable short term price movements and fluctuations in performance.

Investments and the Environment

It is not quite surprising that environmental issues did not play a major role in guiding fund managers’ investment decisions in the past. This perhaps stems from fund managers’ belief that environmental concerns are not yet material to stock valuations, or that their fiduciary responsibility require them to solely pursue profit maximizing decisions while disregarding other “softer” objectives (which may in affect be harmful to investment returns). Perhaps the most important reason is the tendency of fund managers to ignore issues which inherently are of a longer-term importance (e.g. environmental issues), because they are less relevant to their performance. One must keep in mind that fund managers are almost always evaluated based on short-term/quarterly returns, regardless of what their investment horizons are.

There is some evidence to suggest that this has been changing and that the managers’ awareness of environmental issues is increasing. A 2005 survey of 195 fund managers from around the world by Mercer Investment Consulting revealed that the use of positive screening for environmental, social and ethical factors is entering mainstream investment analysis particularly where such screening may potentially yield superior financial performance by targeting companies that adopt socially responsible practices and thereby avoid future liabilities and losses. The study revealed that 70 per cent of fund managers believe the integration of environmental, social and ethical factors into investment analysis will become a mainstream part of investment management within three to 10 years.

Despite this level of awareness however, a concrete connection between awareness and investment decisions and strategies is still absent. Most portfolio managers in North America do not distinguish between addressing environmental risks/opportunities on the one hand and socially responsible investing on the other, placing the North American investment community behind investors elsewhere in the world, who are more open to including environmental information that is financially relevant. The situation is especially worse in Canada, which lags behind the United States with respect to the integration of environmental issues into stock valuations.

Fund managers must recognize that government pressures will likely push them to recognize the inherent long-term environmental risks and opportunities in their investment practices. Fund managers should not wait until their asset-owners push for change on this front, since the responsibility for deciding where the majority of such assets are invested lay with the fund managers themselves, and not the owners.

Qualitative factors such as management quality, corporate governance, market conditions for new products or services, and employee relations are currently being incorporated in investment valuation. Valuation tools therefore do exist to integrate the more qualitative factors and should be used to include environment factors as well. Fund managers cannot be complaisant with regard to environment sustainability, as this will have more of an impact on their industry in the future, and may be another metric by which their performance is measured.

Conclusion

The majority of the issues, opportunities and challenges facing portfolio and fund managers in the coming decade revolve around their fiduciary duties towards their clients. This duty requires managers to ensure that the clients’ interests come before their own. This duty is as old as the portfolio management profession, and will likely remain to be the number one issue that managers must be aware of for years to come. The recent scandals that affected the fund industry have been quite unfortunate, but should not have been unexpected. The newly introduced regulatory changes will help in restoring some of lost confidence in the profession, but managers must be proactive, and transparent in the way in which they conduct their business to ensure that investors’ confidence is restored sooner. Fund managers must be careful in how they structure their fees, and must not solely focus on short term gains to the determent of their longer term investment objectives. The fund managers’ fiduciary duties also require them to maintain a high level of ethical conduct. Such ethical conduct should not be though of only in terms of not breaking the law, but rather needs to be viewed from the perspective of doing what is good. Environmental investing issues are also likely to occupy more of managers time in the future, and fund managers should take this as a challenge to continue to deliver great results, yet with sustainability in mind.

Copyright ©, 2007 Khaled Sultan. All Rights Reserved.

Bibliography

Ambachtsheer, Jane, Socially Responsible Investing – Moving into the Mainstream, 23 June 2005 (www.merceric.com).

Carton, Bruce, A Piece of the Class Action, Investor Global, July 2005

Edelen, M.R. et al. The Wildcard Option in Transacting Mutual-Fund Shares, Wharton Financial Institute Center, 1999

McGeachie, Sue et al., Finance and the Environment in North America, Executive Summary, Environment Canada, 2005

MFS Investment Management, 2006 – http://www.mfs.com

OSC – National Instrument 81-102 Mutual Funds – December 2003

Schonfeld, Mark (03/15/2004). SEC Reaches Agreement in Principle . Retrieved 04/22/2006, from U.S. Securities and Exchange Commission. Web site: http://www.sec.gov/news/press/2004-33.htm

Siggelkow, Nicolaj. Caught Between Two Principals, Wharton Research Center, August 2004

Strong, Robert, Portfolio Construction, Management, & Protection, 4th ed. Thomson South-Western, 2006

The Investment Company Institute – http://www.ici.org/

The Investment Funds Institute of Canada – http://www.ific.ca

United Nations Finance Initiative, A Legal Framework for the Integration of Environmental, Social, and Governance Issues into Institutional Investment, October, 2005

United States Government Accountability Office, SEC Mutual Fund Oversight, June 2005

Warren Buffett, Letters to Shareholders of Berkshire Hathaway Inc., 2005

Wheeler, David et al., Comparative Study of U.K and Canadian Pension Fund Transparency Practices, National Round Table on the Environment and the Economy, 2004

Zitzewitz, Eric, How Widespread is Late Trading in Mutual Funds?, Stanford Graduate School of Business, 2003

Islamic financing focuses more on how the money is invested rather than how much profit there is

Saturday, February 10, 2007NANCY HAUGHT

Ethical investing caters to potential investors who want their money to earn a fair return and accomplish something good at the same time. Islamic investing goes a step further.

In the seventh century, the Prophet Muhammad, a businessman himself, saw the harmful effects of usury, the charging of excessive interest. For hundreds of years, religious leaders and philosophers had warned against the practice: It allowed the rich to profit unfairly from the needs of the poor.

“The Prophet Muhammad forbade interest on money loans,” says Samuel L. Hayes, an professor emeritus at Harvard Business School and co-author of “Islamic Law and Finance: Religion, Risk and Return.” “But he did believe you had a right to earn a return on a house that you owned or a load of dates that you had delivered but hadn’t been paid for.”

Islamic investing is based on investing only in “halal” or “permissible” products and the sharing of profits and losses prescribed by Shariah, or traditional Islamic law. Generally, Islamic financing forbids investment in companies that deal primarily in alcohol, pork, pornography and gambling or profit from charging and accruing interest.

Two Oregonians think this Islamic approach might appeal to non-Muslim investors, too. Mohammad Saeed Rahman, a Muslim, and Blake Goud, a Unitarian Universalist, argue that charging interest undercuts the good that social justice investments can accomplish.

The two are chairman and executive director of the Portland-based Institute of Halal Investing, a nonprofit, online think tank (www.investhalal.org) that offers information on Islamic financing to individuals and brokers who want to know more.

“The door must swing both says,” says Rahman, who worked for 19 years as vice president at Wachovia and Merrill Lynch and has founded several business ventures under the name Rubicon Global. His commitment to Islam, and to investing, has made him a strong believer that “risks and the rewards should go hand in hand.”

Rahman draws a simple example to illustrate Islamic, or halal, financing: Someone with the talent for baking may join forces with someone who has capital to invest. Together they create a bakery, with the investor owning the equipment and the baker using his talent to make a product and build the business. The baker and the investor agree to share in the net profits. Gradually, the baker will buy out the investor’s share in the business. Eventually, the investor’s share of the net profits will fall to zero.

“An investment should be a marriage between talent and capital,” Rahman says. “Using the halal method is good for the investor. As prices go up, his share of the profits goes up. For the person doing the borrowing — you can either manage your loan or concentrate on your business. It is difficult to do both. It is better to use all your energies to create a product and build your business.”

He and Goud, whose background is in economics and public policy, are critical even of micro-credit programs such as the Grameen Bank, whose founder, Muhammad Yunus of Bangladesh, recently won the Nobel Peace Prize.

Grameen Bank loans small amounts of money to poor women and relies on groups of shareholders to ensure the debt is repaid with interest, Goud says. He is looking into ways to adapt the Grameen model so it might be used without charging interest.

Arguments against charging excessive interest are probably as old as the practice itself. Hindu and Buddhist writing that dates from 100 years before the birth of Christ warn against charging interest on loans. Western philosophers from Plato to Plutarch condemned it. Hebrew Scripture prohibits it, and the Christian church argued about it for more than a thousand years. In 1311, Pope Clement V denounced usury, a term that by then carried the connotation of “excessive” interest. During the Protestant Reformation, Luther and Calvin expressed reservations about usury but refused to condemn it universally.

Like conventional investing, a halal approach makes some demands on the individual ethical investor, Rahmen says. A petroleum company with a record of environmental disregard or damage can show up on a list of companies offered for halal investing, for example. His own reading of the Quran tells him it is sinful to cut a tree unless it is needed for protection or shelter. By that particular standard, he reasons, the petroleum company might not be halal.

“Individual investors have to make good decisions about where their money should go,” he says. The institute wants to provide information and analysis to help individual Muslims and other ethical investors decide where to put their money without sacrificing their values, he adds.

“Halal investing is a way of doing business with both compassion and love.”

Nancy Haught: 503-294-7625; nancyhaught@news.oregonian.com

Published: December 18 2006 21:29 | Last updated: December 18 2006 21:29

The growing power of Islam in the financial world will be underlined on Monday with the launch of three benchmark indices designed to track the health of companies that comply with the laws of the Koran.

The three new indices will be called the S&P 500 Shariah Index, the S&P Europe 350 Index and the S&P Japan 500 Index, the index services arm of Standard & Poor’s, the ratings agency, said on Monday.

They will be based on the well-established western versions from which they take their names but strip out the companies that do not comply with Islamic law, and are not shariah-compliant.

Alka Banerjee, vice-president of S&P Index Services, said: “Potential growth in shariah-related investing around the world is enormous, but has been held back by a lack of globally accepted benchmarks and other tailored investment tools.

“The new S&P shariah indices will provide Islamic investors, and the institutions that serve them, with a rigorous and consistent set of international benchmarks to help them gauge the state of the market in this growing area.”

Islamic finance, which is estimated to be worth $500bn, has grown dramatically in the past year, fuelled by the oil-related boom in the Middle East and appetite among western institutions to invest in shariah-compliant products.

The three indices will exclude stocks of companies that operate in alcohol, defence, entertainment, financial services, pork-related products and tobacco as well as companies whose financial ratios violate shariah-compliance measures, such as those with high debt-to-equity ratios.

Of the 500 companies in the S&P 500, 295 are deemed to be shariah-compliant, while 139 are shariah-compliant in the S&P Europe 350 and 286 are shariah-compliant in the S&P Japan 500.

S&P said the launch of the indices, which use December 31 2000 as a base date, was prompted by demand from investors from both the western and the Muslim world.

“Investors from all regions and religions want to know how this sector is performing and what exactly is happening,” Ms Banerjee said.

“These indices will also help providers create structured investment products tailored to the Islamic market.”

Had it been launched at the end of 2000, the S&P 500 Shariah Index would have outperformed its European and Japanese counterparts. It is expected to launch above the 1,400 mark today, while the S&P Japan 500 Shariah Index is expected to launch around 1,200 and the S&P European 350 Index is expected to launch at about 1,100.

Copyright The Financial Times Limited 2006

If you thought managing mutual funds was difficult, try managing funds for Islamic investors. All Islamic investments are subject to two conditions. Islamic scholar Mufti Muhammad Taqi Usmani says: Instead of a fixed return tied up with face value, they must carry a pro-rated profit actually earned by the fund. Neither the principle nor the profit rate is guaranteed.

Also, the amounts pooled together must be invested in ventures that align with Shariah, Islam’s code of principles. The investment channels, as well as the terms reached with fund managers, must conform to the Islamic principles.

What does this mean? Fund managers cannot invest in financial firms that earn interest, such as banks and brokerages, tobacco or alcohol companies, or any adult-entertainment business such as gambling or pornography. Companies steeped in debt are avoided, but so are those with too much cash on hand, according to an article in The Wall Street Journal (WSJ).

Nicholas Kaiser, president of Bellingham, Wash.–based Saturna Capital Corp, manages two Islamic mutual funds. Saturna’s $200-million Amana Trust Growth consistently is among the highest-performing stock funds tracked by investment-research firm Morningstar. The 12-year-old fund has returned 18.1 percent and 7.6 percent on the past three and five years, respectively, according to the WSJ. To date, the fund holds just under 70 stocks, of which nearly 25 percent are non-U.S. companies. Kaiser also manages Amana’s Income Fund, which invests only in dividend-paying common stocks under the expectation it will have more stable stock prices. Both Amana’s Growth and Income Funds are supervised by an Islamic Advisory Board to ensure accordance with Shariah principles.

The inherent restrictions have both limited and assisted his fund management. While it cuts some potential high-performers from the get-go, it also avoids possible troublemakers. For example, Kaiser dropped Enron Corp. before its volatile lawsuit banished it from the stock market because its excessive debt violated Islamic investing principles. He also sold America Online stock when the Internet giant announced plans to merge with Time Warner in January 2000. The acquisition, completed a year later, involved roughly $182 billion in stock and debt.

“When companies merge and take on a lot of debt to make their acquisitions, we often have to re-evaluate,” Kaiser told the WSJ.

Shariah principles, which favor long-term stability over immediate gain, also discourage frequent trading. That nixes the Wall Street firms, such as Merrill Lynch, which closed yesterday at 67.50, up more than 20 percent from its closing price five years earlier.

But market diversification has many companies expanding their product lines, which makes it difficult for fund managers such as Kaiser to maintain strict accordance with Shariah. How does Kaiser, who is not Muslim himself, manage to reap profit and retain Muslim investors? It’s a matter of cultural competence. “Through a process of education, we come up with reasonable rules,” Kaiser told the WSJ.

Kaiser works with Islamic scholars to devise policies most Muslim investors find acceptable. The Amana fund doesn’t invest in firms whose debt makes up a third of its market value, and no more than 5 percent of a company’s revenue can come from non-Shariah compliant operations, such as selling alcohol.

“We do have to know our companies, and that’s probably the biggest benefit we get out of thinking about things as an Islamic investor,” Kaiser told the WSJ.

But cultural competence transcends Islamic fund management. Socially responsible investment practices, which coordinate selections with company values, are on the rise. Last year, these assets were worth $2.29 trillion, up from $639 billion in 1995, according to the Social Investment Forum. Market trends indicate that cultural competency will become a business imperative for fund managers who seek to diversify client portfolios.

One should keep in mind that these criteria are the results of modern fiqh scholarship (ijtihad) and therefore, should be seen to represent the current state of thinking on the issue. In that way, they represent the maximum tolerance levels and not the last word on the subject. In short, if a Muslim investor is contemplating investment in the stock market, he must not only be careful about the profitability but also about the compliance of shariah. These can be done by looking at the nature of business, percentage of income from interest and the financial soundness of the company. While there are a number of tools available to help understand the financial soundness of a company there are not many that can guide an investor in determining the shariah compliance of a stock. Following screening patterns may be helpful in determining the shariah compliance of stocks.

Islamic Investment Criteria

A. Qualitative Screens
There are two types of qualitative screens:
i. Industry screening: Is the company in a business that is prohibited or abhorred in Islam? Apart from investment in banking and finance there are a number of business activities that are considered to be prohibited in Islam, and thus investing in these kinds of businesses is not something a Muslim would like to undertake such as alcoholic beverages, pork and pork products, tobacco products, gambling, lottery, pornography and adult oriented material, prostitution and drugs etc.
ii. Business practices: Following shariah principles are applicable to investing and trading practices applicable to individual investors as well as Islamic financial institutions:

a. Investible funds must be free of interest based debt:
The investor cannot borrow on interest to finance his investments, and therefore cannot trade on margin i.e., borrow to purchase shares. Conventional hedge funds, arbitrage funds, and leveraged buy-out (LBO) funds are prohibited for Islamic investors as they all borrow heavily in order to finance their investment practices.

b. Prohibition of speculation
Unlike conventional investors Muslims cannot base their investment decisions on short-term speculation. They cannot enter the market as speculators but only as investors.

B. Quantitative Screens

There are three types of quantitative screens:
i. Debt/Asset Ratio:
Has the company borrowed funds on interest? Ideally there should be no interest-based debt, but based on the Islamic legal principle “li al-akthar hukm al-kul” (to the majority goes the verdict of the whole) and subsequent scholarly opinions, a company is not a permissible investment if debt financing is more than 33% of its capital. This could be calculated as Total Debt divided by Trailing 12-Month Average Market Capitalization (where Total Debt = Short-Term Debt + Current Portion of Long-Term Debt + Long-Term Debt).

ii.Interest-related Income
Does the company generate any interest or interest-related income? This only includes those companies which do not make earning interest their business, but place their surplus funds in investments that yield interest income. As in the previous case, ideally no income should come from interest-related sources. However, looking at the current situation shariah scholars have permitted to invest in stocks of companies whose income from interest forms less than 5% of a company’s total income. Some scholars have fixed that ceiling at 10% of a company’s total income.

iii. Monetary Assets
To invest in shariah compliant companies, one has to be very careful about company’s monetary assets. Accounts receivables and liquid assets such as bank accounts and marketable securities have to be below the limits fixed by shariah scholars for the investment to be permissible. Some scholars have set this minimum at 51% whereas the majority of shariah scholars agree that “Accounts Receivables” should not be over 45% of company’s total assets (where Accounts Receivables = Current Receivables + Long-Term Receivables).

C. Trading Practices

i. Day Trading
Day trading has little to do with actual investing. Usually day traders watch the market and buy and sell on short-term price fluctuation (normally within one day). For this reason, a number of Islamic scholars have termed this as closer to gambling and thus it is prohibited.

ii. Margin Trading:
Margin trading is buying stocks using money loaned from the broker. Interest is paid for this loan, and therefore it is prohibited. Moreover this is a very risky (and complicated) practice, as one can lose more than what he has borrowed.

iii. Derivatives – Options and Futures
Option is purchasing the right to buy or sell a stock or a commodity at a future date for a fixed price (regardless of the then prevailing price in the market). Exercising this option means buying at the price set in the past. Not exercising the option results in the investor paying the option fee. A great majority of scholars are of the opinion that Futures trading is not permitted in Islam.

iv. Short Selling:
Short selling is borrowing a stock from the brokerage firm and selling it in anticipation that the stock price will further go down. Once the prices are a bit stabilised the stock is purchased back to square up the sale transaction. Thus, the investor as a “shorter” keeps the difference. This transaction involves huge risk that almost has no upper limits. Moreover, from shariah point of view you cannot sell what you do not posses.

The author is PhD in Islamic Economics. At present he is Investment Consultant and Joint Editor Islamic Economics Bulletin. He can be contacted at: shariqnisar@yahoo.com

http://www.milligazette.com/Archives/2005/01-15July05-Print-Edition/011507200530b.htm

The Milli Gazette Online

For a devout Muslim making investments that attract the element of interest is considered ‘haram’ — something not permitted under the tenets of Islam, and this is perhaps the one major reason why not many Muslims invest in stocks or in insurance, or for that matter, even seek housing finance.

But things are changing. Ahmedabad based Parsoli Corporation Ltd, which has been involved in providing tailor-made financial products to Muslims, now offers an option where Muslims can invest in Shariah-compliant stocks, or avail of a housing finance scheme where there will be no element of interest or even help them cover themselves under an insurance cover – takaful — that is within the accepted norms of Islam.

Talha Sareshwala, chief financial officer, Parsoli, said, “It is a huge, an enormously huge, market that needs to be tapped. Whether it is insurance, or stock trading or availing housing finance, Muslims have lagged behind. We intend to change that now with our Islamic Wealth Management System.”

He added that the main aim of Parsoli is to create a new market segment of independent financial advisors. “For example, in the UK, IFAs are the link between the people and the product and IFAs are highly regulated in the UK. That is what we intend to replicate in India.”

It is generally accepted by Muslim jurists that the operation of conventional insurance involves the elements of uncertainty in the contract of insurance, gambling as the consequence of the presence of uncertainty and interest in the investment activities of conventional insurance companies, which violate rules of the Shariah.

Takaful is the alternative form of cover which a Muslim can avail himself against the risk of loss. Most Muslims do not avail of housing finance schemes provided by banks and housing finance companies because there is a hidden element of interest that is involved in such transactions and that this is not permitted by the tenets of Islam.

However, Parsoli is now in preliminary stages of talks with housing finance companies to structure their products in such a way that they can be Shariah-compliant.

“India now needs an Islamic equity index, so that it can act as a benchmark for non-resident Indian money. To cite an instance, the Dow Jones came out with an Islamic equity index and this has been doing great,” said Sareshwala.

Parsoli, in collaboration with IBF-Net, had in 2003, compiled Parsoli-IBF.Net Equity index, India’s first and only Islamic Equity Index, comprising the most liquid stocks of Shariah-compliant companies that are registered on the National Stock Exchange and the Bombay Stock Exchange.

“For the moment though, the PIE is for our customers, but in future, we intend to make this available to all investors,” said Sareshwala.

About 80 per cent of the 1,200-odd customers of Parsoli use the PIE to invest in Shariah-compliant scrips as of date.

The companies are screened every fortnight to determine their Shariah compatibility.

The parameters that Parsoli applies to ensure that companies are Shariah compliant are that its debts to market cap ratio should not be more than 33 per cent, the cash recoverables are less than 45 per cent of the net worth of the company, the main income of the company is not from interest and these companies are not into manufacture of alcohol, leather or are not connected in any way to gambling.

Parsoli is almost single-handedly working in the segment of providing Shariah compliant financial services to Muslims.

According to Sareshwala, companies like Mumbai-based Barkat Investments and Al Falah Investments of Delhi, which was also into stock broking and a member of the NSE.

“Then there is also the Bangalore based Al Amin Investments, which has branched out into the co-operative banking sector. But by and large, these companies did not fare well and the faith of the Muslim investors had been shaken to an extent,” said Sareshwala.

Where Muslims can park money

Stocks: Parsoli is in talks with the NSE to start an Islamic equity index that will enable Muslims to invest in stocks that are Shariah compliant. Parsoli has already launched the Parsoli IBF.Net Equity index a couple of years ago, and acts as a facilitator as of now

Insurance: In January, the company approved the formation of Parsoli Takaful Pvt Ltd. Takaful is the Islamic form of insurance. A few insurance products of existing companies have been identified, which can be Islamically acceptable with a few changes

Housing finance: Parsoli has initiated talks with housing finance companies to introduce a housing loan scheme where Muslims do not have to pay interest. Rather, the product is structured in such a way that the interest element is eliminated.

http://in.rediff.com/money/2005/may/24perfin.htm