Question # 226: As salaamu alaikum wa rahmatullahi wa barakatu. Is it permissible to invest in equity funds if not linked to debt income or one has to be sure/certain that it is shariah compliant? Can one invest in an infrastructure company that is known to be hostile or harms the interests of Muslims surreptitiously/secretly?

Bismi-llahi r-raḥmani r-raḥīm,

Assalamu ‘laikum warahmatullahi wabarakatuh,

All praise and thanks are due to Allah (سبحانه و تعالى), and peace and blessings be upon His Messenger (صلى الله عليه و سلم).

Dear questioner,

First of all, we implore Allah (سبحانه و تعالى) to help us serve His cause and render our work for His sake.

Shorter Answer: Islamically, Investment in equity funds has the same criteria as investment in stocks. Since common stocks have no parallel in Shari’ah, the jurists seems to tilt in favor of granting permissibility to the modern stock with some additional constraints and conditions:

  1. The main business of the company is not in violation of Shari’ah (e.g., manufacture, sell or offer liquor, pork, haraam meat, or that are involved in gambling, night club activities, pornography or riba-based banking and financial services, etc.)
  1. If a company’s main line of activity is permissible but it invests/ lends/ deposits its surplus funds in interest-bearing assets or borrows money on interest, the shareholder must express his disapproval against such dealings in the annual general meeting of the company.
  1. If some income from interest-bearing accounts is included in the income of the company, the proportion of such income in the dividend earned (and capital gains) must be given in charity. However, such donations to charity do not fall in the category of zakah or sadaqah.
  1. Stocks of a company are negotiable only if the company owns at least 51% non-liquid assets. However, some other scholars have opined that even if the illiquid asset of a company are 33%, its shares can be treated as negotiable. Nevertheless, if all the assets of a company are in liquid form, the corresponding shares would represent money only and the money cannot be traded in except at par. 

In modern times, Islamic equity funds have been the most popular with Islamic Fund Managers and the need for Shari’ah compliant stocks has led to the development of the Shari’ah screening of stocks based on quantitative measures as well as on fundamental subjective criteria such as Shari’ah compliance of the business line. The first Islamic index created by an index provider was the Dow Jones Islamic Market Index (DJIM), launched in 1999. The DJIM established an independent Shari’ah Supervisory Board. Stocks of companies in the DJIM are reviewed quarterly for continued compliance. However, the DJIM criteria are a subject matter of continuous change in the light of new insights and that these should not be taken as “divine” rules of Shari’ah compliance. 

Lastly, to answer the second part of the question, no investment should be made in any company that is known to be hostile or harms the interests of Muslims surreptitiously/secretly. 

Long Answer: [The mutual funds which invest in stocks are called equity funds. Hence, Islamically, Investment in equity funds has the same criteria as investment in stocks.] Common stocks have no parallel in Shari’ah. Nevertheless, majority opinion among jurists seems to tilt in favor of granting permissibility to the modern stock with some additional constraints and conditions. First, since stocks represent pro rata ownership interests in companies, the company itself must be engaged in Islamically permissible activities. Second, ownership interest relates to ownership in real assets and not in debts or money. Third, the company neither borrows money on interest nor keeps its surplus in an interest bearing account. However, a company that fulfills this criterion is very rare in contemporary stock markets. Hence, contemporary jurists have developed some “more liberal” criteria for identifying permissible stocks to be included in the portfolio.

A majority of scholars opine that a joint stock company is basically different from a simple partnership in the classical Islamic legal sense. While in a partnership, all the actions of a partnership are rightfully attributed to each partner, the policy decisions in a joint stock company are taken by the majority. Therefore, each and every action taken by the company cannot be attributed to every shareholder in his individual capacity. By implication, if a company is engaged in a halal business, however, it keeps its surplus money in an interest-bearing account, wherefrom a small incidental income of interest is received, it does not render all the business of the company unlawful. As regards the issue of the company borrowing on the basis of interest, here again the same principle is relevant. If a shareholder is not personally agreeable to such borrowings, but has been overruled by the majority, these borrowing transactions cannot be attributed to him. Jurists have provided the following conditions relating to investments in stocks:

  1. The main business of the company is not in violation of Shari’ah. Therefore, equity of companies that manufacture, sell or offer liquor, pork, haraam meat, or that are involved in gambling, night club activities, pornography or that are engaged in riba-based banking and financial services fall outside the permissible domain.
  1. If a company’s main line of activity is permissible but it invests/ lends/ deposits its surplus funds in interest-bearing assets or borrows money on interest, the [shareholder] must express his disapproval against such dealings, preferably by raising its voice against such activities in the annual general meeting of the company.
  1. If some income from interest-bearing accounts is included in the income of the company, the proportion of such income in the dividend earned… must be given in charity, and must not be retained.
  1. Stocks of a company are negotiable only if the company owns some (preferably at least 51 percent) non-liquid assets. If all the assets of a company are in liquid form, i.e. in the form of money that cannot be purchased or sold, except on par value, because in this case the share represents money only and the money cannot be traded in except at par.

(‘Islamic Financial Services’ by Mohammed Obaidullah)

The contemporary scholars have different views about this question. Some scholars are of the view that the ratio of illiquid assets must be 51% in the least. They argue that if such assets are less than 50%, then most of the assets are in liquid form, and therefore, all its assets should be treated as liquid on the basis of the juristic principle: “The majority deserves to be treated as the whole of a thing.”

Some other scholars have opined that even if the illiquid asset of a company are 33%, its shares can be treated as negotiable.

The third view is based on the Hanafi jurisprudence. The principle of the Hanafi School is that whenever an asset is a combination of liquid and illiquid assets, it can be negotiable irrespective of the proportion of its liquid part. However, this principle is subject to two conditions:

  • Firstly, the illiquid part of the combination must not be in ignore-able quantity. It means that it should be in a considerable proportion.
  • Secondly, the price of the combination should be more than the value of the liquid amount contained therein. For example, if a share of 100 dollars represents 75 dollars, plus some fixed assets, the price of the share must be more than 75 dollars. In this case, if the price of the share is fixed as 105, it will mean that 75 dollars are in exchange of 75 dollars owned by the share and the balance of 30 dollars is in exchange of the fixed assets. Conversely, if the price of that share is fixed as 70 dollars, it will not be allowed, because the 75 dollars owned by the share are in this case against an amount which is less than 75. This kind of exchange falls within the definition of ‘riba’ and is not allowed. Similarly, if the price of the share, in the above example, is fixed as 75 dollars, it will not be permissible, because if we presume that 75 dollars of the price are against 75 dollars owned by the share, no part of the price can be attributed to the fixed assets owned by the share. Therefore, some part of the price (75 dollars) must be presumed to be in exchange of the fixed assets of the share. In this case, the remaining amount will not be adequate for being the price of 75 dollars. For this reason the transaction will not be valid. However, in practical terms, this is merely a theoretical possibility, because it is difficult to imagine a situation where the price of a share goes lower than its liquid assets.

(‘An introduction to Islamic Finance’ by Mufti Muhammad Taqi Usmani)

Islamic Equity Funds

Islamic equity funds have been the most popular with Islamic fund managers as alternative financial institutions that conform to norms of Islamic financial ethics. These are more focused in their operations and have a more simplified asset and liability structure… There is greater transparency not only about the types of contracts and products, but also about the specific sectors (utilities, or housing, or metals etc.) and markets (domestic, or international etc.) where the investments would be made.

The validity of Islamic Investment Fund in terms of Shari‘ah is subject to two basic conditions:

  • Instead of a fixed return tied up with their face value, they must carry a pro-rata profit actually earned by the Fund. Therefore, neither the principal nor a rate of profit (tied up with the principal) can be guaranteed. The subscribers must enter into the fund with a clear understanding that the return on their subscription is tied up with the actual profit earned or loss suffered by the Fund. If the Fund earns huge profits, the return on their subscription will increase to that proportion. However, in case the Fund suffers loss, they will have to share it also, unless the loss is caused by the negligence or mismanagement, in which case the management, and not the Fund, will be liable to compensate it.
  • The amounts so pooled together must be invested in a business acceptable to Shari‘ah. It means that not only the channels of investment, but also the terms agreed with them must conform to the Islamic principles.

(‘An introduction to Islamic Finance’ by Mufti Muhammad Taqi Usmani)

Criteria for Screening

The need for Shari’ah compliant stocks has led to the development of the Shari’ah screening of stocks based on quantitative measures such as debt-to-asset (or debt-to-market capitalization), liquidity-to-asset (or market capitalization) and receivables-to-asset (or market capitalization) ratios as well as on fundamental subjective criteria such as Shari’ah compliance of the business line… The first Islamic index created by an index provider was the Dow Jones Islamic Market Index (DJIM), launched in 1999. The DJIM established an independent Shari’ah Supervisory Board.

The DJIM measures the performance of a global universe of investable equities that have been screened for Shari’ah compliance consistent with Dow Jones Indexes’ proprietary methodology.

The selection universe for the DJIM family of indexes is the same as the universe tor the Dow Jones Wilshire Index, a broad-market index that seeks to provide approximately 95 percent market coverage of more than 60 countries. To arrive at the various DJIM Indexes, companies in the Dow approximate the restrictions typically imposed on Islamic-compliant investments and then the criteria relevant to the specific index. For example, the first level of DJIM screening is intended to remove any companies involved in industries, including without limitation, alcohol, pork products, conventional financial services (e.g., banks and insurance companies), entertainment (e.g., hotel, casinos, gambling etc.), tobacco, and weapons and defense. A second level of DJIM screening, based on financial ratios, is intended to remove companies based on debt and interest income levels in their balance sheets. [For a stock to be a shari’ah-compatible investment, the following ratios must not exceed 33%:

  • Total debt divided by trailing 24-month average market capitalization.
  • The sum of a company’s cash and interest-bearing securities divided by trailing 24-month average market capitalization.
  • Accounts receivables divided by trailing 24-month average market capitalization.

(Investment & Finance, the online financial encyclopedia, //investment-and-finance.net/islamic-finance/f/financial-ratio-screens.html) updated as of Jan 01, 2014]

Stocks of companies that pass both sets of screens are included in the DJIM, and are reviewed quarterly for continued compliance. All other indexes in the DJIM family are created as subsets of this benchmark. (‘The Chancellor Guide to the Legal and Shari’a Aspects of Islamic Finance’ by Humayon A. Dar and Umar F. Moghul)

However, the criteria used in such screens are often not free from controversy. Hence, the DJIM criteria or other similar ones are a subject matter of continuous change in the light of new insights and that these should not be taken as “divine” rules of Shari’ah compliance. To cite an example, proponents of the one-third in the financial screen rule cite the following hadith: The Prophet (صلى الله عليه و سلم) advised Abu Bakr (رضي الله عنه) not to donate more than One-Third of his wealth, and commented that “One Third is too much (Al Thuluth Katheer)”. The following fiqhi rule is also cited in its support “Whether a commodity that is part gold and part brass qualifies as gold for purposes of applying the rules of riba is resolved by the percentage of gold in the commodity, i.e., if greater than a third, it is “gold.” Critics of the one-third rule assert that it involves an out-of-context use of the above hadith and also an out-of-context use of the above fiqhi rule. (‘Islamic Financial Services’ by Mohammed Obaidullah)

Purification of Earnings

The profits can accrue either through dividends distributed by the relevant companies or through the appreciation in the prices of the shares. In the first case i.e., where the profits are earned through dividends, a certain proportion of the dividend, which corresponds to the proportion of interest earned by the company, must be given in charity. The contemporary Islamic Funds have termed this process as ‘purification’.

The Shari‘ah scholars have different views about whether the ‘purification’ is necessary where the profits are made through capital gains (i.e. by purchasing the shares at a lower price and selling them at a higher price). Some scholars are of the view that even in the case of capital gains, the process of ‘purification’ is necessary, because the market price of the share may reflect an element of interest included in the assets of the company. The other view is that no purification is required if the share is sold, even if it results in a capital gain. The reason is that no specific amount of the price can be allocated for the interest received by the company. It is obvious that if all the above requirements of the halal shares are observed, then most of the assets of the company are halal, and a very small proportion of its assets may have been created by the income of interest. This small proportion is not only unknown, but also ignore-able as compared to bulk of the assets of the company. Therefore, the price of the share, in fact, is against bulk of the assets, and not against such a small proportion. The whole price of the share therefore, may be taken as the price of the halal assets only.

Although this second view is not without force, yet the first view is more precautious and far from doubts. Particularly, it is more equitable in an open-ended equity fund, because if the purification is not carried out on the appreciation and a person redeems his unit of the Fund at a time when no dividend is received by it, no amount of purification will be deducted from its price, even though the price of the unit may have increased due to the appreciation in the prices of the shares held by the fund. Conversely, when a person redeems his unit after some dividends have been received in the fund and the amount of purification has been deducted therefrom, reducing the net asset value per unit, he will get a lesser price as compared to the first person.

On the contrary, if purification is carried out both on dividends and on capital gains, all the unit-holders will be treated at par with regard to the deduction of the amounts of purification. Therefore, it is not only free from doubts but also more equitable for all the unit-holders to carry out purification in the capital gains also. This purification may be carried out on the basis of an average percentage of the interest earned by the companies included in the portfolio. (‘An introduction to Islamic Finance’ by Mufti Muhammad Taqi Usmani) [Lastly, one should remember, such donations to charity do not fall in the category of zakah or sadaqah]

Allahu A’lam (Allah (سبحانه و تعالى) knows best) and all Perfections belong to Allah, and all mistakes belong to me alone. May Allah (سبحانه و تعالى) forgive me, Ameen.

Wassalaam