Precluded from investing in banks and derivatives on ethical grounds, Islamic funds often fare better than other portfolios, writes CAROLINE MADDEN

AMID ALL the stock market carnage of recent times, one particular type of financial approach has succeeded in quietly outperforming conventional investment methods. Not only has it avoided most banking stocks, but it has shunned risky derivative products and steered clear of highly-leveraged companies. The name of this prescient investment approach? Islamic finance, and more specifically, Sharia-compliant investment funds.

Islamic funds – how do they work?

Essentially, Islamic investment funds are the same as traditional equity funds. They are set up to collect money from investors, pool it and make investment decisions with the aim of delivering positive returns. The key difference is that these funds must comply with Sharia law as set out in the Koran.

One of the fundamental tenets of Sharia law is the prohibition on receiving or paying interest, known as riba. This precludes investments in most banks as they charge and pay interest (although funds can invest in Sharia-compliant banks). This has meant that conventional banks were bypassed by these funds, a move that, in turn, insulated them from the worst of the credit crunch.

Gambling is also prohibited under Sharia law, explains Steven Watts, a partner with KPMG in Toronto who spoke on Islamic finance at this week’s Fintel conference in Dublin. Unlike many US banks, Islamic financial institutions didn’t get involved in dubious derivative products, as they are considered a form of gambling.

An ethical “overlay” is also applied to these funds, based on Sharia law, which prohibits investments in activities such as alcohol, tobacco, pornography and gambling.

“Say, for example, you have a Sharia equity fund,” explains Kieran Fox, of the Irish Funds Industry Association. “Initially, the universe of stocks the fund may invest in is screened. This would be very similar to an ethical fund or a socially responsible fund, whereby a screening process is applied to an index or basket of stocks. So, for this example, we’ll say of the FTSE 100 companies there might be 40 or 60 companies that would be compliant with Sharia principles.”

Another crucial element of such funds is the Sharia advisory board, comprising scholars who are experts in the interpretation and application of Sharia law.

“The Sharia board would be consulted during the initial construction of the fund and provide regular reviews and rulings regarding the fund’s compliance with Sharia principles,” Fox explains.

However, there is a practical understanding that there could be a small portion of revenue generated by the portfolio that is derived from “unpure” or prohibited sources. In this case, the board can “purify” this element of the income, by donating it to charity.

According to Pat Candon, a partner in the investment management group at PricewaterhouseCoopers (PwC), Sharia funds tend to be very transparent as a result of this income purification process because it means the board must have a very clear idea of exactly where the portfolio is invested.

However, KPMG’s Steven Watts says one of the issues holding back the growth of Sharia finance has been the differing interpretations of what is permissible. Broadly, he says, there are two approaches. On the one hand, you have what might be termed the Wahabi position – based on the experience in the Saudi-dominated Middle East. This entails a fairly strict interpretation of Sharia law to financial instruments.

A less black and white approach is evident elsewhere, especially in some Asian Muslim financial centres, where a more pragmatic approach is evident.

The dichotomy means that mainstream financial institutions cannot devise Sharia-compliant products that will be accepted globally and this has hindered the market to some extent.

Growing market for Islamic funds

Although still at an early stage, the Islamic funds industry is expected to grow rapidly. Candon points out that Muslims account for 20–25 per cent of the world’s population, but currently only 1 per cent of all financial assets are Sharia-compliant. He predicts that a growing sense of Islamic identity and increasing religious compliance will fuel growth in this area.

Furthermore, the relative outperformance of Sharia funds, combined with their conservative approach to investing, means that they are now attracting interest from a wider audience.

“What people are now seeing is that, relatively speaking, performance has been slightly better ,” says Brian Forrester, financial services partner with Deloitte.

He believes that a wave of money will come into this market from non-Muslim investors looking for higher returns that can be achieved in an ethical manner.

Of course, while Islamic financial institutions may have avoided the most toxic financial products, Sharia funds have not been immune to the ravages of the stock market. Forrester points out that the Dow Jones Islamic US Index (which tracks Sharia-compliant stocks in the US) has fallen 9 per cent over the last three years. However, this compares to a 13 per cent drop in the SP 500 index.

“They’re certainly in some way protected, but they’re not unaffected,” he says. “If the market goes down, the market goes down.”

Another feature of Islamic funds is that short-selling is prohibited. Some investors may be glad to steer clear of this risky strategy, but Forrester says the flipside of this argument is that short-selling has allowed rival funds to perform better by enabling them to profit in the falling market.

Given the losses that investors have incurred in the last 24 months, PwC’s Candon says it is difficult to see people regaining an appetite for risk, in the short term at least. “People will invest based on performance and, if they can see that these funds are performing relatively well during the current economic crisis, that in itself will attract investors,” he says.

When people decide to dip their toes back into the investment waters, he believes they will do so more conservatively than in the past, with the result that the relatively safe approach taken by Islamic funds could prove attractive.

“Certainly when I speak to my partners around the world who deal specifically with Islamic finance, they have said that there would be a proportion of non-Muslim investors in these funds. I would have thought that that proportion is likely to increase,” he predicts.

Individuals choosing Sharia funds on the basis of performance rather than religious beliefs might wish to select a fund that leaves “income purification” to their own discretion. This means that “tainted” income is not deducted at fund level. Rather, when the investor receives for example a dividend or redemption payment, they are given a breakdown of the percentage that is “impure”, and can decide themselves whether or not they wish to donate this amount to charity.

How can Irish investors access Sharia investment products?

There is now a burgeoning Islamic finance industry in Ireland, mainly relating to the establishment and administration of Sharia funds in the IFSC. This is reflected in the number of Islamic finance experts who have been hired by Irish accountancy and law firms and the fact that the Financial Regulator recently set up a dedicated team to deal with the establishment of Islamic funds here.

However, the management and distribution of these funds takes place largely outside Ireland.

And although there is now a sukuk (an Islamic investment product similar to a bond) listed on the Irish Stock Exchange, it is only available at wholesale level and is not available to retail investors.

There are, however, hundreds of Sharia-compliant funds available worldwide, many of which Irish investors can access. For example, high-net worth clients of HSBC Private Banking in Ireland can access these types of funds. Alternatively, individuals could consider investing in one of the Islamic exchange-traded funds (ETFs) that are now available on the London stock exchange and in the US market.

Islamic banking – a gap in the Irish market?

Clearly, the Islamic ban on riba (interest) has implications when it comes to personal banking, from mortgages to savings accounts to loans. In countries with significant Muslim populations, such as Britain, financial institutions will generally cater to the needs of these people by offering products that are structured in such a way that they adhere to their religious principles, and Islamic banks may also establish operations there.

The Muslim community in Ireland has grown rapidly in recent years, and it is estimated that there are now as many as 45,000 Muslims living here.

However, according to a spokesman for the Irish Banking Federation (IBF), no financial institution in Ireland has yet developed any Sharia-compliant banking products.

According to Ali Selim, of the Islamic Cultural Centre of Ireland, there is a “desperate need” among the Muslim community here for such products. “All these Muslims are renting houses because they cannot buy, because the Irish mortgage system breaks the Islamic legislation because of the interest systems,” Selim says.

He feels that, by not providing mortgages that comply with Islamic beliefs, Irish banks “have sacrificed a huge portion of the Irish population who could be classified as potential buyers”, he says. “In such an economic climate, I can’t understand ... why they don’t think of alternative systems.”

According to the IBF spokesman, some legislative changes would be necessary to facilitate the introduction of Islamic banking products here. For example, because Sharia-compliant finance doesn’t allow the payment or receipt of interest, mortgages have to be structured in such a way as to avoid this.

One approach that has been adopted elsewhere is that the bank effectively buys the house and the customer makes “rental” payments to the financial institution, and then makes a final balloon payment at the end of the mortgage term, at which point they acquire the property from the bank.

Because this involves two property transactions – the bank buys the house and then sells it to the customer – this could trigger two stamp duty charges under current Irish legislation, he explained. This is one example of the legislative framework in this area that would have to be tackled before banks could offer products like this.

“On foot of IBF’s engagement with the representatives of the Islamic community here, the IBF is going to be progressing these issues with the likes of Revenue and other relevant agencies at government level,” the spokesman said. “If the framework for Sharia-compliant finance is to be developed here, there has to be some legislative change and only Government can do that.”

However, even if a framework is established, industry experts consider it unlikely that many Irish banks would enter this market as it simply isn’t considered big enough to sustain several players.

At one point, Permanent TSB showed an interest in entering this space, but any such plans have now been put on the back burner. “We explored it for a period but didn’t progress with it,” a spokesman said.

Sting in the tail

Although Islamic financial institutions may have avoided the worst of the credit crunch carnage by eschewing mainstream banks, debt-based assets and so on, they are still suffering in the downturn. Some Islamic institutions have been caught out by their exposure to real estate and construction, for example in Dubai where the property bubble has now burst.

Islamic banks operate in a co-operative style, which means that their depositors do not receive interest payments but instead share the returns – and risks – of the bank.

Although this means that depositors with these institutions aren’t affected by shrinking interest rates, the co-operative model means that as the institution’s profits shrink, so too do the returns that they are able to provide their depositors.