Dissertation -Shariah-Compliant Stocks Screening and Purification-FMG - July 2015

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Shariah-Compliant Stocks Screening and Purification
By Farid M. Gamaleldin
MSc. In International Accounting and Finance
University of Liverpool
Advisor: Dr. Hao Quach Manh
July 2015

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Contents
Page
Abstract 2
Introduction 2
Research Objective 4
Literature Review 6
Research Methodology 10
Data Analysis: 12
Islamic Shariah Primary Objectives 12
Stock Companies Activities And Governing Rules 13
Stock Screening and Purification 19
Results and Discussion 31
Summary and Conclusion 35
References 37

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Abstract:
Islamic Finance has evolved significantly in the last four decades. Its annual growth
amounted to 10-15% in the last ten years. It is considered a sustainable and
responsible investment. One of the areas which have affected the recent growth of
Islamic Finance is the investment in international stock markets. There are different
opinions about such investment as there is no scriptural basis in Quran or Prophet
Mohamed (PBUH) Traditions regarding investment in stock markets. Contemporary
scholars have contributed through exercising analogical reasoning and referring to
primary objectives and jurisprudence rules in providing methodologies by which
International and locally listed securities are filtered in agreement with Islamic
Shariah. In this research, the researcher tries to explore the tools and rationale behind
methods used in stocks screening and to propose unified framework for equity
screening to take the investment in International securities to higher levels. The
"rules" used in the screening process are not derived from Holy Quran or Prophet
Mohamed (PBUH) traditions and accordingly they are not considered definite rules.
The study will analyze the basis of such rules and try to bridge gaps between them to
have a harmonized standard framework for screening stocks. The indices are prepared
for investors who are respecting the Shariah principles and tend to purify their income
from non-permissible income by donating it to charitable activities. The central
assumption of the study is that the permission to deal with non-permissible income is
an exception and must be limited to achieve Shariah objectives. If such exceptions
continue as "rules" and become a model to be followed, it will be severe violations to
the objectives of Islamic Shariah and may result losing the confidence on the Islamic
Financial Institutions integrity. On the other hand by investing in mixed-income
companies, Shariah-Compliant investors will earn, after purification, less than the
non-Shariah-Compliant investors. Investment in International Stocks Markets should
not be determined only through negative screening process but it should also play an
active role in promoting Islamic Finance Principles.
Keywords:
Islamic Finance, Responsible Investment, Shariah-Compliant Stocks Screening,
Purification.
I. Introduction:
Islamic finance is a sustainable and responsible investment. Principles of Social
Responsible Investments mainly emerged from religious values and evolved to
include environmental, social, and corporate governance (ESG) criteria. (US-SIF,
2012, p.5; Bengtsson, 2007). The principles are evolved further to "sustainability
"which is defined by US Global Compact as "the delivery of long-term value in
financial, social, environmental, and ethical terms"(UNPRI& Global Compact LEAD,
2013, p. 24). Bengtsson (2007,p.973) argue that "the Methodist Church in the UK set
up an ethical fund in 1960, although this fund was not open to the general public" and

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that the first ethical investment fund (AktieAnsvar Aktiefond) open to the public was
established in Sweden in 1965 by the Temperance movement and the dissenting
Baptist movements. The fund portfolio used negative (exclusionary) screening and
excluded Alcohol products, firearms, and tobacco (Bengtsson, 2007, p.973). The
concept of ethical and social responsibility investments was spread in the US during
the 1970s and across the world in the 1980s and 1990s after adding environmental
factor believing that it has a positive effect on financial performance (Bengtsson,
2007, p.969; DB Climate Change Advisors, 2012). There are different techniques that
are employed in sustainability investments which include: negative / exclusionary
(values-driven i.e. exclude companies, sectors, or countries if they breach investors'
values/beliefs) screening, positive /best-in-class (risk and return driven) screening,
constructive engagement, shareholder activism, integrated analysis (financial and non-
financial ESG information) and norms-based screening(excluding companies, sectors
or countries based on norms set out by International conventions and guidelines) (DB
Climate Change Advisors, 2012, P.20).
The Islamic Finance Principles are integrated part of Islamic Shariah (Islamic law).
Islamic Finance is an ethical-based, including being honest, transparent, fair etc.,
which complements with other Islamic Principles. One of the distinguished
fundamentals of Islamic finance is the prohibition of Riba (interest) which is mainly
derived from the Islamic perception towards money. The role of money in Islamic
Shariah is to be a means of transaction and not to be a commodity “that can be sold
/bought” (Ayub, M., 2013, P.90). Mal (Money, property, wealth) is whatever has
value , can be possessed and can be benefited from in accordance with Islamic
Shariah (Al Mosleh,1982 ; Ayub,2013)There are different classifications of Mal in
Islam. From which: "Mal-e-Mutaqawam" and "non-Mutaqawam". Mal-e-Mutaqawam
for Muslims is whatever can be owned, has commercial value and can be benefited
from in normal conditions based on choice (free will) and in accordance with Islamic
Shariah (Al Mosleh, 1982, p.43; Ayub, 2013, p.491). This definition excludes non-
permissible items e.g. alcohol or, pork which are both categorized under non-
Mutaqawam that may be valuable for non-Muslims (in accordance with Hanafi and
Maleki school of thoughts in Islamic Shariah) (Al Mosleh, 1982, p.44). It also
excludes "abnormal" circumstances in which non-permissible items may be consumed
/ transacted, as an exceptional case and on a temporary basis, under the Rule of
Necessity. Impermissible income is considered non-Mutaqawam money and cannot
be utilized or benefited from by Muslims – under normal conditions. If earned
accidently, it should be purified and spent in charity or for social benefits.
The modern Islamic Finance applications and practices emerged in the early 1960s.
The Saving Bank established by Dr. Ahmed Abdul-Aziz El-Naggar in Mit Ghamr
(one of the city on the Nile Delta)- Egypt in 1963 is considered the first attempt to
introduce profit sharing concept (Profit Participation Principle) in bank's financial
transactions instead of interest (Omar et al., 2013, pp. 18-19 ; El-Naggar, n.d.) The
experimental model introduced by Dr. El Naggar included social activity which was

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served through "the Social Service Fund" that was part of the Bank structure as the
bank aimed to achieve socio-economic development for local communities (El
Naggar, n.d., pp. 6-13). The model evolved in the 1970s. The "Islamic Development
Bank" was the first bank to be named Islamic in 1973 (IDB, 2013). Many commercial
Islamic banks were established after the increase of petrol price in 1973. The idea
gained momentum, and Islamic Financial Institutions began to accumulate large
amounts of funds to be invested in accordance with Shariah Principles. Shariah-
compliant funds under management witnessed a significant growth due to the
introduction of Shariah-compliant equity funds and Sukuk as increasing number of
financial institutions are offering Shariah-compliant funds to meet investors demand
(Shanmugam & Zahari, 2009, pp. 46-47).
There are controversial research results concerning the impact of ethical,
environmental, social, governance and sustainability measures on financial
performance (UNEP-FI & MERCER, 2007). Kreander et al. (2005, p.1491)
concluded that their research results are similar to Luther et al.(1992) and Luther and
Matako (1994) which indicated that ethical funds' risk-adjusted performance is
analogous to the market benchmarks. El Ghoul et al. (2011) cited Nelling and Webb
(2009) who found that there is no evidence that Socially Responsible Investments
affect financial performance. Renneboog et al. (2008) argue that Socially
Responsible Investments in many countries underperform against domestic
benchmarks by -2.2% to -6.5%.
The best indicator to illustrate the "importance" of Sustainable and Responsible
Investments (SRI) is its proportion to professionally managed assets and its growth
over time. In USA, the SRI assets increased from US$ 639 billion at the end of 1995
to US$ 6,572 Billion at the start of 2014 which represents 17.9% of the total managed
assets (compared to 11.2% at the end of 2012) (US-SIF, 2012) (GSIA, 2015).The
Total SRI assets in Europe increased from US$ 8,758 billion at the end of 2012 to
US$ 13,608 billion at the start of 2014 which represents 58.8% of the total managed
assets (compared to 49% in 2012)(GSIA, 2015,pp.7-8). Globally, Total SRI assets
increased from US$ 13,261 billion at the end of 2012 to US$ 21,358 billion at the
start of 2014 which represents 30.2% of the total managed assets (compared to 21.5%
at the end of 2012) )(GSIA, 2015,pp.7-8). Ajmi et al. (2014) argue that the assets
managed under Islamic Shariah principles reached US$ 1.3 trillion in 2011.Di Mauro
et al. (2013) stated that the Islamic assets under management increased from US$ 150
billion in the mid-1990s to an estimated US$ 1.6 trillion by end-2012 whereas
Shamsuddin (2014) estimate that the Islamic financial services have grown between
10% and 15% in the recent years and Islamic assets under management reached US$
3.5 trillion.
II. Research objective:
The dissertation aims to study different rules/ criteria applied in screening listed
International and local stocks to invest in accordance with Islamic Shariah and the

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rationale behind criteria, how these criteria evolved over time and propose a guideline
framework for screening and purifying stocks from non-permissible income in context
of Shariah objectives. The screening process and their criteria need to be revisited and
evaluated on a regular basis to ensure fulfilling Shariah primary objectives.
The research objectives can be summarized as follows:
1- To study and compare the different screening rules adopted by various indexes
and funds.
2- To analyze the rationale behind the criteria and their evolvement over the last ten
years.
3- To study the application of criteria and the trend of screened data and verify the
criteria suitability within "exception" rule and "Maqasid" framework.
4- To study the purification process and propose a framework to optimize it within
"Maqasid" framework.
5- To conclude screening framework and purification disclosure and process that
can maintain Islamic Finance creditability and investors' confidence.
Dealing with mixed activities (permissible and non-permissible) is not in compliance
with Shariah, it is an exception. Such exception should serve achieving benefits for
individuals and community within the framework of the primary objectives of Islamic
Shariah. Acquiring stocks of companies dealing in interest as an exception does not
turn interests to be permissible, they must be purified together with other non-
permissible income which should be limited and subject to achieving other objectives
otherwise the exception will become to be a rule (El Baaly, 2015). Within the
exception conditions and constraints and primary Shariah objectives (Maqasid)
framework the research questions / hypotheses will be as follows:
1- Are gaps between screening rules used by different indices to be narrowed
(harmonized) toward achieving Shariah primary objectives (Maqasid)?
2- Does number of companies included in the indices (pass the screening
criteria) tend to increase over time?
3- Is "Sin" (non-permissible) income in the indices adequately disclosed and
tends to decrease over time?
The second and third questions support the objective of spreading permissible (Halal)
transactions and proofing that investing in International Stock Markets will have
additional "Shariah" and "social" reward by attracting more companies to work in
accordance with Shariah criteria.

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III. Literature review:
Khatkhatay & Nisar (2007) examined the norms set by Dow Jones Islamic Market
Index in the context of the Bombay Stock Exchange(BSE 500) and criticized the use
of market capitalization as part of the screening ratios as they consider it not
relevant(p.18) and proposed using total assets instead as they thought it is more
rational. They presented business screening which eliminated companies with
activities inconsistent with Shariah and found that 86.3% of BSE 500 was eligible
companies as an average for the period from 2002-2006 in accordance with Dow
Jones criteria and applied financial screening which found that 32.6% of the eligible
companies (as an average for the period from 2002 to 2006) qualified for debt and
receivables ratio in accordance with Dow Jones criteria whereas they could not apply
liquidity ratio for lack of data. They analyzed the Dow Jones screening norms and
criticized the absence of separate ratio for interest income. They argued that debt and
liquid assets ratio threshold needed to be tighten whereas the level of receivables was
shown to have little relevance. The study is useful as it analyzed the screening ratio
and its implication on the BSE 500. The study did not investigate the rationale of the
thresholds set by Dow Jones Islamic Index.
Derigs & Marzban (2008) reviewed the set of Shariah guidelines used by the major
Islamic indexes and funds to identify Shariah-compliant equity investments. They
further analyzed the similarities and discrepancies among funds using different
Shariah guidelines. The identification was obtained by applying qualitative (sector)
and quantitative screens. The authors prepared a comparative survey to illustrate
qualitative and quantitative screens for nine Islamic funds and indexes. The
quantitative screens were based on the ratio thresholds set by each index Shariah
Board. The authors collected data and analyzed it using mainly qualitative
techniques. The study highlighted the impact of using different guidelines on the
screening process. A stock could be screened as permissible in accordance with a fund
/index criteria and might be rejected and considered impermissible in accordance with
another fund / index criteria. The Study had addressed the dilemma of having
different screening criteria without approaching the rationale behind them to
investigate the root cause of differences.
Jamal et al. (2010) introduced equity market as a place where securities and other
exchange-traded instruments are sold and bought which enable to transfer funds from
surplus to deficit units. They explained that Islamic equity market is characterized by
the absence of interest-based transactions and non-Shariah compliance activities.
They highlighted the lack of International screening criteria and introduced the
criteria adopted by The Shariah Advisory Council of the Malaysian Securities
Commission (SAC) which was established in 1996. SAC applied qualitative and
quantitative screening methodologies. Qualitative screening started with assessing the
companies activities and classified them as non-compliant if their core business were
not in compliance with Islamic Principles e.g. financial services based on interest,
insurance companies, non-halal products (pork-alcohol-tobacco).The SAC had

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established benchmarks based on “juristic reasoning” to be used in quantitative
screening. In addition, SAC had added two additional criteria that the company
maintains good public perception (image) and that the core activities of the company
contribute to the benefits of Muslim ummah (people) and the country. The study
presented the percentage of Shariah-compliant securities in Bursa Malaysia as at 23
November 2009 which amounted to 88% of the total number of securities listed. They
also mentioned the “cleansing of tainted income “without giving details of the
mechanism.
Abdul Rahman et al. (2010) focused their research on a comparative analysis of
Dow Jones Islamic Market Index (DJIM) and the Kuala Lumpur Stock Market
Shariah Index (KLSESI) screening criteria. The study included 565 companies that
represent 88% of the companies listed on the main and second board of KLSE Shariah
Index. The qualitative (sector) criteria excluded companies with core business in
alcohol production and trading, tobacco production and trading, gambling,
conventional insurance, conventional banking. Quantitative criteria included three
main ratios: debt to equity, not to exceed 33%, interest-related income not to exceed
10% of the total income, and monetary assets to total assets not to exceed 49%. They
considered the inconsistencies in the screening rules used by Islamic indices as a sign
of flexibility as the rules may differ to cater different economic, social and political
circumstances. Still they thought that harmonizing the rules would be beneficial and
would enhance cooperation between Muslim communities. The study discussed the
different opinions concerning dealing with mixed activities companies stocks and the
threshold of screening criteria but not addressed the basis of the differences.
Ismail et al. (n.d.) investigated listed and delisted Companies in the Bursa Malaysia
compliance with Shariah in comparative with Dow Jones Islamic Market Index
criteria for the years 2007-2009. They recognized that Bursa Malaysia used only two
screening criteria: core activity (sector – qualitative) and level of interest (non-
permissible) income to total income. ). The authors used four criteria to examine the
companies screened under Bursa Malaysia criteria and compare the impact of the
additional criteria of the level of debt (debt to average market capitalization of the
company) and the level of liquidity (cash, bank and account receivables to total
assets) (which are part of criteria of DJIM) in addition to level of risk factor i.e.
Enterprise Risk Management (ERM). The study concluded that most of the companies
that are screened as Shariah-compliant in accordance with Shariah Advisory Council
of Bursa Malaysia (SAC) did not meet DJIM criteria. The study highlighted the
importance of harmonizing the screening criteria and the discrepancies resulted when
using different screening criteria. The study highlighted that the criteria used by Bursa
Malaysia were loose compared with other indices criteria. The study did not
investigate the rationale behind the screening methodologies.
Elgari (2011) was one of the few scholars who addressed the issue of purification
with relative details. Purification is an important part of investing in the “mixed”
stocks which their core activities are permissible but earn sin income from non-

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permissible activities. He defined purification as “deducting from one’s investment
those earnings the source of which is not acceptable from Shariah point of view”. He
presented different viewpoints concerning the income that needs to be purified. The
first view claimed that only dividends are subject to purification. The second view
argued that all return of the stock of companies with mixed activities including capital
gain must be purified. Third view considered that income derived from impermissible
debt finance should be subject to purification i.e. income is allocated in agreement
with the capital structure. He presented some Shariah scholars’ argument that a fund
manager is required to calculate and dispose the “tainted amounts”. Some scholars
argued that interest income should not be included as part of net income or revenue.
The value of this study is that it is prepared by one of the pioneer scholars who is
participating in different Shariah Advisory Boards.
Yusuf Ibrahim (2012) explained that the screening methodology was based on
qualitative and quantitative criteria determined by the institution’s Shariah Board
based on the assessment of the companies sources of income, business activities,
product lines, financial structures, and the significance of non-permissible income. He
identified core business as one of the major screening criteria as companies that their
core businesses are not acceptable to the Shariah are excluded. He defined the core
activity using the 5% rule i.e. the activity is considered as a core business if it
contributes 5% or more of the Company or the business grouping’s total income and /
or the company total interest-bearing financing. Another criterion was that other non-
permissible investment should not exceed one-third of the company’s market
capitalization. He explained that the companies which their primary or core business
was haram (unlawful) were excluded e.g. alcohol, pork. He presented four types of
financial ratio which were used in the screening process:
1- Cash plus interest-bearing securities to market capitalization (other sources of
non-halal income) not exceed one-third.
2- Total debt to total market capitalization (leverage ratio) not to exceed one-
third.
3- Cash plus account receivables to total assets (liquidity ratio) to be below 70%
level.
4- Other non-operating interest income to total revenues (other non-halal money)
not to exceed 5% and should be cleansed.
He cited Prophet Mohamed’s Hadith (saying) that “One-third is big or abundant
(plenty)” (Termizi) as a justification for using one-third as a threshold and considered
anything that less than one-third is considered small or little. On the other hand, he
believed that the ratio more than 70% is a majority in the case of cash and account
receivables to total assets ratio. This study tried to touch the reason for the threshold
but has not discussed it.
El Baaly (2015) commented on using the Hadith of “one-third is big” in setting up
screening criteria that it is not a proper analogical reasoning or deduction whereas

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Yaqoubi (2015)’s opinion is that it can be used as a kind of “domestication”. The
context of the Hadith was concerned one of the Prophet Mohamed (PBUH)
companion who wanted to “donate” all his wealth as an act of charity; the Prophet
advised him not to do so and guided him to give only one-third of his money to
charity which was already “abundant” according to Prophet saying.
Hadžić et al. (2012) used Financial Times Stock Exchange (FTSE) criteria in
screening 747 companies listed in two stock exchange markets in Bosnia and
Herzegovina. The criteria included sector / qualitative criteria about the core activities
as first step and followed by checking the screening ratios threshold for debt to total
assets (33%), cash and interest-bearing items to total assets (33%) cash and account
receivables to total assets to be less than 50%, and non-compliant income to total
income not to exceed 5%. The authors concluded that 40% of the listed companies in
the two exchange markets met FTSE screening criteria. The study was part of the
researches that studied screening criteria and applied them in local stock market. It is
useful in identifying the differences between indexes criteria. The study dealt with
screening criteria as “given” items and did not discuss their rationale.
Htay and Abdeen (2013) presented different criteria adopted by various indexes.
They criticized the inconsistency in applying Shariah by index providers that may
have an adverse effect on investors. They also addressed the purification process that
is associated with dealing with mixed-income stocks. The authors highlighted on the
positive screening that incentivize investing in friendly community investments.
Despite that the study was brief, but it is useful in addressing and presenting
comparisons between different indexes and addressing the positive screening.
The studies focused on the screening criteria as the static form and did not discuss the
rationale of screening criteria. The new study will focus, besides comparing different
criteria used by various indices, the evolvement of the criteria over time and link such
evolvements with the objectives of Shariah and exception rule.
Sani & Othman (2013) examined the impact of revising the screening methodology
by the Shariah Advisory Council (SAC) of Securities Commission (SC) of
Malaysia and applied MSCI criteria to compare the difference between SAC
criteria and MSCI criteria. They compared different thresholds used by index
providers and the composition of the financial ratio. They concluded that 95%
of the companies complied with the threshold of liquidity ratio and 82% of the
companies complied with the threshold of debt ratio whereas 77% of the
companies complied with the combination of both ratios. When applying
MSCI criteria, only 39% of the companies conformed to MSCI screening
methodology. The main contributor to the difference of businesses in
compliance with Islamic Shariah between SAC criteria and MSCI criteria was
the ratio of account receivables. The study urged for harmonizing the
screening methodology.

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Zandi, Abdul Razak, and Hussin (2014) examined the eligible stocks which were
approved by Shariah Advisory Council of Securities Commission Malaysia (SACSC)
against the criteria of Dow Jones Islamic Market Index (DJIM), Morgan Stanley
Capital International (MSCI), and Standard and Poor’s(S&P). The researchers
claimed that the main differences between SACSC and International Indices were
liquidity and debt ratio. The study concluded that 68.57% of the companies approved
by SACSC have been accepted under MSCI & FTSE screening criteria whereas only
40% of the companies passed DJIM criteria, and 48.57% passed S&P criteria. They
recommended adding leverage and liquidity ratio to Malaysian screening criteria and
to use total assets instead of market capitalization in DJIM and S&P.
The studies presented various Shariah-compliant screening and purifications criteria.
Derigs & Marzban (2008), Yusuf Ibrahim (2012), and Htay and Abdeen (2013)
analyzed different screening steps and criteria and highlighted differences between
them which lead to have specific stocks being compliant under one criteria and non-
compliant under another criteria. Khatkhatay & Nisar (2007) and Hadzic et al. (2012)
applied screening criteria in their local stock markets (Khatkhatay & Nisar used DJIM
criteria in Bombay Stock Exchange (BSE) and Hadzic et al. used FTSE in two stock
markets in Bosnia and Herzegovina). Studies showed that 86.3% of BSE 500 was
eligible companies as an average for the period 2002-2006 and 40% of the listed
companies in two exchange markets in Bosnia and Herzegovina met FTSE screening
criteria. The results supported the possibility of expanding Shariah-compliant
portfolio base. Jamal et al. (2010), Abdul Rahman et al. (2010), Ismail et al (n.d.),
Sani & Othman (2013), and Zandi, Abdul Rahman and Hussin (2014) compared
different indexes criteria with Bursa Malaysia criteria. The studies illustrated that
Bursa Malaysia criteria set by Shariah Advisory Council (SAC) were more lenient
than other indexes criteria. Elgari (2011) and Htay and Abdeen (2013) addressed
purification methodologies which are considered cornerstone to investment in mixed
operations companies. The studies contributed to the objectives of this dissertation
through presenting and comparing between different screening criteria and
purification methodologies. They showed that Shariah screening criteria were
applicable in different stock exchange markets which could increase the number of
eligible companies in Shariah-compliant portfolios/indexes. They also presented the
evolvement of criteria over time and the need to have harmonized screening criteria.
Studies in the field of Shariah-Complaint screening used to focus on comparing
criteria of different indices. Very few of them discussed the criteria and their rationale
or examined purification method. The study will address mainly comparing the
screening criteria and exploring their rationale and discuss different purification
methods.
IV. Research methodology:
The researcher planned to use two main research methodologies: quantitative and
qualitative. A questionnaire was prepared and sent to 100 fund managers to collect

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data about screening and purification methodology. Only eight uncompleted forms
were received. The researcher contacted some of the Islamic funds managers urging
them to respond to the questionnaire. Staff of the funds informed the researcher that
they have strict instructions not to respond to questionnaires about the fund
operations. The initial plan was to use questionnaire to cover wide spectrum of
applied screening criteria within the period from Jan. 2005 to Dec. 2014. The
questionnaire was not limited to the major indexes but also explore funds screening
criteria. Receiving small number of “uncompleted” responses affected the scope of
the study. Few “uncompleted” responses highlighted part of the screening criteria
analysis problem. Criteria are set by Shariah board and applied usually by specialized
institutions e.g. Yasaar for FTSE and Rating Intelligence Partners for S&P. The result
of the dissertation will be limited to the studied indexes and will not include other
funds screening and purification criteria. Some funds may have screening and
purification criteria different from applied in indexes. The researcher believes that the
indexes and standard screening criteria under study still represent the norms of
screening and purification criteria. The researcher was able to have six years (2009-
2014) data snapshot concerning MSCI All Country World Islamic Index (MSCI
ACWI Islamic Index) provided by MSCI. The researcher also prepared an analysis for
the period from January 2014 till May 2015from FTSE published Factsheet. The
researcher used secondary data sources concerning the data about indices screening
methodologies. As the main source of Shariah screening and purification criteria is
Shariah Boards, the researcher arranged two interviews with prominent Shariah
scholars: Dr. Abdul-Hameed El Baaly and Sheikh Nizam Yaqoubi. Dr. El Baaly is
one of the pioneers in Islamic finance and established Islamic Economic Division in
different universities. He is a Shariah Board member in various Islamic Institutions.
He used to be the Secretary General of the Supreme Shariah Board which was
established by the International Association of Islamic Banks. Interview with Dr.
Abdul-Hameed El Baaly was unstructured interview through telephone to be flexible
and discuss in depth several arguments concerning investment in mixed companies.
The researcher used open questions to discuss the background of screening criteria,
different scholars’ opinions concerning AAOIFI standards and the Rule of Exception.
El Baaly emphasized that investment in mixed companies is an exceptional case
which should be dealt with within the context of Shariah primary goals. He also
highlighted the need to have contributions from finance and accounting researchers in
the screening criteria setting up process. Sheikh Nizam Yaqoubi is a Shariah board
member in many Islamic Financial Institutions. He has a significant contribution in
the field of the stock screening as he was a Shariah board member of the board that
issued the “fatwa “of the first Shariah-compliant stock index (Dow Jones). The
interview with Yaqoubi was an unstructured interview in person in Dubai - UAE. As
Yaqoubi is a Shariah Board member who contributed in setting up screening criteria,
the interview was useful in explaining the historical background of the Dow Jones
fatwa which was evolved to be a base of AAOIFI standard. It also discussed the
difference between General Need and the State of Necessity. It further discussed the
rationale of some thresholds and basis of different scholars’ opinions about them. The

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personal relationship with both scholars facilitated arranging the interviews and
exploring in depth issues about screening and purification criteria. One of the most
important conclusions of the interviews is that the screening criteria are not just
Shariah-rules driven but also require contributions from different branches of
management, accounting and finance. The researcher focused on the qualitative
research to explore the rationale for using different thresholds that cannot be
explained quantitatively.
V. Data Analysis:
The data analysis includes mainly qualitative analysis to the basis of screening and
purification criteria. The analysis also includes quantitative data of sample of indexes.
The analysis starts with presenting the primary objectives of Islamic Shariah, Shariah
governing rules with relevant discussions to materiality and operating segment
criteria, and screening and purification criteria for several indexes, fatwa and
standard.
Islamic Shariah Primary Objectives:
The primary sources of Islamic Shariah are Holy Quran and Prophet Mohamed (Peace
be Upon Him) Traditions (Sunnah). In case of having a new transaction which does
not have explicit judgment in Quran or Prophet Traditions, Islamic scholars should
exert all efforts (Ijtihad) and give their opinions based on primary rules (maxims) of
Islamic Shariah. Scholars 'Ijtihad may differ from one scholar to another, from one
country/region to another, and from one time to another based on circumstances
prevailing. El Qaradawi (2010,p.21) quoted Ibn Taymiah’s statement that the main
purpose of prohibiting transactions in Quran and Prophet Mohamed (PBUH)
Traditions is to realize justice and forbid injustice. El Qaradawi (2010, pp. 13-14)
explained the importance of having maxims that can be extrapolated from the detailed
Quran and Prophet Mohamed (PBUH) Traditions provisions to guide and govern
practical opinions provided by scholars for people.
Jurists articulated the primary objectives of Islamic Shariah (Maqasid) as follows
(Ayub, 2007, p.23) (Al-Allaf, n.d.):
1- Protect / preserve religion (faith)
2- Protect / preserve life
3- Protect / preserve intellect
4- Protect / preserve progeny (lineage)
5- Protect / preserve property (wealth).
These five objectives are considered essential for the benefit of individuals and
community. For example, theft is violating protecting property, adultery is breaking
preserving progeny, and drinking of alcohol is violating preserving intellect.

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Objectives are not achieved only through "not doing" things but also through doing
some acts: e.g. marriage to preserve progeny, investment to maintain property.
Preserve property includes the prohibition of interest (Riba), gambling, and excessive
uncertainty transactions. Transactions should be based on justice and transparency.
Money functions are to be a measure of value and medium of exchange (Islahi, 2012,
P.3). Desire money for its own, through interest-bearing transactions, makes it as a
product and hence it becomes goal not a mean (Islahi, 2012, P. 3). Prohibition of
interest is clear in Quran and Sunnah despite some odd opinions from some modern
scholars who claim that bank interest is not Riba. The prohibition includes all parties
involved in the interest-bearing transactions i.e. the one who takes interest, the one
who gives interest, witnesses, and writers of interest agreement(Muslim, n.d., own
translation from Arabic). In addition to the prohibition of interest, Islamic Shariah as a
social responsible investment, prohibits all socially damaged activities e.g. tobacco,
alcohol, pornography, gambling which are violating one or more Islamic primary
objectives (Maqasid).
Stock Companies Activities and Governing Rules:
Stock Company is a result of the evolution of the legal forms of companies to meet
the need of establishing big companies with high capital through the participation of
many shareholders who are seeking profit. Shareholders participate in the company
through acquiring its common stocks. Common stock represents a right to ownership
interest in the earnings and assets of a corporation without direct control over its daily
operations (Elton et al., 2014, p.17; Omar et al., 2013, p.122). The shareholder does
not have direct ownership of the assets which are owned by the Company as a legal
entity, but stocks represent entitlement of a “bundle of rights” to shareholders
(Qaradaghi, 2009; Al Amine, n.d.).
Preferred stocks which grant financial preference concerning priority of receiving
dividends or upon liquidation are not allowed but they can be allowed if they merely
include or exclude procedure or administrative features e.g. voting (AAOIFI, 2014,
p.355). The stocks of the companies are exchanged in Capital Market in which buyers
and sellers place their bids and offers, and stocks are exchanged whenever bids and
offers are matched.
There are three types of stock companies concerning their purposes and operations
(The Shariah Group of Al Rajhi Bank, 2010, p.718):
1- Stocks of companies with permissible purposes and operations: The shares of
these companies can be owned and traded in accordance with regular sales
agreement terms.
2- Stocks of companies with forbidden purposes and operations e.g. gambling,
tobacco companies, alcohol, pornography, conventional banks and insurance
companies: It is not allowed to invest or trade these shares.

14
3- Stocks of companies which have permissible purposes but perpetrate some
impermissible transactions e.g. deposit against interest or borrow interest –
bearing loans: There are different opinions concerning investing in this mixed
type.
There is no difference among Muslim scholars regarding the first and second types,
but there are different opinions concerning the third one. Scholars refer to general
rules (maxims) and principles of Islamic Shariah to form their views.
Some contemporary scholars consider that investing in the third type of mixed
activities is not permissible based on the argument that interest is prohibited
regardless to its volume and that the prohibited transactions are spread over the
company's operations and cannot be segregated from permissible transactions (Al
Nadwi, 1999, p.233; Al Muzeini, 2009; Al Tenaji, 2007, p.5; Al-Amine, n.d., p.103).
El Qaradawi (1988) explains that according to "permissibility and absence of
prohibition principle" all transactions are licit unless they are forbidden by either
Quran or Sunnah or both of them. He (1988, pp. 19-39) further clarified that the rules
which are governing such transactions are: prohibitions aim to avoid harm and
malignancy, whatever leads to impermissible transaction is inadmissible, good
intention cannot justify doing illicit transactions, whatever impermissible is prohibited
for all (without exception for a person or class), and that necessity permits forbidden
transactions (to the extent required to overcome suffering). El Qaradawi (1988, p.256)
argued that borrowing interest-bearing loans can only be done, though disliked, under
real State of Necessity (which not doing it may cause a fatal damage) within the limit
of removing / avoiding such harm and it is required to work hard to avoid doing it.
El Baaly (2015) emphasized that according to the Rule of Exception in Islamic
Jurisprudence, the exception should be limited and not to be expanded. It cannot be
used as a benchmark or being normalized.
Other modern scholars use Ibn Taymiah (one of the prominent scholars) analysis that
there are two types of prohibited items/transactions: items /transactions which are
banned by itself e.g. pork or tobacco-related products that are not allowed to be traded
by all means and item /transaction which is prohibited as it is earned e.g. money and
barley when not earned through a permissible way and mixed with lawful earnings,
then the impermissible amount should be cleansed and permissible amount to remain
as long as it is fungible (Al Nadwi, 1999, pp.345-346). The scholars of this school
believe that based on general tribulation derived from prevalence of interest-bearing
transactions and the people needs and removing hardship principle, shares of the third
type companies can be invested in and traded, as an exception, subject to satisfying
qualitative and quantitative criteria set by Shariah Board/ scholars.
The scholars who allow participating in trading the third type of companies stocks
derive their arguments mainly from different jurisprudence principles. Such principles

15
are used as guidance for deducing opinions concerning modern transactions. They are
primarily in aligning with overarching goals of Islamic Shariah.
The principles include the followings:
 Hardship begets facility (Al Nadwi, 1999, pp.129-133): Once a matter
becomes narrowed, gates of easiness are opened. This rule is one of the bases
of trading mixed stocks. It has many supports from Quran and Prophet
Mohamed (PBUH) traditions from which the following references:
"َ‫ر‬ْ‫س‬ُ‫ع‬ْ‫ل‬‫ٱ‬ ُ‫م‬ُ‫ك‬ِ‫ب‬ ُ‫د‬‫ي‬ِ‫ر‬ُ‫ي‬ َ‫ال‬َ‫و‬ َ‫ر‬ْ‫س‬ُ‫ي‬ْ‫ل‬‫ٱ‬ ُ‫م‬ُ‫ك‬ِ‫ب‬ ُ ‫ه‬‫ٱَّلل‬ ُ‫د‬‫ي‬ِ‫ر‬ُ‫ي‬"-‫(البقرة‬-581)
"Allah intends for you ease and does not intend for you hardship"(Quran,
2:185)
"ُ‫د‬‫ي‬ِ‫ر‬ُ‫ي‬‫يفا‬ِ‫ع‬َ‫ض‬ ُ‫ان‬َ‫س‬‫ن‬ِ‫إل‬‫ٱ‬ َ‫ق‬ِ‫ل‬ُ‫خ‬َ‫و‬ ْ‫م‬ُ‫ك‬ْ‫ن‬َ‫ع‬ َ‫ف‬ِّ‫ف‬َ‫خ‬ُ‫ي‬ ‫ن‬َ‫أ‬ ُ ‫ه‬‫ٱَّلل‬"–‫(النساء‬-88)
"And Allah wants to lighten for you [your difficulties]; and mankind was created
weak."(Quran, 4:28)
"ُ‫د‬‫ي‬ِ‫ر‬ُ‫ي‬ ‫ن‬ِ‫ك‬ٰ‫ـ‬َ‫ل‬َ‫و‬ ٍ‫ج‬َ‫ر‬َ‫ح‬ ْ‫ن‬ِّ‫م‬ ‫م‬ُ‫ك‬ْ‫ي‬َ‫ل‬َ‫ع‬ َ‫ل‬َ‫ع‬ْ‫ج‬َ‫ي‬ِ‫ل‬ ُ ‫ه‬‫ٱَّلل‬ ُ‫د‬‫ي‬ِ‫ر‬ُ‫ي‬ ‫ا‬َ‫م‬َ‫ُون‬‫ر‬ُ‫ك‬ْ‫ش‬َ‫ت‬ ْ‫م‬ُ‫ك‬‫ه‬‫ل‬َ‫ع‬َ‫ل‬ ْ‫م‬ُ‫ك‬ْ‫ي‬َ‫ل‬َ‫ع‬ ُ‫ه‬َ‫ت‬َ‫م‬ْ‫ع‬ِ‫ن‬ ‫ه‬‫م‬ِ‫ت‬ُ‫ي‬ِ‫ل‬َ‫و‬ ْ‫م‬ُ‫ك‬َ‫ر‬ِّ‫ه‬َ‫ط‬ُ‫ي‬ِ‫ل‬"–
‫(المائدة‬–6)
"Allah does not intend to make difficulty for you, but He intends to purify you
and complete His favor upon you that you may be grateful." (Quran, 5:6)
 General need takes the status of necessity (Al Nadwi, 1999, pp.141-147): the
need does not justify committing prohibited transactions, unless there is a
necessity which is limited by strict conditions. The need eases the restrictions
over companies stocks with mixed operations on the basis of “General
Tribulation” and “removing hardship” principles. If other Islamic alternatives
are available, the need is not any more valid. Yaqoubi (2015) explained that
AAOIFI Shariah standard number 21 has not included necessity for justifying
trading companies stocks with mixed transactions as he and other scholars
participated in preparing the standard believe that necessity conditions are
very strict and are related to be near death or losing organ of the body. The
State of Necessity exists when having a compelling situation with genuine fear
of death or of severe injury (Al Mutairi, M., 1997).
 The rules of minimal versus large and predominance and dependence in
Islamic Jurisprudence . The latter explain the logic behind the threshold ratio
set up in the screening criteria:
The rule of minimal versus large: Under the prohibition of interest (Riba), there
are restrictions over some assets transactions that may lead to interest-bearing
transactions e.g. cash and debt. The rule of "The majority has the ruling of all"

16
stipulates that the minimal (little) portion follows the majority (large part) in its
ruling (Al Nadwi, 1999, pp.418-422), and accordingly when cash and debts are
mixed with other assets they follow the majority of the assets ruling. The
thresholds of large and majority are judgmental. Either asset other than cash and
debts is to be more than 50%, or cash and debts are not to be large (Mashaal,
2013, p.17). Some scholars consider that being one-third or more is a threshold of
being large i.e. if cash and debts to total assets or market capitalization ratio is less
than one-third, they are considered ‘little' (minimal) and they follow the ruling of
the predominance assets(Mashaal,2013,p.17). In case of having the majority of
assets as debts, it should comply with the rules of trading debts. In case of having
the majority of assets as cash, it should follow the currency exchange rules (Al
Shebili, 2010, 12-13).
Some scholars argue that mixing assets with cash and debts, regardless to their
ratio, will lift any restriction over dealing with cash and debts as they are looked at
as part of the Company bundle of assets and not targeted separately (Al Shebili,
2010, p. 13) This argument lacks the support of similar incident from Prophet
Mohamed traditions or proof from Shariah principles.
Other scholars' opinion considers mainly the type of activity, its continuity, and
the intention of the investors to participate in the activity, not in acquiring the cash
or debts which are part of the investment assets, and that assets other than cash
and debts are not little/ minor (i.e. equal to or more than one-third of the total
assets or market capitalization according to some opinion) as enough conditions to
apply dependence rule (Mashaal, 2013, p.18). The Dependence rule stipulates that
the assets of the company are dependent on its activities and that the investors of
the company's shares aim to participate in such activities and not to "own" specific
part of the company's assets and accordingly cash and debt can be majority of the
assets but still the share of the company can be traded under The Dependence rule
(Al Shebili, 2010, p. 18). Proponents of this opinion argue that Islamic banks
shares in which cash and Murabaha debts represent the majority of the bank assets
can be traded based on the Dependence rule (Al Shebili, 2010, p. 16; Mashaal,
2013, p.18).
The Dependence rule can be used after starting up the activities for going concern
companies whereas the Majority rule, which was adopted by AAOIFI Shariah
Standard no. 21 can be used before starting the operations as well as when
winding up the activities of the investment (Mashaal, 2013, p.26).
 "Little (trivial/ trifle) is forgiven (excused)"(Al Nadwi, 1999, p.456): This rule
is mainly used to address the treatment of impermissible income in mixed
companies. As long as the impermissible income is considered "little"(trivial)
it can be excised and purified. The threshold of little is a judgmental issue that
may differ from scholar to another. El Baaly (2015) argued that determining

17
the threshold for large, majority, and little / minimal should be proposed by
finance researchers based on scientific justification and practice.
The best guidelines that can help in determining the screening thresholds are
the rule of "Materiality" and “Operating Segments”.
Materiality:
The materiality of an item relates to its impact and a likelihood of occurrence
(frequency). The effect is usually measured by comparing the item value with
a judgmental predefined threshold (Reding et al., 2009, pp.14-7, 14-10).
According to The Framework for the Preparation and Presentation of Financial
Statements (IASB, 2007, p.41), "information is material if its omission or
misstatement could influence the economic decisions of users taken on the
basis of financial statements". Materiality Threshold draws a line between
significant /critical level and tolerable level. Determining materiality amount
depends on the circumstances of the entity and its income and other relevant
factors as “none of the standards provide percentages to be applied to the
relevant benchmarks”(Eilifsen & Messier,2014,pp.6-7).Major parameters to
determine materiality include total assets, total revenues, income before tax,
pre-tax income from continuing operations, and net income”(Eilifsen &
Messier,2014,p.15). The largest eight US and international public accounting
firms use the following percentage ranges for setting quantitative materiality
benchmarks:
Materiality Benchmark %
Income before income taxes 5.0 - 10.0
Total assets 0.5 - 2.0
Total revenue 0.5 - 5.0
Source: adapted from Eilifsen & Messier, 2014, p.36
Patterson & Smith (2003, p.820) quoted former SEC Chairman Arthur Levitt
that “materiality is not a bright-line cutoff of 3% or 5%. It requires
consideration of all relevant factors that could impact an investor’s decision”.
They (2003, p.820) also cited John Fedders (1998), the former Director of
Enforcement for the SEC who “argues that materiality has been impossible to
implement from an enforcement perspective because of its ambiguity”.
SEC Staff Accounting Bulletin (SAB) (1999) accepts the rule of thumb as an
introductory step in assessing materiality to be followed by full analysis of all
relevant considerations. They argue that a matter may be considered
qualitatively material even though it is quantitatively immaterial to the
financial statements taken as a whole.

18
Comunale and Sexton (2005, pp. 2-3) criticize using quantitative rules of
thumb in determining materiality and quoted SEC Staff Accounting Bulletin
No.99 about Materiality (1999) statement that “exclusive reliance on
(numerical thresholds) has no basis in accounting literature or law”, and
instead proposed to use fuzzy logic approach which determines materiality
within a range of unclear” fuzzy” boundaries. They (2005, p. 10) explained
that building a fuzzy system to assess materiality will require to extracting the
quantitative and qualitative(which are harder to assess and require subjective
judgment) factors to be applied and evaluate each of them, state fuzzy rules to
be used and assign the validities of these fuzzy rules.
Materiality for the purpose of integrated reporting (IR) for an organization
relates to relevance and importance of a matter in creating value over time
which influence the assessments of the intended report users (AICPA, 2013,
p.1). When applying the IR materiality process: The impermissible income is a
relevant matter that affects the intended users of Islamic Funds. The
importance of the subject is measured by assessing its magnitude and the
likelihood of occurrence.
Operating Segments:
Financial information is required by stakeholders, including management, on a
regular basis to make a decision concerning the allocation of resources and
performance assessment. Reporting operating segments are determined based
on their significance as a component of the entity. There are two main types of
segments, first: based on products and services and second: based on
geographical areas. The criteria to identify a segment to be reported separately
,as per IFRS Standard number 8 (Operating Segments), include aggregation
rules concerning the nature of the products and services, their production
process, type of customer, distribution and service methods and regulatory
environment and quantitative thresholds which are required to meet any of
them as follows (IASB, 2010, p.A245):
1- Revenue: external and intersegment sales or transfers of a segment are 10
percent or more of the combined revenue of all reported segments.
2- Profit or loss: reported profit or loss of a segment represents 10 percent or
more of the greater of the combined reported profit of all operating
segments that did not report a loss and the combined reported loss of all
operating segments that reported a loss.
3- Assets: the segment assets represent 10 percent or more of the combined
assets of all operating segments.
Both “materiality” and “operating segments” give guidelines to the thresholds
for recognizing the significance of activities that can be used as a start point.
There is no “bright-line rule” to be applied in this regard, but using judgment
based on clear objectives to be achieved is the best available alternative.
Judgment should be exercised by qualified scholars within scientific gathering

19
(not individual or limited committee fatwa) and to be revisited on a regular
basis.
Stocks Screening & Purification:
Historical Background
Adam & Abu Bakar (2014,p.114) cited Mian (2008) who argue that setting
screening criteria was initiated by a team of scholars consists of Muhammad
Taqi Usmani of Pakistan , Prof. Saleh Tug of Turkey and Sheikh Mohammad
Al Tayyeb Al Najar of Egypt in 1987. Sheikh Yaqoubi, N. (2015), who is a
pioneer in the field of Islamic Shariah-compliant stocks screening and a
member of the Dow Jones Shariah Board who issued the DJIMI Fatwa in
1998, explained the historical background of the fatwa of stocks screening
which initiated in the 1990s as a result of dot-com bubble that attracted many
young Moslems to trade in the International Stock Exchange Market using
their families’ wealth to benefit from high return. The young committed
Moslems inquired about the permissibility of trading in such stocks. Sheikh
Nizam Yaqoubi could not respond to inquiries concerning the status of each
company, as such process requires deep analysis for each company that
requires time and resources, but instead proposed general criteria to be applied
for identifying Shariah Compliant companies. A group of scholars adopted
similar stand and participated in Shariah Committee in different Financial
Institutions. These fatwas were in contrary to the resolution no. 65/1/7 taken
by Islamic Fiqh Academy in 1992 which considered investing in companies
sometimes dealing in non-permissible transactions is illegal even if its primary
activities are based on permissible operations (Al Amine, n.d., P.103). RHB
Investment Management claims that it was “the first to introduce the
Systematic Purification / Cleansing Process on Islamic Unit Trust Fund in
Malaysia” in 1996 (RHB Unit Trust Management Berhad, n.d.). Rushdi
Siddiqi proposed the idea of establishing an Islamic Index relying on the
principles of the fatwas of Sheikh Yaqoubi and a group of scholars who
adopted similar opinion which was taken by Dow Jones and established the
Dow Jones Islamic Index in February 1999, which was followed by the Kuala
Lumpur Shariah Index in April 1999 and the FTSE Islamic Index in October
1999 (Yaqoubi, 2015) (Al Amine, n.d., p.107). The Fatwa evolved from
individuals' contribution to Accounting And Auditing Organization for Islamic
Financial Institutions (AAOIFI) Shariah Standard number 21 in May 2004
which took it to a higher level of acceptance.
Dow Jones Islamic Market Indexes (DJIMI):
It is the first International Islamic Market Index which was introduced based
on Dow Jones Shariah Board Fatwa issued in 1998. The Index was launched
in February 1999 (Al Amine, n.d., p.107).

20
Index Universe: the Dow Jones Global Index is the central pool from which
the stocks are filtered and selected in accordance with Islamic Shariah criteria
(Dow Jones Indexes, 2003, p.4).
Index Components selection is subject to two screening steps:
The first step is related to business activities (sector) i.e. to exclude
impermissible activities to arrive at a list of companies which is filtered from
incompliant businesses/ industries. Incompliant businesses include alcohol,
tobacco, pork-related products, conventional financial services, weapons and
defense, pornography, casino and gambling (Dow Jones Indexes, 2003, p.4)
The second step follows the exclusion of the unacceptable primary business
activities by applying accounting-based criteria through testing the level of
debt (leverage), cash and interest-bearing securities, and accounts receivables
weight against the threshold determined by Shariah Supervisory Board. The
Financial ratios that are used for the screening are as follows (Dow Jones
Indexes, 2003, p.5) (Dow Jones Indexes, 2011, p.5):
1- Total debt divided by Trailing 24 Month Average Market Capitalization
should be less than 33%.
Total debt includes short and long-term debts.
Trailing period was 12 Month (2003) and increased to 24 Month (2011).
2- The sum of Cash and Interest Bearing Securities divided by Trailing 24
Month Average Market Capitalization is less than 33%.
3- Accounts Receivables divided by Trailing 24 Month Average Market
Capitalization should be less than 33%.
Accounts Receivables include current and long-term receivables.
The threshold was 45% (2003) and decreased to 33 %( 2011).
Al Rajhi Bank Shariah Board Fatwa numbers 53/1990, 182/1994,
310/1998 & 485/2001:
Al Rajhi Bank for Investment Co. is a Saudi-based Islamic financial
institution and is considered one of the most prominent Islamic Financial
Institutions and its Shariah Board has a significant importance as a leader
in the field of Islamic Finance.
The Shariah Board has issued an important fatwa (opinion) in 1990 which
was evolved over time concerning the Shariah guidelines for dealing in
stocks of companies that have mixed (permissible and impermissible)
operations. The fatwa allows dealing with companies with mixed
transactions(emphasizing that interest bearing borrowing is prohibited
regardless of its amount) based on general tribulation ,removing hardship
and public needs principles subject to the following conditions (The
Shariah Group of Al Rajhi Bank, 2010, pp.719-720):

21
1- There is a genuine need to transact such companies stocks. If there are
other stock companies that avoid dealing with impermissible operations
and satisfy the needs of transactions, no further dealing with mixed
companies is allowed.
2- Purposes of the company should not include dealing with prohibited
activities (e.g. pork, gambling, interest-bearing activities etc.)
3- The Company interest-bearing borrowing to market capitalization (unless
it is less than book value) ratio does not exceed 30% (the ratio was one-
third and revised to 25% of the total assets and then changed to 30% of
the market capitalization (p.717 & p.719)).
4- The Company's impermissible income (from interest or otherwise) to total
income ratio does not exceed 5%.
5- The impermissible income is to be cleansed through donating it to
charitable purposes.
6- There was another criterion that total size of the forbidden amount to be
owned or invested in not to exceed 15% from the total assets. This
criterion was removed (p.717).
7- The Shariah Board emphasized that threshold ratio are judgmental and
subject to amendment whenever required.
8- To get rid of the impermissible part included in the assets of mixed
companies according to the following guidelines:
8-1 the owner of the stocks handles clearing off the sins part of the stocks
when issuing the interim or final financial reports.
8-2 the clearance should include the benefits derived from loan and the
impermissible income whatsoever it has been earned from. The benefit
earned from borrowing can be calculated based on its share of the total
assets. If the borrowed loan to total assets ratio is 20%, it should get rid of
10% of the net income whether dividend was distributed or not (being 50%
of the realized net income based on the incidence of Omar Bin Al Khattab
sons reported by Malek in Al Mowata’a) . In case of no net income, there
is no purification required (pp.721-722).
8-3 In case of having impermissible income, all impermissible income
should be purified regardless to realizing net income or net loss and
whether the dividend was distributed or not.
8-4 It is not allowed to benefit from the impermissible income by any
means. It should be donated to charitable activities (not to be used in
paying tax, alms, advertising ...etc.).
Kuala Lumpur Shariah Index:
Malaysia is one of the most active countries in Islamic finance. Securities
Commission of Malaysia (SC) has created the Shariah Advisory Council
(SAC) that has the duty to formulate Shariah screening methodology to assist
investors to identify Shariah-compliant securities (Zainudin, Miskam &
Sulaiman, 2014).

22
The methodology that was introduced in the mid-1990s consists of two stages:
the first stage screening is related to the activities of the company that issues
the securities. Securities become Shariah non-compliant if they are involved
any of the following core activities: Interest-based financial services and
insurance, gambling, producing and trading non-halal products, tobacco-based
products, non-permissible entertainment and other non-permissible activities
(Zainudin, Miskam & Sulaiman, 2014,p.80).
The second stage includes applying four level of quantitative assessment
(Adam & Abu Bakar, 2014, p.117):
1- 5% benchmark: explicitly prohibited activities (e.g. investment in
conventional banks, liquor, pork, gambling) contribution should not
exceed 5% of income.
2- 10% benchmark: un-avoided prohibited activities income (general
tribulation) e.g. interest income from the fixed deposit should not exceed
10% of income.
3- 20% benchmark: income from rental payment from non-compliant
activities premises must be lower than 20% of income.
4- 25% benchmark: the contributions of activities which have mixed
permissible and non-permissible income (e.g. hotel) must be lower than
25% of the income.
Additional two screening criteria are to be taken into consideration: having
a good image and positive perception by the public and that the core
activities of the company realize “benefit” (Maslaha) to the Muslim
ummah (people) and the community in general. In the first official list of
Shariah-compliant stocks introduced by SC in June 1997, Shariah-
compliant companies represented 57% of the listed securities whereas
Shariah non-compliant companies represented 43%. In November 2008,
Shariah-compliant securities represented 87% of the listed securities
(Ngadimon, 2009).
The SAC announced the revision of screening criteria on 18 June 2012 to
be applied effective from November 2013 to be as follows (Zainudin,
Miskam & Sulaiman, 2014, pp.82-83):
There are two screening stages the first is the quantitative assessment that
is further divided into two tiers:
- the first tier: contribution of non-permissible income derived from
general tribulation activities (e.g. conventional banking, conventional
insurance, gambling, liquor, pork) must not be exceed 5% benchmark of
the group turnover and profit before taxation.
The contribution from mixed activities (e.g. hotel and share trading) and
rental received from non-compliant activities must not exceed 20%
benchmark of the group turnover and profit before taxation.

23
- The second tier consists of two financial ratios: cash placed in
conventional bank accounts to total assets and interest-bearing debt to total
assets that must be less than 33% each.
The second stage is the qualitative assessment that relates to the image of
the company and the realized benefit (Maslaha) from the Company toward
the community. The activities screening was dropped in the revised
selection criteria (Zainudin et al., 2014, p. 82).
FTSE Shariah Global Equity Index:
Financial Times Stock Exchange Shariah Global Equity Index Series
(FTSE SGEI) was launched in October 1999. FTSE SGEI uses FTSE
Global Equity Index Series as a universe from which the companies are
screened in accordance with Shariah criteria set by Islamic scholars. The
screening process comprises of dual steps screening (FTSE, 2014): The
first step involves business sector screening that excludes non-permitted
business sectors e.g. conventional finance, alcohol, pork, gambling,
pornography, tobacco. The second step applied on the companies screened
and passed 1st
step test. The second stage includes the following financial
ratios:
1- Debt ratio: total debt to total assets ratio should be less than 33.333%.
2- Cash and interest bearing items to total assets ratio is less than
33.333%.
3- Accounts receivables and cash to total assets ratio is less than 50%.
4- Total interest and non-compliant activities income to total revenue
ratio should not exceed 5%.
The screening process is performed quarterly. Companies that change
the financial compliance between two successive quarters will be
monitored to check whether their debt and/or cash /interest-bearing
ratios fall within 33.333% +/- 5% (FTSE, 2014). According to FTSE
Ground Rules (FTSE, 2014, p. 9), if such ratios of any company
“remain above or below 33.333% +/-5% for two consecutive quarters,
the compliance of the company will change accordingly”. This is true
for businesses that were above 33.333% threshold and are to be
included in Shariah index when being 5% below 33.333% ratio and to
be excluded from Shariah index when exceeding 333.333% by more
than 5%.
Income from non-Islamic Shariah compliant sources is calculated and
disclosed as a process of dividend purification (FTSE, 2013)
Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI) Shariah Standard number 21: the standard was
issued as of 20 May 2004. The Standard stated that investing in

24
Companies which have allowed purposes but deal with interest and or
other impermissible activities is not permitted in principle but can be
invested in their stocks as an exception under specific conditions
(AAOIFI, 2014, p.356). The Standard stipulates that purposes of the
company should not include impermissible activities e.g. alcohol, pork-
related products, interest-based transactions (AAOIFI, 2014, pp.355-357).
The standard (2014, p.356) emphasizes that interest-bearing transactions
(either receiving or giving) are impermissible and forbidden at any size
and amount. Acquiring and selling the stocks of companies with
permissible activities but include non-permissible transactions is dealt with
based on exception within the general tribulation and removing hardship
principles and as a mean of changing companies to eligible
operations(2014,p.364). Besides the industries screening, the standard has
the following financial ratio thresholds (AAOIFI, 2014, pp.355-357):
1- Interest-bearing borrowed debts (short term and long term) to Market
Capitalization ratio should be less than 30%.
2- Interest-bearing deposits (short term and long term) to Market
Capitalization ratio should be less than 30%.
3- Impermissible income (result from interest or otherwise) should not
exceed 5% of the Company total revenue.
4- When cash and debts are mixed with tangible and other assets and its
purpose not to deal in gold or currency exchange or debts, tangible and
other assets market value should not be less than 30% of total assets
(p.358).
Stocks should be purified by giving the value representing the impermissible
income to charity and not to benefit out of it by any mean (AAOIFI, 2014,
pp.356-357).
Standard & Poor’s Shariah Indices(S&P Shariah Indices):
S&P Dow Jones Indices introduced S&P Shariah Indices in 2006 to meet the
increasing demand for Shariah-compliant stocks. The Indices relied on
“Rating Intelligence Partners” (RI) “to provide the Shariah screens and filters
the stocks based on these screens”(S&P Dow Jones Indices, 2015, p.3). The
S&P Shariah Indices family started by three indices and expanded to include
about 4,000 constituents out of 10,000 companies worldwide, along with 10
sector and 45 country and regional sub-indices(S&P Dow Jones Indices, 2015,
p.3). The screening process consists of two types of screening(S&P Dow
Jones Indices, 2015, pp.10-11):
1- Sector- Based Screens: that exclude business activities that are not in
conformity with Shariah principles e.g. alcohol, gambling, pork,
pornography, tobacco.
2- Accounting-Based Screens: to be applied after removing companies that is
not in conformity with Islamic Shariah. The screening includes three areas
of focus: leverage, cash and impermissible income.

25
- Leverage compliance is tested by Debt / Market Value of Equity (36
month average) < 33%.
- Cash Compliance: Account Receivables / Market Value of Equity (36
And (Cash + Interest Bearing Securities) / Market Value of Equity (36
- Revenue share from non-compliant activities: Non-Permissible
Income other than Interest Income) / Revenue < 5%.
The purification Ratio proposed by the Index is: Dividends x (Non-
Permissible Revenue / Total Revenue).
Additions and deletions are made on the third Friday of each month based
on an ongoing review.
Morgan Stanley Capital International World Islamic Indices (MSCI):
An independent Shariah Board has issued a Fatwa certifying MSCI Islamic
Index Series Methodology since March 2007 (MSCI, 2013). The universe of
the Islamic Indices is MSCI Equity Index or any combination of MSCI Equity
Indexes e.g. All Country World Index (MSCI ACWI) (MSCI, 2011).The
Methodology excludes securities based on two types of criteria: business
activity and financial ratios (MSCI, 2011).Companies that are directly active
or earn more than 5% of their revenue from prohibited activities are excluded
from the index (MSCI, 2011). Prohibited activities include alcohol products,
tobacco, pork-related products, conventional financial services, manufacturers
of weapons, gambling, music and adult entertainment (MSCI, 2011). The
financial screening includes the following ratios (MSCI, 2011):
1- Total debt to total assets ratio not to exceed 30% (reduced from 33.33%)
2- Cash and interest-bearing securities to total assets ratio not to exceed 30%
(reduced from 33.33%).
3- Account receivables and cash to total assets ratio not to exceed 30%
(reduced from 33.33%).
Debts and account receivables to Islamic Financial Institutions are not to be
included in the ratios. MSCI uses total assets instead of market capitalization
as a denominator as the total asset is less volatility than market capitalization
(MSCI, 2013).
Income derived from prohibited activities is calculated and disclosed to be
deducted from the dividend paid to shareholders and given to charity in accordance
with the following formula: The dividend adjustment (purified) factor = (total
earnings –income from prohibited activities including the interests)/total earnings
(MSCI, 2011).
The STOXX Europe Islamic Index:

26
The Shariah Supervisory Board of STOXX Europe Islamic Index has issued its Fatwa
(opinion) defining stocks screening principles and guidelines on 21 February
2011(STOXX, 2011a). The index universe is the STOXX Europe 600 index (STOXX,
2011b). The stocks ‘screening process consists of business activities and financial
ratio. Companies which their primary activities include non- halal (impermissible)
food production (e.g. pork, alcohol and tobacco), conventional financial and insurance
companies, gambling, weapon and arms manufacturing, entertainment and trading of
gold and silver are excluded (STOXX, 2011b). The remaining companies are filtered
in accordance to the following financial screening (STOXX, 2011b):
1- Interest and non-Shariah compliant activities income to total income ration
cannot exceed 5%.
2- Non-Shariah compliant debt to total assets (or total market capitalization,
whichever is greater) ration cannot exceed 33%.
3- Interest bearing assets to total assets (or total market capitalization, whichever
is greater) ration cannot exceed 33%.
Summary of Financial Criteria:
Table 1
Ratio Nominator Denominator DJIMI Al Rajhi KLSI FTSE AAOIFI S&P MSCI STOXX
Debt (leverage)
ratio
Total debt trailing 24 Month
Average Market
Capitalization
<33%
Total debt trailing 36 Month
Average Market
Capitalization
<33%
Total debt total assets ≤ 30%
Interest bearing debt total assets <33% <33.333%
Interest-bearing
borrowing
market capitalization <30% <30%
Non-Shariah compliant
debt
total assets ≤ 33%
Interest-bearing
assets ratio
Cash and Interest
Bearing Securities
trailing 24 Month
Average Market
<33%
Cash and Interest
Bearing Securities
trailing 36 Month
Average Market
Capitalization
<33%
Cash placed in
conventional accounts
total assets <33%
Cash and interest
bearing items
total assets <33.333% ≤ 30%
Interest bearing assets total assets ≤ 33%
Interest bearing
deposits
market Capitalization <30%
Liquidity ratio Accounts receivables
and cash
total assets <50% ≤ 30%
Accounts Receivables trailing 24 Month
Average Market
Capitalization
<33%
Accounts Receivables trailing 36 Month
Average Market
Capitalization
<49%
Non-permissible
income ratio
Impermissible income total income ≤ 5% ≤ 5% ≤ 5% < 5% ≤ 5%
* STOXX denominator is total assets or market capitalization (whichever is greater)
Ratio Composition

27
The majority (five out of eight) of indices /standard providers use one-third and 5%
thresholds in their financial ratio screening. Six of the eight indices / standard
providers use more than two ratios in their financial ratio screening process.
Samples of Indexes:
Table2
SD: Standard deviation
RSD: relative standard deviation = SD/Average
Average, SD, and RSD are calculated by the researcher.
Table3
 Calculated by the researcher
Table4
 Calculated by the researcher
MSCI ACWI ISLAMIC Index
Amounts in MUS$
Year No. of Constituents Adjusted Market Cap Average SD RSD
2009 894 10,686,770.36 11,953.88 24,546.05 205.34%
2010 901 12,209,485.01 13,551.04 26,557.57 195.98%
2011 907 11,357,589.24 12,522.15 27,207.41 217.27%
2012 892 12,019,713.87 13,475.02 27,555.21 204.49%
2013 856 13,607,118.43 15,896.17 32,354.15 203.53%
2014 846 13,189,647.17 15,590.60 31,416.47 201.51%
Source: MSCI
2009 100.00% 100.00% 100.00% 100.00% 100.00%
2010 100.78% 114.25% 113.36% 108.19% 95.44%
2011 101.45% 106.28% 104.75% 110.84% 105.81%
2012 99.78% 112.47% 112.73% 112.26% 99.59%
2013 95.75% 127.33% 132.98% 131.81% 99.12%
2014 94.63% 123.42% 130.42% 127.99% 98.13%
Changes compared with year 2009 as a base year
2009 N/A N/A N/A N/A N/A
2010 0.78% 14.25% 13.36% 8.19% -4.56%
2011 0.67% -6.98% -7.59% 2.45% 10.86%
2012 -1.65% 5.83% 7.61% 1.28% -5.88%
2013 -4.04% 13.21% 17.97% 17.42% -0.47%
2014 -1.17% -3.07% -1.92% -2.90% -1.00%
Year-on-year changes

28
The number of constituents of MSCI ACWI Islamic Index increased in year 2010 and
year 2011 and declined in years 2012-2014. The market capitalizations increased in
the years 2010, 2012 and 2013 and decreased in the years 2011 and2014.
FTSE Shariah All-World:
Table5
The percentages of the number of FTSE Shariah constituents and net MCap. to FTSE
All-World constituents and net MCap. Are calculated by the researcher.
The number of FTSE Shariah constituents increased slightly at the end of the
presented data compared with the number at the beginning of the reported period.
Table6
Amounts in USD m
# of Constituents Net MCap # of Constituents Net MCap # of Constituents Net MCap
31-Jan-14 1,378 16,230,724 2,881 34,625,541 47.83% 46.88%
28-Feb-14 1,377 17,036,386 2,881 36,163,849 47.80% 47.11%
31-Mar-14 1,400 17,114,344 2,949 36,601,584 47.47% 46.76%
30-Apr-14 1,402 17,380,365 2,951 36,899,859 47.51% 47.10%
31-May-14 1,400 17,608,208 2,951 37,527,734 47.44% 46.92%
30-Jun-14 1,412 17,917,778 2,962 38,232,737 47.67% 46.87%
31-Jul-14 1,413 17,623,344 2,963 37,728,006 47.69% 46.71%
29-Aug-14 1,415 17,965,712 2,965 38,482,800 47.72% 46.69%
31-Oct-14 1,415 17,042,675 3,016 37,645,840 46.92% 45.27%
28-Nov-14 1,417 17,141,434 3,018 38,203,263 46.95% 44.87%
31-Dec-14 1,429 16,851,177 3,026 37,451,550 47.22% 44.99%
31-Jan-15 1,428 16,651,556 3,027 36,858,957 47.18% 45.18%
28-Feb-15 1,428 17,469,898 3,026 38,830,216 47.19% 44.99%
31-Mar-15 1,435 17,172,905 3,032 38,215,844 47.33% 44.94%
30-Apr-15 1,434 17,661,445 3,027 39,276,801 47.37% 44.97%
29-May-15 1,430 17,548,527 3,024 39,120,868 47.29% 44.86%
Source: FTSE Factsheet
FTSE All-WorldFTSE Shariah All-World %

29
Source: FTSE Factsheet
Purification:
Purification is an important concept in Islam and is considered one of its five pillars.
“Zakat“– which one of its meanings is purification- is a duty of each Muslim in
accordance with specific conditions. In international stock markets, purification is to
get rid of impermissible income and it complements the screening and investing
process. Investing in the stocks of mixed activities companies is based on the
exception and does not make the non-permissible transactions permissible. Earned
income must be purified from income derived from impermissible activities i.e.
tainted /sin income.
According to permissibility and absence of prohibition principle, all transactions are
permissible unless there is proof for prohibiting them. Some of the properties are
prohibited (banned) by itself such as pork and alcohol i.e. they are Mal non-
Mutaqawam that cannot be bought or sold and should be gotten rid of them fully by
Muslim. Some of the properties are prohibited as a result of impermissible
transactions (as it earned), and purification of such Mal is through disposing of the
part of the money which was earned through prohibited transactions.
Scholars who consider that investing in mixed stocks is prohibited advise that the
owner of such stocks must sell them and dispose of the impermissible income out of
its price (Al Muzeini, 2009, p.16)
All scholars agree that the impermissible income included in the assets of the
companies invested in must be purified by paying it to charitable activities and not to
benefit from it by any means. But they have different views concerning how to
determine such income.
Amounts in USD m
Average Largest Smallest Median
Wight of Largest
Constituent %
Top 10 Holdings %
index Mcap
31-Jan-14 11,778 450,409 89 4,000 2.78% 15.22%
28-Feb-14 12,372 469,400 86 4,097 2.76% 15.26%
31-Mar-14 12,225 478,766 85 4,353 2.80% 15.35%
30-Apr-14 12,397 526,354 87 4,306 3.03% 15.63%
31-May-14 12,577 545,254 85 4,400 3.10% 15.39%
30-Jun-14 12,690 560,337 85 4,436 3.13% 15.30%
31-Jul-14 12,472 576,255 89 4,378 3.27% 15.47%
29-Aug-14 12,697 613,756 93 4,387 3.42% 15.56%
31-Oct-14 12,044 646,690 98 4,100 3.79% 16.32%
28-Nov-14 12,097 697,505 35 4,056 4.07% 16.51%
31-Dec-14 11,792 647,361 108 3,881 3.84% 16.27%
31-Jan-15 11,661 687,125 90 3,901 4.13% 16.30%
28-Feb-15 12,234 748,247 111 4,156 4.28% 16.22%
31-Mar-15 11,967 714,773 104 4,063 4.22% 16.07%
30-Apr-15 12,316 728,967 105 4,325 4.13% 15.77%
29-May-15 12,272 750,547 105 4,239 4.28% 15.91%
FTSE Shariah All-World- Constituents Sizes (Net MCap USD m)

30
- Income derived from loans: There are different opinions about the income
generated from borrowed loans (as a source of funds). Some scholars consider
that the income generated from interest-bearing loans should be included in
the impermissible income and to be purified pro rata to the loans contribution
to the capital structure. Proponents of this opinion argue that interest-bearing
loan contract is a void contract and the loan is considered impermissible and
accordingly the money earned out of it is inadmissible as well (Al Manie,
A.,1994) . Other scholars further argue that income is generated from capital
and labor and hence, only 50% of the income generated from interest-bearing
resources should be purified (as the share of income generated by labor factor
is considered permissible) There is another opinion argues that the loan is
guaranteed by the borrowed Company and prohibition is in receiving the
interest, not paying it, and accordingly the Company deserves its return in full
without purification. Another opinion suggests comparing the net profit
realized with the interest rate, if net profit is more than the interest, the
shareholder should purify the difference between the net profit return and
borrowing interest rate otherwise , purification is not required(Qaradaghi,
2009; Al Muzeini, 2009).
- Interest earned on deposits or any other interest-based vehicle should be
entirely disposed (purified).
- Any other impermissible income should also be purified.
Timing of the purification is another area of different scholars’ opinions (Qaradaghi,
2009):
In case of depositing funds against interest:
1- Purification upon receiving dividends: to calculate the impermissible income
to total revenue ratio and dispose of it from the received dividends.
2- Purification of the impermissible income should take place even if the
Company has not realized net income in accordance with the amount of
impermissible income earned (Al Muzeini, 2009).
3- If the stocks are held for trading purposes (and have not received dividends),
to dispose of the interest earned by the Company from holding period as a
percentage of the stock price.
4- If the stocks are sold on the same day of purchasing them some scholars argue
that no purification is required, others argue that purification is needed for the
period from the beginning of financial year till the selling day.
The researcher believes that accepting the opinion of not purifying traded
stocks will encourage trading mixed-activities stocks which is not a favorable
trend.

31
VI. Results and discussion:
The methodologies that are used by different indices and funds can be summarized as
follows:
1- Business activities that exclude impermissible activities from being the core /
prime activities of the company e.g. conventional financial institutions and
insurance companies, casino, pork products, alcohol, and tobacco. Nature of
business is a crucial screening process.
2- Financial Ratio which can be categorized into the following categories:
2-1 Capital structure: debt to total assets/market capitalization ratio reflects the level
of indebtedness (leverage) of the company. Debts refer to the short-term and long-
term impermissible source of funds (interest-bearing borrowings). Interest-bearing
debt financing should not be large in financial structure. The threshold of being large
may differ in accordance with judgment but many contemporary scholars consider
one-third as a fair level in which debt should be less than it.
2-2 Interest and other impermissible income to total revenue: to check the significance
of the impermissible income in the company’s income. Many scholars consider 5% as
a suitable threshold that impermissible income should not exceed it.
2-3 Cash and Receivables to total assets/market capitalization ratio: Cash and
receivables are sensitive items i.e. their transactions are subject to specific constraints
under Shariah principles. If the majority of the Company assets is cash, the Company
stocks should be traded under the exchange rules and if the majority of the assets are
receivables, stock transactions should follow the rules of trading debts (Mashaal,
2013, p.20). Many scholars consider one-third as a suitable threshold in which cash
and account receivables should be less than it.
2-4 Interest-bearing deposits and investments to total assets/market capitalization
ratio: the majority of funds should not be allocated in interest-bearing assets. The
threshold adopted by many of the scholars is one-third in which interest-bearing
deposits and investments should be less than it.
3- There are other two criteria of Maslaha (public benefits) derived from
activities of the Company and Company’s reputation (image) which are
adopted by SAC-SC Malaysia.
 Using market capitalization as a denominator in financial screening:
Khatkhatay & Nisar (2007) criticized using market capitalization that is used for debt
(Leverage) ratio, liquidity ratio, and receivables ratio in Dow Jones and S&P Indices.
The Dow Jones Indices ratios were calculated initially using Trailing Twelve Month
Average Market Capitalization (TTMAMC) and revised to be Trailing Twenty Four
Month Average Market Capitalization for Dow Jones Indices whereas S&P Indices
use Trailing Thirty-Six Month Average Market Capitalization. They argue that market

32
capitalization does not necessarily reflect the “real worth” of the company as claimed
by proponents of using market capitalization. On the contrary, market capitalization is
subject to high volatility which made the proponents of using it to argue that if a
Company valued its assets and liabilities at market value, it should equate market
capitalization value (Yaqoubi,2015). This may differ from one market to another.
According to The Efficient Market Hypothesis (EMH), information is reflected in
prices immediately and the securities are traded at fair value (Ross et al., 2010, p.
431). In real life, the response to information may differ from one person to another
based on rationality of individuals and their characters. Researchers have categorized
markets in accordance to their response to information to three types (Ross et al.,
2010, pp.433-434): The weak form uses historical data for decision making and takes
time before responding to information, the semi-strong which uses publically
available information and strong forms that use both public and private information. It
is clear that indices that are using market capitalization have suffered from volatility
and shifted from trailing 12-month market capitalization to trailing 24 months and
trailing 36 months. Expanding the period of calculating the average market
capitalization raises a concern about the ratio relevance.
Discussing the research questions:
1- Gaps between screening rules: The researcher noticed that there are common
principles applied in the screening criteria. New indexes launched recently
with similar methodology with minor differences with other indexes. Bursa
Malaysia revised screening methodology announced on18 June 2012 dropped
activities / business screening stage which was considered a major deviation
from other indexes rules. There is a need to have a mandatory screening
standard which take into consideration location and cultural differences.
2- Eligible Constituents: the number of eligible components of the sample of
indexes showed volatile changes in the number of eligible companies over
time. Studies showed that there was significant number of companies passed
Shariah screening criteria in various markets. Islamic Funds have to promote
Islamic Finance principles and play active roles in stockholders meetings.
3- Sin income disclosure: There is a significant deficiency in the purification
process. Many indexes purify income on an annual basis when distributing
dividends. Tainted income should be cleansed regardless to dividends
distribution. Sin income should be disclosed on a regular basis, preferable to
be on a quarterly basis. The methodology of calculating the sin income should
be disclosed.
Proposed Guideline Framework for Screening and Purification Methodology:
Yaqoubi (2015) determined that the main purpose is to have an Islamic Financial
Stock Market in which the activities are fully in compliance with Islamic Shariah. He
further emphasized that “exception” rules do not apply when establishing a new
company i.e. it is not allowed to borrow interest-bearing loans or deposit funds

33
against interest income. Expanding "Halal"(permissible) stocks base and replacing
Islamic Finance instead of non- permissible interest-based borrowing should be part
of the criteria to encourage listed companies to approach Islamic Finance. Islamic
Finance principles are ethical and can enhance the community prosperity. The
objective should be to lift the community to benefits from ethical systems not to
accept unethical transactions as ordinary operations. Positive screening criteria that
aim to add value to the community should be part of the screening process .
The proposed framework consists of exclusionary screening process as an essential
stage in addition to adopt The Principles for Responsible Investment which encourage
playing an active role which can be exercised through sending an annual “Letter of
Objection” to the general meeting to call to adopt “ethical “Islamic Standards and call
for disclosing the “sin” income and purify them and facilitate disclosure through
adopting Shariah-based taxonomies. The framework is discussed in details as follows:
 Basic Assumptions:
1- The screening process is within the context of realizing the overall primary
Islamic goals (Maqasid) which are based on fairness and justice and aim to
achieve the best benefits to community and people.
2- Screening for companies that are listed on recognized regulated stock markets
that meet the minimum disclosure requirements that provide timely and
accurate information and have sufficient liquidity to execute deals.
3- There is a need to invest in mixed activities companies because there are no
feasible enough fully Shariah-complaint companies.
4- The principal aim is to establish stock market that is fully compliant with
Shariah principles.
5- Tainted income is to be adequately disclosed and purified.
6- The screening process and composition of eligible companies are subject to a
review (at least once quarterly for compositions) to ensure compliance with
Shariah principles.
First screening step: Screening of Business activities: Excluding companies with core
activities that are not in compliance with Islamic Shariah. This can be identified if
such activity is one of the main purposes of the Company, or if it represents 10% or
more of either its revenue, net income, or its assets.
Second screening step: Screening by Financial ratios: The main ratios that are
considered relevant and need to be applied are as follows:
2-1 Debt (leverage) ratio: the ratio comprises of total impermissible debt to total
assets. The ratio should be less than 33% for the company to be eligible. Debt raised
from Islamic Financial Institutions or as a result of ordinary trading transactions are
not included in the ratio.
2-2 Interest-bearing securities/items to total assets ratio should be less than 33%.This
ratio represents the placements in interest- bearing assets that should be “limited”.

34
2-3 Non-permissible income: non-permissible income including interest to total
revenue ratio should not exceed 5%.
The researcher believes that cash and account receivables to total assets/market
capitalization ratio is not relevant and should not be included in the screening process.
The listed companies stocks are acquired for their activities and not to buy or
sell/exchange cash or account receivables. Trading stocks of Islamic Financial
Institutions may be questioned if cash and account receivables threshold is included in
the screening process.
Third screening step: to filter the eligible companies according to their contribution to
the community and their compliance with environmental, social and governance
(ESG) issues.
 The Principles for Responsible Investment (PRI) is committed to six principles
that are considered suitable to be adopted as part of the Shariah-compliant
screening framework (US-SIF, 2013):
1- To “incorporate environmental, social, and corporate governance (ESG) issues
into investment analysis and decision-making processes”: including ESG
issues is not contradicting with Shariah principles but they can be considered
in many cases part of it within the context of Maqasid.
2- To “be active owners and incorporate ESG issues into our ownership policies
and practices”: one of the arguments of the opinion to allow investing in
mixed companies is to change these businesses and make them fully in
compliance with Shariah principles. Being an active owner can play an
important role in cooperating with others who have common objectives to
improve ESG issues that are associated with Shariah principles.
3- To” seek appropriate disclosure on ESG issues by the entities in which we
invest”: specific disclosures are useful for Shariah complaint screening and
purification e.g. sin income. Requesting for such disclosures as part of ESG
issues will increase the awareness of Shariah principles and facilitate adopting
them by different companies.
4- To” promote acceptance and implementation of the Principles within the
investment industry”: the more the Shariah principles are accepted and
implemented, the more opportunities for committed persons to invest their
money in accordance with Islamic Shariah and the more the benefits to
communities.
5- To” work together to enhance our effectiveness in implementing the
Principles”: cooperation with others to achieve common goals will bring
benefits to all parties.
6- To” report on our activities and progress towards implementing the
Principles”: there is a need to monitor the progress of the investment in
International Markets and update the screening criteria accordingly.

35
 A template standard letters including the central issues about Shariah
compliant should be sent to annual general meeting of the invested “mixed
“companies explaining objecting the non-compliance activities and illustrating
the benefits of compliance for the society and stakeholders.
 Purification is an important part of the methodology. “Sin income “must be
disclosed on a quarterly basis and should include 50% the income generated
from interest-bearing loans besides the interest income and any other non-
permissible income. The author proposes to establish a charity Waqf
(Trust/endowment) to collect non-permissible income and allocate it in
charitable activities. And proposes also to disclose Sin Income Ratio (sin
income to total net income) and/or sin income per share ratio (sin income to
outstanding number of shares).
 Indices use the classification code e.g. The Industry Classification Benchmark
(“ICB”) to facilitate identifying the non-permissible sectors/subsectors. There
is a need to have “taxonomies” for Shariah Complaint screening and
purification reporting purposes in which the impermissible activities and
income can be segregated and disclosed. Taxonomies should standardize
terminology and screening criteria and methodology.
Constructing a portfolio of financial securities is allocation decisions which in
practice not merely rely on cash flows and market values i.e. pure financial decision
but also takes into consideration preferences and criteria of decision-makers i.e.
mixed decisions and thus it should be treated as multiple criteria decision problems
(Spronk et al., n.d., pp.18-19). Multiple Criteria Decision Aid (MCDA) can be a
useful tool in solving the screening problems which may include financial
performance in addition to other qualitative preference criteria to reach an optimal
point of view (Sevastjanov & Dymova, 2009, p.660; Zopounidis, 1999). Screening
stocks in accordance with Shariah-Compliant criteria is just a step in the allocation
process which should be followed by other steps to satisfy different investors
‘preferences. The outcome of the Shariah screening process stipulated in the Shariah
Standard and different index methodologies represents the “primary” category which
may be filtered further to meet higher level of Shariah objectives (Maqasid) and
sustainability investment principles.
VII. Summary and conclusion:
It is important to have a harmonized Shariah stocks screening and purification
standards that enable to have comparability and enhance the creditability of Shariah-
Complaint portfolios and indices. AAOIFI Shariah Standard no. 21 is considered a
good base. But still there are several areas of improvement that need to be considered.
Screening criteria are not merely “Shariah Scholars” ‘issue. There are different sides
which should be looked at from accounting and finance angels. Standards should be

36
issued by a group of reliable scholars in association with finance and accounting
researchers (not just by individuals or small committees). Standards should be revised
on a regular basis e.g. every five years, to ensure that practicing feedbacks have been
incorporated in them. Standards should be based mainly on principles of Shariah that
aim to avoid harm and bring benefits to all people based on justice and fairness. Rules
should not be rigid or turn to be “formalities” which can be circumvented.
The Standard is based on “Rule of Exception” for the state of general need as a result
of general tribulation and removing hardship principles. The exception cannot be
normalized or used as a benchmark and should be limited in accordance with its
relevant terms and conditions. The Shariah-Compliant screening should be in the
context of Social responsibility Investment. The proposed framework consists of
major steps that are commonly accepted in the practice: business activity screening
and debt (leverage) ratio, non-permissible securities ratio, and non-permissible
income ratio. There is always a room for exercising judgment and having differences
in accordance with environments and industries. The researcher supports the use of
total assets rather than market capitalization. Also, playing active roles as
stockholders are required. It is important to promote the principles of Islamic Finance
and request for proper disclosure which can be facilitated by adopting Shariah-based
taxonomies or incorporating them in commonly used taxonomies. The researcher
noticed that the disclosure of purification of tainted income is not sufficient or even
not existed in some indices that require more care.

37
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Dissertation -Shariah-Compliant Stocks Screening and Purification-FMG - July 2015

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