A Positive Approach to Shariah compliance screening


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Presents a revolutionary positive approach to Islamic screening for investments presented at the 2nd Oxford Islamic Finance roundtable held at Oxford on the 15th of April, 2009.

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A Positive Approach to Shariah compliance screening

  1. 1. A Universal Platform for Shari'a Compliant Equity Screening<br />15 April 2009<br />Dr. Mohd. DaudBakar and Dr. Sayd Farook<br />Second Oxford Islamic Finance Round-Table<br />The Frontiers of Islamic Finance Innovation<br />1<br />
  2. 2. Current Situation<br /><ul><li>Shari'a equity screening firmly established in world markets
  3. 3. Key current credible index providers: MSCI, DJIMI, S&P and FTSE Shari'a Global Equity Index Series
  4. 4. All seek to address timeless Shari'a issues
  5. 5. Business Activity & Financial screens employed have a high degree of commonality but also some important differences and weaknesses</li></li></ul><li>Reminder of Key Shari'a Issues<br /><ul><li>Permissibility of trading activity/activities of the company
  6. 6. Interest received by company on interest bearing bank deposits or investments
  7. 7. Interest paid by company on interest bearing debt
  8. 8. Debt and cash should only be traded at par </li></li></ul><li>Current Shari'a Approach<br /><ul><li>On business activity: Define prohibited sectors and some screens allow a maximum of 5% of revenue from prohibited activities which then has to be purified
  9. 9. Most allow 5% of revenue from Interest income which again has to be purified
  10. 10. Interest paid is mostly screened through tracking the level of debt relative to Total Assets or Market Cap – 33.33% is used by most screens
  11. 11. Debt and liquid assets only trade at par – benchmarked by above ratio and Accounts Receivable and Cash relative to Total Assets or Market Cap – again 33.33% used commonly and a couple of the screens use a 49% and 70% threshold for Accounts Receivable while another use 50% for Accounts Receivable + Cash</li></li></ul><li>Shari'a Rationale for Thresholds<br /><ul><li>5% is based on the collective opinion (ijma) of contemporary scholars, however SECM has allowed 10% on activities which are difficult to avoid e.g. interest income from fixed deposits based on Hanafi principle of ghabnfahish (excessive profit) which was 10% for animals and 20% for assets
  12. 12. 33.33% based on 1/3 being considered as “abundant” in the hadith reported by al-Tirmidhi
  13. 13. 50% based on Shari'a juristic principle: The majority deserves to be treated as the whole of a thing </li></li></ul><li>Total Assets or Market Capitalisation?<br /><ul><li>Total assets represents historical cost of the assets of a company
  14. 14. Market capitalisation represents the market value of the company as valued on the stock market
  15. 15. Significant split amongst index providers re using Total Assets or Market Capitalisation
  16. 16. Can produce significantly different results e.g. intellectual property based companies such as pharmaceutical or IT software companies may have low asset values but high market capitalisation
  17. 17. Market Capitalisation can fluctuate wildly e.g. in recent months and therefore may not provide a very stable benchmark</li></li></ul><li>Is there a positive screening rationale?<br /><ul><li>Current screening methods – do not give any weight to CSR
  18. 18. Market trend is moving towards socially responsible investment
  19. 19. AAOIFI will be mandating CSR governance standard for IFI's from January 2010
  20. 20. This represents an opportunity to market products that comply with AAOIFI standards</li></li></ul><li>Unified Platform for Shari'a Screening: A potential solution<br /><ul><li>DI/OIF proposal to take Shari'a Equity Screening to the next level
  21. 21. In particular addressing the following issues:
  22. 22. Moving from a binary system to a rating system
  23. 23. Greater transparency of screening
  24. 24. Moving from negative to positive screening
  25. 25. Re-evaluating financial ratios used for relevance andlongevity despite fluctuations in the stock market
  26. 26. Dedicate one criteria only relevant id investor seeks to buy/sell a stock versus hold</li></li></ul><li>Unified Platform for Shari'a Screening: A Potential Solution<br /><ul><li>DI/OIF solution will differ from the current screens in several important ways:
  27. 27. Instead of a binary (in or out) system, each criteria will be given a rating allowing stakeholders to gauge how close or far companies are from the threshold for each criteria
  28. 28. This will facilitate comparison across companies and industries and motivate companies close to the threshold to change
  29. 29. Introduce a SR criteria in tune with Islamic ethos and CSR standards
  30. 30. Differentiates between clear haraam/halaal and “grey/difference of opinion” areas by assigning commensurate weightings
  31. 31. Companies who do not provide required information will have their ratings down-graded</li></li></ul><li>DI/OIF Proposal<br /><ul><li>4 individual criteria:
  32. 32. Activity: Will seek to differentiate between clear haraam and “difference of opinion” acivities
  33. 33. Structure: Will seek to address Shari'a issue of company incurring interest on debt.
  34. 34. Tradability: Will seek to address issue of cash/liquid assets/debt (due from & due to) not to be traded except at par – only relevant for those not wishing to hold the stock
  35. 35. Social Responsibility: Will seek to give weight to positive SR initiatives and down-grade the rating for negative SR activities</li></li></ul><li>DI/OF Proposal : Activity<br /><ul><li>Activities put into 4 categories:
  36. 36. HI – Halal income e.g. textiles
  37. 37. UA – Haram income (Universally Agreed) e.g. tobacco
  38. 38. DO – Haram income (Difference of opinion) e.g. arms manufacturing
  39. 39. IS – Haram income (Indirect Secondary activity) e.g. hotel
  40. 40. Relief given to DO activities by the Shari'a board assigning a “relief” factor against this income based on the fact that it is a “grey area”.
  41. 41. Indirect secondary activities refer to an actvity which in essence is halale.g supermarket but will incidentally sell haram products e.g alcohol, pork etc.
  42. 42. Applying these relief's and estimation of haram income from Indirect secondary activities – an overall percentage rating of “halal” income is produced</li></li></ul><li>DI/OF Proposal : Activity contd<br />Assume a fictitious company with mixed activities:<br />DJIMI would classify 60% halal income<br />
  43. 43. DI/OF Proposal: Structure<br /><ul><li>Seeks to address issue of interest incurred on debt
  44. 44. Current screens on debt seem to amalgamate this issue with the shari'a issue of not trading debt except at par
  45. 45. DI/OIF seeks to clearly separate the two issues by having two separate criteria
  46. 46. DI/OIF proposal is to have a traffic light weighting based on a commonly used corporate ratio and measure – the gearing ratio = interest bearing debt/equity
  47. 47. Choice of ratio: for numerator debt chosen over interest exp because interest expense can be difficult to obtain and can often lead to a small fraction; equity chosen over Market Cap because no direct relationship between level of debt and Market Cap and Market Cap can fluctuate wildly</li></li></ul><li>DI/OIF Proposal: Structure Cont'd<br /><ul><li>Traffic light system:
  48. 48. debt/equity > 1 (red = unacceptable)
  49. 49. debt/equity < 0.5 (green = acceptable)
  50. 50. 1>debt/equity>0.5 (amber = borderline, look at other ratings)</li></li></ul><li>DI/OIF Proposal: Tradability<br /><ul><li>This criteria has been given its own category because it is only relevant for investors who want to buy/sell shares and not hold them
  51. 51. DI/OIF effectively breaks down a company's market value into 3 chunks:
  52. 52. 1. Illiquid Net Assets eg. fixed assets, stock, LT Inv
  53. 53. 2. Liquid Net Assets eg. cash/loans, debtors/creditors
  54. 54. 3. Intangible Net Assets eg. Brand, goodwill
  55. 55. Proposed ratio : Illiquid Net Assets/Market Cap
  56. 56. Illiquid assets used instead of liquid assets because with liquid assets the argument can always be made that any fluctuation in share price, as long as the share price is above the value of liquid assets, is due to the fluctuation in illiquid and intangible assets
  57. 57. Market cap chosen in this case because this criteria specifically relates to the trading of shares and the share price which is obviously aligned to the market cap</li></li></ul><li>DI/OIF Proposal: Tradability Cont'd<br />5 level scale used:<br /><ul><li>Illiquid assets/market cap < 20% not acceptable and far from threshold
  58. 58. 20% < Illiquid assets/market cap < 35% not acceptable but close to threshold
  59. 59. Illiquid assets/market cap = 35% threshold for acceptability
  60. 60. 35% < Illiquid assets/market cap < 50% acceptable but close to threshold
  61. 61. Illiquid assets/market cap > 50% acceptable and comfortably over threshold</li></li></ul><li>DI/OIF Proposal: Social Responsibility<br /><ul><li>Current screens give no weight to non-income generating aspects e.g. environmental or social issues despite Islam placing high importance on these issues
  62. 62. 3 areas where SRI can help equity screening & selection
  63. 63. Islamic investors should take into account social issues such as use of child labour and pollution
  64. 64. Positive screening by investors by placing greater preference to company's actively involved in positive SRI initiatives
  65. 65. Where fund managers/investors actively engage with company's to encourage SRI initiatives
  66. 66. Inherent issue is that SRI is a subjective area, hence any rating mechanism must be methodical, transparent and consistent</li></li></ul><li>DI/OIF Proposal: Social Responsibility Cont'd<br /><ul><li>DI/OIF proposal is to rate 3 different categories:
  67. 67. 1. Munkar activities – socially irresponsible activities a company is involved in
  68. 68. 2. Ma'roof activities – activities where the company is making a positive contribution to society/environment
  69. 69. 3. Influential Persons – persons that have influence over the running of the company are linked to munkar activities
  70. 70. 3 step process:
  71. 71. 1. Rate Munkar activities – with overall SR rating for such activities
  72. 72. 2. This rating can then be enhanced if the company is assessed to partake in Ma'roof activities
  73. 73. 3. The rating can then be down-graded if influential persons are deemed to partake in Munkar activities</li></li></ul><li>DI/OIF Proposal: Social Responsibility Cont'd<br /><ul><li>5 level SRI scale:
  74. 74. 1. Proactive company making positive contribution to the world
  75. 75. 2. Avoids harming society or environment by having strong policies
  76. 76. 3. Company is silent on issue and is considered neutral
  77. 77. 4. Company is socially irresponsible towards society and environment
  78. 78. 5. Company is extremely socially irresponsible & unethical</li></li></ul><li>Purification<br /><ul><li>Current screening methods all prescribe the purification of haram income from dividends and/or capital gains with some differences in how and what to apply it to
  79. 79. DI/OIF propose that purification be based on the percentage derived under the “Activity” criteria e.g a score of 87 here would deem that 13% of income, whether received or not, should be given to charity to purify the investors earnings</li></li></ul><li>Ratings Guidance<br /><ul><li>Multiple Ratings Guidance
  80. 80. All 4 criteria will have their individual ratings
  81. 81. For each rating, additional disclosures can be given eg as well as a green level of debt, the actual gearing ratio can be given
  82. 82. Index providers or fund managers can augment these criteria to the acceptance levels prescribed by their own respective shari'a boards
  83. 83. Cumulative Weighted Rating Guidance
  84. 84. The 4 ratings for each respective category can be amalgamated into one cumulative weighted rating
  85. 85. Each criteria (activity, structure, tradability and social responsibility) can be weighted based on Shari'a board or index provider preference
  86. 86. The overall score can then be subject to a threshold level</li></li></ul><li>Multiple Ratings Guidance<br />