The application of screening criteria: Applying screening criteria, when selecting a portfolio, to ensure the Shari'ah compliance of the investment is a crucial element in the investment process in Islamic fund management.
The criteria cover the nature of the business and certain financial ratios which have been agreed by the Shari'ah Boards, on the basis of a tolerance level for compliance that might vary across the different financial markets, depending on the nature of the financing and the level of development of capital markets in each area.
Generally, these criteria require that:
i) Prohibited activities such as gambling, interest-based financial institutions, alcohol production etc are excluded;
ii) The investee company's capital structure is predominantly equity based (with debt less than 33 per cent);
iii) The illiquid assets should be more than 50 per cent (some scholars relax this ratio, but it should not be less than 20 per cent) of the total assets of the investee company;
iv) Only a negligible portion of non-operative income of the investee company (not more than 5 per cent of total income) should be derived from interest;
v) The price of shares of the investee company should not be less than the value of the net liquid assets of the company.
Post investment monitoring of the portfolio is an integral part of the application of the screening criteria. For example, an investee company with non-operating interest income at less than five per cent for the last year may have earnings as high as 20 per cent for the current year.
PURIFICATION Islamic fund managers have to purify their incomes by deducting from the returns on investments the earnings emanating from any non-Shari'ah-compliant sources, and distribute the net pure income among the investors.
They have to calculate the percentage of non-compliant income to the gross revenue (net sales plus other income) for each investee company. This percentage is known as the 'charity rate'. The charity rate for each investee company is multiplied by the dividend income from each company to arrive at the charitable amount.
TRADING IN THE SECONDARY MARKET Fund managers are frequently involved in trading in financial instruments. The way in which this is done depends upon the nature of the investment certificate or securities. Stocks, certificates and sukuk can be traded in the market, depending on market signals, subject to compliance with the following Shari'ah rules:
Instruments representing real physical assets and usufructs are negotiable at market price. Stocks, units, certificates or sukuk, issued on the basis of musharakah, mudarabah and ijara, fall within this category.
Instruments representing debts and cash are subject to the rules of hawala (assignment of debt) and bai al sarf. The latter refers to the exchange of monetary units: 'hand to hand' where different currencies are involved or 'equal for equal' with simultaneous delivery by both parties if the monetary unit is the same on both sides.
Instruments representing a pool of mixed assets are subject to the rules relating to the dominant category. If cash and receivables predominate, the rule of bai al-sarf applies. If real or physical assets and usufructs make up the greater part, trading will be based on the market price.
Fund management could be a useful method for meeting the needs of public and private sector corporations. Public and private sector corporations may establish mutual funds with the dual objective of developing Islamic financial markets, and mobilising financial resources for meeting financing requirements of public and private sectors.
The mutual funds may replace the interest based national savings scheme, treasury bills, other government bonds and the corporate debt instruments. In order to facilitate trading of units/certificates, each fund should be so structured that the debt part of its assets constitutes less than 50 per cent.
Islamic banks need to become more involved in fund management by establishing fund or asset management companies so as to change their investment composition to partnership-based investment activities.
Presently, Islamic bank investments are of a short-term/commercial nature and are based on murabaha and other fixed return modes. If through fund management their investments were to become increasingly partnership based, this would help them with liquidity management and would also improve their assets portfolio by making it more oriented towards profit and loss sharing (PLS), with longer-term investments.
With the goal of mitigating risk through portfolio diversification, Islamic fund managers might consider turning to markets other than the stock market, or targeting other asset classes like commodities and real estate. They could then take advantage of the different categories of funds to offer quasi-fixed return (trade and lease based) and variable return (PLS based) modes, to fit in with the risk profile of the investors.
Courtesy: Horizon
(Concluded)
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