Crossing the Chasm into Shariah-based Products

Several criticisms have been raised in literature regarding the practices of Islamic financial institutions (IFIs). While Muslim critics view Islamic financial products as caricatures of conventional products, non-Muslims find it difficult to comprehend what real value proposition Shariah compliant products offer over conventional products. For example, Islamic finance has remained passive up to now in the international debate on environmental issues and socially responsible investing (SRI). As these issues are very much ‘Islamic’, they remain absent from the investment agenda of IFIs. Some industry observers have been calling for the development of a new generation of products that would give authenticity to Islamic banking practices by promoting these investment facets.

This article will discuss SRI and Shariah compliance, delineating how a dual strategy will improve the perception of Islamic financial products and services in the West. Such a strategy will no doubt also give comfort to industry observers that Shariah-based products, i.e. those products that promote social and moral justice, are possible to engineer, and can be successfully promoted both to the East and West. SRI is an investment strategy that seeks to maximise both financial returns and social good for investors.

Typically, an SRI fund would invest in companies whose products and policies are consistent with the investor’s ethical and moral values. Its historical roots can be traced back to the Religious Society of Friends (Quakers) when in 1758, the Quaker Philadelphia Yearly Meeting prohibited members from participating in the buying and selling of slaves. The founder of Methodism, John Wesley, emphasised responsible investing in his sermon ‘The Use of Money’, calling for people to refrain from harmful business practices and to avoid investments in industries that could be harmful to the health of workers. This has been realised in a variety of ways ever since. Since the late 1990s, sustainable environmental development has increasingly defined SRI, as it seeks to disengage from those businesses and investments that pose a threat to the environment.

The added feature of SRI funds is the positive screening criteria that it uses to select companies to invest with. SRI funds proactively look to support companies that supply the basic necessities of life, and provide products and services that are of long-term benefit to the community. Positive attributes in companies that SRI funds seek include: a sound record on conservation of energy and natural resources, protection of the environment, good customer relations, fair employment, strong community involvement, an equal opportunity policy and business transparency.

A classic example of a company active in this space would be F&C Investments. The company manages some US$4bn under a socially responsible and ethical strategy called ‘stewardship’. F&C engages closely with the businesses it invests in, in order to motivate them to adhere to ethical and sustainable activities and practices. For example, F&C’s governance and sustainability investment (GSI) team identified that IBM has a supplier chain of about 14000 suppliers all over the world, in geographies such as China, India and Brazil, where labour standards (including child labour) have been a known concern. F&C engaged with IBM to make them understand that such labour practices were not only unethical but posed significant business risks to IBM from regulators in Europe and the US and also from the media and the public, among whom the brand could suffer huge reputational loss. IBM was encouraged to introduce and implement a code of conduct for all its suppliers to ensure that they adhered to certain minimum acceptable labour standards.

Another example relates to Unilever, the world’s largest purchaser of palm oil, of which 80% is sourced from Indonesia and Malaysia. The production of palm oil has numerous environmental impacts including deforestation and loss of natural habitats resulting in significant increases in carbon emissions. Following engagement with F&C, Unilever committed to ensuring all palm oil was sourced from certified sustainable plantations, to use its position as chair of the Roundtable on Sustainable Palm Oil to encourage similar practices across the industry, and to support a moratorium on the expansion of palm oil plantations on peat bogs in Indonesia.

Shariah Screening Methodology

The positive engagement features mentioned in the two examples above are currently absent in Islamic screening methodology.The Shariah screening methodology in Islamic funds carries many of the hallmarks of negative screening in SRI funds. They share a list of prohibitive industry sectors. For example, both Islamic funds and SRI funds aim to avoid companies that are involved in the manufacture and sale of weapons, trade with oppressive regimes, are involved in tobacco or alcohol production, gambling, pornography, offensive or misleading advertising. These are often referred to as ‘sin stocks’, and are the first to be screened out from a stock universe. The Shariah compliancy sphere also requires companies to adhere to certain financial ratios, such as interest income, gearing, and accounts receivable (A/R).

However, this Shariah screening methodology is largely reactive at present , disinvesting when companies breach certain financial screens or alter the nature of their business. Islamic funds should strive to achieve more than merely what is compulsory, and proactively seek to engage with companies in order to change their policies and objectives to conform to universally-accepted social, moral and environmental agendas. This is in keeping with the teachings of Islam.

In the West, both the US and Europe have been booming markets for the trillion dollar SRI fund industry. According to the 2007 Social Investment Forum’s report on socially responsible investing trends in the US, assets in socially screened portfolios climbed to US$2.71 trillion in 2007, increasing from US$2.16 trillion assessed in 2003. The European SRI market grew from €1 trillion to €1.6 trillion in 2007. According to research estimates by financial consultancy Celent, the SRI market will reach $ 3trillion in the US alone by 2011. The global size of the conventional SRI fund industry alone is estimated at $5 trillion dollars, while the global Islamic financial industry with all its market segments and asset classes is liberally estimated at US$1 trillion. Here, IFIs have the potential to attract a huge market share if they were to overlap their products with SRI features.

The advantage that Shariah-compliant products have in the investment arena is that they have nothing inherently illicit that would put off conventional investors, yet the opposite is true for conventional products. Hence, while the Islamic financial industry seeks to expose its value proposition to the financial world, an attractive route would be to leverage from the strength of the SRI industry, both in its financial performance and its social and moral stance on society.

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