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The market for Islamic investing – which conforms to Islamic law, or Shariah – should be booming. Nearly a quarter of the world’s population are adherents of the faith and advocates say the sector is inherently aligned with the flourishing sustainable investing movement.
Yet growth has been sluggish. In 2011, it was thought that the Islamic finance sector would grow to $4-5trn in assets by 2015. At current rates, that threshold will be reached in 2030.
Practitioners have attributed this to a poor understanding of financial Shariah principles among Muslims and non-Muslims alike, and a lack of impetus to seek it out. But institutional investors may find much to like about Shariah-compliant approaches – its prudent long-term growth strategies and a finely honed ethical dimension.
As with other faith-based investing styles, a Shariah-compliant strategy shuns industries associated with ‘sin stocks’. There is no single list, but apart from the odd outlier like the pork industry, prohibited sectors tend to overlap with the scope of typical ESG-oriented industry screens: alcohol, gambling, adult entertainment, tobacco and weapons manufacturers.
Secondly, and atypically, financial screens are applied to exclude companies with excessive levels of debt or interest income. This stems from a religious prohibition on the practice of charging interest, judging it exploitative.
The aversion to highly-leveraged sectors such as finance, and a tendency toward growth stocks have supported healthy returns over the past decade for Shariah-observing equity strategies. A major industry benchmark, the Dow Jones Islamic Market Titans 100 Index, delivered 12.5% annually over the period.
Christian Gueckel, Chief Risk Officer of Saudi-based SEDCO Capital, the first Shariah-compliant signatory to the Principles for Responsible Investment, agrees, citing backtesting carried out by the firm.
“We tend to have certain sector biases, with less exposure to banking and finance but more to information technology and healthcare. This has driven returns over the last couple of years due to structural challenges within the banking sector, the low-rate environment, coupled with secular growth in the areas in which we do invest.”
Islamic finance is probably most known for its invention of the Sukuk – the Shariah-compliant equivalent to bonds – to overcome the prohibition on interest-bearing investment products.
This has mostly achieved its objectives, providing Shariah-compliant investors access to a liquid asset class and facilitating participation within the global debt markets. Practitioners are fond of pointing to London’s skyscraper, the Shard – fully Sukuk-financed – as proof of this.
The exact structure of the instrument, which interpolates an underlying physical asset to switch ‘interest’ for ‘rent’, is for the most part academic for secular investors, but can be the subject of heated scholarly debate.
In 2008, the influential Bahrain-based standards-setting body, Accounting and Auditing Organisation for Islamic Financial Institutions, sent shockwaves through the industry after suggesting that the majority of sukuk were not in strict compliance with Islamic teachings, leading to an immediate slowdown in issuance.
Still, the asset class has had relatively stable growth and – like conventional bonds – is increasingly tapped to finance sustainable activities.
Regulators in Malaysia, a forerunner in Islamic finance, issued the SRI Sukuk framework in 2014 to serve as set of standards for green and socially-focused Sukuk, setting the stage for a slew of domestic issuances. Other jurisdictions have been slower to the cause, but ground is still being broken. Indonesia issued the world’s first sovereign green Sukuk in 2018 and Dubai’s Majid Al Futtaimi issued the region’s first corporate green Sukuk a year later, showing an encouraging direction of travel.
However, if the ESG-linked Sukuk market is to scale, robust institutional demand is crucial. With many Muslim-majority countries still considered low-income and developing, exposure to this asset class has the potential to deliver significant social impact and would go toward closing the global investment gap for the Sustainable Development Goals.
Yet despite its progress so far, practitioners of Islamic finance admit that there is much catching up needed to align with the global responsible investing movement, which is now heavily focused on investment impact and climate change.
Akram Laldin, the Executive Director of the International Shariah Research Academy for Islamic Finance and a prominent authority on Islamic finance, attributes this to an ideological approach which has traditionally focused on avoidance. “In the past, the emphasis has been on negative screening or making sure that the investable universe only comprises securities that are halal or permissible,” he explains.
“But preserving the environment, ensuring positive benefits society and other stakeholders not only falls within the general provisions of Shariah, but are closer to the spirit or the Maqasid [aims] of Shariah, more so than a purely compliant approach. Islamic financial institutions must do their homework to ensure that activities which benefit stakeholders are propagated and find alternatives to activities which result in harm.”
And there are bright spots. One is the introduction of Waqf, the Islamic equivalent of an endowment, by the Islamic Development Bank (IsDB), a multilateral development institution, as an alternative to conventional development financing.
Waqf refers to a specific class of revenue-generating asset, held in perpetual trust to provide long-term income to a beneficiary institution. Traditionally, this would be key social infrastructure such as schools and hospitals, which would have their own portfolio of waqf assets, often accumulated over generations.
Since 2001, IsDB has provided debt financing for Waqf assets through a $100m investment fund matched by an equivalent credit line from IsDB. The fund has so far paid out a minimum of 2.5% annually (it expects to distribute 3.5% in 2021) and has a portfolio of 55 approved projects worth $1.04bn.
According to Yoseph Alsawady, an IsDB Investment Specialist, the advantage of a decentralised portfolio of Waqf assets is a “direct feedback loop between investment decisions and beneficiary institution”. This addresses a tendency of conventional development financing to incentivise beneficiary institutions to spend all the funding they are given, regardless of need, to ensure ongoing contributions at that level.
Elsewhere, regulators in Malaysia have launched a framework for Islamic financial institutions which aims to move beyond “the current Shariah compliance culture” through the incorporation of impact measurement, climate analysis and disclosure, ESG value chain assessments, and labour and human rights criteria.
In the UK – one of the largest Islamic finance hubs outside the Muslim world, with $4.7bn in assets – the Bank of England (BoE) has indicated it will soon provide Shariah compliant deposit facilities in a move anticipated to level the playing field for Islamic lenders. BoE deposit accounts are widely used by commercial banks as a cost efficient way to place reserve funds and as liquidity insurance in times of market stress.
Next month, the UK government will launch the Islamic Finance and SDGs Taskforce, to address the “considerable lack of knowledge, misunderstandings and minimal engagement by Islamic financial institutions with the SDGs”. The high-level group will be run by the Glasgow-based Islamic Finance Council.
Omar Shaikh, the Council’s Executive Board Member, believes that regulatory support will lay the foundation for a resurgence in the industry, saying: “Post-Brexit there will be a renewed push towards global trade and foreign direct investment and this will only add momentum to the growth of Islamic finance here.”