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JIABR
1,1 Accentuating the positive:
governance of Islamic
investment funds
42
Mervyn K. Lewis
University of South Australia, Adelaide, Australia

Abstract
Purpose – The purpose of this paper is to examine the nature and structure of Islamic investment
funds and evaluate their governance.
Design/methodology/approach – The methodology employed is the conceptual framework of
Islamic economics.
Findings – It is found that Islamic investment funds have grown rapidly this decade: in Malaysia alone,
the number of shari’a-compliant funds has grown from 17 in 2000 to 149 in 2008, and at a global level there
are 650 funds in operation. However, the industry has developed in a particular way, by focusing on
negative screens, and removing from investments those activities deemed to be unacceptable to Islamic
precepts, rather than pursuing as well the implementation of other aspects of the Islamic ethos.
Originality/value – The conclusion reached is that, if the Islamic investment fund industry is to
provide more completely for the religious and financial aspirations of investors, it needs to go beyond
the negatives and to also accentuate the positive and, drawing upon Islamic governance guidelines,
actively seek out investments that have a positive impact on society and the environment and promote
the welfare of the community. These issues hitherto have been largely unexplored.
Keywords Investment funds, Globalization, Ethical investment, Governance, Islam
Paper type Conceptual paper

1. Introduction
The title of this paper borrows from the 1944 song Accentuate the Positive with lyrics
by Johnny Mercer, which goes:
You’ve got to accentuate the positive
Eliminate the negative
And latch on to the affirmative
Don’t mess with Mister In-Between.
Obviously, while not wanting to eliminate the negative, the theme of the paper is to
accentuate the positive and latch on to the affirmative aspects of Islamic economic,
financial and governance principles.
Ask “the man in the street” what Islamic banking and finance is about and they are
likely to respond (if at all) by talking about the “negatives” – Islam bans interest,
prohibits gambling and speculative activities and does not allow involvement in, or the
financing of, alcohol and the production of pork. That is, the answer received is more
Journal of Islamic Accounting and likely to revolve around what Islam is against, rather than what it is for. This paper
Business Research argues that if Islamic investment funds are to reach their full potential as an avenue
Vol. 1 No. 1, 2010
pp. 42-59
q Emerald Group Publishing Limited
1759-0817
Sections of the paper have benefited considerably from working with Nurul Aini bt Muhamed
DOI 10.1108/17590811011033406 (Muhamed, 2009).
for investment in a globalized setting, there needs to be a greater emphasis on the Governance
“positives”, what Islam stands for. of Islamic
In financial services, as in other fields, globalization should be seen as a process
opening up national economies and markets, enabling knowledge, technology, ideas, investment funds
services and capital to move more easily and quickly from country to country and
widening the extent and form of cross-border activities. “Home bias” (the preference for
geographically proximate investment opportunities) has been on the decline for the 43
past two decades, and the increase in investment rates and cross-border activity in
capital market investments is consistent with a diminishing risk compensation on
overseas investments (Greenspan, 2005). This process was spurred, and continues to be
propelled, by liberalisation and deregulation of capital markets, underpinned by
technological change which is lowering communication and information costs,
reducing geographical isolation and financial autarky and enhancing the international
tradeability of goods and services (Lewis, 1999, 2003).
One manifestation of globalization is an intensification of international trade and an
increase in the scope and significance of all kinds of cross-border transactions.
In Islamic financial services, this process is exemplified by the growth of cross-border
transactions due to the expansion of Islamic investment funds, which operate at a
global level. Fund management of this form has become a growth segment for the
Islamic financial sector over the last decade; all the more so because Islamic investment
banks, unlike their Western counterparts, do little Merger and Acquisition business or
trading activity and have made wealth management and mutual funds a principal
focus (Wilson, 2006).
In exploring this trend, the paper begins by examining the nature of the Islamic
funds, the principles of shari’a-compliant finance (i.e. the “positives” and the
“negatives”), and the global implications of the funds in stimulating Islamic investments
world-wide. It concludes by comparing the Islamic funds with the Western models of
socially responsible investments (SRI), which provide a template (although with
important differences) for how Islamic investment funds may develop in future.

2. Islamic investment funds

Islamic investment funds, like any investment pooling system, collect individual
savings for investment and the sharing of benefits. Those subscribing capital to the
pool receive documentation evidencing their subscription (certificates, units or shares),
entitling them to a pro-rata share of the profits (or losses) of the fund. Each fund
consequently has its own idiosyncratic structure, capital, subscription, maturity and
expected returns and risks.
However, there is some commonality, at least among the Islamic investment funds,
for in order to be described as Islamic, the purpose of the investment must be to earn halal
profits in conformity with the precepts of shari’a, as interpreted by fiqh (Islamic
jurisprudence). While the funds may take many different forms, two essential conditions
must be met. First, neither the principal amount nor the rate of return can be guaranteed.
Instead, the units must carry a pro-rata share of the actual profits earned by the fund and
not a fixed return tied to the face value of the certificates. Second, the funds gathered in
the pool must be invested in business and activities acceptable to Islamic principles.
To this end the funds have a team of shari’a scholars, either internal or external
(outsourced via specialised consultancy firms), to advise on shari’a-compliance.
JIABR 2.1 The global position
1,1 There are no accurate figures of the size of the Islamic financial industry or its rate of
growth (although the 15 per cent per annum growth rate number has been repeated so
often that it has passed into the folklore). The latest estimate (made by Mahmoud
El-Gamal) puts the world-wide assets that comply with Islamic law in a range between
US$700-1,000 billion (as reported in the New Straits Times, 2009, p. B13). Broadly
44 consistent with this estimate, Eurekahedge (2008) estimated the total size of the Islamic
financial industry in June 2008 at US$800 billion. Their figure is an all-encompassing
one and, in addition to Islamic investment funds, incorporates all forms of Islamic
assets such as bank deposits and investment accounts, takaful (Islamic insurance),
securities, and direct investments. If we focus more narrowly on the Islamic investment
fund sector alone, assets under management in Islamic funds at June 2008 were
estimated by Eurekahedge as US$44 billion for the 608 funds that report to it. Allowing
for another 40 or so non-reporting funds would likely see the figure for overall funds
under management in Islamic investment funds rise to around US$60 billion.
Nevertheless, this figure is still well under 10 per cent of total Islamic assets.
While small by global and industry standards, the number of shari’a-compliant
funds has been growing rapidly. In the early 1990s, there were only a few funds
scattered around the world; Failaka International put the number of funds in 1994 at 13
(Smyth, 2006). Since then, numbers have increased strongly from 2002, when 22 new
funds were launched, to 2007, when 158 new funds were issued. With an attrition rate
of less than five funds per year, the total number of funds more than doubled in the
three years 2005-2007. Over 25 new funds were launched in the first quarter of 2008,
although some slowing down since then due to the global financial crisis can be
expected. Following the “Tech wreck” of 2001 and the bursting of the dot.com bubble,
the number of new funds issued from the Middle East declined sharply, but their
numbers were more than made up by new funds from Malaysia.
Some details of the Islamic investment funds launched in 2007, can be summarized as
follows based on the Eurekahedge Islamic Funds Database (Eurekahedge, 2008).
Overall, Saudi Arabia and Malaysia are the two largest markets for Islamic investment
funds in terms of location of the fund management company and client base, although
other areas have a market presence. In terms of head office location of funds issued, the
market shares (in per cent) are Saudi Arabia (25), Malaysia (23), followed by Kuwait (12),
UAE (5), Bahrain (4), Singapore (4) and others. For the domicile of the client base (again
expressed in per cent), a similar pattern holds with Malaysia (24) and Saudi Arabia (23)
dominant, followed by offshore clients (18), Kuwait (8), Bahrain (5), Indonesia (5), and
others. Finally, when it comes to the distribution of assets by geographic mandate, there
is a greater concentration and less regional diversity. Approximately, 63 per cent of
assets are held in the Middle East mandates, with global mandates and the Asia Pacific a
long way behind with 13 and 12 per cent, respectively. This pattern is thought to reflect
the legacy of past investments, a continued preference for Gulf (GCC) economies,
and well-developed marketing channels (Eurekahedge, 2008).
Considering the two key markets of Saudi Arabia and Malaysia, there are important
differences between them. Malaysia has been described as a “Shari’ah-Consistent
Investing Incubator” (Hassan and Girard, 2008), and shari’a-based investment funds
have grown strongly in Malaysia since 1999. This year was a significant one, indeed
a turning point, in the development of Islamic investment funds in Malaysia and
elsewhere when Dow Jones, Financial Times-Stock Exchange (FTSE) and Bursa Governance
Malaysia launched Islamic indices. Not only was credibility given to the Islamic fund of Islamic
management industry, but it also created a new investment category in the form of
index funds. In the case of Malaysia, both the number of shari’a-based funds and the investment funds
net asset value of Malaysian Islamic funds have exhibited stronger growth than that of
the conventional funds, so that at the beginning of 2009 over one-quarter of all funds
(149 out of a total of 579 funds) and 17 per cent of assets were shari’a-based (Securities 45
Commission Malaysia, www.sc.com.my).
A study by Ernst & Young (2008) compared the investment strategies of
the Islamic investment funds in Malaysia and Saudi Arabia with those of global
conventional mutual funds. As well as highlighting the vast discrepancy in the number
of funds at that time (134, 120, and 61,000, respectively), the analysis suggests that
Saudi Arabian funds differ from the other two. Of the 252 registered funds in
Saudi Arabia, 219 are mutual funds and the 120 Islamic mutual funds constitute
55 per cent of the total. In terms of the portfolio composition, there is a much stronger
emphasis in Saudi Arabia on equity investments (62 per cent of the total) than is the case
in Malaysia (46 per cent) and also for the conventional funds (42 per cent). Indeed,
the investment strategies in Malaysia appear to be closer to those found in the
conventional fund industry[1].

2.2 Type of funds

There are several types of Islamic investment funds including equity, ijara,
commodity, real estate, murabaha, money market and mixed funds. These various
funds embody very different patterns of returns. Ijara and murabaha funds offer
virtually fixed returns being based on fixed leasing charges on capital equipment on
hire purchase and cost-plus profit rates, respectively, while equities necessarily are
exposed to greater market volatility in the short run and need to be seen as an
investment for the long-term. Funds which are specialized in real estate development
(many structured as private equity) offer a different balance between risks and returns
again. Hedge funds are becoming one prospective fund category in the industry,
though there are disagreements on their permissibility and structure among the shari’a
scholars (Morais, 2007).
Of the different types of Islamic investment funds, those involving equity
investment comprise more than 50 per cent of the total funds (Eurekahedge, 2008). The
current market trend shows there is expansion of these types of financial vehicles since
their development in the 1980s. They take a variety of forms such as global, regional,
sector, country, hedge and index funds, e.g. the Dow Jones Islamic Market (DJIM) index
fund. Other funds may specialize in particular investments such as leasing ijara,
murabaha, commodities or real estate in the form of Real Estate Investment Trusts
(REITs). Special funds may be launched for industry trading or to finance a specific
project for a specified period. There may also be “open” funds that are open to invest in
all kinds of mixed Islamic portfolios such as murabaha, mudaraba, istisna’ and Islamic
deposits (e.g. Al Baraka General Fund, Al-Amin)[2].
The Ernst & Young study cited above compared the target asset classes of issued
Islamic funds in 2002 and 2006. Equity fund issuance, although still dominant,
has been joined by liquid instruments, including money market and commodity funds,
while private equity and real estate have also expanded. Islamic money market funds
JIABR comprise deposits and Islamic repurchase agreements (Repos – with less than one year
maturity). The Islamic-based instruments classified as fixed income are sukuk
1,1 (Islamic bonds), which in the funds typically have a maturity more than one, and less
than two, years. Clearly, then, there is now a considerable diversity of asset classes issued.

2.3 Attractions of Islamic investment funds

46 Like conventional investment funds, the Islamic investment funds bring a number of
potential general benefits to investors (Al Tayar, 2006). These revolve around
specialized administration, gaining geographic and sectoral distribution of funds,
a variety of maturities from short- to long-term, flexible withdrawal options, clear legal
terms, conditions and responsibilities placed upon the sponsor, a balance between risks
and returns, and specified investment objectives for the particular fund.
There are also some specific advantages gained by investors accessing Islamic
investment funds as a market category. First, there is diversification across Islamic
investments. The benefits of diversification are well known, and investment funds can
achieve this for modest-sized portfolios. Islamic investment funds have the potential to
generate capital for different Islamic markets, with different growth performance and
financial instruments, despite the apparent concentration at present in GCC economies.
Second, Islamic funds can promote ethical and moral values in investment in the global
capital markets and in Muslim countries world-wide. Third, there is the provision
of shari’a supervision. Since each fund has its panel or board of shari’a scholars,
the funds serve as a vehicle for organizing and harnessing religious supervision to
guide investment decisions and portfolio offerings.

2.4 Fundamental requirements for Islamic acceptability

Islamic scholars advising the Islamic investment industry have generally followed the
shari’a principle of muamalat (the field of pecuniary transactions), dealing with human
relationships and contractual arrangements as opposed to ibadat which define the
relationship between God and his creatures. In simple terms, the principle treats
everything as permitted unless it is explicitly prohibited. If followed through,
transactions such as private equity and venture capital may be considered as perfectly
acceptable modes of transacting so long as they meet certain Islamic principles
(Yunis, 2006).
Essentially, two fundamental conditions must be adhered to by Islamic investment
funds. First, the underlying or ultimate asset, which is the subject of the investment,
must be acceptable and halal. For instance, in a real-estate investment fund, the
occupiers of the real estate must conduct shari’a-compliant business or something that
is not inherently haram. Also, rules must be followed as to the proportion of income
from a real estate asset that can be haram and that will not “taint” the underlying
investment. Second, the proposed structure itself needs to be acceptable from a
shari’a-compliant viewpoint, in a number of respects:
.
Funds must be invested in a vehicle that has been structured in a shari’a-compliant
manner based on tangible assets and not speculative in nature (gharar).
.
The constitution of the investment vehicle must prohibit haram activities.
.
The activities of the directors and officers need to be acceptable and their
activities conducted in a shari’a-compliant manner. This requirement, however,
is much broader than is generally interpreted, as is now explained.
3. Principles of shari’a-compliance Governance
3.1 Positive and negative aspects of Islamic
There are positive and negative injunctions to be followed. The negative injunctions
relate to the things that must be excluded from Islamic investment funds (in fact, from investment funds
all forms of Islamic finance). General prohibitions on immoral activities such as
dishonesty, bukhl (miserliness), israf (extravagance), hirs (greed) and iktinaz (hoarding)
coalesce with specific provisions that are clearly specified in the Holy Qur’an and 47
Sunnah. Four well known prohibitions apply to Islamic financing. These relate to:
(1) elements of interest (riba);
(2) uncertainty (gharar);
(3) gambling (maysir); and
(4) prohibition of certain goods (such as alcohol and pork).

Less well-publicized are the positive principles that ought to (and desirably, should)
feature in Islamic economic and commercial activities. These are obligations both to
humanity and society and also to humanity and the environment, along with
decision-making rules. The first grouping refers to doctrines that must be incorporated
into business activities by the participants, for example, buyers, sellers, suppliers and
distributors. Ethics, according to Beekun (1997), are a set of moral principles that
differentiate between what is right and what is wrong, and thus guide Muslims in
their daily activities. Most Islamic concepts and precepts in the Holy Qur’an and the
Sunnah of the Prophet Muhammad carry positive connotations for Muslims’ lives and
shape their relationships with society and the environment. Justice, honesty, prudence
and moderation are among elements that must be embedded in a Muslim’s character,
and thus be reflected in an individual’s activities. Maintaining life in balance and
moderation is encouraged in Islam. Having wealth is permitted so long as it does not
become all-consuming and deflect Muslims from their responsibilities towards the
Islamic community (ummah). The God-given resources and wealth in this world are to
be shared, to ensure that all brothers can at least have the basic necessities. Chapra
(1992, 1993, 2000), for example, emphasized the motivation of Muslims to strive for
al-falah in the hereafter, evidenced in their moderate lifestyle, and so help the needy.
Such broader social and communal objectives, it may be recalled, were prominent
amongst those providing the intellectual basis for Islamic banking and finance in the
formative years (Ahmad, 1980). Certainly, the encouragement of justice, an equitable
distribution of wealth and brotherhood, can be seen in the obligations of Muslims
towards their brothers and sisters. Several methods are employed in promoting justice
and a fair distribution of wealth in society, and these include zakat (tax levy to purify
wealth) and sadaqah (voluntary almsgiving) as mechanisms of wealth distribution and
social welfare.
Environmental concerns and the priority of conservation activities are recognised
too in Islamic teachings. Humans are considered an integral part of the environment,
and this feature is exemplified in the requirement that people maintain a joint
relationship with members of the community and the environment to serve the Divine
Will. That there is a special relationship between humans and their environment is
clearly articulated in the Holy Qur’an:
JIABR There is not an animal (that lives) on earth, nor a being that flies on its wings, but (forms part
of) communities like you. Nothing have we omitted from the Book, and they (all) shall be
1,1 gathered to their Lord in the end (Al Anam 6:38)[3].
Islam holds that all resources and wealth are owned by God, and merely held in trust
by people. In parallel, the environment is presented to humans so that they can learn
from its creation, and utilise it for their own life and society in such a way as to realize
48 the blessings from God (Al-Qaradawi, 1998). Further, the environment serves as a
valuable test of worship towards God, as elaborated by Khalid (2002, p. 337) in the
following terms:
The Quranic view holds that everything on the earth was created for humankind. It was
God’s gift (ni’mah) to us, but a gift with conditions nevertheless and it is decidedly not
something that one runs and plays with. The earth then is a testing ground of the human
species. The tests are a measure of our acts of worship (ihsan) in its broadest sense. That is
living in a way that is pleasing to Allah; striving in everything we do to maintain the
harmony of inner and outer environments.
As a corollary, given amanah (trusteeship), humans as viceregents (khalifah) are expected
to take care of the environment and preserve it for future generations. Construction and
manufacturing, agriculture and the production of goods must be conducted in a
responsible way that does not exploit and degrade the environment (Hamed, 1993).
Thus, the concept of trusteeship underpins the inter-relationships between
humanity, society and the environment. Economic, financial and natural resources are
held in trust from God, and mankind is accountable to God and the community for the
use that is made of them. A further consideration is that decision making about how
resources are to be employed is also an important trust from God, and the Holy Qur’an
mandates that this process be undertaken on the basis of mutual consultation (shura)
with all involved parties (Iqbal and Lewis, 2009). Shura describes a decision making
process with the involvement of many parties to achieve consensus and agreement,
and as such is seen in the Holy Qur’an as the ideal way in which a good person should
undertake affairs:
Those who hearken to their Lord, and establish regular prayer; who conduct their affairs by
mutual Consultation (Al Shura, 42:38).
As a means of governance and management, shura should be adopted and adapted
with the guidance of Islamic sources for investment practices. A necessary counterpart
is supervision, follow-up and monitoring as embodied in the concept of hisba (Lewis,
2005). There are in all, three levels of monitoring and supervision in Islam. The first is
imposed by God, the second is self-controlling, and the third is externally controlled.
Muslims believe that they are monitored and controlled by God in every aspect, and
thus the first level of control directs Muslims to behave in a manner consistent with
Islamic teachings (Hamed, 1993). In contrast to internal control, external control by the
community is to ensure that those given authority do not depart from Islamic
principles. In this case, hisba plays a significant role as an external controlling
mechanism, empowering Muslims individually to act as “private prosecutors” or
enforcers of Islamic standards (Schacht, 1964, p. 52). In effect, hisba as a supervisory
concept seeks to prevent people in whom trust is vested from deviating from Islamic
guidelines and encourages them to follow Islamic precepts (Muhamed, 2009).
 In summary, the positive principles guiding Islamic investment are: Governance
.
Promotion of justice (adl ) and honesty and trust (amanah). of Islamic
.
Involvement in decision-making and governance (shura). investment funds
.
Supervision, follow-up and monitoring (hisba).
.
Purification of wealth (zakat) and voluntary almsgiving (sadaqah).
.
Brotherhood and the advancement of the Islamic community (ummah). 49
.
Protection of nature and the environment.

The upshot of these positive elements is that Muslims cannot be disinterested

investors, buying and selling shares and making investments without knowledge of
the underlying business activities. By implication, since many individuals invest their
savings through institutional investment vehicles, the fund managers must perform
these roles on behalf of the capital providers by monitoring activities, engaging with
investee companies, and contributing to the enhancement of social welfare and the
environment. Some do, but most do not. Instead, they simply observe the negative
stipulations regarding riba, gharar, maysir and haram activities. The reasons can be
traced in part to a lack of appreciation and understanding of the positive aspects in
the Islamic agenda, but are mainly due to the practicalities of the investment universe.

3.2 Screening and cleansing for equities

Over 50 per cent of Islamic investment funds are equities mutual funds or unit trusts
(Eurekahedge, 2008). If such funds were confined to “listed Islamic corporations” the
number of funds would be a small fraction of those on offer. In order to gain a wide
range of investments, necessary for diversification and liquidity, most investment
needs to take place through the major global and regional exchanges. However, the
reality is that almost all the companies quoted on current stock markets are in some
way engaged in an activity which violates the injunctions of shari’a. Accordingly, a
major question from the Islamic point of view is whether investments in international
equity markets are acceptable under shari’a (Hasan, 1995). There is no doubt that
dealing in the supply, manufacture or service of things prohibited by Islam (haram),
such as riba, pork meat, alcohol, gambling and so on cannot be acceptable.
Nevertheless, companies that are not involved in such haram activities could be
considered acceptable. The main objection against them is that in their own internal
accounting and financial dealings they lend and borrow from riba banks and other
institutions, but the fact remains that their main business operations do not involve
prohibited activities. Essentially, non-Muslim entities cannot be expected to work
under the Islamic code of conduct, and in any case only a negligible amount of interest
may be involved. Can such activities ever be considered “Islamic”?
This question has led to an extensive debate amongst shari’a experts (Usmani, 2001).
Some argue that it is not allowable for a Muslim to deal in the shares of such a company,
even if its main business is halal. Their basic argument is that every shareholder of a
company is a sharik (partner) of the company, and every sharik, according to Islamic
jurisprudence, is an agent for the other partners in the matters of the joint business, and
by implication would be giving consent to non-Islamic transactions. Other shari’a
scholars, who are now in the majority, do not endorse this view. They contend that a joint
stock company is basically different from a simple partnership. Being composed of
JIABR a large number of shareholders, a company cannot give veto power to each shareholder,
1,1 as would occur in a partnership. Consequently, if a company is engaged in a halal
business, but also keeps its surplus money in an interest-bearing account, from which a
small incidental interest income is received, this fact does not render all of the business of
the company unlawful. In this case, where income from the interest-bearing activities
and accounts is incorporated, the proportion of such income in the dividend paid to the
50 Islamic shareholders must be given by them to charity. For example, if 5 per cent of
the whole income of a company has come out of interest-bearing returns, 5 per cent of the
dividend must be given in charity. This process is known as “purification”. However,
it must be preceded by screening of the relevant company’s business activities.
Quite clearly, ascertaining such information could be costly for an individual fund,
but has been made less so by the creation in February 1999 of the DJIM, launched in
Bahrain, the Kuala Lumpur Stock Exchange Syariah Index introduced on 17 April
1999 to coincide with the new Hijrah year 1420, and of the FTSE Global Islamic Index
Series in November, 1999. In the case of the DJIM, for example, the screening proceeds
broadly as follows in two stages. First, the primary business of the company must be
halal (permissible), therefore business involving, among other forbidden practices,
conventional banking, alcohol, tobacco, weapons, pork, gambling and providers of
entertainment services (hotels, casinos and cinema) are not acceptable. Second,
financial screens are then applied to screen out companies with unacceptable financial
ratios:
.
companies for which total debt divided by trailing 12 month average market
capitalization is 33 per cent or more;
.
companies for which cash plus interest-bearing securities divided by trailing
12 month average market capitalization is 33 per cent or more; and
.
companies for which accounts receivables divided by 12 month average market
capitalization is 33 per cent or more.
Then, there is reported a dividend cleansing/impure income figure. Here, “tainted
dividend” receipts relate to the portion, if any, of a dividend paid by a constituent
company that has been determined to be attributable to activities that are not in
accordance with shari’a principles and therefore should be donated to a proper charity
or charities. Such cleansing cannot be counted as part of zakat obligations. In this and
other matters, the index compilers are advised by shari’a scholars.
Nevertheless, significant differences remain amongst the shari’a scholars in two
main respects. First, there are differences of opinion about “purification”, in particular
the scholars differ about whether the “purification” is necessary where the profits are
made through capital gains (i.e. by purchasing the shares at a lower price and selling
them at a higher price). Some scholars are of the view that even in the case of capital
gains, the process of “purification” is necessary, because the market price of the share
may reflect an element of interest included in the assets of the company. The other
view is that no purification is required if the share is sold, even if it results in a capital
gain. The reason is that no specific amount of the price can be allocated for the interest
received by the company (Usmani, 2001).
Second, there are differences in the screening procedures between the three major
indices, as set out in Table I. In general, in terms of the screening of equity, Securities
Commission Malaysia has been seen as utilising the most lenient approach in the case
 DJI FTSE SEC
Dimension Criteria Excluded % Excluded % Excluded %
p p p
Industry Alcohol p p p
screen Tobacco p p p
Pork-related products p p pa
Conventional financial services Financial services based on riba/ Level of
interest p tolerence
p
Conventional insurance p
Life insurance pa
Stock broking or share trading in Level of
Syariah: non-compliant securities p p tolerence
Weapons and defense p pa
Entertainment: non-permissible Hotel Level of
entertainment activities p p tolerence
p
Casino/gambling p p
Gaming p
Cinema p
Pornography p
Music p
Companies significantly affected by
above p
Other activities deemed non-
permissible by Syariah p
Financial ratio Total debt Ratio: (.33%) from – – – –
screen Interest bearing debt financial p mrkt cap. p p
instrument Ratio: (.33%) from – –
p mrkt cap p
Contribution of interest income Ratio: (.33%) from – – –
received by company from mrkt cap.
conventional fixed deposit p
Dividend received from investment in –
Syariah non-compliant securities
Note: a There are three different tolerance benchmarks that have been used by Securities Commission, Malaysia, such as 5, 10 and 25 per cent
Source: Muhamed (2009)
Governance

investment funds

Screening criteria

for the selection of the

shari’a compliance equity
organisations as the basis
of Islamic

adopted by three
51

Table I.
JIABR of companies with mixed business, as compared to the Dow Jones indices that use a
1,1 more strict approach. Securities Commission Malaysia, for example, provides three
different tolerance benchmarks: 5, 10 and 25 per cent on mixed activities of investee
companies, depending on the companies’ image. According to Securities Commission
Malaysia, the hotel industry when part of a mixed business is permissible based on
their 25 per cent benchmark, for the reason that it provides maslahah (good deeds) to
52 the public. Despite what may seem to some such anomalies, it does seem more likely
that a higher proportion of Malaysian companies operating in the Malaysian context
will be shari’a-compliant relative to companies that operate in Western markets. This
expectation is supported by the numbers. As at the end of 2008, 855 stocks in Malaysia
(87 per cent of total listed stocks), accounting for 64 per cent of market capitalisation),
were classified as shari’a-compliant (Securities Commission Malaysia, 2009a).
In terms of the selection and screening procedures for stocks, there are some obvious
parallels between the methods used to ensure compliance with shari’a principles
and the procedures undertaken in the socially responsible Western investment funds.
A comparison is now made of Islamic and Western “ethical” investment models.

4. Islamic and Western ethical investment compared

When considering the nature of the principles to be applied for screening for
shari’a-compliance, a distinction was drawn between negative and positive criteria. The
same distinction holds for Western investment funds, although the Western funds have
moved much further than Islamic funds from an emphasis on the negative to focusing on
the positive elements (Bivell, 2008). This development took place in three stages.
When SRI began in the West, it too, like the Islamic funds, focused on the negative.
Some origins of ethical investment can be traced to the nineteenth century with Quaker
and Methodist religious investors seeking to avoid investing in weapons production,
and alcohol, tobacco or gambling, but the movement took shape in a formal sense in the
1970s and 1980s (Knowles, 2000). Essentially, ethical investment revolves around
negative screening, and the filtering out of investments seen to be harmful and
inconsistent with the investors’ or fund managers’ values. Those activities most
commonly screened out are tobacco, alcohol, armaments, human rights abuses, animal
cruelty and pollution.
Next to emerge was the concept of environmental investment, based on identifying
activities and practices that are beneficial to the environment. In Australia, for
example, the Environmental Investment Directory was initially published in 1992 and
provided the first publicly released listing of environmentally positive investments
(Bivell, 2008). Based on positive screening, the environmental investment movement
actively seeks out investment opportunities in sectors that have a positive impact on
the economy, the environment and other relevant areas of society by investing in
activities such as clean technology and clean energy.
Sustainability investment was the third development and it arose in the late 1990s
and early 2000s, coinciding with the growing use of sustainability reporting.
Sometimes called “best-of-breed” or “best-of-class” investing, sustainability investment
endeavours to identify and select those enterprises that are the most sustainable in
their industry. Quantitative and qualitative measures are employed to determine
the organizations’ environmental, social governance (ESG) or ethical performance,
using criteria such as adherence to good corporate governance principles, use of
resources, treatment of staff, approach to customers and suppliers and engagement Governance
with and contribution to the community. These factors are often summarized by the
acronyms ESG and corporate social responsibility, although all three approaches
of Islamic
(ethical, environmental and sustainability) embody a concern for environmental investment funds
outcomes, albeit with different emphases.
A comparison of the Islamic equity funds and the SRI funds reveals a vast canvas of
fund categories and types. Nevertheless, in broad terms, some differences are discernible 53
in terms of portfolios, performance, client base and governance principles (De Anca, 2010).

Portfolios
If the FTSE Shariah All World Index and the FTSE 4GOOD Global Index are used,
respectively, as representative of the Islamic and SRI equity fund portfolios, a number
of differences emerge. Since the Islamic funds tend to avoid those institutions and
enterprises for which interest-based finance is the principal or main activity, the weight
of the “financials” in the Islamic funds is low relative to SRI funds (although some of
these exclude banks because of concerns about third world debt). On the other hand,
SRI funds give a low weight to oil and gas, basic and industrial materials and
these sectors are screened out of many SRI funds. Where the Islamic and SRI funds
overlap is that both invest extensively in consumer services, technologies and
telecommunications on the grounds that these are not heavily polluting (SRI) and have
only a minor involvement in interest or haram activities (Islamic).

Performance
Figure 1 compares the two FTSE indices, representing Islamic and SRI funds, from
2003 to 2008. In general, the two indices perform similarly over the 2003-2006 period
but begin to diverge considerably in 2007 and 2008 when the different composition
starts to exert an influence. In particular, the Islamic index benefited from the
high weighting given to the oil and gas sector, with the rise in oil prices to a peak of
$145.29 per barrel in July 2008, and also from the low weighting of financials in view of
the collapse of banking stocks that began in 2007 and gathered pace in 2008.

240
FTSE Shariah all-world index
220
FTSE4 Good global index
200

180

160

140

120

100
Figure 1.
80
A comparison of the
03 04 4 04 5 5 6 6 07 07 07 8
p- b- l-0 c- -0 t-0 -0 -0 n- n- v- r-0 performance of FTSE
e e Ju e ay c ar g p
-S -F 0- -D -M -O -M - Au -Ja -Ju - No -A Islamic and SRI funds,
30 27 3 31 31 31 31 31 31 29 30 30 2003-2008
Source: Based on DeAnca (2010)
JIABR Client profile
1,1 Earlier, the distribution of clients of Islamic investment funds was reported. Notably,
Saudi Arabia and offshore locations provided over 40 per cent of the clientele. Many of
these are thought to be large-scale investments (IFSL, 2008). By contrast, the SRI funds
attract monies from NGOs, charities and public institutions (many of which are small
scale), and also rely on small investments from a retail base, with some funds accepting
54 minimum investments of around $1,000 (www.uksif.org/).

Governance
Islamic investment funds must be advised by a shari’a authority to determine the
legitimacy of investments in accordance with shari’a. In Malaysia, for example, an Islamic
unit trust requires a shari’a adviser to certify that the fund complies with shari’a
requirements. Shari’a advisers must be registered with the Securities Commission, and are
subject to oversight by the Shariah Advisory Council of the Securities Commission, which
advises on shari’a compliance and screens listed companies for shari’a-compliance
(Securities Commission Malaysia, 2009b). SRIs have less formal arrangements. They rely
on professional SRI organizations for external advice (Statman, 2007) and have a board
comprising professionals, academics, NGO activists and business people determining SRI
principles according to the client base of the fund.

5. Future directions for the governance of Islamic funds

The major challenge facing the Islamic investment fund industry comes from its size.
Earlier, it was estimated that the industry accounts for less than 10 per cent of the
Islamic financial industry. In the two major markets of Saudi Arabia and Malaysia,
Islamic funds account for 55 and 26 per cent, respectively, of the fund market.
However, elsewhere the 650 global Islamic investment funds are dwarfed by the
61,000 conventional mutual funds that have a substantial market presence and have
well-established marketing channels. How can the Islamic funds raise their profile and
enhance their global reach?
Writing in 2006, Smyth (2006) of Failaka International saw the need to improve
investor education and address issues of transparency. He recommended the
assignment of ratings to funds in order to enable professional advisors to recommend
funds based on a recognized and consistent standard. To this end, Failaka has since
developed and offers to its subscribers the following range of subscription-only services:
.
an online database of shari’a-compliant investment funds;
.
research-based advisory services including fund manager due diligence;
.
shari’a advisory services offering fund managers and institutional investors
access to its shari’a board;
.
a guide to shari’a scholars; and
.
Annual International Islamic fund awards, giving recognition to the best
performing funds and fund managers.

Muhamed and Lewis (2008) argued that the funds themselves can do much to gain the
confidence of investors by improving disclosure of fund information, providing
investors with information as to how investments are selected and how the fund is
managed, setting out clearly the remuneration and fee structure, and by making
information readily accessible through, for example, well-designed, informative web Governance
sites. Each fund should have a clear statement of investment objectives, information on of Islamic
asset allocation, the degree of geographic and sector representation, investment
opportunities and give regular reports on fund financial performance. investment funds
A different suggestion is added here and that is to follow down the route taken by
the SRI funds. Islamic investment funds can borrow from their conventional SRI
counterparts and move away from reliance on the negatives (the prohibitions) and 55
emphasize the positive elements in investment selection. Nowadays, SRI boards focus
increasingly on positive criteria and how to foster certain companies to become
“best-of-breed” performers in the sector. Notably, those funds that signed up to the UN
Principles of Responsible Investment have undertaken to incorporate ESG investing
issues into analysis and decision-making processes, be active owners and seek
appropriate disclosure from entities in which they invest (Negline, 2009).
Such an emphasis amongst Islamic funds would be consistent with the requirements
in the Holy Qur’an and Sunnah regarding mutual consultation (shura) and concerns for
protection of nature and the environment. Of course, one would not expect the Islamic
funds slavishly to follow their Western counterparts. Islamic investment has its own
values and objectives following Islamic teachings, and has different foundations to the
conventional Western investment style. Islam brings its own principles that promote
equity, justice, social welfare and brotherhood, which should find reflection in
investment activities. In particular, wealth and property do not belong absolutely to
humans, since they are gifts from God, and thus must be held in trust and shared
and preserved. The ummah and the environment become important parties that
should be taken care of by these investors. Benevolence, altruism and a sense of
brotherhood are important elements that should exist in every individual Muslim.
This strong foundation shapes Muslims’ behaviour across all activities, including
investment.
Nevertheless, if this distinctive set of values is to be put in place, significant changes
are needed in the Islamic investment fund industry. An investment selection process
based only on the negative elements is not sufficient, as it does not encompass all of the
Islamic principles. Prohibitions of riba, gharar, maysir and certain goods such as alcohol
and pork must remain in place, but need to be extended to other aspects. Inclusion of
environmental as well as social elements as integral components of the assessment
criteria can be seen as the best way to preserve the benefit of all relevant stakeholders.
Indeed, from this perspective the environment ought to be regarded as a stakeholder
(representing the interests of future generations), and the preservation of its rights an
obligation of Muslims to rank alongside those commitments to the present community.
Neglecting such a responsibility suggests thanklessness of God’s bequest to humans
(Kamla et al., 2006). Although Islam accepts (in fact encourages) private property and
ownership, owners of property in their roles as vice-regents must use the resources with
responsibility towards others in society and the environment (Zinkin and Williams,
2006). For example, it is unacceptable if investments by Islamic investment funds and
other institutional investors are made in companies that are involved in environmental
pollution or that bring damage to society.
Individual investors, however, can only do so much. One suggestion is that
fund managers and institutional investors strengthen their roles in relation to
investee companies on behalf of their investors (fund holders), stakeholders and other
JIABR minority investors of investee companies (Muhamed, 2009). The institution of hisba can
1,1 in this guise be revived and extended to the context of supervising and monitoring
investee companies by the Islamic investment funds on behalf of their investors
and stakeholders. Rather than exercising the exit strategy as widely practised in
the mainstream approach, in which the holding of shares is deemed as buying
transactions, these funds might be expected instead to monitor and supervise the
56 investee companies continually to ensure that these companies are following Islamic
principles. As such, monitoring and supervising of the investee companies needs to be
conducted not only with respect to the performance of the share values and strictly
financial benefits, but also expanded to embrace features of the governance structures
and compliance with Islamic principles.
There are already some developments underway. In 2006, the family of 70 regional,
country and industry indices derived from the DJIM World Index was expanded to
include the DJIM Sustainability Index, which combines Islamic investing principles
with sustainability criteria. In May 2009, an Islamic “green” fund was launched by the
UK Islamic Bank Gatehouse (owned by the Kuwait investment company Securities
House) and the Swiss Fund Management Company Sustainable Asset Management
(SAM), following in the footsteps of the first ever fund combining ethical and Islamic
principles issued in April 2009 by F&C Asset Management and BMB Islamic. The new
fund is described as “the first shari’a-compliant water-focused investment strategy
fund”. In the remit, SAM identifies companies that meet the investment criteria for
sustainability and have an exposure to water in terms of “technologies, products and
services throughout the value chain of the water industry”. Gatehouse then screens
those companies for shari’a-compliance in terms of the usual interest income and
financial ratios (Islamic Finance News, 2009, p. 16).
There seems every likelihood that such initiatives will herald a new direction for
Islamic funds. Gatehouse argues as follows:
Successful Islamic investment products will be those that not only meet the financial and
activity-based screens for Shariah investments, but also whose entire approach to investing is
based on adhering to wider principles of Islam such as concern for the environment, access to
basic resources and sustainability in general (Islamic Finance News, 2009).
Going down the environmental path is an obvious direction for Islamic funds to take to
widen their global appeal. It is also completely in accord with Islamic principles.
However, the real challenge will be to extend this list to embrace other “positives” in the
Islamic agenda, such as the promotion of justice, active supervision and monitoring,
involvement in decision making, and brotherhood and the advancement of Muslim
communities, areas that so far remain unexplored.

Notes
1. More complete details of Islamic investment funds summarized here are given in Lewis (2010).
2. The various Islamic financing instruments including ijara, murabaha, mudaraba and
istisnaa are described in Lewis and Algaoud (2001).
3. The verses from the Holy Qur’an are drawn from The Holy Qur’an (1998).
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About the author Governance
Mervyn K. Lewis is a Professor of Banking and Finance, in the School of Commerce of the
University of South Australia, at the City West Campus, Adelaide, Australia. Before joining the of Islamic
University of South Australia in 1996, he was for 12 years, Midland Bank Professor of Money investment funds
and Banking at the University of Nottingham. In 1986, he was elected a Fellow of the Academy of
the Social Sciences in Australia. As well as being Visiting Professor at a number of universities,
in April 2009, he was inaugural Securities Commission Malaysia-University of Malaya Visiting
Scholar in Islamic finance. He has published 21 books, 65 articles and 76 book chapters. His last 59
volume is An Islamic Perspective on Governance, co-authored with Z. Iqbal (Edward Elgar, 2009).
Mervyn K. Lewis can be contacted at: mervyn.lewis@unisa.edu.au

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