Chapter 6

Islamic Asset and Fund Management

Learning Objectives

1 Understand the unique nature and fundamentals of Islamic asset and fund management.
2 Identify the criteria for the selection of Islamic stocks for investing and review Islamic fund
performances.
3 Examine the structure, marketing, and distribution of Islamic funds.
4 Understand the Sharī‘ah governance for Islamic funds and its importance for Islamic fund
management.
5 Know the meaning and importance of risk management issues for Islamic funds, including risk-
reward profile, with specific analysis of the risk-reward profile of major Islamic finance products.

Chapter Overview
Asset and fund management is sometimes used as a synonym for investment
management. It generally involves managing the wealth of private individuals or
corporate entities. There are firms that specialize in asset and fund management.
Surplus funds and assets of corporate entities and the wealth of private individuals
are monitored, managed, and maintained in a sustainable way that aims to improve
and enhance their value. There is an increasing demand for Sharī‘ah-compliant
asset management around the world. The Islamic asset and fund management
sector is a significant segment of the Islamic finance industry, and has emerged
as part of the wider asset management industry. The Islamic investment sector has
expanded tremendously so far this century, with various innovative finance products
that are Sharī‘ah -compliant. Globally, Islamic fund managers are licensed under
the relevant laws of the jurisdictions where they operate. They manage mandates
according to the principles of Islamic law. Fund managers offer an array of products
and instruments that have been specifically designed in accordance with the
principles of the Sharī‘ah, for clients who choose Sharī‘ah -compliant investments.
This chapter examines Islamic asset and fund management in the light of current
developments in the Islamic finance industry. According to Ernst & Young’s Islamic
Funds and Investment Report 2010, Islamic assets under management are estimated
at US$52 billion.

A. Review and Fundamentals of Islamic Investing

Fundamentally, Muslims believe that man can only acquire wealth through reasonable efforts to earn
income or by inheritance (such efforts must comply with Islamic law, and are called legitimate
investment). Legitimate investment business activities through trade and investment have been common
practices within Muslim communities for hundreds of years. This is as a result of clear prescriptions found
in the Qur’an. The principles of legitimate and Islamic business practices have been passed down from
generation to generation. To ensure total compliance with the principles of the Sharī‘ah in Islamic asset
and fund management, there are many fundamentals of Islamic investing that must be followed. They will
be described in detail within this chapter. To prevent unforeseen economic consequences and detriment,
good financial planning and asset management are crucial. Several verses in the Qur’an encourage people
to plan ahead.

Key points:
● Wealth is regarded as a trust from God and mankind only acts as its trustee.
● As such, sustainable investment practices are encouraged.
● Fund managers, who manage investment funds on the behalf of investors, along with Islamic asset
management firms, must be professional in carrying out their respective responsibilities.
● The fiduciary aspect of the beneficiary, or fiduciary relationship, present in fund managing is
parament.
● The increasing awareness among Muslim communities of Sharī‘ah compliant financial products
has created a global environment in which unique-compliant investing demands from Islamic
investors are being met with innovative Sharī‘ah compliant products and business practices, such
as Islamic asset management.

Non-interest-bearing Products
● A portfolio is a group of assets, or all of the assets in a firm’s balance sheet, or in the case of
individual investors, stocks, bonds, shares, and rental real estate.
● In the filtering of Islamic investment portfolios, the first fundamental consideration is the
exclusion of all ribawi (interest-bearing) products, services, or investments.
● All forms of deceitful dealings, which in Islam are any dealings that contain elements of interest,
particularly where one person earns multiple incomes at the expense of another, are forbidden.
● Whether fixed or floating, simple or compound, all forms of interest are prohibited. ‘Nominal’ or
‘excessive’ interest amount to the same thing and are treated alike under the prohibition rule.
● Financial returns on money must bear the two inseparable features of Islamic investing, i.e.,
profit and loss, which in Islamic banking and finance, are shared proportionately among all
parties in joint-business ventures.

Avoiding Speculative Investments

● Such investments may involve gharar (uncertainty) and maysir (gambling).
● Long-term investments in the secondary market for conventional securities may pose a serious
challenge to a number of prospective Islamic investors in the Gulf region and Southeast Asia,
primarily due to the speculative nature of many of the products found on those markets
(futures, options, derivatives, etc.).
 ● Fund managers must avoid all such investment activities that involve excessive risk (which is
different from the usual commercial risk), speculation, or uncertainty are prohibited in Islam.
● Risk can be defined as the variation of future price, so, it is natural for some assets to carry more
risk than others.
● The uncertainty and contingency in contracts (such as short-selling) are prohibited unless they
are properly streamlined to reflect the mandatory requirements of the Sharī‘ah.
● Additionally, conventional insurance and derivative are not permissible in Islamic investment.
● The speculative feature in options, utilized in derivative instruments, involves the confinement
of rights without the corresponding obligations or liabilities and is determined solely by the
fluctuation in the market prices of the underlying asset.

Social Responsibility
● Fund managers and their clients are required by the Sharī‘ah to discharge their social
responsibility through their investment activities.
● When structuring Islamic finance products, fund managers must keep this in mind.
● Monetary redistribution mechanisms for discharging obligatory and voluntary Islamic social
obligations include, zakat (compulsory alms), sadaqah (voluntary alms), waqf (charitable
endowment), and even takaful (Islamic cooperative insurance).
● The principles of Islamic investing require the parties to the contract to calculate the annual
zakat due at the end of a financial year if the surpluses reach a threshold figure (nisab).
● Note: Voluntary charitable alms are also encouraged and should be part of a comprehensive
social responsible investment platform.
● Part of the pool of funds from the surpluses may be used by fund managers for endowment
purposes based on the principles of waqf.
● Also, based on the principles of waqf. Finally, fund managers must ensure that the assets they
manage are adequately insured with the relevant takaful policies to avoid unnecessary exposure
to any risks that may ultimately result in loss, and to protect and preserve their clients’ wealth.

Contractual Terms and Certification by Sharī‘ah Experts

● By engaging the services of Sharī‘ah experts who approve all draft contracts, processes, services,
and investment activities, fund managers can ensure that their actions properly conform to the
principles of Islamic law.
● Therefore, necessary certification by Sharī‘ah experts is sought for all contracts. It is common
practice.

B. Selection of Islamic Stocks for Investment

Islamic Stock Market Indices
● Islamic indices track stocks or corporations that are compatible with the Sharī‘ah.
● A stock market index is used to measure fluctuations in the performance of stocks in a financial
market so that fund managers and investor are able to make better informed decisions on their
investments.
 ● In most cases, capital need by corporations to finance their businesses, cannot be raised
internally, so the corporation, as a separate legal entity, proceeds to the securities markets to
generate capital to finance its business operations through the sale of securities in a place called
a stock exchange.
● Buyers and sellers of securities trade in this organized market (prominent stock exchanges
include the Kuala Lumpur Stock Exchange (KLSE), the Hong Kong and New York Stock (NYSE)
Exchanges, and the London Stock Exchange (LSE)), which may be national, regional, or
international in its scope.
● The most prominent Islamic indices are the Dow Jones Islamic Market Index (DJIM, see Figure
6.1 for an overview), FTSC Global Islamic Index, S&P Global Investable Sharī‘ah Index and MSCI
Barra.
● A stock market index is a statistical method of measuring a section of the stock market by
compiling the share prices of representative stocks.

The Process of Selecting Stocks

● The investment selection process of stocks for Islamic investment funds is in many ways similar
to that of conventional mutual funds.
● The major requirement for Islamic investment is Sharī‘ah compliance at every step of the
process, including all steps of the investment selection process.
● To ensure that Sharī‘ah guidelines are properly followed, Islamic investment funds adhere to a
systematic investment selection process, as illustrated in Figure 6.2
○ sector screen
○ financial screen
○ selecting Sharī‘ah-compliant transactions and instruments
○ purification of income distribution

Sector Screen or Industry Screen

○ The first stage of the investment process, where the underlying business activity of the
company will be evaluated and certified to be compatible with Sharī‘ah restrictions
(with respect to exposure to certain business activities) is known as the sector screen or
industry screen.
○ For Islamic funds, investment in industries that deal with prohibited goods or services,
such as companies producing or selling alcohol, biotechnology firms using aborted
embryos and human cloning, and conventional financial institutions, are not allowed.
○ As a conglomerate may have more than one business, investment in such companies
and their subsidiaries are closely monitored and screened for compliance.

Financial Screen
○ The second phase is the financial screen, which involves analyzing the nature of a
company’s Sharī‘ah non-compliant financial behavior.
○ For Islamic investments, being halal (permissible) is not enough; additionally, Sharī‘ah
scholars require that the firms under investment should operate according to Islamic
 financial norms (namely that all business activities are devoid of any prohibited financial
practice such as riba, maysir, and gharar, or any other prohibited elements in
commercial transactions).
○ Over the years, Sharī‘ah scholars continue to debate acceptable debt ratios for selecting
feasible investable firms for Islamic funds, and to date, there is no one screening
methodology used for selecting Sharī‘ah compliant stocks.
○ For example, different ratios have been stipulated by AAOIFI, DJIM, FTSE Global Islamic
Index Series, etc.

Table 6.1: AAOFI Ratios for Financial Screening

Formula Limit
Conventional debt/total assets <30%
Conventional debt/total assets <30%
(Cash+ interest-bearing deposits)/total assets
(Total interest income + income from non-compliant activities)/total revenues <5%
Accounts receivable/total assets <45%

Selecting Sharī‘ah-compliant Transactions and Instruments

○ Due to the restriction placed on Islamic investors, many conventional investment
practices are not viable investments for them, as such practices often rely heavily on
interest-based debt to finance activities.
○ Conventional investment funds may invest in interest-bearing debt securities, preferred
stocks, warrants, common stocks, and any other suitable instruments.
○ Shari‘ah-compliant debt certificates are currently evolving; as such, the scope of Islamic
investment funds is limited by the availability of common stocks in the halal industrial
sectors (Figure 6.3 illustrates the results of Amana Trust Income Funds as presented in
the Financial Times).
○ Islamic investment funds cannot invest in fixed income instruments (due to their riba
elements) such as corporate bonds, treasury bonds and bills, certificates of deposit,
preferred stocks, warrants, and some derivatives.
○ Islamic fund managers cannot speculate or take any unnecessary risks, including trading
on margin or utilizing interest-paying debt to finance their investments.
○ They also cannot engage in sale and repurchase agreements (ex. repos and buybacks).

Purification of Income Distribution

○ Some Sharī‘ah scholars do not allow for any sort of conventional leverage (the use of
credit or borrowed capital to increase the earning potential of stock).
○ However, most scholars think that such investments are acceptable on the precondition
that ‘contaminated’ earnings be cleansed or purified.
○ If some part of a fund’s income is doubtful, then those earnings should be foregone.
○ Islamic funds should adopt proper financial screening as accurately as possible- say if an
Islamic fund observes that 8 percent of its income comes from interest-related dealings,
 then the fund must disburse that portion of its income through charity in order to purify
the fund’s earning.
○ Though cleansing of dividend earnings is an established practice, Sharī‘ah scholars have
not come to a consensus on one particular viewpoint/method of purification, as some
jurists are proponents of capital gains-based purification.
○ Zakat may be used as a form of purification technique (although the nisab of zakat for
individuals is well-defined, zakat calculation on investment profits is still a debated
issue).
○ Islamic funds may set aside a portion of profits for zakat, and their Sharī‘ah supervisory
boards may identify the recipients of this money.
○ Since identifying companies that pay or receive zero interest is so difficult, some
Sharī‘ah scholars suggest that a fund can invest in companies with less than one-third
leverage-related ratios and purify its income by donating the interest-tainted income to
charity.

Islamic Finance in the News: Going global from Iowa to Kuala Lumpur (Source: Peter
Guest, “Going global from Iowa to Kuala Lumpur”, Financial Times, August 3, 2008.).

“Des Moines, Iowa, seems an unlikely headquarters for a major player in the Asian Islamic
funds market, but Principal Global Investors, through its long-standing joint venture with
Malaysia-based CIMB, has ambitions to tap into the massive demand in Asia-Pacific for
Sharī‘ah-compliant products...‘Clearly there’s a lot of potential there, because they’re a
tremendous economic success story and an Islamic country. For that reason, they’ve
got a pretty good chance of being a base for what is, internationally, quite a fragmented
business at the moment.’ Malaysia currently represents the main source of Islamic
bond, or sukuk, issuance worldwide—more than 60 percent—and is the second largest
market for Islamic mutual funds, with 27 percent of the market, behind only
Saudi Arabia, which has 28 percent.”

Addressing Issues of Non-compliant Stocks

● One of the most important functions of the Sharī‘ah supervisory board is the constant
monitoring of business operations of the Islamic fund.
● As firms may engage in mergers, acquisitions, or divestments, their Sharī‘ah compliance should
be re-scrutinized periodically since occasionally a firm may fail behind the benchmark
requirement for Sharī‘ah compliance.

Sharī‘ah advisors may classify the degree of non-compliance into any of the following categories:

● Temporary non-compliance with industry or financial screens- The Sharī‘ah board may permit
the transaction of stocks while benchmarks are occasionally breached up to a given approved
level.
 ● Short-term non-compliance with industry or financial screens- The fund manager should report
to the supervisory board if a stock becomes non-compliant for a longer period of time. The
manager should also analyze the impact of returns from that firm on the overall return of the
fund and set aside a certain portion of earnings and donate it to an appropriate charitable
cause.
● Permanent non-compliance- When a stock falls short of compliance benchmarks of Sharī‘ah
approvals permanently, the Sharī‘ah board may ask the fund manager to divest from such
stocks.

C. Structure, Marketing, and Distribution of Islamic Investment Funds

What is an Islamic Investment Fund?
● Islamic investment funds can be defined as a joint pool to which investors contribute their
surplus money for the sole purpose of investment in legitimate business.
● Fund managers typically issue a form of certificate to the subscribers (investors) to a fund
certifying their rate of subscription, which entitles them to profits earned by the fund,
distributed in accordance with their respective investment portfolios and proportion of
investment, known as pro-rata profits.
● The certificate or document given to the subscribers may be called ‘shares’, ‘units’, ‘certificate’,
or ‘instrument’, and documents their rate of ownership in the joint fund.

The validity of this certificate is subject to two basic conditions: (1)There must not be a fixed return on
the certificates and (2) the amount of funds realized from the pool should be invested in a form of
investment that is acceptable under the Sharī‘ah.

From its early stage, investment in common stocks (defined by AAOIFI as investment vehicles that
should be financially independent of the institutions that establish them and be managed on the basis of
either mudarabah or agency contract or other profit-and-loss sharing contracts has been well accepted
by Sharī‘ah scholars with the precondition that Sharī‘ah screening is performed properly)

Structure of Islamic Investment Funds?

The structure of Islamic funds is derived according to their different classifications, usually their
respective investment style, and different categories.

There are four major Islamic investment funds commonly used by an Islamic funds
manager.
a Islamic debt funds
b Islamic equity funds
c alternative investments
d special asset classes

Islamic Debt Funds

 ● Islamic debt funds are created through investing the capital of the mudarabah-based or
musharakah-based funds in fixed-income yielding operations that involve some sort of debt as
well as a fixed income for the financial intermediary.
● Such fixed-income yielding operations may include murabahah and ijarah, subsequently leading
to the establishment of the murabahah (commodity) funds and ijarah (operating lease) funds
respectively).
● Figure 6.4 summarizes the five basic steps in the structuring an Islamic debt fund, the fund
manager creates an equity-based special purpose contract such as mudarabah.

Figure 6.4: The Five Steps in the Structure of Islamic Debt Funds

The fund manager creates a special purpose mudarabah or musharakah contract

Funds are raised through the issuance and sale of certificates or instruments to subscribers who
contribute their individual surpluses to the common pool of funds

The funds are invested in either murabahah or ijarah operations that involve
some sort of debt and fixed income yielding for the intermediary

The percentages of revenue due to each of the subscribers are predetermined at the contact stage

After the deduction of the amount of money due to the fund manager, the investors are given their
respective pro-rata profits from the net profit realized through the investment activities.

● The cost of managing the business activity is determined as fixed-income yielding for the
intermediary, who as the third party may manage the business activity if the fund manager
decides to outsource it.

Commodity Funds
● Commodity funds involve murabahah operations or bay’ bithaman ajil (BBA), where the fund
manager uses the subscribed pool of funds to purchase different commodities for the sole
purpose of resale.
● The amount of profits realized from the resale constitutes the main income of the fund, which is
distributed among the subscribers (based on their pro rata subscription to the fund).
● These transactions must be structured in close-ended form, non-negotiable in the secondary
market.

Ijarah Funds
● A lease fund where the amount realized from subscription is used to purchase an asset, such as
real estate, which is then leased to a third party, is known as a ijarah fund (created through the
 pool of surplus financial resources from willing investors used to purchase a leasable asset for
the purpose of establishing a lease agreement with a third party who is ultimate user).
● Rules concerning ijarah contracts provide that ownership of the underlying asset still vests in the
Islamic fund but the usufruct is given to the lessee up to the appointed time, as provided for in
the underlying contract.
● The subscribers to the fund are issued certificates that contain their individual share or unit of
the underlying asset purchased with their surplus funds.
● The certificate (commonly known as sukuk) is evidence of their subscriptions to the fund and
guarantees their entitlement to any profit that accrues from the underlying asset leased out to
the lessee.
● The income is distributed pro rata to the subscribers accordingly, after deducting the managerial
expenses (see Islamic Finance in Practice panel for actual practice for ijarah funds).
● Sukuk, unlike commodity funds, are negotiable instruments that can be traded in the secondary
market as they represent the pro rata ownership of their holders in the tangible asset leased
out.

Islamic Finance in Practice: Ijarah Real Estate Fund, Global Investment House, Kuwait (Source:
www.globalinv.net/contentdisp.asp?pageId 56).

This is a REIT investment model, which seeks to provide the unit-holders with returns between 8
percent and 10 percent per annum. The returns are payable based on the capital contributions of the
unit-holders after any incentives, expenses, and fees payable to the fund manager (Global Investment
House) and applicable taxes are deducted from the returns. As a REIT, the underlying property is
developed and/or acquired as real estate then leased out to ensure a stable cash inflow. Through
diversified portfolios of real estate properties, Global Investment House targets countries in the
Middle East, North Africa, and Turkey in its acquisition and developmental drive. The Ijarah Real Estate
Fund invests in a diverse portfolio of real estate properties in line with Sharī‘ah principles to mitigate
risk. The Fund operates under the standards of the Central Bank of Bahrain for Accreditor Investors.

The Ijarah Real Estate Fund made its first investment in Kuwait through a sale and leaseback
arrangement with a listed firm in Kuwait. The fund invested US$10.7 million in this arrangement,
which matured on December 25, 2008. Consequently, the Fund received monthly rentals at a profit of
11.50 percent. The transaction was closed in January 2009.

Islamic Equity Funds

● Due to the fact that investors are required to bear the risk of the transaction to be entitled to
any of the accrued profits, Muslim scholars prefer the returns are earned through equity
investment (based on either a mudarabah or musharakah contract).
● In the creation of Islamic equity funds, investment funds are selected through a proper
screening process to ensure that all their investments fully comply with Sharī‘ah requirements.
● The fund manager or firm is the financial intermediary as a result of the cardinal role it plays in
managing the surpluses of investors contributed to a common pool for the purpose of
investment.
 ● Because the equity investor becomes a pro-rata shareholder of the business itself, the fund
manager or firm’s activities must fall within the permissible category in Islamic commercial
transactions (must not engage in any debt or leverage and must avoid any prohibited financial
practices).

Alternative Investments
The three forms of alternative investments commonly practiced in the Islamic finance industry are:
● private equity funds
● Islamic venture capital funds
● real estate funds or real estate investment trusts (REITs)

Private Equity Funds

○ Asset classes that comprise equity securities not publicly traded on a stock exchange are
called private equities.
○ Generally, these are structured as private limited companies with only a few large-
capital individuals or institutional investors as the stakeholders.
○ Private equity funds, Islamic (for Islamic private equity funds, Sharī‘ah compliance, as
with all compliant investment funds, is required) and conventional, often engage in non-
exchange traded or illiquid investment strategies aimed at holding their equity position
in a growth company for a relatively long period of time.

Islamic Venture Capital Fund

○ Venture capital can be defined as the capital invested in startup firms and small
businesses with exceptional long-term growth potential.
○ Similarly to private equity, venture capital is not exchange-traded, but engages in long-
term investment positions in firms at different stages (start-up, distressed firms in the
middle business cycles, etc.).

Venture capital investments may take place at any or a combination of different stages in a
company’s life cycle.

Eventually venture capitalists, usually after holding the investment for an extended period of
time, liquidate the investment. They can do so by using several procedures, including a trade-
sale, write-off, a secondary sale, an initial public offering, a company buyback, and
reorganization or company restructuring.

The structure of an Islamic venture capital fund, which like conventional venture capital funds,
are typically structured as open-ended and diverse funds, is based on a contractual arrangement
between the fund manager and the institutional and individual investors. The investors are
passive and act as ‘limited partners,’ as in mudarabah contracts, Islamic contractual
arrangements used to raise capital in compliant venture capital arrangements.
 Real estate funds or real estate investment trusts (REITs)
○ REITs are companies (structured as a limited company and the majority are listed on
stock exchanges) that own and operate income-yielding real estate or items that relate
to real estate.
○ Some REITs focus on only owning and managing income-generating real estate projects,
while others do some lending or financing activities in the real estate sector as well
(there is a third category of REITs that engage in both financing and managing their own
real estate).

Based on their investment style and income-generating sources, conventional REITs may be
classified into three broad categories, which are:
Equity REITs- acquire and develop its properties primarily to operate them as part of its
own portfolio rather than to resell them once they are developed.
Mortgage REITs- focus on financing the real estate owners and operators through credit
facilities.
Hybrid REITs- An amalgam of the above two categories, whereby the REIT acquires and
develops properties and at the same time lends money to real estate owners and
operators.

○ Islamic REITs are patterned after the ijarah contractual framework and its variations.

Special Asset Classes

● Conventional portfolios may be restructured by purging the non-Islamic elements in the
contracts and streamlining them, based on the Islamic financial instruments.

Three special asset classes have been identified:

1. Islamic hedge funds
2. funds of funds
3. mixed funds.

Islamic Hedge Funds

○ Hedge funds are investment vehicles designed for a limited number of investors and
targeted at maximizing returns through various advanced investment strategies.
○ They are acceptable, but remain an issue of contention among Islamic finance scholars
in the Islamic finance sector if they are free from all forbidden elements such as short-
selling and dealing in conventional options, futures, currency swaps, and other
derivatives.

Funds of Funds
○ A conventional fund of funds works like a mutual fund investing in another mutual fund.
 ○ The rationale behind such a fund of funds strategy is to attain broader diversification
benefits (when one fund invests in another fund with a different investment objective, it
attains diversify in its exposure).
○ This strategy may be less efficient in the Islamic banking sector since the limited number
of Islamic funds as well as the higher commissions and fees involved (because they are
charged for both funds).

Mixed Funds
○ A mixed fund may invest in a pool of different assets.
○ Islamic mixed funds require investment in both equity and debt instruments, such as
equities, leases, commodities, etc.

Distribution and Marketing of Islamic funds

● Though Islamic funds are structured as separate business entities by legal requirement, many
Islamic funds are managed and promoted by other Islamic banks or financial institutions.
● However, while still in their infancy, Islamic fund management entities, are beginning to take
advantage of more expansive marketing and distribution systems to market their products to
investor clients.

Distribution and Marketing for Islamic Investment Funds

To promote their investment products, Islamic funds may engage in different business strategies with
other Islamic banks and financial institutions.

Joint Ventures
○ Islamic investment funds may enter into joint venture agreements with other Islamic
banks or conventional banks to gain higher market exposure and increase the investor
network, particularly in new geographic locations, at a lower cost.

Franchising
○ Islamic investment funds may engage in franchising to promote their products in
different markets, which require Islamic funds’ products to have brand value among
prospective investors.

Outsourcing
○ When structuring an Islamic fund, the principal financial institution may decide to
outsource management expertise rather than managing the fund itself.

Challenges in the Marketing and Distribution of Islamic funds

● Despite the fact that interest in Islamic funds has grown significantly over the years, the number
of Sharī‘ah-compliant investment funds and investable securities is still inadequate.
● Another major challenge is a general lack of appropriate management skills within the sector.
 ● Though investors may be interested in Islamic investments, they may not know the Islamic
investment process and its uniqueness in terms of risk features.
● Web-based distribution channels for conventional investment funds have led to increased
success for such funds; however, in the Islamic finance sector, web-based distribution may not
be realistically feasible (primarily due to the fact that conventional funds enjoy an increased
level of production (economies of scale) when compared to Islamic funds).
● Although Islamic funds may access potential markets through joint ventures, franchises, or other
strategic alliances, such strategies only reach a smaller investor base, which may eventually lose
their goodwill and confidence in Islamic funds, as the products are not delivered directly.

D. Sharī‘ah Governance of Islamic Funds

● The Sharī‘ah governance framework, which continues to remain innovative, has been
introduced to ensure all investment products, services, and contracts comply with the
fundamentals of the Sharī‘ah.
● The modern practice of Islamic wealth management has mimicked the wider Islamic finance
industry by establishing standing Sharī‘ah boards (an alternative being Sharī‘ah consulting firms).
● Additionally, a separate Sharī‘ah body or officer may be entrusted to ensure all procedures,
services, and contracts for investment activities comply strictly with the rulings and
recommendations of the Sharī‘ah board.

Composition of the Sharī‘ah Supervisory Board

● The composition of Shariah supervisory boards should be such that Islamic investors can trust it
and its members.
● Members of the board should possess appropriate educational credentials and must have a
thorough understanding of financial transactions and the financial system.
● AAOIFI requires a minimum of three members for the Sharī‘ah supervisory board, however,
Islamic funds may select an individual Sharī‘ah scholar to assume the supervisory role.

Functions of the Sharī‘ah Supervisory Board

The responsibility of the board may vary for different funds based on their charter and may include, but
not be limited to, the following functions:
● monitoring the fund’s compliance with the Sharī‘ah
● overseeing the fund’s portfolio purification
● reporting on the fund’s compliance status
● assisting the fund’s management
● advising on zakat and identifying the procedures for its distribution

Independence of the Sharī‘ah Committee and Islamic Fund Infrastructure

● The Sharī‘ah supervisory boards should remain independent from management influence, which
is more likely to impart better supervision and ensure investor confidence.
 ● This is due to the fact that Islamic investors often perceive the Sharī‘ah board as the safeguard
of compliance as well as ensuring their best interests.
● As Islamic funds engage in product innovation at frequent intervals, the operational process
should include cross-checking prospective new products for compliance in the first place by the
Sharī‘ah board.

Global Islamic Finance: Islamic Fund Management in the Global Finance Industry (Source: Bank
Sarasin-Alpen publication on Islamic Wealth Management Report 2010. Available at www.sarasin-
alpen.com/internet/ieae/index_ieae/about_us_ieae/media_relations_ieae/media_release_30.03.2
010.pdf)

Over the past several years, particularly the period between 1999 and 2009, saw the establishment of
Islamic funds in the United States and Canada. Islamic fund management has mainly focused on
Islamic home financing products, which is significant to the development of the Islamic finance
industry in the region. While they have been more recently launched in Europe and North Africa,
Sharī‘ah-compliant asset management companies have thrived in South-East Asian and the GCC
countries for years. According to the Islamic Finance Information Service (IFIS), the total value of
Islamic funds as of 2009 was US$22.8 billion in about 556 Islamic funds. Since the financial crisis in
2009 especially, more Islamic funds have been established to fulfill the increased demand for
compliant funds in Muslim communities on all continents. It should be noted also, that non-Islamic
financial houses have also embraced Sharī‘ah- compliant products. Investment Report for 2009:
“Despite this setback [the global financial crisis], the fundamentals of the Islamic fund industry remain
strong. With almost US$50 billion in fund assets under management and a large, expanding and
untapped Muslim population, there are likely to be considerable opportunities in the future. This is a
time when strategic choices have to be made and market participants have to adapt to survive.”

Compensation and Monitoring Fees

● Within the global Islamic banking and finance sector, similarly to the conventional sector,
compensation and monitoring fees for Sharī‘ah board members should be commensurate with
their professional expertise and academic qualifications.
● They may be compensated in the same manner as the BoD on the basis of monthly
remuneration (additional payment for meetings, out-of-pocket expenses, and a special
allowance for the chair of the board is also possible).

Disclosure Issues
● Disclosure issues in the investment industry are gaining in importance.
● For Islamic funds (besides the regular disclosure of financial reporting and other management
information), the disclosure of Sharī‘ah compliance information is also crucial.
● Disclosure issues, especially in the wealth management space, are particularly important
because investors will want to know the state of their wealth at any point in time.

E. Risk Management for Islamic Investment Funds

 ● Fund managers in both the conventional and Islamic financial sectors strive to attain similar
investment and risk management objectives in managing their investment portfolios.
● Though Islamic risk management requires Islamic fund managers to employ unique risk
management techniques for Sharī‘ah compliant products, essentially, they replicate many of the
basic risk management strategies applied in conventional investment funds.

Risk-Reward Profiles of Islamic Investment Products

● Risk-reward profiles refer to charts of the theoretical maximum profit or loss a particular
investment can have in the portfolios of investors and are used by investors to theoretically
compare the expected returns on an investment to the amount of risk undertaken to realize
such returns.

How to Calculate Risk-Reward Profile: Risk-reward profile ratio = $ Reward / $ Risk

Each of these Islamic investment products has a unique risk-reward profile and knowledge of each risk
profile will help guide potential investors in identifying the best product for investing. This is especially
significant for a developing sector like the Islamic banking and finance sector.

Risk Management Strategies for Islamic Funds

Market Risk Management for investment funds arises from the price volatility of the securities under
investment. To manage the market risks of their portfolios, Islamic fund managers adopt two main
strategies: portfolio diversification and portfolio protection.

Portfolio Diversification can be defined as a business strategy for reducing risk through the
investment in a wide variety of assets. Diversifying portfolios create two main obstacles for
Islamic fund managers.
1 They need to diversify their portfolios within a limited range of Sharī‘ah- compliant asset
classes
2 As the Islamic market has relatively lower depth in terms of trading activity and lower
breadth in terms of the number of asset classes traded, the market may be more
volatile compared to the conventional markets.

Portfolio Protection
○ As most conventional derivatives are structured on the basis of riba and in some cases
involve excessive risk-taking (gharar), such derivatives are not allowed in Islamic
investment.
○ In recent times, some murabahah- and arbun-based (a down payment made by a buyer
to the seller with an option to rescind the contract by foregoing the payment as a
penalty) solutions have been applied to mitigate risk exposures in currency, equity, and
commodity funds.
 ○ The use of futures and short positions however, is widely rejected by the majority of
the Sharī‘ah scholars and Islamic fund managers because of the exceedingly speculative
nature of such arrangements.

Liquidity Risk Management in the Islamic Funds Market

● Due to the fact that the Islamic funds market (unlike the funds themselves) is more liquid than
its conventional counterpart, a surplus of liquidity, is being channeled to other investments
(though, it should be noted that there is a low return rate on liquid assets managed by Islamic
financial institutions).
● As such, Islamic fund managers face managing more-constrained liquidity issues.
● One important liquidity issue is the investment exit strategy because there is no secondary
market in the conventional sense.
● Islamic fund managers may have to depend on the sponsor principal, nominated liquidity agent,
or other asset management company to exit an investment.
● As most investors prefer investment in more liquid asset classes, fund managers should be
prepared for higher cash outflow possibilities during falling markets when individual investors
may wish to liquidate their position ( in such cases, they are likely to liquidate their investment
portfolios at a lower price and risk losing the net asset value of the fund).
● To encounter such liquidity crunches, fund managers may enter agreements with other
financial institutions or liquidity providers.
● As an immediate measure, fund managers may leave some of the short-term cash balances in
interest-free current accounts.

Key Terms and Concepts

arbun (or bay’ al-arbun) (p. 246)
bay’ bithaman ajil (p. 231)
economies of scale (p. 241)
ethical investment (p. 219)
exchange-traded derivatives (p. 246)
fiduciary relationship (p. 218)
financial screen (p. 223)
firm-specific risk (unsystematic risk) (p. 246)
fund managers (p. 218)
halal industry (p. 219)
hedge funds (p. 237)
ijarah fund (p. 231)
investment portfolios (p. 219)
investable securities (p. 240)
Islamic debt funds (p. 230)
legitimate investment (p. 217)
liquidity (p. 240)
nisab (p. 220)
over-the-counter (OTC) derivatives (p. 246)
portfolio diversification (p. 246)
portfolio protection (p. 246)
private equities (p. 234)
pro-rata profits (p. 229)
real estate investment trust (REIT) (p. 236)
risk-reward profile (p. 245)
sadaqah (p. 220)
sector screen (industry screen) (p. 222)
stock exchange (p. 222)
stock market index (p. 221)
venture capital (p. 234)
 Summary

1 The Islamic asset and fund management framework is unique and has specific requirements
such as the prohibition of riba, gharar, and maysir with the strict requirement of approval of an
investment fund by a Sharī‘ah board, which may sometimes exclude Islamic investors from
conventional investment funds.

2 Although the criteria for the selection of Islamic stocks for investing and review of the Islamic
fund performance are similar to those of conventional funds, an additional requirement for
Islamic funds is strict Sharī‘ah compliance of the entire investment process from the screening
stage to the distribution of income stage. The Islamic investment selection process comprises
sector screen, financial screen, selection of Sharī‘ah-compliant transactions and instruments,
and purification of income distributions.

3 The Islamic investment funds are based on Islamic finance instruments such as mudarabah,
musharakah, murabahah, ijarah, and other permissible instruments known to the Sharī‘ah.
Therefore, the structure, marketing, and distribution of Islamic funds must be based on these
fundamental contractual arrangements.

4 The Sharī‘ah supervisory board is the main body in the Sharī‘ah governance framework for
Islamic funds. However, Islamic investment firms may engage the services of Sharī‘ah
consultancy firms or independent scholars to review their investment portfolios and issue
relevant rulings and recommendations to guide both investors and fund managers.

5 Risk management in Islamic investment funds is as important as in conventional funds. Prudent

practices are adopted to manage the funds effectively through the use of risk- reward profiles
and liquidity risk management.

Practice Questions

1. What are the main features of Islamic wealth management?

Muslims believe that wealth generally belongs to Allah and that man can only acquire it through
reasonable and legitimate efforts to earn income or by inheritance. Transactions that are in accordance
with the Sharī‘ah are commonly referred to as legitimate investments/transactions. Clear injunctions in
the Qur’an which encourage Muslims and people generally to earn money or wealth through legitimate
means, invest it and spend part of it on permissible things that are Sharī‘ah-compliant have been
instilled in Muslim communities over the last several centuries. Since Islam is considered a means to an
end (the end of one’s life not being the end), mankind is required to manage both communal and
individual wealth in line with sustainable means that cater for the interests of the current generation
and do not jeopardize that of future generations.
To ensure total compliance with the principles of the Sharī‘ah in Islamic asset and fund management,
the foregoing fundamentals of Islamic investing are fundamental to Sharī‘ah fund management and
corporate governance.

Today, often times, people called fund managers manage investment funds on behalf of investors. These
people along with Islamic asset management firms, must be professional in the discharge of their
responsibilities, and a relationship with beneficiaries should be based on trust. All Islamic investment
management procedures correspond with the values of socially responsible investment based on ethical
dealings and give confidence to Islamic investors that their money is being invested according to their
belief and value system.

2. Distinguish between Islamic wealth management and conventional funds management.

Though Islamic wealth management and conventional fund management are very similar, the two are
differentiated by a fundamental difference. Due to restrictions placed on Islamic investors, namely
Islamic banking and finance’s prohibition of riba (interest), gharar (speculation), etc. Islamic wealth
management entails fund managers to make sure that all investments and actions comply with Islamic
principles, such as those mentioned above, to ensure absolute Sharī‘ah-compliance in investing. The
individuals involved with Islamic wealth management must remain cognizant of the various
considerations present in Islamic law when making decisions regarding all stages of Islamic wealth
management. From screening and selecting stocks to purifying the funds for Islamic portfolios, fund
managers face additional obstacles, besides those present in the day to day operations of conventional
funds management (risk assessment, profitability, etc.).

3. As an expert in Islamic funds management, explain the criteria for the selection of Islamic stocks for
investing to an Islamic fund manager.

There is a systematic investment process that may be followed to ensure that Sharī‘ah guidelines are
properly followed. The first stage is the sector screen process, where the underlying business activity
company will be evaluated and certified to be compatible with Sharī‘ah restrictions (investment
activities involving interest, excessive risk, which is different from the usual commercial risk, speculation,
or uncertainty). Next comes the financial screen, which involves analyzing the nature of a company’s
Sharī‘ah non-compliant financial behavior. Sharī‘ah scholars generally require that the firms under
investment should operate according to Islamic financial norms, being devoid of any prohibited financial
practice or revenue stream (alcohol, tobacco, defense, etc.). After this, Sharī‘ah-compliant transactions
and instruments, including but not limited to Musharakah, Mudarabah, Murabahah, and Ijarah. The
implication of purification for Islamic funds, the last stage of the Islamic investment process, is that if the
fund observes some part of its income is doubtful, then those earnings should be foregone and given to
charity.
4. How will you address the issue of non-compliant stocks in a secondary market?

The secondary market for conventional securities may pose a serious challenge to the large number of
prospective investors, particularly those in the Gulf region and South-East Asia, because of the
speculative nature of many products on the market, most notably derivatives-based products, futures,
and options that involve excessive risks. Currently there are a range of Sharī‘ah compliant bonds or
stocks that can be invested in the secondary market and which attract some form of revenue. However,
there are not many. I would address the issue by seeking to increase the number of investable funds and
securities that are compliant. One way to incentivize management firms to do so is to help increase the
demand for such financial products. In the wake of the financial crisis of 2009, Islamic finance has
already witnessed an increase in acknowledgement. With the implementation of training programs and
educational initiatives that inform potential investors, both Islamic and conventional, of the merits of
Islamic finance, especially following financial troubles brought on by many of the things that are
prohibited in Islamic finance (excessive risk and speculation), I believe the demand for compliant
products will rise (as will the supply of compliant products designed by IFIs and conventional
institutions). In addition to better marketing for Islamic products, continued innovation with regards to
the design of Islamic financial structures and mechanisms based on products traditionally found on the
conventional secondary market (that are inherently higher risk, i.e. hedge funds, derivatives, etc.)

5. As an Islamic funds manager, what steps would you take to establish Islamic investment portfolios
that would be acceptable to a large population of Islamic investors in a Muslim country?

Note: answer to question three. Additionally, besides selecting the appropriate and compliant financial
products to utilize within the portfolios, it is important to assess the profitability and risk in the design of
a successful investment portfolio, which should be diverse in nature.

6. Describe the classification of Islamic investment funds.

There are four major Islamic investment funds commonly used by Islamic funds managers. They are
Islamic debt funds, Islamic equity funds, alternative Islamic investments and special Sharī‘ah-compliant
asset classes. Islamic debt funds are created through investing the capital of the mudarabah-based or
musharakah-based funds in fixed-income yielding operations (which may include murabahah and ijarah)
that involve some sort of debt as well as a fixed income for the financial intermediary). Preferred within
the Islamic banking and finance community, Islamic equity funds are selected through a proper
screening process to ensure that all their investments comply with Sharī‘ah requirements. The structure
of an Islamic equity fund may be based on either a mudarabah or musharakah contract.

There are also three forms of funds under the alternative investment heading as commonly practiced in
the Islamic finance industry. Sharī‘ah compliance, (as with all compliant investment funds) is required in
Sharī‘ah-compliant private equity funds, which are comprised, like their conventional counterparts, are
not publicly traded on a stock exchange. These kinds of funds often engage in non-exchange traded or
illiquid investment strategies aimed at holding their equity position in a growth company for a relatively
long period of time. Like private equity, venture capital, compliant or conventional, is not exchange-
traded but engages in long-term investment positions in firms at different stages, such as start-ups or
distressed firms in the middle of business cycles. Islamic REITs, companies that own and operate
income-yielding real estate or items that relate to real estate and are Sharī‘ah compliant, are patterned
after the ijarah contractual framework and its variations. This is different from conventional REITs,
which depend wholly on debt contracts.

Lastly, conventional portfolios may be restructured by purging the non-Islamic element in the contracts
and streamlining them, based on the Islamic financial instruments. Three special asset classes have been
identified (Islamic hedge funds, funds of funds, and mixed funds). Hedge funds are alternative
investment vehicles designed for a limited number of investors and targeted at maximizing returns
through different advanced investment strategies (that in the case of Islamic hedge funds are structured
in a Sharī‘ah compliant manner). Conventional funds of funds work like a mutual fund investing in
another mutual fund. Islamic funds of funds work similarly, differing only in the fact that all funds must
be compliant with Islamic law. A mixed fund may invest in a pool of different assets, which funds of
funds, must all be Sharī‘ah compliant.

7. What is the significance of Sharī‘ah governance for Islamic investment funds?

The Sharī‘ah governance framework will constantly ensure Sharī‘ah compliance in all the processes,
procedures, services, contracts, and investment activities of the firm. This is significant because it allows
Islamic investors to find confidence in the comprehensive nature of the Islamic investment process, and
most significantly, be assured that their investments comply with the Sharī‘ah. Sharī‘ah corporate
governance is carried out by the establishment of Sharī‘ah boards and other entities entrusted to
oversee, evaluate, and make suggestions as to the compliance levels during all stages of the investment
process.

8. What role should the Sharī‘ah supervisory boards play in ensuring Sharī‘ah compliance of Islamic
investment funds?

The Sharī‘ah supervisory board’s responsibilities entail the constant monitoring of the business
operations of the Islamic fund. They do so by monitoring the fund’s compliance with the Sharī‘ah,
overseeing the fund’s portfolio purification, reporting on the fund’s compliance status, assisting the
fund’s management, and advising on zakat and identifying the procedures for its distribution.

Ideally, Sharī‘ah board members should possess a combination of strong academic and professional
backgrounds in Islamic jurisprudence. Sharī‘ah supervisory boards should remain independent from
management influence. Fund managers however, should report to the supervisory board if a stock
becomes non-compliant for an extended period of time. When a stock falls short of compliance
benchmarks of Sharī‘ah approvals permanently, the Sharī‘ah board may ask the fund manager to divest
from such stocks. Also, Islamic funds may set aside a portion of profits for zakat, and their Sharī‘ah
supervisory boards may identify the recipients of such funds.
9. As an Islamic finance expert, what kind of risk management strategies would you propose for
Islamic funds?

Besides utilizing the two main types of risk management strategies employed by conventional fund
managers (portfolio diversification and portfolio protection), I would continue to attempt to facilitate
the design of new Islamic products as an indirect form of risk management. I would do so through an
amalgam of marketing, incentivization, and joint venture techniques. Islamic fund managers need to
diversify their portfolios within a limited range of Sharī‘ah- compliant asset classes, so by expanding
these asset classes, such diversification will be less difficult. Additionally, as the Islamic market has
relatively lower depth in terms of trading activity and lower breadth in terms of the number of asset
classes traded, the market may be more volatile compared to the conventional markets. The addition of
more Islamic products into the marketplace will help alleviate this problem.

10. Explain the dynamics of liquidity funds management of the Islamic fund markets.

The Islamic funds market is more liquid than its conventional counterpart. While a surplus of liquidity in
the Islamic funds market allows funds to be channelled to other investments, there is a low return rate
on liquid assets managed by Islamic financial institutions. One important liquidity issue is the investment
exit strategy because there is no secondary market in the conventional sense. As such, Islamic fund
managers may have to depend on the sponsor principal, nominated liquidity agent, or other asset
management company to exit an investment.

As most investors prefer investment in more liquid asset classes, fund managers must also be prepared
for higher cash outflow possibilities during falling markets when individual investors may wish to
liquidate their position ( in such cases, they are likely to liquidate their investment portfolios at a lower
price and risk losing the net asset value of the fund). Fund managers may enter agreements with other
financial institutions or liquidity providers during times of liquidity crunches. However, initially, fund
managers may leave some of the short-term cash balances in interest-free current accounts.

Activities

1. Using whatever research tool is within your reach, prepare a short note on the history of the Dow
Jones Islamic Market Index and explain its significance in the global Islamic finance industry.

On the Dow Jones website, students will find several documents pertaining to the methodology of the
DJIM indices as well as other fact sheets concerning specific aspects of the indices for certain markets. In
their notes, students should discuss the uniqueness of the Islamic indices development process as
compared to both conventional indices and other Islamic indices. They should also describe key points of
the methodology used to create the index in depth. Finally, they should make sure to elaborate on the
importance of the indices, particularly the how they allow investors to track the performance of Sharī‘ah
compliant stocks (subsequently allowing for greater confidence in investing in the Islamic investable
universe).

2. Prepare a short note on five major Islamic mutual funds.

It is clear that there are numerous ways in which students can complete this question correctly. Due to the
fact that Ch. 6 focuses on Islamic fund and asset management, students should discuss specifically what it
is about the mutual funds’ management allows them to deem their mutual funds to be Islamic. Though
the chapter details the answer to this question, students may find idiosyncrasies while reading through
relevant literature from the respective mutual funds’ websites. They should not go into too much depth
about each fund, but should include points about the respective funds’ investment diversity, Sharī‘ah
compliance and governance, and history.

3. In the distribution and investment strategies for Islamic investment funds, there may be a need to
enter into a joint venture with a conventional financial institution. Prepare a ten-minute presentation
on the joint venture between the American Express Bank (AMEX) and Faisal Finance, which led to the
Islamic Multi-Investment Funds.

To complete this activity, students should discuss the origins, outcomes, and details (Sharī‘ah board
members, sector restrictions of the mutual fund, if any, etc.) of the joint venture agreement. Their
presentations should discuss the benefits of having such an agreement as well as the Sharī‘ah
considerations relevant to it. Essentially, students should show a firm understanding of the development
of Islamic multi-investment funds, and how partnerships like the one they are discussing in their
presentations are necessary for sustained and comprehensive growth within the Islamic banking and
finance sector,

Margin Challenges

1. Apart from the prominent stock exchanges listed in this chapter, list three more stock exchanges
where Sharī‘ah-compliant products are traded.

There are products that are Sharī‘ah-compliant being traded on stock exchanges around the world,
especially those located in Muslim majority countries. The students’ answers to this question will likely
vary, but for the most part, any larger exchanges or smaller exchanges located in Muslim majority
regions will be sufficient to correctly answer the question. There are many exchanges that would be
sufficient to answer the question. Examples of stock exchanges where compliant products are traded
include: the Islamabad Stock Exchange (ISE), the Indonesia Stock Exchange, the Egypt Exchange (EGX),
the Irish Stock Exchange (ISE), etc.

2. Why must products and stocks being offered by Sharī‘ah-compliant firms go through the Sharī‘ah
screen?
Products and stocks being offered by Sharī‘ah-compliant firms must go through the Sharī‘ah screening
process to ensure compliance. The complexity of the compliance screening is such that prohibited
elements will be excluded in all business activities. The screening process is multilayered. In addition to
an industry screen and financial screen of equities (which screen companies for interest-bearing cash
and short-term investments, interest bearing debt, and liquid asset requirements), equities must be
screened from a sector perspective. Investments are only considered to be compliant (usually) if the
total sum of a company’s non-permissible income (income from alcoholic beverages, cinema, pork,
tobacco, etc.) is under 5%. If Sharī‘ah -compliant firms offer mutual funds for example, screening their
investments (especially since they will not always be the originator of all of the investment products in
their fund) for non-permissible elements is crucial. Simply put, the activities of Sharī‘ah-compliant firms
must undergo a screening process not so much to identity non-compliant elements originating within
such firms but those originating within the conventional firms that compliant-firms sometimes do
business with.

3. Identify the Sharī‘ah supervisory board of an Islamic fund management firm and list its members.

As stated in the question, students should pick a Sharī‘ah supervisory board, list its members, and give a
brief biographical summary of each member. This information will typically be easily accessible either
within the Islamic fund management firm’s website or the firm’s published documents.