ISLAMIC INVESTMENT FUNDS

A GENERAL INTRODUCTION

Abu Dhabi
April 2015
Agenda

 Role of Investment Funds

 Types of Investment Funds

 Key Principles of Islamic Investment Funds

 Islamic Fixed Income Funds

 Islamic Equity Funds

 Screening methodologies
 Purification approaches

 Islamic Real Estate Investment Funds

Benefits of Collective Investment Funds

 Alternative savings

 Economies of scale

 Diversification

 Liquidity

 Professionalism
Types of Investment Funds

By investor’s cash-flow profile:

Closed-ended funds
Open-ended funds
Interval funds
Defined maturity funds
Exchange Traded Funds (ETFs)

By assets:
Equity funds
Money-market, fixed-income funds
Balanced funds
Real Estate Investment Funds/Trusts (REIFs/REITs)

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Types of Investment Funds (cont’d)

By style of management :
Active management funds
Index funds (passive)

Special fund:
Private Equity/Venture Capital Funds

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Assets of Islamic Investment Funds

 Islamic Money Market Funds

 Money market sukuk (short-term)
 Deposits in Islamic banks

 Islamic Fixed Income Funds

 Sukuk

 Islamic Equity Funds

 Sharia-compliant equities

 Islamic Real Estate Funds (REITs)

 Sharia-compliant real estate investments

 Cash and liquidity must always be placed in Sharia-compliant manner (in Islamic banks, money
market sukuk, or in conventional banks but without interest)

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Key Principles of Islamic Investment Funds

 Established to invest only in Shariah-compliant securities  stipulated in fund

prospectus or investment contract

 Consistently invest and operate in Sharia-compliant manner  regular

certification for compliance is required
 No repo; no short selling; no derivatives; no borrowing

 Sharia compliance officer and Sharia Advisor

 Established approach to ‘purify’ itself from possible non-Sharia compliant

investment

 Other principles for best practices for investment funds apply: e.g.
professionalism/competence, management of conflict of interest, segregation of
clients assets etc.

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Typical Structure of Investment Funds

Sharia Advisor Investors

Fund Manager Investment

(Wakeel) Fund
Custodian
Investments
(Securities)

Wakala structure

The fund may take form as a Trust, Collective Investment Contract, or Company
(Special Purpose Entity)

Custodian needs not be Islamic bank, but conduct upon assets must be within
Sharia (e.g. no interest on cash; no repo on securities)

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Money Market and Fixed Income Funds

 Invest only in eligible fixed income instruments: sukuk , money market sukuk, deposits in
Islamic banks

 Main challenge for Islamic money market and fixed-income funds:

 Availability of instruments
 Diversity of instruments/issuers
 Liquidity of instruments, thus liquidity of the funds

 Thus, development should starts with government sukuk

 Making instruments available at different maturities
 Regularity of issues ensure supply
 Creating benchmark for private securities

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Islamic Equity Index

 List of eligible equities (members of an Islamic equity index) is fundamental in Islamic equity
funds

 Prepared by the Exchange or other index providers; approved by a Sharia Advisory Board

 Screening methodology
 Core Business: must not be prohibited activities
 Prohibited businesses:
o Conventional financial services (based on riba )
o Conventional insurance
o Gambling and gaming
o Manufacture or sale of tobacco products
o Production or sale of non-halal products (e.g. pork, liquor)
o Non-permissible entertainment businesses
o Weapon production and distribution
o Others non-permissible activities (including businesses that invest in or deal with non
Sharia-compliant investments)
 Could be expanded and combined with other Social Responsibility features (e.g.
environment, child protection)

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Islamic Equity Index (cont’d)

 Screening methodology (cont’d)

 Non-core, ancillary, and other businesses may include activities that are common
part of business (e.g. hotel selling liquor), unavoidable activities (managing cash in
banks with interest), or even those strictly non-Sharia permissible, as long as they
are small.

 Quantitative assessment of business:

 Single-limit approach (e.g. MSCI, DJI): for all non-permissible activities  no
more than 5% of total business
 Multiple-benchmark approach:
o Strictly prohibited business (e.g. banks): 5%
o Rental from non-compliant activities; hotel operations; stockbroking: 20%
 Calculations based on (i) revenue; (ii) pre-tax profit.

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Islamic Equity Index (cont’d)

 Screening methodology (cont’d)

 Financial Screening:
 Leverage: the use of debt to finance the company
 Liquidity: interest-generating assets (cash, securities)
 Calculations based on (i) assets; (ii) enterprise value.

 Monitoring
 Regular monitoring based on availability of information (annually, semi-annually,
quarterly)
 Screening done not limited to the existing index members, but the whole universe
(screen-in and screen-out)
 Rebalancing of index

 Information; disclosures
 Methodology must be transparent
 Immediate announcement of screening results
 Dividend information, for cleansing/purification purposes

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Islamic Equity Index – Screening Approach

Market Universe
Screening out companies with
non-permissible core
businesses

Eligible List - Core

Screening out companies with non-
permissible activities within the
business mix
Eligible List

Financial screening of eligible companies:

-Financing composition (leverage)
-Financial asset composition
Approved List
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Purification/Cleansing Approaches

 Key principle: income received from the non-permissible portion of investment must be
purified

 Purification at the Index level

 A portion of dividend representing non-permissible income should be deducted from

the index’s return. E.g. from liquor sales of a supermarket; insurance business of a
holding company
 Dividend to be deducted (purified) =

Dividend x (Non-Permissible Revenue or Earnings* / Total Revenue or Earnings)

•Include interest income

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Purification/Cleansing Approaches (cont’d)

 Purification at the Fund level

 For all funds: The portion of dividend coming from non-permissible activities should
be given out for charitable purposes (clearly defined in prospectus)
o Use same calculation as a above

 Funds with active management: additional purification resulting from gain on sale of
equities that are subsequently considered as non-compliant
 Key principle: If an equity drops from the compliant list, the funds cannot
continue to hold it – thus: sell.
a) If price > cost, and the sale is conducted immediately after announcement (on
the same or immediate trading day), capital gain may be kept
b) If price > cost on the announcement date or immediate trading day, and the sale
is conducted after a period of lapse, only a portion of capital gain up to the
announcement date/immediate trading day may be kept. Any gain left should be
given out
c) If price < cost on the announcement date/immediate trading day, sale may be
postponed until equity price (+ any dividend paid) equal the cost.

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Purification/Cleansing Approaches (cont’d)

Example:
After a period of lapse
At the time of
announcement on
non-compliance
At the time
of purchase

Notes:
• The fund cannot buy to reduce the average cost
• Common question: how long can the fund wait until it has to
sell?

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Purification/Cleansing Approaches (cont’d)

 Purification at the Fund level (cont’d)

 The fund cannot buy equities not listed in the compliant list:
 Any purchase in this nature is considered non-compliant, and thus subject to
sanction (on the fund manager, not the fund)
 Still need a remedy:
• Must be sold immediately if cost is recoverable. Any gain (+dividend) should be
given out
• If cost is not yet recoverable, sales may be postponed within a certain period
(e.g. 1 month)

 Index (passive) funds do not have purification other than for dividends (like
purification for the Index)

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Islamic Real Estate Investment Funds

 Real estate is usually a debt-heavy investment

 Financing real estate construction using equity is extremely expensive
 Unless financing via sukuk, real estate equity investment is usually non Sharia-
compliant

 Conventional REIT/REIF
 Originally established to:
 Mobilize savings (institutional and individual) for development
 Provide steady, long-term income from investment
 Exposure to improved property value
 Characteristics:
 Assets mostly (70%-90%) in income generating property
 Most income (>70%) after operations is distributed through dividends
 Eligible for tax breaks (corporate income tax, dividend tax, and others)
 Certificate (shares) tradable on stock exchanges

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Islamic Real Estate Investment Funds (cont’d)

Sharia Advisor Investors

Trustee
Management
Investment
Company
Fund (listed)
(Mudharib)

Property
Real Estate
Manager

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Islamic Real Estate Investment Funds – Key Issues

 Property development and its financing

 Fully operating property should be financed by equity. Debts can be refinanced by
equity more cheaply – REIF can be issued for that purpose
 If Islamic REIF assets include property under construction, financing should be
Sharia-compliant. Regulation should set limit on % of property under construction

 Use of real estate and tenancy

 Should be mainly for Sharia-permissible businesses. Tenancy for non-permissible
businesses must be limited
 Limits can be differentiated based on:
 Existing tenants vs. new tenants (e.g. 20% and 100% permissible, respectively)
 Tenancy of newly acquired property (e.g. at least 80% permissible)
 Sub-tenancy (?)

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Islamic Real Estate Investment Funds – Key Issues
(cont’d)

 Purification

 Cash management

 Insurance

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Closing Points

 Islamic investment funds – important part of the Islamic finance ecosystem

 Business foundations for Islamic investment funds:

 Availability of investible assets
 Presence of asset management business and its supportive enabling
environment

 Government initiative in developing sukuk market is needed for Islamic funds

(especially fixed-income funds)

 Different methodologies and approaches exist; policies should strike a balance

between international acceptance and local context

 Some opportunities may exist today; but there are detailed works to do.

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 Annex
Comparison in Islamic Equity Index
Methodologies

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Islamic Equity Index – Business Screening

Guideline/Index Limit
SC Malaysia 5% limit for strictly non- 20% limit for hotel/resort
permissible businesses operations; stockbroking;
(conventional banking; rental received from non-
conventional insurance; permissible activities
gambling; liquor; pork; non-
permissible entertainment;
interest income; tobacco)

Dow Jones/S&P 5% limit for non-permissible business

(based on revenues)

MSCI 5% limit for non-permissible business

(based on revenues)
FTSE 5% limit for non-permissible business including interest income
(based on revenues);
5% purification recommended

General guidelines; exception applies

Islamic Equity Index – Financial Screening

Guideline/Index Limit
SC Malaysia <33% for total cash & equivalents over total
assets (excl. cash/instruments placed in
Islamic accounts)
Dow Jones/S&P • <33% for total cash and interest-bearing
securities divided by trailing 24-month
average market capitalization
• <33% for total accounts receivables
divided by trailing 24-month average
market capitalization
MSCI • 33.33% limit for total cash and interest‐
bearing securities (excl. Islamic
instruments) over total assets
• 33% limit for total accounts receivables
and cash over total assets
<33% for total interest
bearing debt (excl. Islamic
instruments) to total assets
<33% for total debt divided
by trailing 24-month
average market
capitalization
33.33% limit for total debt
(excl. Islamic instruments)
over total assets

FTSE • <33.333% for cash and interest bearing <33.333% for total debt over
items over total assets total assets
• <50% for total accounts receivable and
cash over total assets

General guidelines; exception applies

 Thank You
Ketut A. Kusuma; kkusuma@ifc.org; +1-202-458-4987