Shariah-compliant Stocks:

- Fundamentals
- Screening Methodologies
- Pricing

Dr Buerhan Saiti
- Stock Indices

Acknowledge Dr Nazrol Mustafa Kamil

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 Modern Corporations
• OIC Academy has approved share companies and by that, has
accepted two Western legal concepts – artificial/legal
personality and limited liability

– Problem with limited liability shield

• Basic Islamic moral principle – that obligations are
irreducible and indestructible without agreed release or
forgiveness from creditor
• Bankruptcy does not extinguish but only suspends claims

– Rationale for approval

• Parties dealing with such companies are aware of their
limited capacity for liability, and presumably consent to
that character
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© INCEIF 2015
 Secondary Market Trading
• Tradability of shares in secondary markets is crucial, otherwise
liquidity concerns will severely limit the attractiveness of shares

• Classical Islamic law, while encourages trading and markets in all

tangible goods, restrains the trading of financial interests

• Given the fungibility and liquidity of shares, would it be construed as a

ribawi item?

• Two approaches have been proposed to address this concern

– Shares as reflecting partnership interest
– Shares as ownership of the enterprise

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 Shares as Partnership Interest
• Relationship between shareholders can be construed as a musharakah
arrangement

• Relationship between shareholders collectively and company management

(board of directors) can be that of rabbal mal and mudarib (mudarabah
arrangement), respectively or wakalah (agency with fee)

• Classical law holds that partnership must be terminated and liquidated upon
withdrawal of a partner
• How to effect sale of shares in the secondary market?
• Rationale for partnership termination requirement is to determine
partners’ equitable share in the partnership
• Modern accounting procedures and techniques can satisfy this
condition
• Partners’ consent to new partners can be obtained in advance
• New shareholder is new party to the musharakah contract
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 Shares as Partnership Interest
• Profit / loss distribution (for e.g. dividends paid) are
made by nominal (par) value
– This seems to contradict the legal maxim that
distribution of loss must be by capital contribution
(actual)

– However, in practice such distribution is done by

nominal value, justified on the basis of:
• Istihsan – avoidance of hardship in calculation
and determination of actual cost to each
shareholder
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 Shares as Ownership of Enterprise

• Shareholding can be interpreted as ownership of the

enterprise which in turn is equated to undivided co-
ownership of the company’s assets

• As such, co-owners (shareholders) can sell their

interests to third parties without the permission of
other co-owners

• Concept of sharikah milkiyyah (partnership in

ownership)
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 Shares as Ownership of Enterprise
• Underlying assumption - that shares represent ownership of tangible goods
and property that are freely tradable (allowed by the Shari’ah)
– New business, majority of funds in cash yet to be invested
– Company divests significant portion of business for strategic reasons,
transition period, new business venture yet to be identified
– A significant portion of company’s assets in the form of accounts
receivable
– Company whose value is reflected in intangible assets (intellectual
property, good will, future income streams)
• Consider dot-com companies, pharmaceutical or bio-medical
research companies
• OIC Academy fatwa
– As long as the assets represented by the share are in greater part (al-
ghalib) by value real assets (a’yan wa-manafi’) as opposed to cash or
obligations (dayn), then trading is permissible
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Shari’ah Benchmark for Listed Shares
• Primary Activities Criteria
1. Conventional finance (riba)
2. Gambling/gaming (maysir)
3. Prohibited goods & services
– Pork, alcohol, prostitution
4. Conventional insurance (gharar)
5. Entertainment deemed non-permissible
6. Tobacco manufacturing or sale
7. Stock-broking or share trading in non-Shari’ah
approved securities
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Shari'ah Stock Screening

• Currently there is no international Shari'ah standard for stock

screening

• Different funds or fund managers utilize different standards

based on their Shari'ah council

• In Malaysia we have the list issued by Securities Commission

and recently by Dow Jones-RHB Islamic Malaysia Index

• At the international level we have the Dow Jones Islamic

Market Indexes and FTSE Global Islamic Index Series

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Shari'ah Stock Screening
• Rules to ensure that ordinary shares are Shari'ah compliant

• The stock screening process can be divided into two stages:

– 1. Evaluation in terms of company activities, products and industry
– 2. Computation of a set of financial ratios & compare them against specified
benchmarks

• The screening process begins by screening the co. in terms of its

activity, products and industry – alcohol, tobacco, pork-related
products, conventional financial services, weapon and defense,
entertainment (hotels, casinos/gambling, cinema, pornography,
music, etc.) are excluded

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 Business/Sector Screening – excluded industries
Dow Jones Meezan, Pakistan SC, Malaysia
Conventional finance and Conventional finance and Conventional finance and
insurance insurance insurance
Gambling and gaming Gambling and gaming Gambling and gaming
Alcohol production and Alcohol production and Alcohol production and
sale sale sale
Pork related products Pork related products Pork and non-halal food
Tobacco manufacturing Tobacco manufacturing Tobacco manufacturing
and sale and sale and sale
Entertainment, media and
broadcasting (cinemas, music,
pornography)
Hotels
Weapons and defense
Real estate holding and
development

© INCEIF 2015
 Business/Sector Screening – excluded industries (2)
FTSE Shari’ah Index
Conventional finance and
insurance
Alcohol
Pork related products and
non-halal food production
Tobacco
Weapons, arms & defence
Entertainment (Casinos,
Gambling, Cinema, Music,
Pornography, Hotels)
© INCEIF 2015
S&P Shari’ah Index MSCI Islamic Index
Conventional finance and Conventional finance and
insurance insurance
Alcohol Alcohol
Pork Pork related products
Tobacco Tobacco
Weapons & defence
Gambling, Pornography Gambling, Casinos, Music,
Advertising and media Hotels, Cinema, TV,
except: Cable/Satellite, Adult
• if revenue >65% from GCC entertainment
• News channels
• Newspapers
• Sports channels
Cloning
Trading of gold and silver
as cash on deferred basis
 Business/Sector Screening – “mixed” businesses

Meezan, Pakistan SC, Malaysia

2 criteria: 2 additional criteria:
i. Non-compliant i. Good public perception or image
business cannot ii. Core activities important in line with
exceed 33% of total maslahah while non-permissible activity
assets very small and difficult to avoid or involves
ii. Income from non- rights of non-Muslims
compliant business 5% Benchmark *
cannot exceed 5% of Conventional banking & insurance, gambling,
gross revenue alcohol, pork, non-compliant entertainment,
interest income, tobacco
20% Benchmark *
Hotels, share trading & stock broking, non-
compliant rental

* The benchmarks are applied to both revenue and

profit before tax

© INCEIF 2015
Mew Methodology

© INCEIF 2015 14
 Business/Sector Screening – “mixed” businesses (2)

FTSE Shari’ah Index S&P Shari’ah Index Dow Jones &

MSCI Islamic Index

Total interest + non- Non-permissible None

compliant income < income other than
5% of total revenue interest < 5% of total
revenue

© INCEIF 2015
 Business/Sector Screening – Discussion
• Note : Index providers do not provide details of rationale for screening
criteria
– Thus, they can only be implied or presumed
Excluded sector Probable reason for exclusion
Media and broadcasting May include material with nudity or obscene
images
Hotels Serve alcoholic beverages and non-halal food
Weapons and defense Use of weapons prejudicial to Muslim interests
Real estate holding & development High levels of leverage

• Should airlines be excluded?

• Air (and sea) transportation also serve alcohol (they are
also typically highly leveraged)
• In the case of Malaysia, interestingly, Malaysia Airlines was
previously not Shari’ah compliant while Air Asia is
• Reason? Complimentary vs. purchase, or, negative
perception of free-flow alcohol? What changed?

© INCEIF 2015
 Business/Sector Screening – Discussion (2)

• Should there be an allowance for “mixed” businesses?

• In the case where there is no such tolerance, some have
suggested a secondary list where an excluded firm may
prove Shari’ah compliance, subject to periodic audit or
certification
• One consideration to possibly justify a more “liberal” approach
– equity markets in Malaysia and Pakistan are substantially
smaller than in the US
– Applying too stringent a criteria would shrink the universe
of investable stocks
• Could culminate in lesser diversification and a sub-
optimal portfolio (within a risk-return framework)

© INCEIF 2015
 Debt Financing Screening
Dow Jones
Short Term + Long Term Debt
≤ 33%
Trailing 24 month Average Market Capitaliza tion
Meezan,
Pakistan Total interest bearing debt
≤ 45%
Total assets
SC Malaysia
Interest Bearing Debt
≤ 33%
Total assets
FTSE
Shari’ah Debt
Index ≤ 33%
Total assets
S&P Shari’ah
Index Debt
≤ 33%
Trailing 36 month Average Market Capitaliza tion
MSCI Islamic
Index Debt
≤ 33%
Total assets
© INCEIF 2015
 Debt Financing Screening – Discussion
• Some have criticized use of market capitalization as denominator
– In bear markets, market capitalization typically falls while debt
remains constant or rises
• Prolonged bear markets may force compulsory exit by Muslim investors
and funds, thus exerting further downward pressure on price
• Using a trailing 24-month average market cap can delay exclusion but a
stock market down cycle can persist
• Disinvestment by Islamic funds during a slump may worsen companies’
economic woes
• Islamic equity fund performance may be negatively affected as selling
shares when prices are falling may not be the best strategy
– Conversely, in a bull market, debt-laden companies are included by
virtue of high stock valuations
– As a whole, it may be unjust to include or exclude companies on the
basis of stock market cycles or external market forces, which are
beyond the control of the companies individually
– Perhaps there is a need to develop a ratio that neutralizes effects of
temporary market fluctuations
• Dow Jones’ amendment to the ratio (moving to 24-month trailing average
from 12-month) represents such a view
© INCEIF 2015
 Effect of bull/bear markets on market cap-based financial ratios

Criteria for Shari’ah Compliance Effect when market

Financial [Dow Jones, S&P]
Ratio is bullish | bearish

Interest - based Debt Must be less

than 33%
Market Capitaliza tion

Interest - bearing assets Must be less

than 33%
Market Capitaliza tion

Cash and accounts receivable Must be less

than 33% or
Market Capitaliza tion 49%

© INCEIF 2015
 Debt Financing Screening – Discussion (2)
• Note that in Malaysia Shari’ah compliant debt financing is
excluded from the ratio computation
• Rationale: To promote Shari’ah compliant financing?
• At present financial reporting standards do not differentiate
Shari’ah compliant and non-Shari’ah compliant debt
– Perhaps why many other Shari’ah jurisdictions include
all debt
• What is the objective of the debt financing screening ratio?
– If to exclude over-leveraged firms
• Need to also consider operating leverage (variation
in profitability attributable to changes in business
conditions) in relation to financial leverage (amount
of debt undertaken) in ascertaining overall level of
optimal leverage

© INCEIF 2015
 Interest Earnings Screening

Dow Jones
Cash + Interest Based Securities
≤ 33%
Trailing 24 month Average Market Capitalization

Meezan, Indirectly from “mixed” business ratios

Pakistan
Non - compliant assets
≤ 33%
Total assets
Non - compliant income
≤ 5%
Gross revenue
SC Malaysia Indirectly from “mixed” business ratio
Interest income
≤ 5%
Total revenue

© INCEIF 2015
 Interest Earnings Screening (2)

FTSE
Shari’ah
Index Cash + interest bearing items
≤ 33%
Total assets
S&P Shari’ah
Index
Cash + interest bearing securities
≤ 33%
Trailing 36 month Average Market Capitaliza tion

MSCI Islamic
Index
Cash + interest bearing securities
≤ 33%
Total assets

© INCEIF 2015
 Interest Earnings Screening – Discussion

• Some have opined that investments in interest-

bearing instruments are “voluntary” and non-
critical or “incidental” when compared to the firm’s
core business
– Thus, the permitted quantum should be
minimal
• However, in some instances, investments in
interest-bearing instruments may not be that
superfluous vis-à-vis a firm’s core business
– For example, hypermarket Carre Four – how
does one treat such a business model?

© INCEIF 2015
 Cash and Receivables Screening
Dow Jones
Total Accounts Receivable
≤ 33%
Trailing 24 month Average Market Capitaliza tion

Meezan,
Pakistan Total illiquid assets
≥ 10%
Total assets
SC Malaysia
Cash
≤ 33%
Total assets

FTSE Shari’ah
Index Cash + accounts receivable
≤ 50%
Total assets

S&P Shari’ah
Index Accounts receivable
≤ 49%
Trailing 36 month Average Market Capitaliza tion

MSCI Islamic
Index Cash + accounts receivable
≤ 33%
© INCEIF 2015
Total assets
 Cash and Receivables Screening – Discussion

• Rationale for receivables screening – Shari’ah stipulation that cash and

debt must be traded at par – otherwise, tantamount to riba
• Some argue that this screen is misconceived and invalid
– Using level of cash and receivables to judge Shari’ah compliance is
flawed and irrelevant
– Shares represent undivided co-ownership of an enterprise
– When a shareholder sells his shares, he is selling his share of that
enterprise, not individual firm assets (which may be liquid in
nature)
– Key perspective – one should not unbundle a firm’s assets and think
of shares as representing divided co-ownership of those assets
– Share prices reflect the value of a firm as a going concern, with
capacity and potential to create value from the putting together of
economic factors of production (capital, resources, labour,
entrepreneurial skills)
• It is the case of synergy – potential outcome of combination of
assets is greater than the sum of the parts

© INCEIF 2015
 Cash and Receivables Screening – Discussion (2)
• One view – as long as the firm is still a going concern, share trading at
any price should be allowed, regardless of liquidity of firm assets
– Even in the extreme example that a firm’s assets are 100% in the
form of liquid assets, an individual shareholder cannot trade his
shares with the firm’s receivable (debt)
– Exception – the case of a takeover where a shareholder acquires all
(or majority) shares of the firm and culminating in liquidation or
asset stripping
• Instances of non-compliance to the receivables ratio due to market
conditions or nature of business
– Prudent management of investment companies may prescribe
holding more liquidity in volatile or uncertain market conditions,
especially when equity prices are falling
– Competitive market forces may necessitate more aggressive credit
sales
• For example, car manufacturers such as Ford, General Motors
and Daimler-Chrysler have effectively become “banks” because
much of their profits are derived from financing vehicle sales
through extended payment terms

© INCEIF 2015
 Dividend/Income Purification
Index / Dividend/income purification norm
Authority
Dow Jones None

Meezan Not available

SC, Malaysia None

FTSE Purification of dividends at 5%, to be paid by investor

S&P Dividends x (Non Permissible Revenue / Total Revenue)

MSCI Proportion of prohibited income to be deducted from dividend

paid
Applies “dividend adjustment factor” to reinvested dividends
AAOIFI AAOIFI Shari’ah Standard 21 [Clause 3/4/6/4]
Divide total prohibited income by number of issued shares of
company
Multiply this with number of shares owned by investor
AAOIFI Shari’ah Standard 21 [3/4/6/1]
Burden of purging on shareholder on last day of financial
year

© INCEIF 2015
 Dividend/Income Purification – Discussion
• Basic idea – some threshold of non-compliant income (esp. interest)
allowed but must be “cleansed” via channeling to charity
• Common practice is,
– Purifying applied to dividend payout, quantum calculated as ratio of
non-compliant income to total income
– Some contend that this represents incomplete purging, appears to be
window dressing to solace the conscience of Shari’ah compliant
investors
• The ideal is,
– Pro rata amount of interest income earned per share during period of
holding, regardless of dividend payment, to be paid upon declaration
of results
• Amount to be paid in gross (pro-rated by percentage of
shareholding) and not multiplied by ratio of non-compliant
income to total income – see AAOIFI Standard
• Not dependent upon magnitude of dividend payment – remove
non-compliant income that goes to retained earnings
• Also, dividend policy varies with firms, some companies never
issue dividends
© INCEIF 2015
 Dividend/Income Purification – Discussion (2)
• Purification should not be applied to realized capital gains
– Movement in share prices attributable to the firm’s core
business, and not marginal income generated by interest
or other minority non-compliant business
– Remote correlation between share price movement and
interest income
• AAOIFI Shari’ah Standard 21 [3/4/6/1]
– Element of unfairness – shares may have exchanged
hands numerous times during a year
– May encourage sell-down just prior to financial year-end,
creating unnecessary and unwarranted volatility
– Suggestion - Pro-rate purging quantum by portion of time
that share is owned
• Other issues
– Deduct (firm manager/fund manager/individual investor)
versus inform, interests of non-Muslim shareholders
– Purification versus screening - Do we need screening?
Can’t we just purify any and all tainted income?

© INCEIF 2015
 Shari’ah Stock Screening – Other Issues

• In some cases, criteria applied introduce element of

subjectivity
– Public perception / image, ‘uruf (custom) and rights of
non-Muslim communities are subjective considerations
• e.g. Malaysia Airlines
• Supermarkets selling cigarettes vs. tobacco
companies, hotels serving alcohol vs. breweries

• Lack of detailed public disclosure on rationale for approval

criteria

• Lack of standardization on some aspects

– Use of financial ratios
– Hotels, cinemas, music, media companies, weapons, etc.
– Dividend purification

© INCEIF 2015
 Shari’ah Stock Screening – Other Issues (2)

• Criteria should not remain static

– Some degree of non-permissible activities is
tolerated on the basis of the need to promote
Shari’ah compliant securities
– This compromise should be viewed as
transitionary
– Efforts should be made to progressively
revise current benchmark standards
– Otherwise, it could lead to erroneous public
perception or understanding that “some
haram activities are permissible” as a general
rule rather than the exception

© INCEIF 2015
 Shari’ah Stock Screening – Other Issues (3)
• Islamic equity funds should incorporate social responsibility and ethical
dimensions into their Shari’ah compliance criteria
– At present, Shari’ah compliance does not necessarily imply
presence of good business ethics
– By contrast, ethical investment funds address aspects of corporate
social responsibility, environmental protection & conservation, and
occupational safety & health in their investment decisions
• Nonetheless Islamic equity funds and ethical funds may share
some common grounds
– Examples of ethical stock market indices and funds
• The Calvert Group, Domini Social Index, Friends Provident
Stewardship Fund, Dow Jones Sustainability Index, Wilderhill
Clean Energy Index, etc.
– Surely the Shari’ah compliance connotation can be extended to
include all that is good and wholesome
• Does the Shari’ah condone the following practices –
environmental pollution, exploitation of developing countries,
avoidable animal testing, deceptive advertising?

© INCEIF 2015
 Shari’ah Stock Screening – Other Issues (4)
• Islamic equity funds should incorporate social responsibility
and ethical dimensions into their Shari’ah compliance criteria
(continued)
– Emphasize on a positive criteria rather than negative
screening by favouring investments in companies that do
“social good”
• For example, supply of basic necessities at reasonable
prices, goods & services that benefit society,
investments in renewable energy sources, philanthropic
businesses, etc.
– Be proactive rather than reactive
• Engage corporations or use financial muscle to
influence positive change in policies (for e.g., using
shareholders’ voting rights)
– Recognize that purely mechanical application of “ethical
criteria” (e.g., board composition, hiring practices) could
result in abuse or manipulation
© INCEIF 2015
 Shari’ah Stock Screening – Other Issues (5)

• Automated screening
– Rely on established industry classification
taxonomies
– May produce unintended outcomes
– E.g. Louis Vuitton
• Substantial revenues come from sale of wines
and spirits
• Investment performance
– Does a smaller investment universe penalize
performance of Islamic portfolios (due to less
portfolio diversification)?

© INCEIF 2015
 Shari’ah Stock Screening – Summary of Key Issues

• Lack of detailed public disclosure of rationale for screening

norms
• Lack of standardization in screening norms
– Arbitrariness or subjectivity in some cases
• Whether “mixed” businesses should be excluded
• Market capitalization versus accounting (book) values
• Should there be a cash and receivables (liquid assets) screen?
• Method of income/dividend purification
• Quantum of tolerance – criteria should not remain static
• Incorporating aspects of ethics and corporate social responsibility
• Unintended repercussions of automated stock screening
• Investment performance of Islamic stocks and portfolios vis-à-vis
conventional

© INCEIF 2015
 What to do with non-compliant stocks?

• [SC Malaysia fatwa] Muslim shareholders are advised to take

the following actions in dealing with stocks that are deemed
non-Shari’ah compliant
– Dispose of non-approved securities within a month of
knowing status
• Any gain should be channeled to charity
– “Approved” → “Non-approved”
• Capital gains up to date of announcement can be kept
• If below original investment cost, allowed to hold,
receive dividends and bonus issues until recover cost
• Original investment cost includes brokerage costs and
other related transaction costs

© INCEIF 2015
Shari’ah compliant securities which are subsequently
considered as Non-Shari’ah compliant

• Action to be taken by the investor/fund manager :

– On the announcement date
• Price of share > original investment cost
– Action: liquidate immediately. Any capital gain can be kept by the investor
• Price of share < original investment cost
– May hold the share until price of share equals to original investment cost
– Liquidate when total dividends received (if any) together with the market
price of the non-approved share equal the original investment cost
– After the announcement date (due to inadvertant mistake)
• Price of share > original investment cost
– Liquidate immediately. Any profit (the difference between original investment
cost and closing price of announcement date) can be kept
– Residual Profit (the difference between disposal price and closing price of
announcement date) to be channelled to charitable bodies

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 • Price of share < original investment cost
– May hold the share until price of share equals to
original investment cost
– Liquidate when total dividends received (if any)
together with the market price of the non-approved
share equal the original investment cost

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© INCEIF 2015
Example –Assuming investor holds the
share and dispose on 20th May 2005
Investment Cost Announcement date Disposal price
(20 January 05) (29 April 05) (20 May 05)

2.50 4.00 5.00

Kept by investor Channelled to charitable bodies

(RM1.50) (RM1.00)
Investment cost = RM2.50/share
Closing price on the announcement date = RM4.00/share
Disposal Price = RM5.00/share
Dividend received on 15 May ‘05 = RM0.50/share
Capital gain at announcement date =RM1.50/share (kept by investor)
Difference between disposal price and and closing price on announcement date = RM
1.00/share (channelled to charitable bodies)
Dividend received can be kept by the investor
Question: What is the right approach if the disposal price on 20 th May 2005 is
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©RM2.00?
INCEIF 2015
 Non-Shari’ah compliant securities which are
advertently/inadvertently bought by
Shari’ah fund
• Must be disposed within a month of knowing the status of the securities
• Any capital gain or dividend received during or after the disposal of the securities has to be channeled to
charitable bodies
• Investor has a right to only obtain the original investment cost

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Purification of Income
• Investor/Unit trust fund receives income from invested
companies in the form of dividend and capital gain. Not
all income are considered “clean”. Some are derived from
non halal sources such as interest income
• Purification of income requires identifying the non halal
portion of income received from invested companies and
deducting it from the total income prior to distribution
• The income net of purification is then distributed to the
investors
• The “tainted” income cannot be distributed to investors
but instead donated to charities

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  It is also possible for the fund to allow discretion to the investor in
deciding the recipient charitable organization
 No consensus among Shari’ah scholars in implementing purification
 No standard available from AAOFFI

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 Issues in Stock Screening

• Criteria introduces element of subjectivity

– Public perception / image, ‘uruf (custom) and rights of non-Muslim
communities are considerations
– e.g. Malaysia Airlines
• Lack of detailed disclosure on specific application of approval criteria
• International standards (Dow Jones, FTSE) stricter
– Also excludes defense/weapon making, film and music
– Use of financial ratios
– Dividends from mixed income must be “cleansed”
• Criteria should not remain static
– Some degree of non-permissible activities is tolerated on the basis of
the need to promote Shari’ah compliant securities
– This compromise should be viewed as transitionary
– Efforts should be made to progressively revise current benchmark
standards
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© INCEIF 2015
 Issues in Stock Screening
• At present, Shari’ah approval does not necessarily imply presence of good business
ethics
– Corporate social responsibility, environmental protection, occupational safety and
health
– Existing ethical stock market indices
• The Calvert Group, Domini Social Index, Dow Jones Sustainability Index,
Wilderhill Clean Energy Index, etc.
– Purely mechanical application of “ethical criteria” (e.g., board composition, hiring
practices) could result in abuse or manipulation
• Case in point, Enron
• To address such a concern, more substantial measures need to be employed
– Proactive index managers and regulators, market transparency and full
disclosure
 Perhaps Shari’ah-based stock indices should incorporate such ethical criteria
• Surely the Shari’ah compliance connotation can be extended to include all that
is good and wholesome

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© INCEIF 2015
Preference Shares

• Malaysian Companies Act 1965 has defined preference share as a share that
does not give a right to the shareholders to vote at its general meeting or
any right to participate in any distribution of the company that has stated
the amount, whether through dividends, redemption, dissolution or
otherwise

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© INCEIF 2015
• The characteristics of a preference share are as follows:
– Predetermined dividend
– Higher entitlement to assets if business is liquidated
– No voting rights

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Preference Shares (cont.)

• OIC Fiqh academy ruled that preference shares are not

permissible
• Syariah Advisory Council of Malaysian Securities Commission
ruled that non-cumulative preference shares are permissible
based on tanazul where the right to profit of the ordinary
shareholder is given willingly to a preference shareholder.

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 Preference Shares
• Hybrid instrument
– General features : Fixed dividend, no voting rights, priority in liquidation
• Rationale:
– Investor : More secure income, less risk in liquidation
– Issuer : Firm feels it is not prudent to assume additional debt, dilute its equity or
share expected profits, redeemability (mandatory offer not required),
restrictions on voting rights given to foreign shareholders
• Non-cumulative preference shares allowed by SAC of SC based on tanazul (to drop
claims to right)
– During general meeting to approve issuance of preference shares, ordinary
shareholders give their agreement
• Dissenting opinion
– That income to shareholder is proportional to company profits – an
unchangeable tenet of Islamic partnership
– Priority in liquidation – violates principle that losses should be borne by partners
in proportion to their capital contribution
• The notion of a hierarchy of capital suppliers is repugnant, not in the spirit of Islamic
partnership
– Higher payout ratio is acceptable but not fixed rate of dividend 49
© INCEIF 2015
 Short Selling
• Sale of a security (e.g. shares) not owned by the investor at the time of sale
• Selling high, buying cheap
• Typical mechanism:
– Mr. A assesses stock A as being overpriced at $20
– Day 0 : Mr. A “borrows” 100 shares of stock X from Mr. B
– Day 0 : Mr. A short-sells 100 shares of stock X to Mr. C at $20
– Day 3 : Price of stock X drops to $15, Mr. A buys 100 shares
– Day 3 : 100 shares of stock X delivered to Mr. A
– Day 3 : Mr. A “returns” 100 shares of stock X to Mr. B
– Mr. A makes profit = Sale proceeds ($2,000) less Cost of purchase ($1,500) less
transaction costs
• Securities Borrowing and Lending (SBL) was introduced by SC at end of 1995 to
regulate short-selling
• SBL was suspended at end of 1997 following economic crisis

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 Short Selling
• Merits
– Makes arbitrage possible, which can help to eliminate market inefficiencies
• E.g. two stocks mispriced, it takes time for their valuation to align via the
market’s net buying of the cheaper stock and net selling of the expensive
one
• With short-selling, punters can short the expensive stock and go long on
the cheaper one
– Facilitates hedging
• Those with exposure to falling prices of stocks but cannot immediately sell
(e.g. share option holders, pledged shares, shares under moratorium)
• Demerits
– Potential loss from short-selling strategy theoretically infinite
– Unrestrained short-selling pressure could lead to collapse in share prices

51
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 Short Selling
• Shari’ah validity of short-selling still being debated
• SAC of SC permits short-selling on the following basis:
– Istihsan with maslahah
• Clear advantage to original shareholder and provides liquidity to the market
– Istihsan with ‘urf khas (‘urf iqtisadi khas)
• Customary practice accepted in economic activities
• Dissenting opinion
– Hadith : “… sell not what is not with you”
– Ownership / possession at time of sale instead of deliverability
– Economic implications
• No doubt could contribute to more efficient share market, but
• Allows speculative trading, shortened investment horizon
– If indeed brings benefit (maslahah) to society and it is an accepted custom
(‘urf), why was it suspended?
• Indicative of room for abuse and undesirable repercussions?

52
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Types of Indexes

• A stock index is essentially a barometer of stock market

performance.

• Indexes are essentially statistical sampling. There are three types

of stock indexes:
– Equally weighted (price weighted) index;

– Value weighted (capitalization weighted) index

– Geometrically weighted index

• Each method of computation has its own advantages and

disadvantages.
© INCEIF 2015 53
Types of Indexes

• Equally Weighted Index

– It is computed by adding the closing prices of the component stocks and dividing by
a divisor.

– Example: Dow Jones Industrial Average (DJIA), Major Market Index (MMI) and
Nikkei 225

© INCEIF 2015 54
Types of Indexes

• Equally Weighted Index

– It is computed by adding the closing prices of the component stocks and dividing by
a divisor.

– In a price weighted index, every stock has equal weight.

– Since every stock has equal weight, it has ‘equal influence’ on the index’s closing
value.

– Because an index should be representative, small companies are often also included.

© INCEIF 2015 55
Types of Indexes

• Capitalization Weighted Index

– In a capitalization weighted index, each component stock has a different weight in

the calculation.

– The weight of each stock will depend on its market value proportionate to the
market value of the total index.

• Market value or market capitalization refers to the price per share multiplied by the
number of shares outstanding.

– A capitalization weighted index gives a larger weight to big firms which have a
large number of shares outstanding.

© INCEIF 2015 56
Types of Indexes

• Capitalization Weighted Index

– In a capitalization weighted index, each component stock has a different weight in
the calculation.

– Example: S&P 500, TOPIX, FBM KLCI

© INCEIF 2015 57
Types of Indexes

• Capitalization Weighted Index - Examples

– Suppose there are three stocks in the Index and computation begins on day 1.

© INCEIF 2015 58
Types of Indexes

• Capitalization Weighted Index - Examples

– Suppose there are three stocks in the Index and computation begins on day 1.

– On day 2, the index would be reported to have gone up 2.29 points.

– In a capitalization weighted index, larger capitalized firms would have more

influence
© INCEIF 2015 59
Types of Indexes

• Geometrically Weighted Index

– It is neither common nor very popular method.

– It is a difficult method to replicate for index calculations.

© INCEIF 2015 60
– Example : Valueline index
 Stock Index Futures

• Kuala Lumpur Composite Index (CI) – weighted average share price

of 100 companies listed on the Main Board representing various
sectors and most frequently traded
• CI futures not Shari’ah compliant because the underlying shares
include non-Shari’ah compliant companies
• Would a hypothetical Shari’ah Index futures (presently not in
existence in M’sia) be allowed? In other words, are stock index futures
permissible?
• Shari’ah issues that question the permissibility of stock index futures
– Object of trade (mahallul ‘aqd) is just a number, does it qualify
the status of property (al-mal)?
– Selling something that one does not own
– Issue of qabd (taking goods into possession before resale) – a
buyer can sell futures contract before expiration/delivery date
– Bay’ al-dayn bil al-dayn (sale of debt for debt) – for e.g. exchange
of futures contracts of differing expiration dates

© INCEIF 2015
 Stock Index Futures – Shari’ah Permissibility
• SAC of Malaysia’s SC permits Shari’ah Index futures on the basis of:
– Hikmat tasyri’iyyah – create maslahah to the investor in particular
and to the economic system in general, serving as a hedging
instrument
– ‘Urf iqtisadi khas (common practices specifically occurring in
economic activities)
• To critically assess the justification given
– If indeed stock index futures used purely for hedging purposes,
perhaps acceptable
• But in reality significant trading on stock index futures is
speculative in nature
• Benefit (maslahah) in genuine hedging activity but cannot
ignore costs associated with pure speculative stock index
futures trading
– Just because something is customary (‘urf) does not make it
Islamically valid (for e.g., interest-based lending)
– Even hedging as a valid motive in itself can be questioned
• Is not the purpose of investing in stock to accept some degree
of risk in exchange for potential return?
• A legal maxim in Islamic jurisprudence states – al ghurmu bil
ghunmi (the taking of profit is associated with risk taking)

© INCEIF 2015
 Is Trading in Shares Equivalent to Gambling?

Share Trading Gambling

Underlying asset
Origin of risk
Primary determinant
of financial outcome
Regardless of share No underlying asset
price movements,
there is almost always
an underlying asset
Risk reflected in Risk is created and
market operation built into the contract
(demand and supply)
Free market of Random event
demand and supply

Gain and loss In the long and in the Zero sum game (total
distribution aggregate, there is a gain equals total loss)
net gain

© INCEIF 2015
 Speculation in Share Trading

• The majority academic opinion is that share

trading is categorically not the same as
gambling
• However, this does not imply that any and all
forms of transactions in the stock market are
viewed favourably from an Islamic
perspective
• In particular, many scholars have voiced their
concern and dissent over the practices of
speculative trading in the stock market

© INCEIF 2015
 Investment vs. Speculation

Investment
Entails detailed analysis and
research of quantitative and
qualitative data (past share price
behaviour, company
announcements, economic
conditions, analyst reports, etc.)
Long term perspective
 E.g., Warren Buffett’s investment
horizon
Based on hard facts and figures
Forecasting the prospective yields
of assets over their whole life
Speculation
Typically relies on rumours or
unsubstantiated hearsay
Speculation seeks a quick gain
Often motivated by emotion (hope,
hype)
Forecasting the psychology of the
market
 Keynes’s famous beauty contest
analogy

© INCEIF 2015
 Speculation at its Extreme
• History has witnessed many instances where speculation, at the
extreme, led to irrational behaviour and undesirable economic and
social repercussions
– The South Sea Bubble, The Great Crash of 1929
– Stock Market Crashes of 1973, 1981 and 1997
– “Tulip Mania”, 17th Century Holland
• A flower belonging to the onion family, national symbol of the
Netherlands
• Mutations result in unusual colours or patterns, visually appealing
• Slow growing process, limited supply but high demand
• Became the object of price speculation
• 1620s : price of one tulip equivalent to 120 sheep
• 1634 : price of one tulip equivalent to 12 acres of good land
• Price fluctuation engineered to produce huge profits
• Ordinary businesses of the country neglected
• Majority of population sold house, land and valuables to take part in
tulip speculation
• Feb 1637 : Beginning of rationalization, panic and rush to sell
• Price fell drastically within a short time
• “Those who do not learn from the lessons of history are doomed to
repeat them” – Abraham Lincoln, former U.S. President
• There is popular argument that lays blame for the surge in oil prices in
2008 on speculative trading of oil futures

© INCEIF 2015
 Deficiencies in Contemporary Stock Markets
• Some research advocate that the current stock market-based corporate
model is guilty of misallocation of resources
– Flawed pricing process
• Information arbitrage efficiency (that all publicly available
information is incorporated in share prices so that no abnormal
profit can be made) prevails over fundamental valuation
efficiency (that shares prices reflect the real economic worth of
companies)
• Volatility of the Nasdaq index
– 1052.1 (1995)  2192.7 (1998)  4069.3 (1999)  5060.3
(2000)  2175.4 (2004)
– Classic case of share price bubble & bust
• Prices could not have been efficient in the fundamental sense
– There is evidence that there was no change of the required
magnitude in the economic fundamentals during that period
– Technology companies
► Total stock market value : 7% (1990)  36% (2000)
► Share of employment : 6% (1990)  9% (2000)
► Share of sales : 6% (1990)  10% (2000)
– During the period of 1995-2000, Amazon.com made
increasing losses in each successive year and yet its share
price rose rapidly

© INCEIF 2015
 Deficiencies in Contemporary Stock Markets (continued)
• Share price volatility is a negative feature of stock markets
– Reduces efficiency of price signals in allocating investment
resources
– Increases riskiness of investments, discourages risk-averse
corporations from financing growth by equity issues
– At the macroeconomic level, stock market volatility contributes to
financial fragility of the whole economy
• Use of stock options to align interests of management with those of
shareholders ineffective
– Encouraged over-reporting of earnings
• Shortcomings of take-over mechanism
– Evidence suggests that take-over selection process in the market for
corporate control
• Works only to a limited extent on the basis of profitability and
stock market valuation
• But operates to a much greater extent on the basis of size
• Resource misallocation arising from takeovers by companies with
overvalued equities
– E.g., Nortel acquired companies, paying with its overvalued stock
– Post-tech stocks bust : acquisitions written off, jobs lost, productive
capacities destroyed

© INCEIF 2015
 Failings of the Stock Market

• Capitalist economic theory advocates that the stock market

plays the following roles
– To allocate financial resources efficiently
– To promote good management of corporate resources
through market discipline (via takeover mechanism and
stock option remuneration)
– To bolster healthy economic growth and stability
• The preceding research findings raises doubts as to whether
these roles have been realized
• Question is, where did we go wrong?
– There is a growing school of thought that attributes
observations in the financial markets to idiosyncrasies of
human conduct – sometimes called “irrational
exuberance”  behavioural finance
– Many writers conclude simply that the stock market is
demonstrating the perils of speculation

© INCEIF 2015
 In Defence of Speculation

• While speculative trading is often labeled as an

activity of ill repute, there are arguments to justify
its existence
– Conceptually, speculation is a natural
phenomenon
• After all, any form of trade and commerce is,
to some extent, speculative in nature
– The presence of speculators ensures critical
mass necessary to provide adequate market
liquidity
– It has been argued that greater volume of
transactions would lead to quicker and more
accurate price discovery

© INCEIF 2015
 Speculation – An Islamic Perspective

• With speculative trading, the stock exchange provides opportunities

for gains to be made by profiting from fluctuations in share prices
which are not necessarily related to the economic performance of the
company
• A fundamental precept underlying Shari’ah prescriptions is that all
financial transactions must represent real economic transactions
• Hence, speculative trading, which represents exchanges in an artificial
market detached from the economic realities underlying the objects of
trade, should not be present in an Islamic economic and financial
system
• However, no law can be enforced against speculation per se, as prima
facie, it involves lawful activities of buying and selling
– It is only the intent of the speculator, which manifests itself later
on, that distinguishes speculation from genuine investment and
trading
• Thus, to keep speculation in check, one feasible approach would be to
remove market mechanisms that sustain or promote speculative
trading

© INCEIF 2015
 Speculation-Friendly Market Mechanisms

1. Short-selling
• This mechanism promotes market velocity (more buying and selling)
• Inherently short-term outlook, sell-and-buy strategies occurring within a
short time frame
• Fiqh perspective – majority of jurists disapprove of short-selling, citing that
it represents the selling of something one does not own
2. Margin trading and financing
• Provides speculator with high degree of leverage, enabling him to make
larger purchases with a smaller amount of funds
• Margin trading expands and contracts volume of transaction, which
contributes to fluctuations in share prices, without any real change in
supply of stocks or the underlying economic conditions
• Variations in margin requirements and interest rates introduce an
unnecessary dimension of uncertainty and instability
• Typically entails interest-based financing which is prohibited by the
Shari’ah
3. Derivatives
• Derivative instruments like stock index futures and stock options thrive
under volatile market conditions
• Some jurists allow derivatives on the basis of their use for hedging
purposes but in reality, only a small percentage of derivatives are used for
that objective

© INCEIF 2015
 Curbing Speculation – Implementation Challenges

• Paradigm shift required

– Need to return to the fundamental purpose of a stock
market
• Market players meant to perform a useful economic
function
• The stock market should not be merely a platform to
extort quick gains
– That market volatility is a negative feature of the stock
market
• Economic interests of exchanges and stock broking
companies
– Stock exchanges and stock broking companies derive
revenue from the volume of transactions
• Market liquidity
– How to ensure reasonable market liquidity (ready buyers
and sellers) in the absence of speculators

© INCEIF 2015
 Speculation – Concluding Points

• While share trading has been deemed allowable in Islam, such

permissibility was construed under a set of circumstances and
conditions
• One who participates in share trading should be mindful that
its Shari’ah validity is questionable when it takes the form of
irrational speculation
• Repercussions of excessive speculation
– Neglect of productive economic activity
– Effects on social dynamics
– Misallocation of economic resources
– Instability to the financial system
• Useful guidelines to avoid the pitfall of speculation
– Long term investment horizon
– Basis for decision making should be logic, not emotion
– Motivation for the Muslim investor should be as a form of
ibadah, not merely greed for material gain

© INCEIF 2015
 The Story of the Monkeys and the Villagers

• Once upon a time in a village in a far away land, a

man announced to the villagers that he would buy
monkeys for $10.
• The villagers seeing that there were many monkeys
around, went out to the forest and started catching
them.
• The man bought thousands at $10, but, as the supply
started to diminish, the villagers stopped their
efforts.
• The man further announced that he would now buy
monkey's for $20.
• This renewed the efforts of the villagers and they
started catching monkeys again.
• Soon the supply diminished even further and people
started going back to their farms.

© INCEIF 2015
 The Story of the Monkeys and the Villagers (continued)

• The man again increased his offer rate to $25, but the
supply of monkeys became so little that it was an effort to
even find a monkey, let alone catch it!
• The man now announced that he would buy monkeys at
$50! However, since he had to go to the city for some
business purpose, he appointed his assistant who was asked
to act as buyer, on his behalf.
• In the absence of his boss, the assistant told the villagers:
“Look at all these monkeys in the big cage my boss has
collected. I will sell them to you at $35 and when my boss
returns from the city, you can sell them back to him for
$50.”
• So all the villagers thought that it was good idea to make
some quick money, so they squeezed together all their
savings and bought all the monkeys.
• But later on they never saw the Boss or his assistant again,
only monkeys everywhere!

© INCEIF 2015
 Thank you

Wa Allah A’lam
77
© INCEIF 2015