Wealth and investments: Islamic finance

Understand the principles of Sharia-compliant investing, how the opportunity set changes and the considerations when selecting an investment manager
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Sharia-compliant investing outperforms peers

Did you know that while nearly 25% of the world is Muslim, not even 1% of global financial assets are Sharia-compliant? Not only that, while many funds deteriorated following international lockdowns, many shariah funds outperformed as they lacked exposure to industries that were severely affected by the pandemic.  

Untouched potential amongst Islamic investors notwithstanding, non-Muslim investors are also turning their eyes towards halal investments as demand for socially responsible investing rises globally. These signs point towards massive, unrealized growth potential for Shariah-compliant investment funds.

What are Sharia-compliant investments?

Traditionally, Islamic funds have been nearly synonymous with equity products. But today, new Islamic asset classes are gaining prominence. These include asset leasing, real estate, commodities trading (trade finance), and sukuk (Islamic fixed-income securities). Mandatory Islamic finance principles influence asset allocation and strategy selection in Sharia-compliant investing, no matter the asset class.

  • Riba = Interest

    Under Sharia law, money is merely a medium of exchange. Because it has no intrinsic value, it cannot be ethically used to obtain more money. Interest is therefore prohibited in all transactions, as it benefits one party at the expense of another.

  • Gharar = Unreasonable uncertainty

    Transactions that have uncertainty are also prohibited as speculative transactions that lack information could lead to undesirable outcomes. Futures contracts are a good example, whereby the assets transacted might not even exist when the delivery date rolls by.

  • Halal = Permissible

    Halal transactions are permitted transactions. Conversely, Haram (impermissible) transactions involve activities that are strictly prohibited under Islam. Examples include trade of alcoholic beverages, pork meat, and gambling.

  • Mudarabah = Profit and loss sharing principle

    All investment stakeholders must shoulder a proportionate amount of risk and split rewards accordingly as well. Depositors must be involved in the agreement and all risks and rewards are calculated in proportion to realized profit or loss.

  • The asset backing principle

    Financial transactions must involve exchange of tangible and identifiable underlying assets. Traded assets must demonstrate clear benefit and value to its owners. Conversely, transactions backed by demonstrably harmful assets are banned.

Exhibit 1: Sharia-compliant portfolio construction (relative to peer group)

Asset class Conventional Sharia compliant Islamic principle
Cash Money market instruments Sharia-compliant contracts Ban on uncertainty
Non-interest-earning deposit accounts Ban on interest
Fixed income Government and corporate debt Sukuk Profit and loss sharing principle
Asset-backing principle
Equity (public and private) All sectors Constrained universe Ban on financing certain economic sectors; restrictions on conventional leverage
Alternatives Derivatives n/a Ban on uncertainty

The Mercer advantage

To invest with adherence to Sharia principles, practical implications exist for both strategic asset allocation and portfolio implementation. However, it’s a continuum with adherence levels varying from light to strict and wide-ranging implications - that’s where Mercer can help.To invest with adherence to Sharia principles, practical implications exist for both strategic asset allocation and portfolio implementation. However, it’s a continuum with adherence levels varying from light to strict and wide-ranging implications - that’s where Mercer can help.

Verification required

Sharia supervisory boards or equivalent authorities have the power to verify if portfolio holdings are Sharia compliant. Typically, Sharia supervisory boards are independent bodies made up of Islamic scholars of finance.

Operational considerations

No interest should be earned from the time between receiving investment capital contributions and allocating contributions to the solution. Similarly, all disinvestments should be returned to clients without any interest earned.

Legal considerations

All contracts ranging from the investment policies, to signed investment management agreements, along with underlying implementation providers, must be Sharia compliant.

Sharia investing: What you need to know

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Mercer has developed best in class Sharia-compliant portfolios

Asset-class characteristics and considerations from a Sharia-view

  • Public and Private Equity

    • Reduction in size of equity universe
    • Industry/sector screening
    • Balance sheet and leverage screens
    • Income purification
    • Allowable equity universe tilts toward lowleverage equities in faster-growth sectors
    • Structuring solutions possible if acceptable to investor

  • Fixed Income / Private Debt

    • Exclusion of traditional fixed income and private debt investments
    • Fixed income represented through Sukuk and asset-backed strategies

  • Infrastructure

    • High leverage presents an implementation challenge
    • Some structuring solutions possible (Sharia wrapper, replacing conventional debt with Sharia equivalent, etc.)
    • Lower leverage and/or structuring solutions can result in a drag on returns vs. traditional

  • Real Estate

    • High leverage presents an implementation challenge
    • Some structuring solutions possible (Sharia wrapper, replacing conventional debt with Sharia equivalent, etc.) possible
    • Implementation costs can reduce return relative to traditional

  • Liquid Alternatives

    • Generally excluded due to use of derivatives and speculative strategies
    • Wrapper structures may allow for implementation if approved by investor

Appointing a Sharia-compliant investment manager 

Sharia-compliant investing brings a unique set of challenges. Interested investors are advised to commit to Sharia compliance and develop clear frameworks to stay on track throughout the investment process. Understanding asset class opportunity sets and their underlying exposures will enable investors to adjust for risk and returns accordingly.

Besides having comprehensive knowledge of opportunity sets, good Sharia-compliant managers should understand both technical and financial aspects of Sharia-compliant criteria. They should ideally have experience integrating Sharia principles into active fund positions and a track record of being endorsed by Sharia advisory boards.

We’re here to help

We look forward to assisting you with your Sharia investment needs and supporting you on strategy design and implementation.