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ISLAMIC EQUITY FUNDS – Book Sample

ISLAMIC EQUITY FUNDS

INTRODUCTION BACKGROUND OF THE SUBJECT

The use of mutual funds as financial products in general increased tremendously during the last three decades as there has been a greater awareness of the benefit of diversified portfolio under full-time professional management with the safeguard of trustee supervision and statutory control.

This investment vehicle normally suits all categories of investors in the medium-and-long-term. The principal concept of mutual funds is that risks and rewards are shared by investors. Thus, mutual funds are essentially investment tools.

The argument in favor of mutual funds compared to other types of investments are powerful such as: funds provide a level of diversification by industry; investors achieve diversification by company.

There are different types of mutual funds such as: closed and open-ended funds, low and high risk funds, income and growth funds. In general, open-ended funds are known as mutual funds (Al-gari, M. Ali, 1998, p. 5). In addition to this, mutual funds work in different sectors so that there are commodity funds, leasing funds and equity funds.

This study is on equity funds and addresses a central question that: can equity funds be worked on Islamic principles? This notion has been approached in three dimensions: first, to be pursuant to Islamic rulings, equity funds must not transact in equities of companies which produce or trade in prohibited goods; second, equity funds run on Islamic basis must get rid of interest income generated through interest-based lending; third, Islamic equity funds should not trade in stocks of companies which have higher gearing ratio, i.e., their assets are basically in the form of cash and debts.

Therefore, these are the issues which need to be clarified and resolved with the view to implement the notion ⁻of equity funds in an Islamic perspective.

PRINCIPLES OF ISLAMIC EQUITY FUNDS

The subject related to Islamic Equity Funds (IEFs) is yet an emerging field. Its shape is still in transition specially with respect to Islamic principles that govern their operation. Of many issues in this connection, the most significant are: (i) area of activity for companies whose shares are the target for IEFs; (ii) the interest element in companies income; (iii) the debt equity ratio of companies. Here is a discussion of these issues in two stages via: (a) fiqh-based guidelines regulating works of IEFs in practice, and

(b) an assessment of these guidelines in light of the recent fiqh view.

Guidelines regulating works of IEFs

The first part of this section is an overview of the mechanism whereby IEFs deal in stocks of companies without, however, contravening Shari ‘ah boundaries. The second part , that follows would be an assessment of this mechanism vis-a-vis the current fiqh perspective.

Business activity of shareholding companies

In order to trade in shares of companies, IEFs must be certain about permissibility of the product of such companies. The ideal situation is trading in shares of companies whose activities are permissible and in accordance with Shari ‘ah requirements. But some companies undertake such prohibited businesses or mix them with permissible ones. In brief, the fiqh opinion is that: if objectives of the company are legally consistent with Shari ‘ah rules, then its business is accept Exhibit and Muslim investors could buy shares of this company, (The Islamic figh Academy, 1992). This is the principle.

In practice, so far it is easy to screen companies in this regard and sort out the permissible and non-permissible businesses. Those who are in charge of IEFs now have regular checking of these things through their investment advisors. Investment advisors are usually given’ instructions to avoid investment in shares which are backed-up by any of the prohibited goods or services. More practices have increased the ability of IEFs in this regard to the degree that periodical checking becomes very frequent, on monthly basis.

According to Dow Jones. Islamic market Index (1998), all IEFs undertake scr^eening of non-permissible industries t tment in stocks which are backed by prohibited goods/services..

The interest as a component in companies’ revenues

This matter is pretty delicate and more difficult to manage. IEFs now have the technique of exploring companies with the view to deal in shares of companies whose objectives and areas of activity are allowed in the Shari’ah rulings. But these reviewed companies borrow and lend frequently on interest basis. IEFs are then encountered with a critical question that: do they – in principle transact in stocks of such companies whose businesses are pursuant to Islamic principles but undertake interest-based borrowing and lending?

This issue has been addressed before. Strict compliance with the fiqh conditions requires that interest should play no part in the affairs of a company. One of the fiqh views in relation to dealing in shares of this type of companies is that of the Islamic Fiqh Academy which says in this concern: (i) as long as business as such is legitimate in principle, setting a shareholding company with accept Exhibit objectives and activities is consistent with Shari’ah rules; (ii) fiqh scholars unanimously agree on prohibition of participating in companies whose basic objective is prohibited like dealing in riba or producing and/or trading in prohibited goods and services; (iii) the fiqh principle is prohibition of buying shares of companies that frequently deal in prohibited things such as riba although its basic activities are prohibited, ((The Islamic Fiqh Academy Journal, Vol. 7, pp.712-13)).

IEFs differ in parameters applied to controlling the interest element in incomes of companies. The parameters range between 10% and 5% so that companies whose interest income/total income ratios within this range could be a target for trading in their shares.

To purify the return to unit investment holders, IEFs figure out income from interest-based investments and deduct this percentage and use it for humanitarian and charity purposes.

The debt-equity ratio of companies

Balance sheets of some companies contain a disproportionately big percentage of debts compared to the shareholders’ equity. The problem with shares of such companies is that sale of debt, or in this case in particular sale/purchase of shares backed by debt and/cash is regulated by the special fiqh rulings in connection with debt and cash – the sarf.

The Islamic Fiqh Academy decides on this matter and the formal legal opinion of the Academy is_, that i f the dominant shareholders’ equity is mainly

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