The past 2-3 years of our financial system have been
marked by two major trends, depressed interest rate scenario and
emphasis on Shariah Compliant investment products. The depressed
interest rate scenario meant that people started to channel their funds
out of fixed income securities and into avenues that provided higher
returns. The boom in the stock market witnessed during the period is
reflective of the trend.
In addition, an added inclination towards Shariah
Compliant Products was also observed among the investing public of
Pakistan. The fact that nearly all leading banks started adding Shariah
compliant products in their product offerings is a good indicator of the
potential demand in the sector. But these products offered by the bank
usually offered a rate of return close to the returns on their other
non-compliant products which meant that a product fulfilling both
factors i.e. attractive returns with Shariah compliance was still
One product that has hit the Pakistani financial
markets in recent times has the potential to fulfill this unmet demand
to a certain extent. The product we are referring to is "Islamic
Equity Funds" or Shariah- Compliant Equity funds".
ISLAMIC EQUITY FUNDS
An Islamic equity fund is a joint pool wherein the
investors contribute their surplus money for the purpose of its
investment in joint stock companies to earn Halal profits in strict
conformity with the percepts of Islamic Shariah.
The profits are mainly achieved through capital gains
by purchasing shares and selling them when their prices appreciate or
through dividends distributed by the relevant companies.
The two basic conditions that have to be met for all
equity funds are as under:
* Instead of a fixed return tied up with their face
value, they must carry a pro rata profit actually earned by the fund.
Therefore neither the principal nor a rate of profit tied up with the
principal can be guaranteed.
* The amounts pooled together must be invested in a
business acceptable to Shariah.
It is obvious that if the main business of the
company is not lawful in terms of Shariah, it is not allowed for an
Islamic fund to purchase, hold or sell its shares because it will entail
the direct involvement of the share holder in that prohibited business.
Similarly, nearly all Shariah experts are agreed that
if a company conducts all of its transactions in full conformity with
the Shariah — including that the company neither borrows money on
interest nor keeps its funds in interest bearing accounts — then it is
permissible to purchase, hold or sell its shares. However, such
companies are rare.
Keeping in view this fact, modern day scholars around
the world have come up with different criteria for determining
acceptable debt-to-asset structure of companies and the amount of
interest income the company can earn as a percentage of total income.
These criteria are applied to different companies to determine the
Shariah compatibility and to adjudge whether the companies are
permissible investments from a Shariah point of view.
Naturally some of the income thus derived from such
investments is "impure" and has to be quantified and purified.
The procedure normally followed for this purpose is that the Asset
Management Company (AMC) donates the amount of impure income thus earned
ADVANTAGES OF INVESTING IN ISLAMIC EQUITY FUNDS
The advantages available to investors due to
investment in Islamic Equity funds are summarized in the following. Some
of the below mentioned are advantages that are generally associated with
mutual fund investing but some are specific to Islamic Equity Funds and
can not be witnessed in conventional equity funds.
The biggest attraction of Islamic funds remains the
Halal profits generated by such funds. Although there is still some
disagreement as to whether the profits earned by such funds are 100%
Halal, as these companies do allow interest bearing debt and interest
income to a certain extent. However, as most of these funds are backed
by the approval of prominent scholars from around the world, they are
generally considered to be generating Halal and Shariah-Compliant
Like any other mutual fund, an Islamic equity fund
provides its investors with diversification. An individual investor has
limited amount of funds available for investment and as a result he can
invest in only a limited number of stocks.
The limited investment capital of an individual
investor has dual implications. Not only is he unable to benefit from
some of the profitable Shariah-compliant opportunities available in the
market, his risk is also concentrated to a limited number of stocks.
This problem can be reduced to a certain extent by
investing in Islamic equity funds as the joint pool of funds can be used
to invest in a larger number of stocks thereby enabling the investors to
benefit from a larger number of profitable opportunities and also reduce
their risk through diversification into different sectors and stocks.
The fund managers at the helm of affairs in an
Islamic Equity fund or any other mutual fund are better equipped than an
average investor to recognize profitable opportunities in the market and
in determining the Shariah compatibility of an individual stock or
By investing in an Islamic Equity Fund, the investors
are able to invest in better avenues providing higher risk-adjusted
returns using the expertise and acumen of the professional fund
As stated above, these mutual funds are required to
comply with a set of criteria laid out by scholars and Shariah experts.
Complying with a set of criteria may seem to be a constraining factor at
first thought but in actuality it has, in the past helped some Islamic
funds perform better than conventional funds. The criteria have been so
effective in some cases that even conventional fund managers are
starting to follow the criteria.
The effectiveness of the Funds' Islamic criteria
became more evident after the Enron and WorldCom scandals as Islamic
investors were "out" of these companies when these companies
were still "viable" entities. This was because of the debt
screening criteria that Islamic funds use which led to exclusion of
these companies from their universe as these were highly leveraged.
ECONOMIES OF SCALE
Like all funds, an Islamic equity fund enjoys
economies of scale. These economies are visible in transaction costs as
the fund managers due to their larger volumes are able to obtain lower
rates than an individual investor. This lower cost entails higher
returns and is ultimately passed on the investors.
Advocating only the advantages and positive points an
investment avenue would be an improper analysis of the avenue. In the
following, we discuss some of the disadvantages/risks that can be faced
by prospective investors of an Islamic equity fund:
INABILITY TO CAPITALIZE ON PROFITABLE OPPORTUNITIES
Shariah Compliant funds are restricted to a certain
extent as far as investment opportunities are concerned which means that
at times the funds have to forego attractive investment opportunities
which in turn has a direct impact on their returns.
Although this may not be a major cause of concern for
some investors who are completely Shariah minded. In fact, this acts as
major incentive for them. On the other hand, there are investors who are
more inclined towards the monetary benefits and for them, this acts as a
disadvantage that by investing in Equity based Islamic funds, they miss
out on some Non-Shariah Compliant but profitable investment
NON-SHARIAH COMPLIANT ACTIVITIES
The fund managers of a Shariah Compliant fund
continuously stumble upon investment opportunities that can enhance the
returns of the funds but are deficient in terms of their Shariah
compliance. The investors in an Islamic equity fund cannot ensure that
the fund managers have resisted this temptation and the returns earned
by the fund are 'pure' and are free of any Haram income.
Although Shariah Audits are conducted periodically in
some funds but the risk is not completely mitigated and the chances of
non-Shariah Compliant practices in order to enhance returns always
One of the disadvantages of any equity based fund is
that its investments are concentrated in the stock market. These funds
are restricted by their policies to only invest in the stock market and
therefore are not able to reap the true benefits of diversification that
are experienced by a fund that is diversified into different asset
classes other than stocks.
As mentioned in an earlier section that the investors
in an Islamic equity fund benefit from the expertise of professional
fund managers but this benefit comes at a cost. The returns to the
investors in an Islamic Equity fund or for that matter in any other fund
are reduced due to the fund managers' fee that is deducted along with
the administrative expenses from the gross returns earned by the funds.
In addition to the fund managers' fee a Shariah based
equity fund may have to bear an additional fee burden as some of the
funds where Shariah Advisory has been outsourced, a certain amount as a
percentage of the Net Assets has to be paid to the Shariah Advisor as
fee for his services.
STOCK MARKET — A RISKY INVESTMENT AVENUE
The excess returns that can be earned by investing in
the stock market are not entirely risk-free. In order to maintain a
no-arbitrage situation in any market, it is only natural that any excess
returns that are being earned also carry a higher amount of risk. If
that was not the case, then all rational investors would opt for the
stock market and earn a higher return than other fixed income
instruments with the same level of risk.
Therefore a risk in opting for equity based Islamic
funds is that the investor is exposed to the risk of adverse movements
in the stock market which can lead to loss of principal as well.
Despite the disadvantages and risks mentioned above,
Islamic equity funds have received a good response internationally. This
is evident from the fact that currently there are more than 100 Islamic
equity funds worldwide. These funds are not limited to Islamic countries
but are found all around the world including United States of America,
United Kingdom and other major European and Asian countries. The total
assets managed through these funds currently exceed US$3 billion. With
the continuous interest in the Islamic financial system, there are
positive signs that more funds will be launched. Some major Western
companies have already joined the fray and some of the others are
thinking of launching similar Islamic equity products.
These funds all over the world observe the criteria
as laid out by the Shariah advisors of the respective funds. As a
result, we see that these funds have been more inclined towards the
technology, health care and energy stocks as these stocks generally
fulfill the pre- requisite conditions for investment.
Regarding the market for such funds, the major market
for such funds has been the Middle East and the estimated size of that
market is around US$ 800 billion. This figure is only an estimate as
derived by calculating the assets of high net worth individuals of the
Middle East regardless of their investment preferences. The exact size
is obviously very difficult to estimate but potential for such funds is
huge if we also include the retail investors. Fund managers around the
world have begun to recognize this and have designed funds that are
specifically targeted to this segment of the market.
As mentioned above Pakistan being one of the major
Islamic countries of the world and with its current interest rates
scenario and additional emphasis on Shariah holds great potential for
Islamic financial products. This increased attention towards the equity
market coupled with the above mentioned consumer awareness and the
apparent benefits of investing through a mutual fund points to a bright
future for Islamic equity funds.
This demand for such product has largely been unmet
in the past but recently the increased potential has led to the
introduction of two Islamic Funds being launched in the market, i.e.
Unit Trust of Pakistan Islamic Fund (commonly known as UTP Islamic Fund)
sponsored by Abamco and Meezan Islamic Fund (MIF) sponsored by Meezan
Bank Limited through its subsidiary Al Meezan Investment Management
The response to these funds has been highly
encouraging and both these funds have been able to attract the attention
and the funds of the investors. The response to these funds can be
judged by taking a look at the amount of funds that they have been able
to attract in a short period of time.
Fund Size as of
30th June' 04*
UTP Islamic Fund
26th December 2002
Meezan Islamic Fund
8th August 2003
Rs.1, 311 million
Rs.1, 953 million
*Figures rounded off
Encouraging welcome of these funds by the investing
public of Pakistan has led to increased attention towards this sector by
the Asset Management Companies and as a result a few projects are
already in the pipeline and are expected to hit the market in the near
future. Such funds are expected to come in with diverse trading
strategies such as income funds, growth funds etc.
The launch of such funds will no doubt add to the
investment options available to the investors specially the retail
investors who are more conscious of Shariah compatibility when selecting
their investment avenues. In addition such finds might just prove to be
one of the initial stepping stones in Islamization of our financial
system as such funds channel the retail funds towards Shariah compliant