a positive approach to shariah compliance screening

Second Oxford Islamic Finance Round-TableThe Frontiers of Islamic Finance Innovation

1

A Universal Platform for Shari'a Compliant Equity Screening

Dr. Mohd. Daud Bakar and Dr. Sayd Farook

15 April 2009


Current Situation

• Shari'a equity screening firmly established in world markets

• Key current credible index providers: MSCI, DJIMI, S&P and FTSE Shari'a Global Equity Index Series

• All seek to address timeless Shari'a issues

• Business Activity & Financial screens employed have a high degree of commonality but also some important differences and weaknesses


Reminder of Key Shari'a Issues

• Permissibility of trading activity/activities of the company

• Interest received by company on interest bearing bank deposits or investments

• Interest paid by company on interest bearing debt

• Debt and cash should only be traded at par


Current Shari'a Approach• On business activity: Define prohibited sectors and some screens allow a

maximum of 5% of revenue from prohibited activities which then has to be purified

• Most allow 5% of revenue from Interest income which again has to be purified

• Interest paid is mostly screened through tracking the level of debt relative to Total Assets or Market Cap – 33.33% is used by most screens

• Debt and liquid assets only trade at par – benchmarked by above ratio and Accounts Receivable and Cash relative to Total Assets or Market Cap – again 33.33% used commonly and a couple of the screens use a 49% and 70% threshold for Accounts Receivable while another use 50% for Accounts Receivable + Cash


Shari'a Rationale for Thresholds

• 5% is based on the collective opinion (ijma) of contemporary scholars, however SECM has allowed 10% on activities which are difficult to avoid e.g. interest income from fixed deposits based on Hanafi principle of ghabn fahish (excessive profit) which was 10% for animals and 20% for assets

• 33.33% based on 1/3 being considered as “abundant” in the hadith reported by al-Tirmidhi

• 50% based on Shari'a juristic principle: The majority deserves to be treated as the whole of a thing


Total Assets or Market Capitalisation?

• Total assets represents historical cost of the assets of a company

• Market capitalisation represents the market value of the company as valued on the stock market

• Significant split amongst index providers re using Total Assets or Market Capitalisation

• Can produce significantly different results e.g. intellectual property based companies such as pharmaceutical or IT software companies may have low asset values but high market capitalisation

• Market Capitalisation can fluctuate wildly e.g. in recent months and therefore may not provide a very stable benchmark


Is there a positive screening rationale?

• Current screening methods – do not give any weight to CSR

• Market trend is moving towards socially responsible investment

• AAOIFI will be mandating CSR governance standard for IFI's from January 2010

• This represents an opportunity to market products that comply with AAOIFI standards


Unified Platform for Shari'a Screening: A potential solution

• DI/OIF proposal to take Shari'a Equity Screening to the next level

• In particular addressing the following issues:

– Moving from a binary system to a rating system

– Greater transparency of screening

– Moving from negative to positive screening

– Re-evaluating financial ratios used for relevance and longevity despite fluctuations in the stock market

– Dedicate one criteria only relevant id investor seeks to buy/sell a stock versus hold


Unified Platform for Shari'a Screening: A Potential Solution

• DI/OIF solution will differ from the current screens in several important ways:

– Instead of a binary (in or out) system, each criteria will be given a rating allowing stakeholders to gauge how close or far companies are from the threshold for each criteria

– This will facilitate comparison across companies and industries and motivate companies close to the threshold to change

– Introduce a SR criteria in tune with Islamic ethos and CSR standards

– Differentiates between clear haraam/halaal and “grey/difference of opinion” areas by assigning commensurate weightings

– Companies who do not provide required information will have their ratings down-graded


DI/OIF Proposal• 4 individual criteria:

– Activity: Will seek to differentiate between clear haraam and “difference of opinion” acivities

– Structure: Will seek to address Shari'a issue of company incurring interest on debt.

– Tradability: Will seek to address issue of cash/liquid assets/debt (due from & due to) not to be traded except at par – only relevant for those not wishing to hold the stock

– Social Responsibility: Will seek to give weight to positive SR initiatives and down-grade the rating for negative SR activities


DI/OF Proposal : Activity

• Activities put into 4 categories:

– HI – Halal income e.g. textiles

– UA – Haram income (Universally Agreed) e.g. tobacco

– DO – Haram income (Difference of opinion) e.g. arms manufacturing

– IS – Haram income (Indirect Secondary activity) e.g. hotel

• Relief given to DO activities by the Shari'a board assigning a “relief” factor against this income based on the fact that it is a “grey area”.

• Indirect secondary activities refer to an actvity which in essence is halal e.g supermarket but will incidentally sell haram products e.g alcohol, pork etc.

• Applying these relief's and estimation of haram income from Indirect secondary activities – an overall percentage rating of “halal” income is produced


DI/OF Proposal : Activity contd

Assume a fictitious company with mixed activities:

DJIMI would classify 60% halal income

Activity % Inc. Category Halal Haram

Relief Notes

Textiles 60 HI 60Defence 35 DO 35 17.5 50% reliefTobacco 3 UA 3 0Food 2 IS 2 1.5 Say 75% halal

income60 40 19


DI/OF Proposal: Structure

• Seeks to address issue of interest incurred on debt

• Current screens on debt seem to amalgamate this issue with the shari'a issue of not trading debt except at par

• DI/OIF seeks to clearly separate the two issues by having two separate criteria

• DI/OIF proposal is to have a traffic light weighting based on a commonly used corporate ratio and measure – the gearing ratio = interest bearing debt/equity

• Choice of ratio: for numerator debt chosen over interest exp because interest expense can be difficult to obtain and can often lead to a small fraction; equity chosen over Market Cap because no direct relationship between level of debt and Market Cap and Market Cap can fluctuate wildly


DI/OIF Proposal: Structure Cont'd

• Traffic light system:

– debt/equity > 1 (red = unacceptable)

– debt/equity < 0.5 (green = acceptable)

– 1>debt/equity>0.5 (amber = borderline, look at other ratings)

G A R

0 0.5 1.0

gearing ratio

G A R

0 0.5 1.0

gearing ratio


DI/OIF Proposal: Tradability• This criteria has been given its own category because it is only relevant for

investors who want to buy/sell shares and not hold them

• DI/OIF effectively breaks down a company's market value into 3 chunks:

– 1. Illiquid Net Assets eg. fixed assets, stock, LT Inv

– 2. Liquid Net Assets eg. cash/loans, debtors/creditors

– 3. Intangible Net Assets eg. Brand, goodwill

• Proposed ratio : Illiquid Net Assets/Market Cap• Illiquid assets used instead of liquid assets because with liquid assets the argument can

always be made that any fluctuation in share price, as long as the share price is above the value of liquid assets, is due to the fluctuation in illiquid and intangible assets

• Market cap chosen in this case because this criteria specifically relates to the trading of shares and the share price which is obviously aligned to the market cap


DI/OIF Proposal: Tradability Cont'd

5 level scale used:

• Illiquid assets/market cap < 20% not acceptable and far from threshold

• 20% < Illiquid assets/market cap < 35% not acceptable but close to threshold

• Illiquid assets/market cap = 35% threshold for acceptability

• 35% < Illiquid assets/market cap < 50% acceptable but close to threshold

• Illiquid assets/market cap > 50% acceptable and comfortably over threshold

T- T+ T++T--

T

35% 50%20%Illiquid Assets /

Market Capitalisation

T- T+ T++T--

T

35% 50%20%Illiquid Assets /

Market Capitalisation


DI/OIF Proposal: Social Responsibility

• Current screens give no weight to non-income generating aspects e.g. environmental or social issues despite Islam placing high importance on these issues

• 3 areas where SRI can help equity screening & selection

– Islamic investors should take into account social issues such as use of child labour and pollution

– Positive screening by investors by placing greater preference to company's actively involved in positive SRI initiatives

– Where fund managers/investors actively engage with company's to encourage SRI initiatives

• Inherent issue is that SRI is a subjective area, hence any rating mechanism must be methodical, transparent and consistent


DI/OIF Proposal: Social Responsibility Cont'd

• DI/OIF proposal is to rate 3 different categories:

– 1. Munkar activities – socially irresponsible activities a company is involved in

– 2. Ma'roof activities – activities where the company is making a positive contribution to society/environment

– 3. Influential Persons – persons that have influence over the running of the company are linked to munkar activities

• 3 step process:

– 1. Rate Munkar activities – with overall SR rating for such activities

– 2. This rating can then be enhanced if the company is assessed to partake in Ma'roof activities

– 3. The rating can then be down-graded if influential persons are deemed to partake in Munkar activities


DI/OIF Proposal: Social Responsibility Cont'd

Rating Munkar Ma'roof Influence1 Proactive2 Avoids G3 Neutral A4 Irresponsible R5 Unethical 2R

• 5 level SRI scale:

– 1. Proactive company making positive contribution to the world

– 2. Avoids harming society or environment by having strong policies

– 3. Company is silent on issue and is considered neutral

– 4. Company is socially irresponsible towards society and environment

– 5. Company is extremely socially irresponsible & unethical


Purification

• Current screening methods all prescribe the purification of haram income from dividends and/or capital gains with some differences in how and what to apply it to

• DI/OIF propose that purification be based on the percentage derived under the “Activity” criteria e.g a score of 87 here would deem that 13% of income, whether received or not, should be given to charity to purify the investors earnings


Ratings Guidance

• Multiple Ratings Guidance

– All 4 criteria will have their individual ratings

– For each rating, additional disclosures can be given eg as well as a green level of debt, the actual gearing ratio can be given

– Index providers or fund managers can augment these criteria to the acceptance levels prescribed by their own respective shari'a boards

• Cumulative Weighted Rating Guidance

– The 4 ratings for each respective category can be amalgamated into one cumulative weighted rating

– Each criteria (activity, structure, tradability and social responsibility) can be weighted based on Shari'a board or index provider preference

– The overall score can then be subject to a threshold level


Multiple Ratings Guidance

79 G [T+] 4

Activity RatingRepresents 79% halal income.

Additional Disclosures:• Purely halal income = 60%• Purely haram income = 3%• Mixed income = 37% (with reliefsof 19%)

Social Responsibility RatingRepresents an ‘Irresponsible’ level

Additional Disclosures• Munkar activities = Red• Ma’roof activities = 1 (increase)• Influencial persons = -1 (decrease)

Debt RatingRepresents a ‘Green’ level of debt

Additional Disclosures:• Gearing = 0.4

Tradability RatingRepresents a level of illiquid assets close to boundary but acceptable

Additional Disclosures:• Level of illiquid assets = 40%

79 G [T+] 4

Activity RatingRepresents 79% halal income.

Additional Disclosures:• Purely halal income = 60%• Purely haram income = 3%• Mixed income = 37% (with reliefsof 19%)

Social Responsibility RatingRepresents an ‘Irresponsible’ level

Additional Disclosures• Munkar activities = Red• Ma’roof activities = 1 (increase)• Influencial persons = -1 (decrease)

Debt RatingRepresents a ‘Green’ level of debt

Additional Disclosures:• Gearing = 0.4

Tradability RatingRepresents a level of illiquid assets close to boundary but acceptable

Additional Disclosures:• Level of illiquid assets = 40%

a positive approach to shariah compliance screening

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