The Case For Sharia-compliant Investing

Publisher: FA Financial Advisor

Once viewed as a niche market, environmental, social and governance (ESG) investing has taken the investment community by storm over the past few years, finally starting to attract significant assets after a long period of significant product innovation. While the future continues to look bright for ESG—some estimates have global asset levels in the category increasing to $50 trillion over the next twenty years—there’s another component to this broader ESG discussion that investors should consider, particularly if they’re concerned about avoiding governance-related issues in their portfolio holdings. And that component is Sharia-compliant investments.

Sharia-compliant investing approaches, which require that investments adhere to specific tenets of Islamic beliefs, have been available for some time but have only recently started to gain popularity in the U.S. Given the overlap between the principles of Sharia and ESG, coupled with the growth trajectory of socially responsible and sustainable investments overall, now may be a good time for financial advisors to learn more about this approach and the role it can play in a portfolio.

Understanding Islamic beliefs, and by extension Sharia-compliant investing, can be very complex. Therefore, to be successful in evaluating and accessing these types of products financial advisors must educate themselves on what Sharia-compliant investing means, how it works, where it fits in a portfolio and why it could play an important role for a wide range of investors, not just those who invest through a religious lens.

Why Sharia-Compliant Investing Is Important Now

Islamic law imposes a range of restrictions on investments and the underlying businesses in which investors can hold securities. In order to be Sharia-compliant, companies and investments must pass several screens for permissible asset classes and business activities.

There are some key requirements for Sharia-compliance that advisors should be aware of. For starters, there can be no investments in what are considered to be unethical goods or activities including alcohol, gambling, firearms, tobacco, adult entertainment and pork products. In addition, interest-based businesses are prohibited, and the risks involved in investing in a security must be shared instead of shifted to another party. For example, stocks and ETFs are eligible for Sharia compliance consideration, but preferred shares and interest-paying securities are not. Additionally, a well-constructed Sharia-driven approach involves a portfolio screening process which excludes companies that derive more than 5% of their total income from non-compliant income sources.

As to the question of why this approach may merit consideration now, we see a number of trends developing that make Sharia-compliance strategies important tools for all types of investors. First, the continued expansion of the ESG market has spurred an emerging social consciousness in many investors, and Sharia-compliant investing provides another avenue for accessing ethically-driven investments, presenting an opportunity for advisors to cater to a growing demand.

Additionally, according to a recent industry report from PricewaterhouseCoopers, the Sharia marketplace is poised for explosive growth due to the growing population of Muslim investors and the fact that religious Muslims have been underserved by the structured finance and asset-management industries for decades. Considering that Muslims represent a quarter of the world's population, it is possible this investor base will rapidly expand in the future as younger generations and investment-savvy members of the community begin putting their money to work using Sharia-compliant investment strategies.

The Benefits Of This Investment Strategy And The Products Available

In many of the conversations we have with the marketplace, the tendency is for people to immediately pigeonhole Sharia-compliant strategies as being only for those who invest through a religious lens. The truth is that these approaches not only provide investors access to bundles of assets that, when incorporated into an investment strategy, help diversify both equity and fixed-income portfolios, but they can also play a key role in avoiding the types of over-levered companies that may be particularly susceptible to volatility during a market downturn.