What is the Shariah index?

Thursday, Aug 22, 2024

When you invest and if that aligns with some of your deepest values, the point of investing becomes more satisfying. That's where the Shariah investment comes into play.

A Shariah index has a group of companies that abide by the law of Shariah. Also known as halal investing, which keeps certain considerations in mind to screen the stocks.

If you want to be a socially responsible investor, you'll learn how to as you continue reading about Shariah investment.

What's a Shariah Index?

In short, it's an index that's curated with stocks that follow the Islamic financial rules, which are the backbone of the Shariah stock portfolio. It gives the investors a choice to invest ethically.

Here's a bit of history

Although the inception of the concept dates back to 1960, when Islamic scholars realized that many Muslim investors wanted to grow wealth without compromising their faith, Shariah investment grew as a way.

S&P in 2010 introduced the Shariah index in India in BSE. Now both the NSE and BSE have Shariah Indices listed in them. But lately, it has gained popularity and you need to know much more about it to understand.

Here's some fact, as per the 2022 report by Islamic Corporation for the development of the private sector, Islamic assets have grown to $4 trillion, which was $2.17 trillion between 2015 and 2021.

Clearly, there's a real demand for Shariah investment.

What Makes an Investment Shariah-Compliant?

We’ve just been reading but here's how the stocks in the Shariah index comply with the Shariah rules and you can screen the same way for your Shariah stock portfolio.

A big no to interest or riba

Any companies that are heavily into interest-based activities, like banks, are off their list. As Islam believes in helping others with kindness, they encourage charity and do not charge interest on the money. Which also means no investments in the fixed-income market.

It's impossible to find any companies that don't charge interest, hence, the limit is up to 3% of the total income, which is acceptable.

Ethical business only

They don't tolerate business in alcohol, tobacco, gambling, adult entertainment businesses, and pork-related businesses. It's unlawful in Islam as it harms health, disrupts society, and is a substance of addiction.

Low debt or not otherwise

Companies with higher debt than assets pose a high risk and hence why they are out of the way.

Gharar isn't acceptable

When the notion is contrary to the certainty factor, it's prohibited. This means any company that makes money on uncertainty, like insurance, gambling, or trading, or is caused by unclear contracts, is referred to as a Gharar.

This uncertainty raises risk and deception as per the law.

How are the companies in Shariah investing screened?

Creating a Shariah index isn't a simple task. It involves a thorough screening process:

1. Screening of the business sector: The first filter in the process is to exclude companies immediately involved in prohibited activities, as mentioned above.

2. Screening based on financial ratio: Next comes looking into their finances.

For instance, the FTSE Shariah Global Equity Index excludes companies if:

Total debt is more than ¼th of total assets
Cash and interest-bearing securities make up more than 33% of total assets
Accounts receivable and cash are more than 49% of total assets

3. Screening based on dividend and purification ratio: Any company that gets less than 5% of the dividends from prohibited activities will pass screening 1 as long as they purify it by donating it to charity.

The major Shariah indicators

Let's look at some of the big players in the Shariah index:

1. Dow Jones Islamic Market Index: Launched in 1999, this was the first global Sharia-compliant benchmark.

2. FTSE Shariah Global Equity Index Series: covers 48 countries and over 17,000 Shariah-compliant stocks.

3. S&P Shariah Indices: Offers a wide range of indices, including the S&P 500 Shariah, which had a 10-year annualized return of 13.46% as of 2024.

Why Are Investors Choosing Shariah Investment?

There are solid reasons why Shariah indices are gaining traction these days:

Aligning with ethical value

For Muslim investors, it's a means to grow money while following their beliefs.

Risk Management

The screening process often results in a portfolio of companies with lower debt and stronger balance sheets.

Performance

Contrary to what some might expect, Shariah indices often perform competitively with conventional indices. For instance, the S&P 500 Shariah index has consistently outperformed the conventional S&P 500.

Challenges are in Shariah investment as well.

Like any investment approach, Shariah indices come with their own set of challenges:

1. Limited Investment Universe: The stocks under the index can be limited due to highly strict screening.

2. Sector Concentration: Some sectors, like technology, tend to be overrepresented in Shariah indices due to their generally low debt levels.

3. Higher Costs: Shariah-compliant funds often have higher expense ratios due to the additional screening required.

How to have a Shariah stock portfolio with Shariah Indices?

Here's how you can go about it:

There are smallcases, mutual funds and ETFs

Begin researching these Shariah-compliant funds. Here is one such smallcase: Green Ethical Portfolio.

Get a handle on the methodology

The screening criteria differed for each index, see how they were selected.

Look at the geographic exposure

There are indices that go by offering specific regions. The MSCI World Islamic Index for instance covers about 23 developed markets under it.

Watch out for the fees

The Shariah-compliant funds have higher fees as the screening process requires extra attention.

What changes can you see in Shariah investment as we go?

Here are the changes we may see:

The market's growth

With the global Muslim population, the demand for Sharia-compliant investments can increase.

The barrier breaker AI

The efficiency of the Shariah investment process can be improved with technology, machine learning, and AI

Convergence with ESG

There's growing recognition of the overlap between Shariah principles and Environmental, Social, and Governance (ESG) criteria.

Wrapping up

Shariah investment lets you do value-based investing and this has opened the door to not just Muslims but also non muslim investors.

With the intricacies involved in screening the stocks, you can let the researchers do this job as they understand this principle of investing.

It's easier to start with a Smallcase rather than individually nitpicking the stocks in the Shariah portfolio, as they are well-researched.

If socially responsible investing is your way, get on with Shariah investment. Start one such investment in a Smallcase curated by GreenPortfolio, which is a SEBI-registered company that offers portfolio management services as well as smallcases.

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