Islamic Equity Funds are an important example of the general Islamic concept of Musharaka, which is a partnership between two or more parties. Although Musharaka is at the heart of the Islamic mode of finance and investment, for a variety of reasons it has not yet taken root in the system.

There is a great deal of scope for financial engineering by Islamic financial institutions to arrange deals which can provide a limited or full equity participation for an agreed period of investment on a clearly defined profit sharing basis.

A specific example of the Musharaka concept is Islamic equity funds which are a relatively new phenomenon for Islamic investment institutions. But it can be reliably stated that they will play an increasingly popular role in future.

There are a variety of equity funds, but the most common ones are open-ended unit trusts or mutual funds with the underlying investments in stocks/shares which are listed on one or more stock markets.

It can be easily demonstrated that over any reasonably long period a diversified portfolio of equities in any developed market has provided a higher total rate of return than most other types of assets class - for instance, compared with the two most important ones; short term money market instruments and bonds. There is sufficient evidence from financial theory showing that due to the higher risks associated with investment in equities, they provide higher returns.

The main 'risk' in equities comes from their higher price volatility, loosely defined ss percentage movement of prices from an average price base. This is also true for a portfolio of equities, although some risk can be reduced by diversification across different sectors and markets, particularly if they happen to be negatively, or non-correlated with each other.

It is thus the duty of all those associated with the promotion of equity funds to explain fully the nature of this investment to the prospective investors. Only those who have a full understanding of this aspect of equity investment and can afford to remain invested over the medium term, say over three years, should be encouraged to invest. This is particularly relevant as stock markets go through bull and bear phases (markets in a strongly positive or negative cycles).

Real rates of return provide a better yardstick for comparative purposes. The following are the average rates of return for three developed markets, the USA, UK and Germany over a period of the last 20 years or so.

Average Real Rates of Return on Investment

Of course, the past is not necessarily a guide to the future except for a long term investor.

There are some differences among Shariah scholars on the eligibility of companies for equity investments. However, the following general criteria may be acceptable to most scholars:

•   The companies should carry on business in a manner consistent with Islaimic principles
•   Investments are not made in companies involved in riba-based businesses, thus conventional banks, finance and securities companies will be excluded
•   Insurance
•   Manufacture, distribution and trading of alcoholic beverages
•   Gambling and games of chance
•   Pork
•   Manufacture and distribution of armaments and munitions.

More details of the above simple criteria have been worked out with the help of Shariah scholars. 'Short selling' is of course, not allowed and most forms of derivatives, particularly those baised on an index, cannot be used.
However, currency hedging in specific circumstances is, acceptable.

There are two further important considerations. Firstly, for a company's equity to be an acceptable investment, w!mt proportion of its business interest could be unacceptable under the Shariah? Some scholars feel that this percentage should be very low, say one to two per cent, while there others who have considered that this should be somewhat higher. This rule is in many large companies, particularly developed countries where such companies have fairly diverse ranges of business interests.

What is meant by 'business interest', in case? Should the restriction apply to turnover of a company, or the profits that are generated over the year? Or is it reasonable to look at the net assets employed in a given business activity? Many companies do provide a reasonable amount of information but it may not be possible to have a complete breakdown to see all this.

However, the second and main question which has been a major stumbling block in getting approval to invest in the equity company - has been that almost all companies earn or pay interest. Companies earn interest on their cash flow, pay interest on their borrowings in their normal course of business. These borrowings can be short and long term. Strict compliance with the Shariah implies that interest should play no part in the affairs of a company. Buying equity of a company means that one is a part owner of that business and hence one has duties, obligations and responsibilities well beyond having other types of business relationshipships with such a company.

So one is talking about participation in non-acceptable activities as a part-owner of the enterprise. Although involvement in interest is not permitted under the Shariah, one may argue that receipt of interest should be treated differently to its payment; or should both be 'netted out'?

Most companies would have a number of banking relationships and so the borrowing and lending may not be with a single bank.

It may also be that one corporate has businesses in several countries and so it may not be feasible to have its borrowing and lending with a single bank. Lending in the present context may simply be in connection with the utilisation of cash held by a company on a day-to-day basis, on which there will be some interest earned. Considering all such issues, it is little wonder that some would consider that one should avoid involvement with such instruments. For what it is worth, one could say that one ought to avoid investing in companies which may have a high gearing, but that in itself is too imprecise.

'Purification' or 'filtration' of a portfolio: the use of these terms would be easily understood from the following description. As stated above, it is almost impossible to avoid areas of activity that are unacceptable under the Shariah, particularly the riba element. A practical solution to this real life problem is to try and calculate, where applicable, income and caih flows derived from companies in which a fund has invested, from activities not in accordance with the principles of the shariah. An amount representing such sums should be donated to suitable charities. Some may argue that this donation could te made directly by the fund's sponsor or it should be left for the investor to choose an appropriate medium. The first option may be deemed to be more appropriate. Several technical and practical considerations in the determination and distribution of such income arise, but there is ins ifficient space to discuss them here.

Major Islamic Equity Funds 1986-1996

Source: Complied by Islamic Banker, April 1996. * Yet to be Launched    ** No Longer Operational.