176 AN INTRODUCTION TO ISLAMIC FINANCE
With the growth of Islamic funds, a comprehensive array of indices
which track the performance of Shari’ah - compliant equity portfolios are
being offered by reputable sources such as Dow Jones. Empirical stud-
ies have concluded that Shari’ah - compliant funds have performed as well
as — and, in some cases, better than — conventional funds, and there is no
signifi cant risk associated with investing in Shari’ah - compliant funds over
conventional mutual funds. In fact, studies comparing the performance of
Islamic and conventional funds before and during the global fi nancial crisis
of 2008 show that Islamic funds performed better on a risk - adjusted basis.^2
Equity Funds
Islamic equity funds are similar to the Socially Responsible Investment (SRI)
funds of the conventional market. In constructing equity funds, the stocks
of companies involved in businesses considered unlawful under the Shari’ah
are screened out before a fi ltration process is applied by each fund manager
regarding certain fi nancial ratios such as the existence of debt or income
from debt securities.
While the fi rst part of this process is easy enough, the second part is not as
straightforward because it relies on the judgment of individual fund managers,
and different jurisdictions have different practices with regard to other fi lter-
ing criteria. The following are the general guidelines used for screening and
fi ltering the stock of a company before it is included in an equity fund.
■ (^) Shari’ah - compatibility of business: The main business of the company
should be in conformity with the principles of the Shari’ah. This con-
straint eliminates all companies dealing with the fi nancial services indus-
try operating on interest, such as conventional banks and insurance
companies; companies manufacturing, selling or offering liquor and pork
products; and businesses involved in activities such as gambling, night
clubs, casinos, pornography, and so on (see Table 9.1, for example).
■ (^) Existence of debt: Stocks of companies that depend heavily on debt
fi nancing, as determined by their debt ratio, are eliminated. Different
funds set different levels of tolerance depending on how strictly they
want to adhere to the Shari’ah. The typical level of tolerance is a maxi-
mum debt - to - equity ratio of 33 percent. This constraint is applied for
ensuring that the company is capitalized in an acceptable manner and
with the expectation that debt may be eliminated in the future. Some
Shari’ah scholars, however, encourage shareholders to raise their voices
against the use of debt fi nancing altogether.
■ (^) Interest income: Fund managers also try to avoid those stocks where
companies have substantial amounts of income derived from interest on
securities. This could be the case of companies that invest excess liquidity
in debt securities and therefore earn interest income that becomes part
of the company’s profi ts. However, if only a negligible portion of income
is driven through interest, Shari’ah scholars have given permission to