Screening and Purification Criteria:Shari’a Application to Investments 127cash receivables less than 45-50 per cent and interest income less than 5 per
cent. Many scholars are now requiring any interest income to be included in
the 5 per cent overall tolerance level. One can either base the calculation of
these parameters as a proportion of total assets, orof market capitalization
of the corporation.
Presently, Dow Jones and lately Standard & Poors use market capitali-
zation. All other providers, such as Morgan StanleyCapital International,
FTSE, Ratings Intelligence, Amiri S3, etc use total assets. The rationale of
the ratios, and the pros and cons of the total asset/market capital debate can
be debated at length.
In general, market capitalization as a base is more volatile than a total
assets base. This is very important for index providers as frequent changes
in constituents without any underlying change in the nature of the business
is likely to distort the index and it’s utility forbenchmarking purposes.
Secondly, many Islamic financial institutions finance both listed and private
companies. For them to have a consistent yardstick, a total assets base
provides a more robust measure, as no market capitalization indicator for
unlisted companies is likelyto be satisfactory.
Only in the exceptional case of companies that have very large intellectual
property content can a case can be made to modify judgements based on
total assets criteria. This can be done on a case-by-case basis without
resorting to a wholesale move toa market capitalization base.
Anecdotal evidence suggests that in the bull market phase, a market
capitalization base may yield more Shari’a-compliant companies than a total
asset based methodology. Whilst a larger universe is desirable from a
portfolio investment perspective, it is unlikely to carry much weight with
Shari’a scholars. Recent research done by several students and scholars has
tended to confirm these findings. The global universes are not that different,
and the overall portfolio performance of those based on total assets or
market capitalization is not divergent enough to allow screening arbitrage
of any magnitude. Given these findings, it is likely that institutions such as
the Accounting and Auditing Organization for Islamic Financial Institutions
(AAOIFI) will issue standards which allow either methodology or a
combination of the two.
With regards to financial compliance, the issues are somewhat straight-
forward once the definition of terms and their composition are agreed.
However, even in this area, one can encounter difficult issues. For example,
if a corporation is generally compliant but the gearing ratio shoots just over
the prescribed limit in a particular year, should its status be changed to
“fail?” This could just be an aberration due to the arbitrary cut-off balance
sheet date. One thus needs to determine whether it is long-term change in
the corporation’s operating profile or a mere blip in its activities. If the latter
is the case, then Shari’a scholars would need to be consulted if the current
“pass” status is to be retained for the next period. This could be quite an
issue for large “index” constituents as frequent changes of status create
instability and unsuitabilityfor use as benchmarks.