Sharia (other variations Shariah, Shari’ah) is the Muslim or Islamic law which regulates many aspects of a Muslim’s life including the type of investments allowed. For instance, interests are considered usury according to the Riba rule therefore bonds are prohibited to investors following the Sharia law. A Shariah compliant fund is an investment vehicle fund structured in accordance to Shariah rules. Shariah funds can be managed as mutual funds, ETFs or hedge funds. They are in essence common funds with an extra layer of Islamic rules integrated in the investment polices of the fund not dissimilar to SRIs. The funds are required to be fully compliant with Shariah rule; however, the companies structuring, managing and promoting the funds do not have to be necessarily Shariah compliant.
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It is an attempt to instill communal, ethical and socially responsible values into investing. E.g. It prohibits taking undue profits, overcharging of commodities in scarce supply, manipulation of demand-supply gap to the benefit of hoarders, etc., It also does not allow excessive debts, It prohibits investing into Tobacco, Cigarette, Alcohol, and other domains which are harmful for health. Hence it brings in a sense of responsibility as well as humanity into how your investment will give you fair returns by preserving the ethics and values.
Commodities
Commodities funds generate profits by buying and reselling Halal commodities. Because of the restrictions on the use of derivatives, commodities fund make use of two types of Shariah approved contracts:
Istisna- It’s a contract where the buyer of an item funds upfront the production of the item. A detailed specification of the item has to be agreed before production starts and the cost of production can be paid partially according to manufacturing stages.
Bay al-salam- It’s similar to a forward contract where the buyer pays in advance for the delivery of raw materials or fungible goods at a given date. The spot price of the item includes the profit of the person who has taken the task of purchasing good and, of course, the cost of the product.
Equity funds
Funds that invest in common shares in companies engaged in halal business. Companies are also screened in order to check for Shariah compliant accounting principles. Because of the limited pool of companies the funds can invest into, equity funds can have higher volatility compared to similar funds in the same space.
Murabaha
They are similar to development funds, also referred to as ‘cost-plus’ financing, where a fund will buy goods and resell them to a third party at a given price. The price is made of the cost of goods plus a profit margin. Cost and margin are agreed in advance.
Ijara
Funds that acquire and keep ownership of an asset (real estate, machinery, vehicles or equipment) and then makes profits by leasing it out in return of a rental payment. The fund is responsible for the management of the asset and will normally receive a management fee. The leased item must be used in a Halal manner.
Riba
The payment or receipt of interests are considered usury and unjust. Debt is also disapproved making investments in highly leveraged companies unacceptable. Funds cannot pay fixed or guaranteed return on capital. Instead of borrowing and lending, Islamic finance relies on sharing the ownership of the assets and therefore risk and profit/loss.
Haram
Companies involved in prohibited business activities cannot be part of a Shariah fund strategy. Prohibited business activities can relate to food (production and sales of alcoholic beverages including pubs and restaurants, pork products, tobacco), gambling (casinos, on-line gambling, betting, lottery schemes), adult oriented (video, magazines, on-line material, strip clubs), dubious, immoral and illicit trades (prostitution, drugs).
Maisir
Islam forbids gambling in any form. With help of Bahrain-based International Islamic Financial Market and New York-based International Swaps and Derivatives Association, global standards for Islamic derivatives were set in 2010. One main objective in Islamic derivatives is to avoid "excessive" risk. The “Hedging Master Agreement” provides a structure under which institutions can trade derivatives such as profit-rate and currency swaps.
Day trading
Day trading is considered akin to maisir. Marketable securities generally have a multi-day settlement period, during which time the underlying instruments, while cleared, are not formally registered in the name of the purchaser. As day traders do not wait for settlement to complete, they are using a type of credit cushion provided by their broker. Some day traders also rely on a margin account to finance their trading activities.