Principles of Islamic banking and finance/PIBF203/Portfolio management/Shari'ah compliant portfolio management process

Shariah-compliant portfolio management process
The task of ensuring that a fund is managed in a Shariah-compliant manner goes beyond static compliant lists and spreadsheets used to automatically screen potential investments using data retrieved from conventional data providers. Unfortunately, a large number of Islamic funds are managed in this manner while valid Shariah compliance goes far beyond these simple procedures. Shariah compliance is about providing fund managers with credible Shariah advisory, data, and screening services, purification, and ongoing compliance monitoring capabilities. Investment trusts that want to which are willing to offer Shariah-compliant investment products have to extend their conventional portfolio management processes by a set of Shariah-related concepts so that the entire investment process operates in a Shariah-compliant manner.

Shariah issues in investment policy analysis
The investment policy analysis includes identifying investors’ preferences and requirements, which also requires analyzing the investors’ perceptions about shari’ah issues and which Islamic school of thought to follow. It might occur that the client has his own shari’ah Board, as it is frequently the case with GCC clients. Thus, he would provide the asset manager with the shari’ah guidelines to follow or would for instance suggest the usage of a commonly used shariah mandate defined by an accredited Islamic governing institution such as AAOIFI. Market insight reveals that several asset management firms manage the portfolios for different institutions or high net worth individuals using client-specific Shariah mandates or guidelines.

In the case of launching a public fund a Shariah Board has to be appointed which defines the Shariah guidelines to follow and periodically checks that investment practices and portfolio holdings adhere to the guidelines they have defined. The selection of the Shariah Board members is one of the most important decisions to take while planning the launch of the fund. The reason is that different schools of thought exist across the Muslim world, which can also be noted through the diversity of Shariah guidelines defined. Shariah guidelines defined by Malaysian scholars might be considered too liberal for GCC investors whereas Pakistani or Indian Shariah scholars define different Shariah guidelines to those defined by GCC Shariah scholars for instance. Therefore, the target investment group should dictate the appropriate Shariah Board. A German fund for instance should appoint a Shariah Board which contains, but must not be limited to, scholars from Germany and Turkey to ensure that German Muslims who predominantly originate from Turkey can identify themselves with the offered product. The same applies to a Western fund targeting GCC or especially Saudi Arabian investors. In that case it would be wise to appoint a Shariah Board well known in Saudi for its credibility and opinions.

After the Shariah ruling source has been identified the trust should provide these investors with the appropriate mechanism to ensure that investments are conducted in accordance with the prescribed Shariah guidelines. This can be done through selecting an appropriate Shariah screening provider that would provide tools or means to identify the subset of investments, which would be considered Shariah-compliant. Shariah screening can be done either with Islamic indices or with relying on a customizable Shariah screening system. Using a screening system encompassing the diverse Shariah guidelines defined by different Shariah scholars has a number of advantages.

◦ Tailored funds. The investment trust is capable of providing different products for different Islamic investor groups. The perception of Islamic investors from Arab countries differs from that of Muslims from Pakistan and India or from South East Asia for instance. Thus, the use of a screening system facilitates the management of multiple managed accounts with different Shariah perceptions.

◦ Independence from index provider. The use of Islamic indices is advantageous in that it provides you both with an asset universe and a performance benchmark. The major problem with Islamic indices is that the index is constructed using a specific Shariah mandate which might differ from the one your client or Shariah Board has imposed on your funds. Another disadvantage is that indices might not cover your entire requirements – for example, the limited asset universe means that there might be equities of interest, which are not part of the index. Another issue with indices is that they change their constituents over time based on criteria independent from Shariah issues such as minimum market capitalization or liquidity requirements. Compliant equities might be removed from an index and thus the asset manager loses track as to whether his holdings are still compliant or not. Using a flexible screening system enables trust funds to check the compliance of an asset they want to include in their asset universe and to remain unaffected by non-Shariah related index revisions. Finally, an adequate benchmark needs to be determined in order to evaluate the asset manager performance. Benchmarks used could be a conventional index, an Islamic index provided by index providers, or a customized Islamic index where the index is constructed using the same Shariah requirements as the ones used to evaluate compliance for the managed portfolio. Using a conventional index might be misleading because the conventional index includes for instance equities from the financial sector which are not eligible for investment for the Shariah-compliant managed portfolio. Therefore, the best choice would be to benchmark the fund to a customized index, which is determined using the same Shariah guidelines used to screen the fund positions.

Shariah issues in financial analysis
The investment policy statement defined in the policy analysis is used as input to further analyse and identify the appropriate investment strategy and to explore potential asset classes and assets to be considered for investment. The financial analysis phase has to be extended to analyse the effect of the Shariah guidelines on the asset universe, expected risk and performance, as well as the compliance sustainability of the investments. Based on recent research using different Shariah mandates, about 30% to 35% of the global asset universe would be considered Shariah-compliant. Asset managers have to analyse their portfolio strategies and their expected returns and risks based on this limited asset universe. Since the Shariah guidelines are based on financial figures which change over time, an equity which is Shariah-compliant today might turn non-compliant in the near future and therefore asset managers should be able to assess the probability or risk of an equity to turn non-compliant so that they are not faced with a forced liquidation due to a sudden compliance change. Finally, purification which is a process of cleansing your investments from any non-compliant portions should be analysed and accounted for by the managers to calculate net expected returns after purification. Purification will be discussed in more depth in the Shariah screening section.

Shariah issues in portfolio construction
Based on the definition and analysis reached in the planning phase both the conventional portfolio requirements (objectives, legal and internal guidelines for instance) and the Shariah requirements are to be considered within the portfolio construction process. Once the portfolios are implemented an ongoing Shariah compliance check needs to be run to ensure that holdings have not changed compliance. In the case where holdings do change compliance, the asset manager is granted a predefined time window within which he has to liquidate these shares. Based on the Shariah mandate followed, this time window might range from immediate liquidation up to a period of 90 days.

Since Shariah investments have to adhere to local laws, legal requirements might enforce structuring investment processes differently from one country to another. A good example of this is the purification of investments. In the GCC for instance dividends can be accounted to the fund and on a periodic basis (for instance quarterly) can be purified from the impure portion and be donated. In the West this might be a problem due to taxation issues whereas if the total dividends are pooled into the fund, it will be complicated to purify these dividends without taxing the impure amount and to deduct these amounts from the fund wealth. To overcome this problem, a Luxemburg-based fund for instance calculates purification amounts once dividends are received and before pooling these dividends into the fund and thus is able to deduct these non-compliant portions immediately. Another approach followed in Western countries is not to purify dividends directly and instead to report to the investors the amounts they have to purify in order to consider their investments purely Shariah-compliant.

Shariah issues in performance analysis and portfolio revision
Shariah compliance is dynamic in nature and therefore with the availability of newly published financial information, an investment may turn from compliant to non-compliant. Therefore exactly as is the case with conventional guidelines, the Shariah feasibility of the portfolio is not a constant and has to be frequently checked and the portfolio has to be rebalanced if compliance does not hold any more. A compliance report should be generated that reflects the compliance status of the portfolio as well as the reason of non-compliance if non-compliant equities are held. It is also important from a Shariah perspective to generate violation reports through which the Shariah governing authority can investigate whether non-compliant holdings exceeded the allowed liquidation time window. Another relevant Shariah issue is the periodic reporting of purification amounts to investors as described above, to finalize the Shariah compliance requirements of the proposed Shariah-compliant portfolio management process.