Islamic Fund Structure - Unit Trust and Mutual Fund Structure

Islamic Fund Structure

 

Islamic Fund Structures

Shariah Compliant Equity Funds

Shari’ah Perspective

Unit Trusts are based on the concept that risks and rewards are shared by the investors, employing the expertise of professional managers. This is in conformity with Islamic partnership principles of musharakah and mudarabah and is already applied within the Islamic financial system.

 (1) Investment must be made in ethical sectors. In other words, profits cannot be generated from prohibited activities such as alcohol production, gambling, pornography etc.

(2) Investing in interest (riba)-based financial institutions are not allowed.

(2) All wealth creation should result from a partnership between an investor and the user of capital in which rewards and risks are shared. Returns in invested capital should be earned rather than be pre-determined.

Islamic Unit Trusts

The Islamic unit trust schemes are collective investment funds which offer investors the opportunity to invest in a diversified portfolio of Shari’ah-compliant securities which are managed by professional managers in accordance with the Shari’ah. The Islamic unit trust schemes are required to additionally appoint a Shari’ah committee or a Shari’ah adviser to ensure that their operations are in accordance with Shari’ah.

The common types of financial contracts and products that are used by Islamic financial institutions are recounted below:

1. Mudarabah: a contract in which all the capital of a venture is provided by the Unit Trust and the business expertise and management is the responsibility of the third party. Profits are divided between the third party and the Trust according to the terms of the contract.

2. Murabaha: a contract in which a third party wishing to purchase equipment or goods (primarily commodities) requests the Trust to purchase such items and charge them the cost plus a reasonable profit. The profits accrue to the Trust.

3. Musharakah: a joint venture in which both the Trust and the third party contribute funds, producing equity participation.

4. Ijara and ijara wa iqtina: a contract in which the Trust finances equipment, a building or an entire project for a third party against an agreed rental and the third party undertakes to make payments to the Trust which will eventually result in the ownership by the third party of the equipment or project

There are many financial products in conventional financial markets which are not interest-based, or where the element of interest could be eliminated.

a) Property funds and property investment trusts,

b) Trading in commodities,( Shariah Compliant)

c) Financial options and futures,

d) Forward transactions in foreign currencies; and

e) General trade-financing transactions.

The Islamic Unit Trust may combine three important factors:

a) Conventional investment expertise,

b) Islamic finance expertise; and

c) Shari’ah guidelines provided by Islamic religious scholars.

In this way, individual Muslim investors, Muslim corporate bodies and Islamic financial institutions can take part in the international markets and thus benefit from the growth of these markets.

Islamic Unit Trusts will give priority to equity investments in:

a) Islamic banks and financial institutions’

b) Stock markets of Muslim countries; and

c) Companies managed under the Islamic system.

Shari’ah Principles for Investment Funds

Mudarabah Fund

In the Mudarabah fund the amount may be invested in a specific business activity on the basis of profit and loss sharing.

Equity Fund

(Source: Principles of Shariah Governing Islamic Investment Funds by Mufti Taqi Usmani)

In an equity fund the amounts are invested in the shares of joint stock companies. The profits are derived mainly through the capital gains by purchasing the shares and selling them when their prices are increased. Profits are also achieved by the dividends distributed by the relevant companies. Similarly the contemporary Shari’ah experts are almost unanimous on the point that if all the transactions of a company are in full conformity with Shari’ah, which includes that the company neither borrows money on interest nor keeps its surplus in an interest bearing account, its shares can be purchased, held and sold without any hindrance from the Shari’ah side. But evidently, such companies are very rare in the contemporary stock markets.

Murabaha Fund

(Source: Principles of Shariah Governing Islamic Investment Funds by Mufti Taqi Usmani)

This kind of sale has been adopted by the contemporary Islamic banks and financial institutions as a mode of financing. They purchase the commodity for the benefit of their clients, and then sell it to them on the basis of deferred payment at an agreed margin of profit added to the cost. If a fund is created to undertake this kind of sale, it should be a closed-end fund and its units can not be negotiable in a secondary market.

Ijarah Fund

(Source: Principles of Shariah Governing Islamic Investment Funds by Mufti Taqi Usmani)

The Ijarah Fund will involve in companies dealing in the leasing of assets according to Shari’ah principles. The ownership of these assets remains with the Fund and the rentals are charged from the users. These rentals are the source of income for the fund which is distributed pro rated to the investors.

Mixed Fund

(Principles of Shariah Governing Islamic Investment Funds by Mufti Taqi Usmani)

Another type of Islamic Fund maybe of a nature where the subscription amounts are employed in different types of investments, like equities, leasing, commodities, etc. This may be called a Mixed Islamic Fund. In this case if the tangible assets of the Fund are more than 51% while the liquidity and debts are less than 50% the units of the fund may be negotiable. However, if the proportion of liquidity and debts exceeds 50%, its units cannot be traded in according to the majority of the contemporary scholars. In this case the Fund must be a closed-end Fund.

Islamic Funds and Socially Responsible Investments-Shari’ah Committee

Islamic unit trust schemes must be supervised by a Shari’ah committee or Shariah adviser to ensure that the fund is managed and administered in accordance with Shari’ah principles. The Shari’ah Committee should function independently of trustee and portfolio manager.

Shari’ah Supervision of Islamic Funds

The following are some of the important Shari’ah supervisory functions enumerated by international Shari’ah scholar, Shaikh Yusuf Talal Delorenzo:

Portfolio purification

Fiscal purification of earnings: income from interest-bearing investments should bededucted from total earnings

Moral purification:

The concept may be best understood in the context of the Qur’anic concept of “enjoining the right and prohibiting what is wrong”. [3104, 110 and 114 –7:157 – 9:71]

Zakat: it is the moral duty of individual Muslim investor to pay zakat calculated as a proportion to their own personal wealth.

Portfolio selection: Screening Stocks

Scrutiny of stocks is one of the most important functions of Shari’ah Boards. Portfolio monitoring

Apart from selecting stocks, it is equally important to monitor them as business situations continually change.

Working with fund management

The Shari’ah Board has a role to pay when it is a matter to avoid interest, or of purifying the interest that has accrued when no other course of action is available.

Monitoring of fund fees

Islam exhorts transparency in business dealings, hence the Shari’ah Board should ensure that investors are made aware of the fund’s fees and how these are structured.

Monitoring fund documentation

All documentation requires making references to the Shari’ah and its interpretations. It is, therefore, important that the Shari’ah Board is involved in the preparation and review of all pertinent legal and business documentation.

Additional Requirements for Islamic Unit Trust Funds

While Islamic Unit Trust Funds require to appoint a Shari’ah Committee, the following are additional requirements:

1. Composition of Investment Committee Members should play a role in ensuring that the investments made by the Islamic trust fund are in line with Shari’ah principles. In this regard, the Investment Committee of the Islamic unit trust fund must comprise of at least two (2) members who are Muslims.

Furthermore, there will be no qorum for the purpose of the Investment Committee meeting unless one (1) Muslim member is present.

 2. Compliance Unit must include a compliance officer or an assistant who is a Muslim.

3. Additional Role, powers and duties of the Shari’ah Committee consultant require:

(a) The Shari’ah Committee, or a company appointed to advise on Shari’ah matters) will appoint one (1) representative to attend the Investment Committee meeting when discussing matters relating to the Islamic unit trust fund. The representative is expected to advise on matters related to Shari’ah principles.

(b) The Shari’ah committee / representative must undertake necessary measures to avoid any potential conflict of interest, when attending more than one Investment Committee meeting of Islamic unit trust funds managed by different management companies.

(c) The Shari’ah committee / representative responsible for scrutinising the fund’s transaction report provided by the trustee must prepare a report to be included in the fund’s annual report certfifying that the fund has been managed and administered in accordance with Shari’ah principles.

(d) A Shari’ah committee member must also meet the following criteria:

is not an undischarged bankrupt

has not been convicted for any offence arising out of criminal

proceeding

is of good repute

possess the relevant qualifications and expertise, particularly in Fiqh Muamalat and Islamic jurisprudence

 

Islamic Indexes for Islamic Funds

The Dow Jones Islamic Markets (DJIM) is one of the important Islamic indexes and their approach Islamic screening is considered in this section by way of an example (Islamic indexes: the DJIM framework by Rushdi Siddiqi, Islamic Asset Management pp 46-55, Euromoney Books 2006).

Islamic screening takes place at three levels:

1. Prohibited industries.

2. Acceptable financial ratios.

3. Monitoring, removal and replacement.

Parameters for acceptable industries

The first level of DJIM screening for Shari’ah-approved companies is divided into two parts. First, an Islamic investor may not purchase fixed-income securities, preferred shares, convertible notes or other similar instruments. The reason for this is that a predetermined rate of return is stipulated, while the principal is guaranteed. This clearly falls within the riba prohibition on interest-bearing loans, even if the primary business of the company (whose securities, shares or notes are tendered) is halal or in compliance with the Shari’ah law. Secondly, an Islamic investor may not purchase the shares of companies whose primary or basic business is haram (unlawful), including (but not limited to): alcohol; tobacco; pork products; conventional financial services (banking, insurance, etc); defence/weapons; entertainment (such as hotels, casinos or gambling, cinema, pornography and music).

Revenue breakdown

In quantifying business revenue, the funds may undertake the process of ‘purification’ to remove impermissible securities from the fund. The threshold set by the DJIM Shari’ah supervisory board is impermissible revenue of 5 per cant, so anything above that amount results in non-inclusion (or deletion at quarterly reviews) of the company.

Financial ratios  

What generally distinguishes Islamic (equity) investing from socially responsible investing (SRI) and faith-based investing (Christian and Catholic funds) is the emphasis on the balance sheet of the company in question. It should be noted that there are a number of references in the Bible to ‘dealings against interest or usury’ (for example, Exodus 22:25-6; Leviticus 25:35—37; Deuteronomy 23:19-20; Nehemiah 5:7; Psalms 15:5; Proverbs 28:8; and Ezekiel 18:8, 18:17 and 22:12). Their enforcement, however, is another issue.

Leverage

This is first level of DJIM financial screens examines the leverage (or gearing) ratios of the company in question. Contemporary Shari‘ah scholars have allowed the acquisition of shares in a company with leverage that does not exceed one-third of equity, defined as market capitalization or assets.

The DJIM Shari’ah supervisory board has advised in favor of setting the debt/market capitalization ratio requirement at less than 33 per cent. To reduce volatility, the DJIM uses a 12-month trailing average for market capitalization.

Cash plus interest-bearing securities

The second level of DJIM financial screens attempts to ascertain the level of nonoperating interest income. Such dubious income, however, must be kept to a minimum if the company is to conform to Shari’ah precepts. Some Shari’ah boards state that non-operating interest income/revenue (or sales) should not exceed 5 per cent, while other boards set a 10 per cent or even 15 per cent limit. Unlike the one-third provision, which is based on a hadith reference, the 5, 10 or 15 per cent is based rather on an interpretation of what is ‘minor’.

The Shari’ah allows investing in shares of companies in which the primary business activity is deemed lawful if the accounts receivable do not represent the majority (more than 50 per cent) of total assets.

Review process for continued compliance

The companies in the DJIM are reviewed on a quarterly basis for continued compliance, while the companies in the FTSE Global Islamic Index Series and the KLSE Islamic Index are reviewed on a semi-annual basis. Generally, Shari’ah supervisory boards of Islamic mutual funds allow 30 to 60 days (some even 90 days) to remove a non-compliant company so as to minimise any adverse financial impact on the portfolio/fund.

 

 

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Comments 3 comments

Riri 23 months ago

I strongly agree with u. HKICPA is only a "Big-4" prative entertainment club. How many things they have done to us? Their fees can be covered by their Company. Therefore, they have no feeling towards any increment. And we are only a small potato. Compared with other professionals such as engineers, their annual fee is only a few hundred. Why so great difference. Why we need to pay for HK$12,500 for a sole proprietorship?Why they need to hire 200 staffs? The Society of Chinese Accountants & Auditors only hired a few staffs. SCAA has done a lot of things to us such as many reasonable price seminars, members' forum and free Annual Dinner. The contents of SCAA's seminars are better than HKICPA. Therefore, HKICPA has done a lot of "Pretty Dame Good" things to us. It is not reasonable to increase the price to us. If Big 4 is generous enough, please asks them to donate to HKICPA individually. They enjoy the facilities much more than us.


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ZIa Ahmed khan 4 years ago from Kuwait Author

I only advise on projects and entrepreneurship, I do not fund projects.


noahbnd@gmail.com 4 years ago

Do you find projects in Africa

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