Special Piece by Dr Mushtaq Shah
In the past few years a plethora of apps have appeared that offer Shariah or halal equity screening services to retail investors. However, the differences between them are not always obvious. In this article we look at the history of equity screening and outline what we believe is best industry practice and the level of diligence an institutional investor would require to satisfy regulators.
Conditional Shariah Compliance
Clear cut cases are quite easy to identify so you don’t really need a screening provider (for example Islamic banks – which can also get tricky btw). However, such an approach leads to a very limited universe of unconditionally Shariah compliant companies.
As per our research, there are possibly just about 300 companies which are nearly unconditionally Shariah compliant, that too mostly concentrated in the Middle and Far East. The pioneer Shariah scholars (including Sheikh Taqi Usmani, the late Sheikh Abdul Sattar Abu Ghuddah, Sheikh Mohammed El Gari, Sheikh Daud Bakar, Sheikh Nizam Yaqubi, Sheikh Nazih Hammad, Sheikh Yusuf Talal DeLorenzo ) felt that such a universe was too restrictive and Muslims should have access to a diversified portfolio of equites for their savings and investment.
So in conjunction with Dow Jones, they worked on the concept of conditional Shariah compliance. This entailed two levels of screening, one based on financial ratios and the other on business activity of the company or the revenue that it earns. In the late 1990’s Dow Jones assembled a Shariah committee of renowned scholars (mainly the names above) who have both a strong grounding in Shariah as applied to finance and a good understanding of western finance and modern joint stock companies. They then launched the first Shariah compliant equity benchmark index in 1999.
The financial ratio thresholds were a mapping of Shariah principles to standard western accounting. Indeed they were then adopted by AAOIFI. There have been some changes in these ratios over time, with the coming mainly from leading global index providers such as the Dow Jones and the S&P and then subsequently being adopted by AAOIFI – albeit with a lag. We believe it’s fair to say that the AAOIFI in general has not been the thought leaders in this area.
The financial ratio part is relatively straightforward and here technology can be applied quite efficiently. There are many reliable third party providers of the raw accounting data in a digital form which can then be used to compute the relative financial ratios. This part is what most mushrooming Shariah screening apps call AI or ML based screening – which is all but otherwise! The fact is – it’s a simple straight forward algorithm, nothing intelligent about it!
Defining business activity: The Key differentiator!
The real issue lies in analysing business activity especially since larger corporations are quite complex in terms of what they do. Just excluding /including companies based on SIC industry classifications is not the level of detail any institutional investor would be comfortable with. To do this properly one cannot really rely solely on technology.
Shariah Compliance reviews need a team of analysts and a constant dialogue with a Shariah committee well versed in these matters – off course, aided by technology to an extent. It is just not sufficient to get an initial Fatwa from a Shariah scholar on the relevant criteria. What is needed is a more in depth process in conjunction with said scholars.
At RI/Islamicly we have documented minutes of around 50+ Shariah scholar board meetings from the last 20 years where we have perhaps discussed the commercial activities of around 300+ companies. We believe that our Shariah sensitive knowledge base and audit trail is second to none!
However, all this comes at a cost. The Shariah scholars need to be compensated for the time they spend working on the area. We employ 10+ analysts who work full time on this. Constantly sending out surveys and speaking to companies. These analysts are aided by a 10+ member in-house technology team. This is why our data is more expensive than anybody elses as it is of an institutional quality.
But what does institutional quality actually mean?
In short it means that if we are ever sued for misclassifying a stock, we have an audit trail of processes and documentation that shows that we have not cut corners and taken an appropriate and reasonable amount of care in our work. We can justify the classification in detail.
So who sets the rules/ the limits to screening?
All rules are set by the Shariah scholars board – period. This is done after due and continuous consultations with credible regional and global bodies of Shariah thought and jurisprudence. The Shariah compliance assessment provided by RI/Islamicly is a result of such a well deliberated process – rather than being an interpretation of a non-scholar researcher or some so called AI/ML algorithm – which is put to work on non-standardised data and missing/hidden Shariah sensitive disclosures.
This robust and time tested process employed by RI/Islamicly helps in giving a clear direction to Shariah sensitive investors. We have often heard comments like, “Why you have defined companies that use China in their supply chain as compliant , given the issues China has with Uighur Muslims?” We have discussed these type of issue in depth with our Shariah scholars Board. Their view is this that there is no clear cut answer. None of these companies have been banned from trading with China, indeed most Muslim countries including Saudi Arabia, Pakistan, Malaysia etc have strong trade links with China. It would be both presumptuous and inappropriate for us to advise not buying stocks of companies that trade with China.
Like all things on the internet – Cheap and beautiful may not be the BEST!
