Islamic funds are funds which comply with the Islamic (Shariah) principles. Shariah is the moral code and religious law of Islam, which is derived from the Qur’an (the Muslim holy book, as the word of Allah), the Sunnah (the example of the life of the prophet Muhammad), and fatwas (the rulings of Islamic scholars).
Any investors, whether they are Muslims or non-Muslims, can invest in Islamic funds. Some investors may invest in Islamic funds for religious reasons and some may regard them as socially responsible products. Other investors may invest in Islamic funds in order to seek diversification in their portfolios.
Key features of Islamic funds
1. Investments comply with Shariah principles
Islamic funds can only make investments which are Shariah compliant. The Shariah principles prohibit Islamic funds from:
- investments in conventional financial services (ie banking, insurance, etc) or debt instruments which make financial returns by earning interests or excess.
- investments in businesses that involve activities/products which are forbidden by the Shariah principles, for example, alcohol, pork-related products, gambling (eg casinos), leisure and entertainment (eg hotels, cinemas and music industry), pornography, arms and defense-related equipment, tobacco, biotechnology companies involved in human/animal genetic engineering.
- engaging in transactions involving speculations which are seen as being akin to gambling.
As Islamic financial products continue to develop, other Shariah-compliant products such as sukuk (commonly known as Islamic bond) and Shariah-compliant derivatives (eg Shariah-compliant Islamic cross currency swaps and Islamic FX forwards) are getting more and more popular.
A fund's compliance with Shariah principles is usually monitored by a Shariah compliance adviser appointed by the fund manager. Islamic funds generally are audited annually or semi-annually to ensure its investments are Shariah compliant.
2. Purification – Donation of incomes which are not Shariah-compliant
If an Islamic fund received income that is considered "impure" by Shariah principles, like any interest income embedded in Shariah compliant cash investments and dividend income from the prohibited business activities of investee companies received by the fund, it may be required to "purify" its portfolio of income to remain Shariah compliant. The Shariah compliance adviser determines the amount which may have been derived from activities not in accordance with Shariah principles and will donate such amount to charitable organisations as approved by the Shariah compliance adviser.
Investors should note that interpretation of Shariah investment principles may vary among Islamic professionals from different jurisdictions. In Malaysia, for example, dividend purification is not a mandatory requirement for Islamic funds. The Shariah Advisory Council (SAC) of the Malaysia Securities Commission will decide the Shariah compliant status of listed securities in Malaysia. Various factors including the company's involvement in Shariah non-compliant activities, the level of contribution of interest income received by the company from conventional fixed deposits and dividend received from investment in Shariah non-compliant securities will be considered in the analysis carried out by the SAC. Fund manager should dispose Shariah-compliant securities which are reclassified to be Shariah non-compliant should their market values exceed the original investment cost on the announcement day. The "announcement day" refers to the day whereby the Shariah status is announced. The source of Shariah compliant status of listed securities is the SAC, international index providers for Shariah-compliant securities and the fund's Shariah compliance advisors.
For the purpose of cleansing of the Islamic fund, capital gains arising from the disposal of the Shariah non-compliant securities made at the time of the announcement day can be kept by the fund. Excess capital gains derived from the disposal of the stock after the announcement day at a market price that is above the closing price on the announcement day should be channelled to charitable bodies.
What should investors consider
In light of the special requirements under the Shariah principles, investors should understand the investment objective, applicable investment guidelines/restrictions and the operations of an Islamic fund and refer to the offering documents before making investments.
In particular, investors should note the following:
- The potentially narrower investment universe due to the Shariah restrictions, which prohibits Islamic funds from investing in certain sectors or instruments.
- For an Islamic fund to remain Shariah-compliant, interest and dividends received from "impure" underlying investments or excess capital gain derived from the disposal of the relevant securities will be donated to charities. Therefore, performance of Islamic funds may not be as good as funds with similar investment objectives which are not subject to Shariah principles.
- An Islamic fund may need to dispose investments which were originally approved by the Shariah compliant adviser and/or its home regulator as Shariah-compliant at the point of purchase, but were later re-classified as Shariah non-compliant. The Islamic fund may incur a loss in the event of such disposals.
- Shariah is not a codified system and the principles thereunder are subject to interpretation, where there may not be consensus among different Shariah experts.
- Compliance with Shariah principles is not a regulatory requirement in Hong Kong. It is the sole responsibility of the fund manager to operate an Islamic fund in accordance with such principles.