Shariah-compliant finance was taking an ethical view of investing long before the rise of sustainable investment strategies in western financial markets.
Now, as both Shariah-compliant and sustainable investments expand, investors and issuers are finding increasing complementarity between Shariah-compliant investments and those that also comply with international standards on sustainable investing.
Trevor Norman, Director of Islamic Finance and Funds at VG, explains how these two investment markets are converging.
The sustainable finance spectrum ranges from negative screening (where the primary focus is to achieve a financial return, while also making a positive impact) to impact investing (where the primary focus is to achieve a positive impact, while also making a financial return).
The underlying function of Islamic finance is to serve the needs and requirements of Muslim clients and as such it operates within certain core principles derived from Shariah Law. This requires that any Islamic financial institution operates within appropriate moral and ethical principles, and that it promotes transactions that are for the public good, which has a natural link to sustainable investing.
The term that is commonly used to summarise this is maslaha. The literal translation is ‘benefit’ but maslaha refers to any action taken to promote any one of the five basic objectives of the Shariah: protection of faith, life, offspring, property and reason. In summary, the activities of Islamic finance are only appropriate if they serve the public's benefit or welfare and are not speculative.
Features of Shariah-compliant structures
There are several features of Shariah-compliant investment structures that conventional investors or their advisers may question, but the majority of these arise either from a lack of knowledge or simple misunderstanding. Such features include Shariah screening, terminology, and the role of a Shariah Supervisory Board but all of these, and other potential barriers, can be resolved through education and sharing of information.
- Myth: “Shariah Law only allows Muslims to invest in companies undertaking certain activities.” Quite the opposite. Muslims are allowed to invest in any company or transaction, unless the underlying activities are considered to be haram (disallowed or harmful activities under Shariah), or where it is financed in a haram manner, for example when there is too much interest-bearing debt.
- Interest vs. profit: Whereas the earning or payment of interest is forbidden (as “usury”, in cases where the return is guaranteed irrespective of performance of the underlying investment), the sharing of profits (and losses) from economic activity is fundamental to the concepts of partnership in Islamic finance. This is best summarised by a phrase, commonly used in Islamic financial contracts, “the profits that Allah bestows on our joint venture”.
- Terminology: Recently, an adviser queried “the differences between the three forms of contract starting with M?” – he was referring to Mudarabah, Murabaha and Musharakah. Even after 20 years involvement in this sector, there are still times I have to think which of these may apply in a particular contractual relationship between two parties in a commercial investment structure or transaction. Each of these Islamic contracts has an economic parallel in conventional finance – an example being Ijara which is very similar to conventional leasing – although the subtle differences must be noted and adhered to.
- Cost vs. benefit of a Shariah Supervisory Board (SSB) - Several misconceptions exist about the role of Scholars; their role is a passive adviser to be consulted over issues requiring clarification not, as frequently misconceived, active investment selection or involvement in the management of the structure. Fortunately, the days of ‘fatwa shopping’ (in which investment managers would consult a series of scholars until they received the opinion they wanted) are long behind us and many investment structures are now subject to more general approval overall, use of precedents and standardisation of documentation as the Islamic finance sector has matured.
In summary, the real problem is a lack of knowledge regarding the differences between a Shariah-compliant investment structure and a conventional structure; or as I would prefer to put it, a lack of knowledge regarding the similarities.
Principals guiding investors worldwide
There are many variations of the definition and basis of sustainable investing, but the generally agreed summary is that it is a type of investing that takes into account investors’ personal values and beliefs. As such, it will mean different things to different people. An individual’s values are derived from sub-sets of social, moral, religious, political and environmental principles, many of which overlap with others, and some may even conflict.
Social: Societal factors dictate what is acceptable to a particular society and what is not. As previously mentioned, in a Muslim society these are generally summarised within the concept of maslaha which requires that a Muslim considers what could be beneficial to society as a whole, prior to making investments.
Moral: Investors will not invest in any industry or company that does not align with their moral values. For example, an investor with strong feelings that certain industries, such as tobacco manufacturing are against their morals would not want to invest in this sector. Typically, this form of investing is viewed as negative screening, and has certain similarities to haram screening which is one example of the overlap between these categories.
Religious: Every religion has its own practices, beliefs, and culture; while certain sectors of the media seem to concentrate on the differences, I prefer to highlight the similarities. Under Shariah Law it is prohibited to invest in alcohol production – a belief shared in the preaching of John Wesley, the founder of the Methodist Church, along with his injunction to refrain from investing in industries that harm others.
Political: The political climate can affect the way investors perceive the state of the economy and thus influence their investments. This is particularly important in times of crisis, where investors’ confidence in governments and their policies influence the choice over whether to invest or divest.
Environmental: Environmental or ‘Green’ investing is rapidly growing in importance. What started in the 1990’s as a move away from fossil fuel investing toward renewable energy investment, has developed into an increased focus on mankind’s effect on the environment and this in turn has led to the establishment of several ‘green’ investment funds.
Ethical investing is a very personal matter determined by the importance and influence of individuals’ values, so generic policies and standards for ethical investing are not always possible. However, within the green sector, standards for green bonds are evolving, such that with a greater sharing of information by organisations such as the Climate Bond Initiative and the International Capital Market Association’s Green Bond Principles it is anticipated that international standards and guidelines will be agreed.
Convergence of Shariah-compliant and sustainable financial products
Sustainable investment is not new; there has been overlap in the asset management industry for some time. Shariah-compliant fund managers are embracing sustainability standards in order to broaden their investor base some conventional managers are adopting procedures and screening to attract Muslim clients.
Malaysia has led the way in this sector. In 2014, the Malaysian Securities Commission revised its Sukuk guidelines to state that the proceeds of SRI Sukuk can be used to preserve the environment and natural resources, conserve the use of energy, promote the use of renewable energy and reduce greenhouse gas emission. These are still early days in the development of Green Sukuk, but it does already seem clear that Sukuk structures lend themselves easily to sustainable finance. By their very nature, Sukuk are restricted to a pool of approved assets and environmentally friendly projects which enable the, and so enable a sustainability focussed client to invest in renewable or clean energy initiatives.
One advantage of Sukuk is their similarity to a securitised debt instrument that is more widely understood by conventional markets. In mid-2000 we established a Sukuk structure for a client; following discussions regarding the differences and similarities of Sukuk and conventional debt securities, the investment arm of a UK high street bank purchased the whole ticket for one tier of the overall issue based upon the quality of the underlying issuer and the return that was supported by the underlying assets. Conversely, in another structure, we were working towards issuing conventional debt secured against the leases of a pool of assets, but following interest from an Islamic financial institution the structure was reworked to become Sukuk al-Ijara.
It’s as simple as knowing what matters to you
In 1996 VG launched Jersey’s first Shariah-compliant real estate fund for a Geneva-based Islamic Finance Institution which led to us establishing a number of similar structures for other clients. As a result, we have developed a deep cultural understanding of the Muslim world, knowledge of sustainable investment structures and useful expertise in an expanding and very exciting part of global financial markets.
A major factor in the continuation and development of our Shariah-compliant offerings was the flexibility of Jersey’s commercial laws. I have never had a problem accommodating Shariah-compliant forms within Jersey’s legal system and equally the Jersey Financial Services Commission has been receptive to the requirements of these structures.
VG’s long-standing track record of establishing Shariah-compliant and sustainably focussed structures, coupled with Jersey’s credentials as jurisdiction for sustainable and Shariah finance provides a natural fit for clients looking for a provider to administer Shariah-compliant and sustainable funds.