Incorporating Socially Responsible Principles in Islamic Investments – Part 1 The Islamic

The Islamic asset management industry needs to evolve. So thinks Rizwan Malik who believes that the stagnancy of the screening methodology is leading to lost opportunities. He argues that the industry needs to take account of SRI principles and finds that many companies in the GCC are already doing so. In light of this Islamic finance needs to move away from negative screening and incorporate more positive screening criteria.

Introduction

In 1999, Dow Jones issued a set of screening methodologies to determine stocks deemed compliant with Shari’a. It provided Shari’a-sensitive individuals the opportunity to enter the capital markets. Since, these screening methodologies have been adopted by other index providers and fund managers with slight amendments. However, the fundamental tenets of these methodologies remain the same, narrowing the number of available stocks to invest in for Shari’a-sensitive individuals. In addition, these screening methodologies have failed to account for ethical precepts commonly adopted by the socially responsible investments (SRI) industry. This contradicts Islamic finance’s own ontological assessment of itself as being socially responsible.

The Islamic economic and finance system is perceived as a socio-economic finance system that incorporates ethics and morality into economic activities, with values such as fairness, justice and equity informing its activities. Hence, it is natural to assume that for the Islamic finance industry to succeed there has to be more collaboration between the Islamic finance and SRI industry. The Holy Quran instructs “Eat and drink from the provision of Allah, and do not commit abuse on the earth, spreading corruption” (Quran 2:60). In this regard it is important for the Islamic fund management industry to include factors related to the environment, labor and human rights and other SRI issues in their decision-making process. Incorporating SRI principles can have two significant benefits for the Islamic funds industry. First, it will increase the portfolio of Shari’a-compliant investments by attracting investments from ethical sources. Second, it will allow SRI investors to diversify their portfolio into Islamic investments which tend to be less risky than their conventional counterparts.

At present, Islamic fund management does not take into account SRI-related issues; rather focusing on whether the output of the business is Shari’a permissible. This has resulted in a negative screening methodology meaning that stocks are rejected on the basis of some criteria. On the other hand positive criteria mean companies are accepted for the work that it is doing. In the SRI industry, positive screening means selecting shares in companies that encourage CSR practices These include good governance, labor relations, and sustainability of investments. Such screens use “Best in Class” approach to rank companies according to CSR criteria. Further strategies include “Sustainability”, “Norms based”, “Engagement”, “Integration” and “Impact investing”. SRI and Islamic screening have some overlap. Some of the common businesses excluded under both Islamic and SRI screens are alcohol, tobacco, gambling, weapons & adult entertainment. At the same time there are some significant differences between the two industries (Table 1). For Islamic investors, their focus is the compliance of eligible assets to Shari’a, followed by performance whereas SRI and Islamic screening have some overlap. Some of the common businesses excluded under both Islamic and SRI screens are alcohol, tobacco, gambling, weapons & adult entertainment. At the same time there are some significant differences between the two industries (Table 1). For Islamic investors, their focus is the compliance of eligible assets to Shari’a, followed by performance whereas for the SRI investors, importance is on sustainability and the environment before financial performance.

Historical Development of Islamic Equity and Socially Responsible Investments

Islamic equity investments began with the Fatwa by Justice Mufti Muhammad Taqi Usmani (Pakistan), Professor Saleh Tug (Turkey) and Sheikh Mohammad Al Tayyeb Al Najar (Egypt) in July 1987. The Fatwa stated preconditions for investing in public listed equity securities. Further, the International Fiqh Academy issued a ruling in 1992 that approved stock of companies that do not engage in activities which violate Shari’a principles. This was a significant ruling for the development and realization of Islamic mutual funds industry since it permitted Muslim investors to participate in the equity markets.

Islamic funds are still in their infancy, compared to conventional and socially responsible investment funds both in terms of its assets under management (AUM) and its growth. Islamic funds witnessed 7.6% growth in 2010, significantly lower than its conventional counterpart, which saw 35% growth. The total number of Islamic funds reached 1065 in 2013.

The concept of SRI investments has its roots in religion. The earliest reference is found in the Quaker movement and their avoidance of investing in companies involved in the slavery business in the 17th century. The first investment policies were organised around avoiding companies involved in sinful acts like tobacco, alcohol and gambling.  The first responsible investment fund in US, “The Pioneer” fund, was launched in 1928 and excluded investments in companies involved in alcohol and tobacco. This fund is still in existence although under a different name. The first SRI mutual fund was the Pax World Fund founded in 1971 by Luther Tyson and Jack Corbett who actively worked on a variety of projects for the United Methodist Church. In the 1980s-90s there was an increased focus on environmental issues including the establishment of the United Nations World Commission on Environment and Development in 1983 and the Earth Summit in 1992. A number of SRI indexes have been launched with the first launched in 1990. During the 1980s the SRI funds evolved to include negative screening i.e. avoiding businesses involved in prohibited activities; the screening criteria has since expanded to include positive screening, i.e. investing in companies involved in promoting socially responsible ventures etc. According to the Global Islamic Asset Management Report 2014, the SRI industry is worth more than $33 trillion globally.

Socially Responsible Investment Screening

The SRI investment screens have evolved over the years. They have developed and increased to include social, environmental, religious screens. Table 2 lists screens used in SRI industry. These screens can be classified into either positive or negative screens.

There are three types of SRI strategies:

Social Screening: This includes both positive and negative screening. Negative screens are the simplest for firms

1. Shareholder Advocacy: By significant ownership of the company, shareholders influence the decisions of senior management by lobbying for socially responsible investments.
2. Community Investing: Directing funds towards underserved communities that do not receive financial interest. The aim is to provide credit, banking and other basic financial services to communities.

Some of the SRI factors are shown in Table 2

Analysis of the GCC Shari’a compliant stocks against SRI Principles

The development of joint-stock companies in the Muslim world is quite a recent phenomenon, and therefore investment activism is constrained given that most limited companies do not necessarily subscribe to an Islamic normative. Investigating further, however, reveals that in many Muslim countries, the idea of social responsibility is gradually affecting the way companies function. To explain, GCC stocks were selected from DJIM,  as Islamic finance in these countries appear to be more advanced and developed compared to other countries. In total there were 63 Shari’a-compliant companies from the GCC region from various industries including financial services, real estate, energy, consumer goods and services, healthcare, industrial, transportation, and telecommunications (Table 3).

Of the total stocks, 66% of them incorporate some SRI principles, while 34% of these stocks do not. Of these 34% companies, 32% are real estate companies, while others are from transportation and consumer goods industries. 27% of the total stocks have only employed Corporate Governance principles. This includes financial institutions, construction and real estate industries. Most of these companies have an internal corporate governance framework and issue reports on a regular basis.

31% consider environmental issues as part of their overall strategy. This means that companies operate in an environmental friendly way or these companies have employed resources that reduce externalities arising as a result of their operations and employ resources that will make a positive difference. An example of this is Aviation Lease and Finance Co, a Kuwait-based company which manufactures aircrafts that consume less fuel.

16% consider labour standards including health & safety in the workplace. 21% give back to the community they work in. This may be in the form of being involved and supporting the initiatives employed by the community, being part of charitable projects, initiatives for youth development, etc. Two organisations mentioned the usage of anti-corruption measures which include fair dealings, anti-money laundering, etc. By being located in the Muslim world, some companies as part of their CSR activity distribute zakat; however only one organization under review has highlighted this. Similarly only one company mentioned that it follows UN Global Compact and only a single company stated that it follows Islamic principles.

It is clear from the brief analysis that no one single company follows a set pattern of CSR or SRI activities although 66% of the companies are showing some commitment to SRI/ESG principles. A more comprehensive strategy is needed to integrate SRI principles along with Islamic principles and an overt declaration to supporting both.

Following the UN Global Compact offers an avenue in which this can be achieved.

Conclusion

The Islamic banking and finance industry has experienced tremendous growth since the introduction of the first screening methodology in 1999 by DJIM. Since then a number of screening methodologies have been developed all around the concept of avoiding businesses that are not in compliance with Shari’a. However, it is time for Shari’a screening methodologies to include wider SRI principles in addition to these negative screening and promote the socially responsible elements. This will move the existing screening methodology away from being just Shari’a compliant to achieve Maqasid al-Shari’a. The Islamic banking and finance industry has started moving in this direction. F&C asset management launched an Islamic fund in 2010 which incorporated both SRI and Islamic principles. Sedco Capital based in Saudi Arabia has launched funds that comply with UN Global Compact, and most recently Arabesque asset management is also launching funds that are both socially responsible and Shari’a compliant.

To develop more robust criteria which integrate both SRI principles and Shari’a norms, the UN Global Compact offers principles that can be used by the Islamic finance industry in the creation of screening methodologies. In Part 2, I look at how Islamic ethical precepts adhere to these principles.