Islamic finance 101: Debunking the common myths
Islamic finance is one of the fastest-growing sectors in the world, targeting a vast portion of the global population that has been largely underserved by the financial services industry.
It’s thought that the Islamic finance industry will reach $3.8 trillion in assets globally by 2022, from $2.2 trillion in 2016.
Traditionally, Islamic finance has focused on banking and mortgages, but more recently it has included investment in its remit, with Sharia-compliant funds now gaining in popularity.
But despite the prolific growth of this industry, there are still many common misconceptions about Sharia-compliant investment products. So let’s debunk some of these myths.
Is it only for Muslims?
While the premise of the Islamic finance industry is to create financial products that are designed to meet Sharia standards, that’s not to say that only the Muslim community can use them.
In fact, there are no restrictions for any investor wanting to buy Islamic products, and because of the socially responsible principles that these products have to adhere to, they can be a useful tool for anyone who wants to invest ethically.
While there can be different interpretations of Islamic law, the basic premise is to invest in businesses that are socially responsible, while avoiding those with excessive levels of debt.
Companies which derive most of their profit from “forbidden” sectors like alcohol, gambling, weapons, pornography, or tobacco are also prohibited – and for Muslim and non-Muslim investors alike, that might seem like a positive way to allocate their money.
Is it purely focused on charity?
Charity is a core pillar of the Islamic faith, but that’s not to say that these investment products are prohibited from making a profit.
Indeed, Islamic finance institutions will aim to make a return, but they cannot profit from interest (known as “riba”).
Islamic law essentially prohibits you from using money to make more money, so you can’t make a return by simply lending your cash to someone else. You can, however, profit from doing “work” – so asset-classes like equity, property, and commodities are permissible if the money has been earned.
Aris Parviz from online platform Wahed Invest also highlights that investing can be used as a tool for carrying out charitable work.
“If you put that money away into an investment portfolio, hypothetically, over 30 years, it could be a huge sum of money – and then you have increased the impact that you give back to society.”
He points out that if any profit comes from interest, this can also be given to charity as a way of “purifying” the portfolio.
Do you have to forgo returns?
A concern which often gets thrown around when people talk about types of ethical investment is that you have to sacrifice returns.
“There is a belief in some minds that Islamic investments are substandard in performance compared to conventional assets because they are constrained from participating within certain industries,” says Lawrie Chandler, director of Edale Investments.
In fact, often the opposite is true. Bearing in mind that Sharia-compliant funds screen out firms that take on copious amounts of debt, Islamic investors often end up buying some of the strongest and most sustainable companies in the market.
Indeed, Chandler points out that the bias towards under-leveraged businesses meant that Sharia investors were pretty much unscathed during and after the financial crisis.
Can you can only invest in equities?
The vast proportion of Shariah-compliant funds invest in equities, which Chandler says is because it’s easy to create them (most mainstream investment houses use their environmental, corporate and governance team to apply a Sharia filter to a stock list).
However, there is a greater range of asset classes available to Islamic finance investors than some people realise. Indeed, real estate and commodity funds are also becoming more common.
Islamic bonds, which are called sukuk, are another little-known asset class. Rather than benefitting from interest in the way a traditional bond would, sukuk give a certificate of ownership that allows the investor to receive profit generated by the underlying asset.
Chandler says that sukuk have a similar risk-return profile to corporate bonds. “The defining characteristic of sukuk is that they are asset-backed, so investors are buying and selling the rights to an underlying real asset, usually a piece of real estate or a movable asset such as equipment or vehicles.”
He also suggests that a balanced investor allocate up to 40 per cent of their portfolio in sukuk.
Is it about sending money overseas?
Some people may also believe that Islamic finance is focused on investing in companies that only operate in Muslim countries. “I think that is just because it’s a newer industry,” says Parviz. “It’s just due to a lack of understanding.”
Lack of knowledge of this emerging market can indeed cause misconceptions – both among Muslim and non-Muslim investors.
But as this sector grows, bolstered by the standardisation of products and surge in demand for ethical investments, this financial model is set to compete with more traditional markets.
Main image credit: Chris Hondros/Getty Images