Shariah screening refers to the process of identifying Shariah-compliant investments. Shariah clearly defines activities in which Muslims are not to be involved, such as riba and the consumption of alcohol and pork. Consequently, Muslims cannot invest in assets of businesses earning primarily from such activities. In regard to real estate certain tenants are not tolerated. In regard to equities further criteria apply.
To quantify these Shariah requirements, Shariah scholars define Shariah mandates containing a set of sector, financial screens as well as procedural requirements to ensure that investments adhere to the Shariah. It is worth mentioning here that screening criteria might differ from one Shariah Board to the other and thus might result in a different compliant stock universe to invest in.
Sector screens are general prescriptions through which all companies operating or involved in specific types of non Shariah-compliant business activities are excluded exceeding a specific threshold are considered non-compliant and excluded from investment decisions.
Financial screens, on the other hand, are used to analyze how deeply an individual company is involved in financial practices that are not Shariah-compliant. The main cause is Riba and the financial screen is used to select best-in-class companies considered tolerable due to necessity as companies fully free from such prohibited activities are the exception.
- 1 Standard Shariah Mandate
- 2 Automated and Researched Screening
- 3 Screening Providers
- 4 References
Standard Shariah Mandate
The following Shariah mandate is broadly based on the AAOIFI Shariah standards defined for screening equities.
Companies are only to be considered compliant from a sector perspective if the total sum of non-permissible income derived from the following is less than 5 % of their total income:
- Alcoholic beverages
- Pork products
- Tobacco products
- Production and Distribution of Music media
- Gambling / Casinos
- Financial Services (interest, derivatives, banks, asset managers…)
- Non-operating Interest
- Conventional Insurance
- Cinema / TV channels, production and broadcasting and advertising
- Hotels serving alcohol or operating casinos
- Adult Entertainment / Pornography
- Weapons and Defense
- Gold and Silver Hedging
The financial ratios to be used to screen the companies are as follows:
- Interest-bearing cash and short-term investments / 12-month daily avg. market capitalization < 30%
- Interest-bearing debt / 12-month daily avg. market capitalization < 30%
- Liquid assets including cash, short-term investments and receivables / assets < 70%
Companies that operate according to the Shariah and / or have a Shariah board supervising their activities are to be considered automatically compliant such as Islamic banks and Islamic insurance companies.
Since the sector screening considers companies with a non-compliant income up to 5% permissible, this non-compliant portion has to be purified or cleansed from the investment afterwards.
Automated and Researched Screening
Automated screening refers to the process of using automated data feeds to decide whether an equity is Shariah-compliant or not.
- Sector screening is conducted using broad industry classifiers such as ICB or GICS. Each company is assigned a single industry classifier based on the majority of revenue. If this industry classifier is related to a non-compliant or suspicious industry it is considered non-compliant.
- Financial screening is conducted using automated data feeds. So if debt ratio is to be calculated the total debt as reported by the data provider is used in the ratio.
- Sector screening is conducted using researched data so that different non-compliant income activities are identified and considered rather than depending on a broad sector classification.
- Financial screening is based on researched financial data which if the companies are listed in Islamic countries or have Islamic financial transactions results in a huge compliance difference. In the case of debt for instance, only the interest-bearing debt is considered in the ratio calculation since there might be Shariah-compliant debt in the form of Sukuk.
Automated versus Researched Screening
Automated screening might result in compliance credibility issues since companies that should be deemed non-compliant are considered compliant and vice versa. Researched screening on the other hand will ensure that Shariah screening is done according to the intended Shariah requirements defined by the governing Shariah boards.
Screening providers include:
Major Islamic Indices
Shariah Screening and Data Providers
- Participation and Trading in Equities of Companies Which Main Business is Primarily Lawful but Fraught with Some Prohibited Transactions by Sheikh Nizam Yaqub
- Sustainability, Islamic Finance and Managing Risk While Seizing Opportunities by Michael Saleh Gassner
- Identifying Shariah-compliant equities – a challenging task by Shehab Marzban and Mohamed Donia
- Review and analysis of current Shariah-compliant equity screening practices by Ulrich Derigs and Shehab Marzban
- New strategies and a new paradigm for Shariah-compliant portfolio optimization by Ulrich Derigs and Shehab Marzban
- Shariah Compliant Equity Investments: An Assessment of Current Screening Normsby M.H. Khatkhatay and Shariq Nisar