Portfolio Diversification

Once you have decided to follow ethical investing guidelines, the next step is to select the assets to invest in. It would have been easy to just choose the best performing fund and buy its shares. However, there is always a disclaimer that past performance is no guarantee of future returns. Every investment brings in its share of risks. There is always a risk/return tradeoff. Higher returns almost always carry higher risks. Hence, the case for diversification. Based on your appetite for risk, you choose the investment that balance your desire for return versus the risks. This is also called the asset allocation.

First, we need to explain the difference asset classes available in the market place. From ethical investment perspective, there are three major classes of assets: equity stocks, fixed income sukuks (Islamic bonds), and real estate. Since the choices for Sharia Compliant funds are extremely limited, only one, two or no funds are offered within each category.

The stocks are categorized by the market capitalization into large-cap (>$10 billion), mid-cap ($2-$10 billion), and small-cap (<$2 billion). The small-caps can be further divided into micro-cap ($50 – $300 million) and non-cap (<$50 million). Usually, the smaller companies are expected to have higher returns and also high risks. Large-caps are usual household names which tend be more stable, thus giving lower return and lower risks. There is also separate categories for international stocks and emerging markets. These carry additional political risk with higher potential return. Some fund managers also further divide stocks into growth, value, and income stocks. As the names imply, growth are stocks that have potential to grow, value are under-valued stocks, and income are the ones that give regular dividends. Some funds are the mix of these and are called “blend’.

Fixed income securities include bonds and money market funds that pay a fixed amount of interest to the investor periodically. Since Muslims do not deal in interest, these securities are not an option in a Halal portfolio. There is an Islamic equivalent of bond called Sukuk . Sukuk are offered by some Islamic and European countries and there are two Sukuk funds available to the US investor.

Another diversification category is real estate. Instead of owning property and managing it, the investor can buy shares of Real-estate investment trusts or REITs. There are no well-known halal REIT funds available, but some brokers can offer pool of REITs which meet Sharia guidelines.

Diversified portfolios start from conservative, which are mostly fixed income securities. They offer lowest return and with very little risk. These are for retired people who are very much concerned about preservation of capital. The other end of the investment spectrum is the aggressive portfolio, which consists of mostly stocks. The level of risk increases with demand for higher returns. There are middle categories which can moderate the risk and return by adjusting stock and sukuk mix to arrive at the desired portfolio.