Shariah Boards and Halal Screening

Islamic funds maintain a committee of scholars who work independent of the fund managers and advise the managers about Shari’ah compliance of various securities. The opinion of the committee is binding on the fund managers. The boards determine if a company is involved in activities which are prohibited in Islam. These include interest based debt financing, earning interest on cash, trading or manufacturing related to pork, alcohol, gambling, etc. The boards also constantly monitor the companies to make sure they remain compliant and add or delete companies from the list. The boards also monitor the investment activities of the fund to make sure it is operating based on the board opinions.

The Dow Jones Islamic Markets (DJIM) is a well-known Islamic index to screen companies for Shari’ah compliance. The screen is based on three levels, namely, industry, financial ratios, and monitoring for continuous compliance.

The first screen is for non-Halal businesses which include alcohol; tobacco; pork products; conventional financial services (banking, insurance, etc);defense/weapons; entertainment (such as hotels, casinos or gambling, cinema, pornography and music). Even if a company is doing Halal business, riba based securities of these businesses are not allowed. These include fixed-income securities, preferred shares, convertible notes or other similar instruments.

The next screen for DJIM is the revenue source of the business including all divisions and subsidiaries. It is quite possible that an large conglomerate might be involved in some businesses which may not acceptable to DJIM criteria. The index allows the maximum of up to 5 per cent of the revenue from such sources. Even in that case, equivalent portion of the profits from such revenue will have to be removed from the overall profits.

Once a selection of companies is made, further check is made into their debt to equity ratios. Even though any borrowing on interest is prohibited, DJIM Shari’ah advisors have allowed up to a third leverage for a company because Muslims have no control over finances of a company in international markets. This is considered minor compared to the equity. The allowance is based on a 12-month trailing average of market capitalization instead of assets. Based on this criteria some companies were deleted from the index, for example, WorldCom (2nd Qtr. 2001), Tyco (1st Qtr. 2002), Enron (3rd Qtr. 2001), Global Crossing (2nd Qtr. 2001).

Another screen used by DJIM is interest income. It is a common practice in the companies to put excess cash in fixed income securities or accounts. Though this is not allowed in Islam Shari’ah scholars allow a minimal of interest income as long as any profits for investors are given out in charity. DJIM considers five percent of revenue from interest as minimal. This shows that interest income is not a major source of income for the company and it is utilizing its resources to generate profits through productive means.

DJIM also looks into accounts receivable to total assets ratio. Shari’ah does not allow discounting of account receivables. However, every business carries certain account of receivables since not every transaction is conducted in cash. DJIM allows companies which do not have more than 50 percent of assets in account receivable. Finally, DJIM reviews the companies in the index every quarter to add new compliant companies or remove the companies which no longer meet the screens.