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Sharia compliance of Stocks

Sharia compliance of Stocks

Contractual arrangement. Equity investment through stock ownership is essentially a mudaraba-type arrangement. In the mudaraba contract, the rab-ul-mal provides the capital while the mudarib undertakes and operates the business. The underlying arrangement is a profit and loss contract. The modern-day common stock is essentially a profit-loss instrument. The investor receives dividends when the company is profitable and experiences capital gains when the stock price appreciates. Conversely, the investor receives no dividends when the company experiences a loss and may also experience a decline in the stock's value if the market price falls. So, with stock investment, the investor is taking on the price risk and uncertainties that come with equity ownership. It is this risk-taking that justifies the returns that the investor receives. Seen from a risk-return viewpoint, there is no fixity of return and therefore no riba in earnings from stock investments. 


Underlying line of business. For a stock investment to be fully Sharia-compliant, the underlying line of business of the issuing company is the only other factor to consider. As long as the company avoids activities forbidden by Sharia, common stock investment functions primarily as a mudaraba-type arrangement, completely aligned with Islamic principles. 


Screening of Stocks for Sharia compliance. Stock is a sharia compliant instrument in its contractual arrangement. However, to be fully Sharia compliant, its underlying line of business shall be also Sharia compliant. The need to identify Sharia-compliant stocks has led to the development of Sharia screening techniques. The first, created in 1996 by the Sharia Advisory Council (SAC) of the Securities Commission of Malaysia, applies to the Malaysian market. The second, developed in 1999 by Dow Jones, provides a global index called the Dow Jones Islamic World Market Index (DJIWM). Later, to tap into the Islamic market, other indices like S&P, FTSE, and MSCI also developed their own Sharia screening methodologies. AAOIFI also offers a criterion for screening stocks. Sharia indices employ diverse methodologies and parameters to adapt to their operating environment. Sharia screening considers two main categories: the company's core business activities and its financial situation. This includes analyzing the level of interest-based debt in the company's capital structure and the amount of interest income it generates. Here's a breakdown of the key differences: 


1. Business Activities: Most Shariah indices, including Dow Jones, FTSE, S&P, MSCI, and AAOIFI, converge on excluding companies involved in activities like alcohol, pork products, conventional financial services, tobacco, and entertainment, which are generally considered to violate Shariah principles. However, there are exceptions. Notably, weapon manufacturing is a point of contention. S&P, the SAC Malaysia, and AAOIFI consider it permissible, while other indices do not. 


Another key difference between these indices lies in their treatment of mixed businesses. The SC Malaysia allows a certain portion of non-Shariah compliant activities within a company's operations as long as they are not the core focus. Other indices, after excluding fully non-Shariah compliant businesses, focus primarily on a company's financial leverage.


2. Financial Analysis: Dow Jones goes beyond the income statement and analyzes the company's balance sheet to identify excessive debt levels in the capital structure and unacceptable level of interest income. The SAC focuses primarily on the income statement.


The screening process for Dow Jones' Islamic Index is stricter compared to the more liberal approach of the Malaysian SAC. The rationale behind these differences lies in economic realities. The Malaysian criteria, designed for the domestic market, aim to provide a wider range of Sharia-compliant investment options for Muslim investors. A stricter filter might limit choices and hinder economic activity. Dow Jones, on the other hand, has a global focus and can afford a more stringent approach due to the larger pool of potential Sharia-compliant stocks worldwide.

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