Islamic investing, based on Sharia compliance, is a huge and growing field, but automated screening is problematic, with gray areas involving lines of business and computing relative debt ratios. This paper examines how third-part Sharia compliance assessment could compensate for shortfalls in the Islamic indices.

1. • Cognizant 20-20 Insights
Sharia Stock Screening:
A Fund Manager’s Conundrum
Executive Summary screening. Lastly he has the option of numerous
third-party screening providers (e.g., IdealRat-
A Sharia-compliant Islamic equity fund is an
ings) and off-loading the entire screening process.
integral part of the Islamic wealth management
bouquet. Unlike a conventional equity mutual This white paper identifies key issues surround-
fund, managers must focus on investing ethically ing Sharia stock screening and how these issues
in businesses which comply with the Islamic could be resolved by adopting a more prudent
law, or Sharia. For example, Sharia prohibits screening framework.
Riba (interest), Maysir (gambling) and Gharar
(uncertainty). Sharia Screening: A Snapshot
Sharia stipulates that any fund manager man-
A fund manager has to abide by a set of business
aging an Islamic fund needs to get the approval
and financial parameters before selecting and
from a Sharia supervisory board set up by a finan-
including a particular stock in an Islamic fund
cial institution, which would be comprised of at
portfolio. There are various Islamic screening
least three Sharia scholars who are champions of
methods followed by stock indices and banks,
Islamic banking. They are responsible for laying
namely Dow Jones Islamic Market Index (DJIMI),
down guidelines (Fatwas) for the fund manager
FTSE Global Islamic Index Series, S&P 500,
and monitoring his investment practices.
MSCI (Morgan Stanley Capital International)
and Accounting and Auditing Organization for A fund manager selects a set of Sharia-compliant
Islamic Financial Institutions (AAOIFI). Sharia stocks by screening and selecting from an overall
stock screening is based on the business activity universe of stocks that meet his fund’s investment
performed by the companies; their financial objectives. The resultant set is reviewed by the
ratios are generally perceived as an easy and Sharia scholars and on compliance they sign off on
direct function because they rely on data feeds the investment. The screening conducted by the
from the various data providers (e.g., Bloomberg). fund management is two-fold: business activity/
But in real life, it is far from simple; there are industry screening and financial screening.
various issues that plague the Sharia screening Business activities that are considered to be non-
of a stock and its subsequent selection/omission compliant with Sharia include alcohol, tobacco,
from a fund portfolio. gambling, cinema, adult entertainment, advertis-
ing and media, conventional financial services and
A fund manager could follow the current prevalent
defense. The various financial ratios used for the
system of picking stocks from the Sharia-
Sharia screening of securities primarily consider
compliant indices from various index providers
interest, cash and receivables with the company
(e.g., DJIMI). He could also use an in-house
and debt availed by the company.1
developed proprietary tool that performs the
cognizant 20-20 insights | january 2012

2. Challenges to Islamic Stock Screening LVMH at a Glance
Automated vs. In-depth Researched Screening
Most fund managers use the Global Industry Revenue by Business Group
Classification Benchmark (GICS) or the Industry
(Euro millions) 2010 2009 2008
Classification Benchmark (ICB) to filter stocks on
the basis of their lines of business (LOBs). GICS Wine & Spirits 3,261 2,740 3,126
is an industry classification taxonomy developed
by MSCI and the S&P. It comprises 10 sectors, Fashion & 7,581 6,302 6,010
24 industry groups, 68 industries and 154 sub- Leather Goods
industries into which all major public companies
Perfumes & 3,076 2,741 2,868
are categorized. ICB is a taxonomy, developed by
Cosmetics
Dow Jones and FTSE, which is used to segregate
markets into sectors within the macroeconomic. Watches & 985 764 879
It uses a system of 10 industries, divided into 20 Jewelry
super-sectors further segregated into 41 sectors,
which then contain 114 subsectors. Selective 5,378 4,533 4,376
Retailing
The issue with both GICS and ICB is that their
Other Activities 39 (27) (66)
categorizations for a company classification
& Eliminations
is one dimensional and based only on the core
business activity in which an individual enterprise Total 20,320 17,053 17,193
is engaged. It does not take into account the
other non-core businesses that the company Source: www.lvmh.com
might have. Let us consider the example of Louis Figure 1
Vuitton (LVMH), the renowned French fashion
house. Louis Vuitton, per the ICB, is classified as on the different industries or businesses in
a “clothing and accessories” company. Businesses which it operates. But since very few organiza-
belonging to this subsector are described as tions actually use SIC classifications and report
“manufacturers and distributors of clothing, revenue generated through the SIC classification
jewelry, watches or textiles.” Hence, a fund system, the problem largely persists. Sometimes
manager on the basis of the ICB classification a business description keyword filter is also
would consider LVMH as Sharia compliant. built into the screening system. For instance,
However, a close examination of LVMH’s financial the keyword “roulette” might signify that the
statement for fiscal 2010 (see Figure 1), reveals selected company is involved in gambling or the
that revenues from wines and spirits (Sharia casino business.
prohibited) represents more than 16% of the
company’s total revenue, and hence much above Automated screening may result in classifying
the Sharia allowed benchmark of 5%. compliant companies as non-compliant and vice
versa. For instance, if a fund manager exercises an
As a result, if a fund manager uses an automated automated screening on a global asset universe,
screening he could treat LMVH as a compliant the tool would classify about 8.38% (4.36% +
company whereas in reality it is non-compli- 4.02%) of companies wrongly as compliant or
ant. The fund manager could largely solve this non-compliant (see Figure 2), which means that
problem if he employs the Standard Industry if a fund manager invests in 50 equities for his
Classification (SIC) system, where any company fund’s portfolio, six may actually end up being
is typically assigned multiple SIC codes based non-compliant.2
Automated vs. Researched Screening
Global Asset Universe Researched Screening
Fail Pass
Fail 66.64% 4.36%
Automated Screening
Pass 4.02% 24.98%
Source: www.islamicfinancenews.com
Figure 2
cognizant 20-20 insights 2

3. Another major issue with automated screening with a legal government or state defense body)
and relying on the list of Sharia-compliant stocks would be treated as Sharia non-compliant.
as provided by indices such as DJ and FTSE Again, all intelligent weapons that require high-
is that these global indices have assessed too precision targeting mechanisms to launch —
few companies in their portfolio. Hence, when a thereby minimizing unintended casualties (e.g.,
fund manager uses these lists to pick up stock civilians) — could be deemed compliant. On the
for investing, he realistically misses out on a other hand, weapons that can be used without
number of potentially winning stocks, as they are such targeting functionality are deemed as non-
not listed in a DJIMI, FTSE or any other Sharia- compliant. Finally, all weapons manufactured for
compliant stock index. mass destruction (e.g., chemical/nuclear weapons)
are treated as non-compliant even if they are
Inconsistently Published Financial Statements manufactured for the consumption of the legal
Many organizations report erroneous and/or defense body or other similar organizations.3
incomplete financial disclosures on a quarterly
and annual basis. There are a large number of Mistakes in Computing Interest
companies that do not report interest income Bearing Financing Ratio
as a part of their quarterly/annual financial Debt capital becomes a key element when
statements. In this scenario, the data which a computing the ratios for the financial screening
fund manager uses can be erroneous and results of a company’s stock. However, many practitio-
in an improper selection of a Sharia-compliant ners do not consider the fact that nowadays there
stock. Many companies in their financial reports are many companies in the Islamic world that
do not differentiate between cash and cash issue debt capital not through conventional ways
equivalents (e.g., money market instruments, but through issuance of Sukuk, which is similar to
Treasury bills that can be readily converted into a bond in conventional terms that complies with
liquid cash). It has also been noticed that many Sharia. Since Sharia does not permit the issuance
companies use old financial data to calculate the of a bond which pays out interest to the beneficia-
various financial ratios, resulting in misleading ry holder, the issuer of the Sukuk sells an investor
information. In other cases, data providers may group a certificate, which then rents it back to the
miss out on important corporate announcements issuer for a predetermined fee.
such as stock splits, bonus declarations, dividend
payouts, etc. declared by companies. When a practitioner performs the financial
screening, he frequently includes debt capital
Gray/Ambiguous Aspects in raised through Sukuk as well, though it should
Business Activity Categorization be omitted from the conventional debt amount.
There are certain industries or LOBs which are Let’s assume a company has a debt capital of
generally regarded as Sharia non-compliant. But $50 million on its books, of which $15 million is
on closer inspection, there exist certain gray areas. raised through Sukuk while the rest is conven-
As a result, various eminent Sharia boards cannot tional debt. The total assets of the company
be unanimous in the treatment of such companies. are $125 million. If the practitioner erroneously
Let us take the example of the defense industry. does not segregate between non-interest and
Generally this industry is deemed to be Sharia interest-bearing debt, the interest bearing ratio
non-compliant by most practitioners. But since to total assets is calculated as 40% (i.e., 50/125).
per Sharia, defense is necessary to guarantee the Since this ratio needs to be 33% or less to be
safety of the citizens and the functioning of the compliant, in this case the company is treated as
state, many Sharia scholars, instead of rejecting non-compliant. But if the actual interest-bearing
all defense and weapon manufacturing organiza- ratio is computed, by deducting Sukuk, this ratio
tions as non-compliant, have instituted certain becomes 28% (i.e., 35/125), thereby making it a
clauses and segregated the industry based on the Sharia-compliant stock. A few prominent indices,
nature of the weapons produced, mechanisms like DJIMI, compute this ratio by applying “total
used, the target audience, etc. debt” instead of “total interest bearing debt” and
hence fund managers who use data from DJIMI
All weapons sold to legal military institutions (e.g., fail to get the correct picture.
United States Marine Corps) could be deemed as
compliant, whereas the ones which are specifical- The Securities Commission Malaysia does not
ly sold to non-military establishments (e.g., sold in employ the interest-bearing ratio for the purpose
the retail market or to institutions not affiliated of stock screening. According to this body, it is
cognizant 20-20 insights 3

4. irrelevant to take into account where the funds and HSBC Amanah. This was attributed to
are originating from; it believes the sole deter- Amanah’s use of more conservative financial
mining criteria should be the end use of such ratios.4
funds. This contradicts Sharia principles which
forbid Riba. Issues with “Purification” of
Non-compliant Earnings
Lack of Uniformity in Rules, In the case of prohibited company earnings
Fatwas Across Geography which is less than 5% of the total revenues,
The screening techniques as followed by various Sharia stipulates that such earnings need to be
players across the globe vary widely. The reasons cleansed or purified. Once the fund manager is
can be attributed to culture, government regu- certain of the amount of total income that is to
lations and different Islamic schools of thought. be considered as Haram, he can proceed with the
Hence, the rules applicable in places like Malaysia purification process. He can either resort to the
might not be applicable in Europe or Gulf Coop- dividend method of computing purification or
eration Council (GCC) countries. The Sharia- the Haram income method.5 After computing the
compliant investments are considered taking purification value, he directly deducts the propor-
into consideration the localized requirements. tional amount of non-Sharia income of the total
Professor Ulrich Derigs and Dr. Shehab Marzban, earnings (the direct method), and subsequently
both of the University of Cologne, Germany, are passes on the net earnings to the investors.
two prominent exponents of Sharia compliance
who conducted a study to learn how different Alternatively, he can inform the investors about
Sharia compliance strategies applied to the same the proportion of the earnings that the investor
asset universe could deliver differences among needs to subtract from the total income (the
the sets of assets classified as compliant. They indirect method), sometimes subject to Zakah
chose the asset universe of S&P and the following (a form of religious charity as per Sharia law). In
were the key findings: order to cleanse the Riba-contaminated earnings,
it is quite difficult to compute the interest part
• Differences between S&P and DJIMI were of the earnings for an equity investment fund as
negligible (1.3%). This was attributed to the “interest earned” may not be a separate heading
fact that both these indices use average in the income account or may be disguised by
market capitalization as the denominator in offsetting interest against certain types of expen-
calculating the financial screening ratios. diture. It is practically impossible to obtain all
• Differences between S&P/DJIMI and MSCI/ the detailed information required to determine
FTSE/HSBC Amanah were quite high (21-26%). the amount of Haram earnings that may arise
The reason for this was that the latter set uses within an investment pool that could include 100
total assets as the denominator. different stocks and in most cases the effort spent
in performing the analysis will totally outweigh
• Though identical in the use of the same denom-
the benefit in having the precise figures.
inator in the financial ratio calculation, there is
a difference of 6% to 8% between MSCI/FTSE
Assets and Variation Among Classification Compliance Strategies
Compliant Asset HSBC
S&P DJ MSCI FTSE
Universe Size Amanah
S&P 271 1.30% 24.40% 24.90% 21.60%
DJ 266 25.70% 26.20% 22.90%
MSCI 247 1.60% 8%
FTSE 241 6.50%
HSBC
232
Amanah
Source: Islamic Banking & Finance
Figure 3
cognizant 20-20 insights 4

5. Some confusion also arises in determining leading to such status change (e.g., discontinua-
whether purification is necessary, particularly tion of a Sharia business; an airline stops selling
in the case of capital gains arising from the sale alcohol/cigarettes to its passengers; or an auto
proceeds of a fund. One school of thought says company closes down its financing arm), such as
that there ideally would be an interest component a rise or decline in market capitalization due to
in the capital gains as the asset value of the certain internal/external factors or merger and
company in context would reflect some interest; acquisition activity, which as a result renders
the other school of thought ignores this interest the stock non-compliant. For instance, an LOB
component, arguing that it is too miniscule to (such as alcohol) is shut down or new initiatives
consider. Though the latter is easier, the former are launched. It’s the prerogative of the asset
option is more ideal especially in a scenario when management company’s internal compliance
a dividend is declared for a particular fund. If department to keep a close eye on these activities
the fund manager does not calculate and subse- so that they could inform the fund manager, so
quently deduct the purification amount on the that he could make necessary adjustments in his
appreciation, and the unit holder redeems his portfolio and plan for any future adjustments as
units when he has not received any dividend, he and when required to align to Sharia needs as well
would receive a higher price as the price of the as fund objectives. The internal Sharia scholar
unit would ideally result from the appreciation in board also needs to be apprised so that the
the share price held by the fund. Conversely, when scholars could study the new changes, analyze
the units are redeemed post-dividend payout and the same and pass a new Fatwa if required. Apart
the amount of purification has been deducted from that, the compliance monitoring system is
by the fund manager before the dividend is dis- vital for historical performance analysis, which
tributed, reducing the net asset value (NAV) per newly launched funds calculate to observe how
unit, he will get a lower price compared with the compliant holdings would have performed.
former case.
Lack of Eminent Sharia Scholars
Smaller Asset Universe and Limited Currently there are too few Sharia scholars
Sector Exposure available compared with the number of Islamic
All of the Islamic indices have a limited universe financial institutions. As a result, many Sharia
of stocks. There are many companies that are not scholars occupy board positions on at least
included in these indices. A leading third-party 20 to 25 institutions. There are scholars who
Islamic stock screening provider recently stated regularly sit on the board of 70 to 80 institu-
that it has used its proprietary screening tools tions, which could easily be burdensome and
to screen out almost 4,500 companies that are impact their quality of judgment and subsequent
presently trading on various U.S. exchanges (e.g., Fatwas. Proponents of Sharia finance see this as
NYSE) as Sharia compliant, whereas the current a problem and growth inhibitor.
Islamic market indices have a much smaller
Funds@Work, a financial services strategy
Sharia-compliant company universe of around
consulting firm, has compiled Sharia-advisory
2000. Hence, fund managers find it difficult to
statistics over the past two years. It states that
select a particular stock, however appropriate it
there are 1,141 board positions in 28 countries,
might be for his portfolio construction, if the same
of which the top 10 scholars hold 450 positions
does not feature in the index the fund manager
(~40%). Apart from that, as the boards of two
is following. Also there are certain sectors which
different financial institutions might be comprised
form an integral part of any traditional fund,
of almost identical scholars, there is always a fear
but are absent because of Sharia regulations. A
of conflict of interest as both institutions might
perfect example in this is the traditional banking
be in the same industry and geography, offering
and financial services sector; almost all the
an identical product bouquet and catering to the
companies (barring some strictly Islamic financial
same target audience.
institutions) are deemed Sharia non-compliant.
Degree a Company is Deemed
Lack of Consistent Monitoring on Stock’s Compliant/Non-compliant
Compliance Status Change
Current screening methods do not normally
Many stocks that form a part of the fund reveal to the fund manager by what margin a
manager’s Sharia-compliant fund portfolio in particular stock is deemed as Sharia compliant
a particular year might become non-compliant or non-compliant. There might be companies
the next year. There can be various reasons whose portion of Haram income just surpassed
cognizant 20-20 insights 5

6. the acceptable threshold of 5%. If that stock is a the fund manager misses out on many oppor-
potential stock for the fund manager’s portfolio, tunities for choosing an appropriate stock for
there could be some communication between the his fund, simply because it is not included in
fund management and the company in question, the Sharia-compliant list of DJIMI, though
so that in the future the proportion of Haram it appears in the compliant list of a third-
income can be slightly reduced in order to classify party provider. These providers have their
the same as Sharia compliant. On the other hand, own Sharia board chaired by eminent Sharia
there may be companies whose proportion of scholars, and their screening techniques and
Haram income is just below the 5% limit. Those proprietary software are endorsed by Fatwa
companies could be kept under tighter supervi- issued by the board.
sion as they are at the borderline of becoming
non-compliant, and, if not monitored carefully,
• Last but not least, the fund manager faces
a lot of issues in the course of his purifica-
might soon become so. tion process in the absence of a standardized
structure, and ultimately ends up in purifying
Solutions to Make Sharia Screening
more/less that the optimal purification
More Effective amount and wasting a lot of time as a result.
Use of Third-party Sharia Stock Screening Third-party providers have a structured, well
Providers defined and logical purification model in
Fund managers are now gradually moving towards place, which mitigates this problem. Figure
third-party Islamic equity screening providers 4 depicts a prototype model of Sharia stock
for screening purposes. The reason behind it is screening that is somewhat similar to the
threefold. screening procedure followed by many third-
• First, the results are much more accurate party providers. In this model, an in-depth
and detailed as compared to straight vanilla analysis is undertaken at the business logic
automated screening. screener layer, which is currently quite non-
uniform and ambiguous and is a prime area of
• Second, from the fund performance perspec-
concern in the Sharia stock-screening process.
tive, the Sharia-compliant asset universe as
A two-layer screening approach is adopted
furnished by third-party screening providers
in which both the automated and the manual
is much larger than the normal universe
mode of screening is used at different stages.
published by the FTSE, DJIMI and S&P. Hence,
Third- party Islamic Equity Screening Provider:
Business Logic Process Flow
Procurement
Receives Data Feeds on Stocks
from Market Data Providers (e.g. Bloomberg)
Team
Data Stored
Data
in Stock
Database Receives Data from External Sources (Company Website,
Analyst Report, Balance Sheet, Company News & Corporate Actions)
Screens Out Universally Accepted Stock Treated as Stock Added to Sharia
Conducts Level 1 HALAL Items e.g. Healthcare Sharia Compliant Compliant List
Receives Data from Automated
Internal Research
Data Procurement Team Screening Through Screens Out Universally Accepted
Stock Treated as
Algorithm & HARAM Items e.g. Alcohol
Sharia Non-Compliant
Team
Proprietary
Software Screens Non-Universal
HARAM Items
Screens Out Ambiguous HARAM Screens Out Indirect Secondary
Items e.g. Arms Manufacturing HARAM Items e.g. Hotels with Casino
Stock Treated as Income Treated as HARAM Receives Data on Ambiguous HARAM
Sharia Non-Compliant Items & Secondary HARAM Items
Internal Manual
Review Team
Income Treated Is Income Conducts 5% Eligible Conducts Level 2 Manual Review
as HALAL Eventually HARAM Income Test of These HARAM Items
HARAM
Stock Treated as
Sharia Compliant
Stock Added to Sharia Compliant List
Figure 4
cognizant 20-20 insights 6

7. Here’s how it works: There are a host of parameters that a fund
manager should consider before selecting a
• At the outset, the data procurement team
particular third-party screening provider:
collects stock data from global market data
providers (e.g., Bloomberg, Thomson Reuters, • Quality of screening output: The fund
IDC, Six Telekurs, etc.) and other secondary manager needs to minutely analyze the quality
sources (e.g., company balance sheets, analyst of screening that is performed by third-party
reports, corporate actions, etc.), and stores providers. It needs to be seen that the resul-
the same in the internal equity database. tant Sharia-compliant set of companies are
signed off by reputed scholars who form the
• The internal research team picks up a stock
screening provider’s advisory Sharia board.
and the level 1 automated screening through
complex algorithms and its proprietary • Type of product suite: A fund manager could
software. If the stock belongs to a company select a product suite based on his needs.
like Diageo, which is an alcoholic beverages There are screening providers who provide
company (i.e., its primary activity being customized packages on stocks belonging to
alcohol), it would be straightaway catego- various regions. For example, Amanie offers
rized as a company engaged in a universally 15 different packages, of which the “Global
accepted Haram business (i.e., alcohol) and Package” covers all regions and is the most
rejected. If the stock belongs to a company like expensive one, while there are packages
Nike, which is a footwear and clothing company, focusing on particular areas as well. There are
and is not engaged in any Haram or ambiguous other providers that offer different packages
secondary businesses, it would qualify as based on different requirements. For example,
universal Sharia-compliant stock. The rest of Amiri S3 offers four different packages
the selections can either be companies whose (Platinum, Gold, Silver and Bronze).
activity is ambiguous like an arms manufac-
turer such as Alliant Techsystems, which is
• Cost: The fund manager needs to do a detailed
cost-benefit analysis especially in the long
a large aerospace and defense company, or term (typically a three- to five-year view)
companies whose secondary business activity before purchasing any particular product. If it’s
is Haram (its primary business being Halal) like too expensive and economies of scale cannot
Marriott, a hotel chain which, while its primary be obtained, then the fund manager needs to
business is compliant, sells alcohol/pork items opt out of it. The fund manager also needs to
and operates nightclubs. see whether there is any hidden cost involved
• These ambiguous set of stocks are then in the deal.
manually reviewed (level 2) by the in-house
• Ease of integration and customization:
review team, who analyze whether these The fund manager needs to see whether
stocks are to be deemed as non-compliant or the program has a comprehensive set of
not. For example, if the revenue generated by APIs (application programming interfaces),
Marriott from all non-compliant activities like supports different integration technologies
alcohol/pork sales, etc. exceeds the stipulated and can be plugged into another product if
relaxation limit of 5%, it would be deemed as required. Apart from that, he needs to see
non-compliant. The ambiguous stocks on the whether the software/product can lend itself
other hand need to be screened more subjec- to customization and configuration.
tively and it is qualitative in nature as in the
case of defense companies, where the nature • Product version upgrades: The fund manager
needs to see how the third party upgrades its
of weapons produced, the technology and
products, and whether he has to pay for each
their buyer category are carefully analyzed.
new version of the product or the company
It has been frequently argued by some Islamic has adopted an evergreen policy where the
banking pundits, that the fund manager should asset management company does not have to
concentrate in maximizing the alpha on his pay for each upgrade. He also needs to check
portfolio rather than involving himself in the whether it is possible to skip versions (e.g., the
nuances of stock screening. This should be company is currently using version 2.0 and
entrusted to a third party in exchange for a pre- wishes to use the latest version 4.0, without
determined fee. Currently, there are quite a few upgrading to version 3.0 first).
professional third-party screening providers in • Implementation support and training: The
the global market. fund manager should consider implementation
cognizant 20-20 insights 7

8. needs while choosing a provider with sound The fund manager’s responsibilities once he has
implementation knowledge. Some providers outsourced the screening and purification task
may charge the asset management company a to a third-party screening partner should remain
separate fee for implementation, but most will more or less identical. Though he would no
include the implementation cost in the overall longer be involved with these tasks, it is the fund
training costs. Regarding training needs, fund manager who remains responsible for his fund’s
house resources need to be trained to work on performance, compliance, etc. All the leading
third-party software/product suites and the advisories have their own Sharia board chaired
advisory firm should provide for that. by eminent scholars, so it’s unlikely that their
screened list of Sharia-compliant stocks would be
• Industry recognition and depth of existing
clientele: Various awards and recognition questioned by Islamic institutions and regulators.
that a particular product suite has received These advisories also have proprietary tools to
should be viewed as another valid indicator of calculate non-compliant income purification.
the quality and acceptability of that particular Hence the fund manager has to make a call as
product. The existing list of clients and the to whether he should outsource the purification
various client segments should also assist part to these providers or keep it to himself. If he
the asset management company in making does outsource, it is unlikely that he would opt
a choice. For example, IdealRatings (per its for a shadow purification computing in which he
Website) caters to asset managers, index would conduct an in-house computation of purifi-
providers and brokers/dealers, and does cation (parallel to the third-party purification), as
business with numerous prominent clients. it would involve much additional effort and time.
• After-sales support: After-sales support is a Though theoretically possible, it is also unlikely
key criterion that needs to be considered while that the fund manager would opt for a shadow
selecting a third-party screening advisory. This screening of stocks when he has outsourced the
helps in building a long-term relationship with screening piece, though the asset management
the vendor. The fund manager needs to see company might retain its own screening
whether that provider has a toll-free helpline, mechanism — maybe not for current use but for
Web or e-mail support. future needs.
Figure 5 compares the key attributes of four A fund manager who has not used the service
prominent third-party Sharia finance advisory of third-party screeners usually picks stocks
companies — IdealRatings, Amiri Capital (Amiri of companies that are present in the Sharia-
S3), Amanie Advisors and Sharia Capital Inc. — compliant list published by index providers such
using information gathered purely from their as DJIMI. But even after outsourcing, he may
respective Websites. still continue to use this list. It is at his discretion
whether he would solely use the list provided by
Third-party Islamic Equity Screening Providers and Their Key Attributes
Ideal Ratings Amiri S3 Amanie Advisors Shariah Capital, Inc.
Covers 42,000+ stocks and Only system to issue Fatwa Can deliver Sharia Screening tests approved by
100+ nations. Data securely in its own right. 40,000 approved data set for all five scholars within the
delivered to end-consumer companies covered, strong 5 methodologies (4 DJMI Sharia Board. Over
has an iPhone app for coverage in GCC. 29 tests indices and AAOIFI). 4,500 companies covered.
instant screening. Periodic to validate screening. Covers 33,000 stocks in Claims to have one of the
(even daily) and ad hoc Customized financial ratios 70 nations. Data request largest Sharia-compliant
audit reports for Sharia for clients. Direct access to template can extract data stock universes. Thomson
board. Data updated on key static screening results from multiple sources. Reuters as per contract
daily basis enabling fund on Bloomberg terminals. Uses “Business Descrip- collects publicly reported
manager to take prompt No software installa- tion Keyword Filter” for corporate financial informa-
investment calls. Back tion required. Different business screening. Offers tion from 242 countries
testing tools for suitability packages as client needs. various geography-based prior to stock screening.
of conventional funds being Has a Blackberry app for packages. Subscription
Sharia compliant. instant screening. can add up to 20 stocks to
portfolio.
Source: Respective Websites
Figure 5
cognizant 20-20 insights 8

9. third-party screeners or resort to the index list as Conclusion
well. Whatever he does, there is usually an annual
The Asian Development Bank estimates that
compliance audit executed by an external agency,
Islamic assets, currently estimated at U.S. $1
which checks whether the Sharia-compliant
trillion, will increase 10% to 15% per year over
stocks forming a part of the fund’s portfolio abide
the next two to three years. The Islamic funds
to all the stipulated Sharia principles.
industry grew to U.S. $58 billion in 2010, a 7.6%
Inclusion of Fresh Scholars in Sharia Board increase. The addressable universe for Islamic
The industry needs to induct more Sharia scholars fund managers is more than U.S. $500 billion,
to various Sharia boards. Specific schools need which will add more than U.S. $70 billion to the
to be set up to nurture the young talent with GCC pool by 2013. Plenty of Islamic funds have
requisite knowledge. The Centre for Islamic been launched over the last four to five years,
Finance at the Bahrain Institute of Banking and though the number of funds liquidated is also
Finance (BIBF) is preparing to launch a program quite alarming. There needs to be a standardized
for young scholars along these lines.6 Another legal, accounting, regulatory and Sharia supervi-
critical need is that a ceiling should be created to sory framework, which would provide an essential
limit the number of memberships that a particular foundation for future growth, as well as a level
Sharia scholar may simultaneously hold. With the playing field for Sharia-compliant funds in the
aging of scholars, financial institutions need to global marketplace.
hire fresh talent. Otherwise, nearly all institutions
Though Sharia-compliant funds are issued
might suddenly experience a serious paucity of
primarily by the Islamic banks, global private
quality scholars.
banking players like Bank of America Merrill
Uniformity in Financial Ratio Screening Lynch, Morgan Stanley, UBS, etc. are about to
Techniques and Treatment of Sukuk Across hop on the bandwagon with their own set of
Geographies products. In such a scenario, especially when
As noted earlier, different indices and other there is a dearth of quality Sharia-compliant fund
financial institutions calculate the financial ratios products (vis-à-vis traditional fund products), a
in different ways. S&P and DJIMI use average proper Sharia screening mechanism assumes a
market capitalization as a divisor for their role of utmost importance. The efficiency in stock
financial ratios; others, such as FTSE and MSCI, screening would precisely determine the future
use total assets as a denominator. Apart from success of an asset management company in the
that, the treatment of debt raised through Sukuk largely untapped Islamic wealth management
should also be treated similarly across the board, segment. The asset management company could
as many institutions do not exclude debt availed build an in-house screening system or alterna-
through Sukuk from interest-bearing conven- tively outsource it to a third party, apart from
tional debt. Uniformity is needed so the financial the prevalent practice of following the Sharia-
ratios for a particular company cannot be inter- compliant list provided by an index provider.
preted in various ways, which might mislead the
fund manager. The concept of third-party screening is relatively
new and some fund managers are still circum-
Growth of the Islamic Fund Management Industry
Number of islamic Funds
70 200
Estimated AUN(US$ B)
58 173
60 51.40 53.90
48.7 150
50
39.50
40 34.10
100 78
30 23.29
20 16.78 15.84 46
50 29 27
10 7.61 11 19 23
5.54 4.86
0 0
2005 2006 2007 2008 2009 2010 2007 2008 2009 2010
Year Year
Estimated AUM(US$ B) Number of Islamic Funds Launched
YOY Growth (%) Number of Islamic Funds Liquidated
Source: The Islamic Funds & Investment Report 2011 (E&Y, Eurecahedge and Zawya)
Figure 6
cognizant 20-20 insights 9

10. spect about the credibility of the process these for the fund manager, while adhering to Sharia
companies follow as well as the resultant cost- principles, to be more competitive by gaining
benefit. But in the future, with the growth of greater bandwidth and flexibility in terms of stock
the Islamic fund industry and increased global selection from a much larger stock universe —
competition, these advisories might well be the thereby improving investor returns.
preferred way of screening. It would be convenient
Footnotes
1
Interest bearing financing ratio (i.e., total interest bearing debt/total assets < 33%) Interest generating
—
assets ratio (i.e., total interest generating assets/total assets < 33%) Tradability ratio (i.e., cash plus
—
accounts receivables and pre-payments / total assets < 70%).
—
2
www.islamicfinancenews.com January, 2011.
3
www.opalesque.com November, 2010.
4
Prof. Ulrich Derigs & Shehab Marzban, ‘Inequalities of screening’,
Islamic Banking & Finance Volume 6, Issue 2, p. 12.
5
Dividend approach of purification: (prohibited or Sharia non compliant income / total income)
* dividend received Haram income purification: (total prohibited income including interest) /
no of shares issued * no of shares held.
6
Asa Fitch, ‘Islamic Finance Industry needs for experts’, www.thenational.ae, April 11, 2011.
References
Islamic Banking & Finance I Islamic Finance News I Eurecahedge I Euromoney plc I Islamic Research
& Training Institute (IRTI) I The Islamic Funds & Investment Report 2011 I Failaka Advisors I Journal of
Banking & Finance I E&Y I Bank Sarasin I Institute of Islamic Banking & Insurance I Islamic Financial
Services Board I QFinance I Zawya I Funds @ Work AG
About the Author
Biswadeep Sengupta is a Senior Consultant within Cognizant Business Consulting’s Banking and
Financial Services business unit. He has for the last five years functioned as a lead business analyst and
consultant for various bank implementation projects across various geographies. Biswadeep’s areas of
expertise include asset and wealth management, retail banking and consumer lending. He holds an MBA
in finance and strategy and can be reached at Biswadeep.Sengupta@cognizant.com.
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