“They have these quote-unquote Sharia boards, but they can be similar to the rating agencies during the financial crisis, where all these terrible derivatives were rated triple-A, but by whom? By the people who paid the check to the rating agencies. It’s the same problem here,” says Matthew Martin, founder of Blossom, a microfinance network based in Jakarta, Indonesia.

He cites the sale/leaseback structure many Muslim borrowers use to get around the ban on paying interest. In one of these deals, a bank might sell the borrower a commodity, like wheat or barley, for, say, $200,000, and then buy it back for $100,000. Theoretically, the borrower will then owe the bank $100,000, which he will repay in installments, creating the mathematical equivalent of making principal and interest payments.

“Many [Islamic] scholars have ruled this type of financial arrangement is valid, with certain conditions,” Martin says.

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), based in Saudi Arabia, is part rating agency and part regulatory board, not unlike the old Financial Accounting Standards Board (FASB). They have about 20 Islamic scholars from around the world, including the U.S., who discuss issues of Sharia compliance and render opinions about particular deals.

“If you want to launch a sukuk, you need to present it to them and get their stamp of approval,” Virji says. “If you come to some mutual fund companies, and you’ve got a project, whether it’s a REIT or sukuk, one of the things we want to know is who endorsed this in terms of Sharia compliance. Is it backed by AAOIFI or not?”

The lack of standardization can limit the type of investments available because, faced with diverging scholarly opinions, some managers opt out of an asset class altogether. When it comes to REITs, for instance, some scholars say they should be avoided because it’s impossible to determine what percentage of tenants in, say, an underlying mall will be selling items that are prohibited under Sharia law.

“It’s so murky, some managers just avoid REITs altogether,” says Imraan Jakoet, portfolio manager at Sanlam Investments in Bellville, South Africa.

Seeking Standardization
The lack of standardization in what makes an instrument Sharia compliant can be seen in a $2 billion sukuk issue Goldman Sachs tried to sell back in 2011. While the deal was blessed by eight of the world’s top Islamic scholars, it became entangled in a debate over whether the bonds would continue to trade at par after they were sold. A properly constructed sukuk limits the debt to the value of the underlying assets. There were also questions about how Goldman planned to use the proceeds and whether those uses would comply with Islamic law.

“Goldman’s controversial sukuk in 2011 did not establish a clear link to the assets backing the sukuk, undermining some of the principles behind Islamic finance,” says Saqlain of Islamicbanker.com.

Goldman refrained from offering the bonds, restructured the deal and last October brought it to market with five other lenders. It sold well, as did a sukuk deal last year by the U.K., which lured bids for more than 10 times the amount offered.

Of course, not all Muslims are as strict as others. One attorney, who structures Sharia-compliant trusts for Muslim clients and requested anonymity, says some clients want language in their trusts to ensure no money is invested in the typical Sharia prohibitions, but they wouldn’t really mind if they owned a hotel that sold alcohol, for instance. He’d define those investors as “morally compliant”: They’re doing the right thing, but their trust structure wouldn’t likely be approved by an Islamic scholar. And then there are the strict Muslims who want everything done by the book and want their trust signed off by a scholar. Those scholars can be expensive, the attorney says. He likened them to lawyers, where the most well known can charge in the tens of thousands of pounds to render an opinion.

“Some people want their trust documents to say, ‘I don’t want pork or gambling or alcohol,’ but they’re very happy for the trustees to buy a hotel that makes lots of money,” the attorney says.

Most of his Muslim clients have fallen into the former category, he says. He estimates that less than a quarter take the more conservative approach.

But while not all need a scholar to sign off on every investment, many generally want their portfolios to be largely limited to Sharia-compliant listed equities and mutual funds, such as the Amana Income and the Amana Growth funds, as well as sukuk and real estate.

“There’s a lot of depth in listed equities. When you move into fixed income, that’s where we don’t have as much offerings as some institutional investors might want. One of the challenges of the industry is developing enough fixed-income product to meet the needs of sophisticated investors,” says Aamir Rehman, managing director at Fajr Capital Advisors, a Dubai-based Islamic finance advisory firm.

The first Sharia-compliant ETF was launched in August in the U.S.; several companies are working on Sharia-compliant REITs. There’s also a compliant fixed-income mutual fund in the U.S., run by Azzad Asset Management, that invests in sukuk and Islamic bank deposits. Financial experts say the crowdfunding concept may also be a good fit for Islamic investors, since it’s a reward-based equity structure rather than debt.

Martin, of Blossom, actually started his microfinancing network last October after realizing there weren’t a lot of Sharia-compliant financing options for entrepreneurs. He couldn’t go to a bank for a loan because Muslims are prohibited from paying interest. Blossom is a microfinancing network that provides capital in amounts of $10,000 to $200,000 to Muslims who can’t borrow money from a bank, though those providing the financing are not making loans. Rather, they’re getting an equity interest in the business they’re capitalizing.

Martin says his model is different than a bank making a conventional loan, where the borrower must repay a fixed amount regardless of whether the business prevails. His company offers profit-sharing instruments.

“It doesn’t matter whether there’s a typhoon or your business goes to zero. The bank will hound you until you send the monthly check,” Martin says. “With the profit-sharing model, it’s completely based on the performance of the business. If the business does well, the investor does well. If they’re not profitable, the lender does not profit. It treats the borrower as a partner.”

The Sharia screens are similar to those used in socially responsible investments (SRI)—with some exceptions. For example, Muslims have a prohibition on investments related to pork.

“There are a substantial number of faith-based institutions that invest in Islamic funds precisely because of those ethical screens, like tobacco, alcohol, gambling and firearms. Those screens are very common across almost every faith,” Rehman says.

And like with SRI investments, some might question whether investors are getting the best returns, given that their investment decisions are ultimately based not on finance but on religion. Experts, however, say many Muslim investors don’t necessarily care about achieving the best possible returns. They value spirituality as highly as they value returns, and if their non-financial values cut into returns, so be it.

“People want to see that their investments are consistent with their values, irrespective of what religious background they come from,” Rehman says.

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