At first glance, it would seem that Shariah investing and Environmental, Social, Governance (ESG) share a common objective – to bring a positive social impact through investing despite the difference in screening methods.
Let’s take a closer look at both Shariah and sustainable investing to see what opportunities are available for investors where Shariah meets ESG.
What is Shariah Investing?
Governed by certain Shariah rules and parameters, Shariah investing is not only seen as a religiously guided investment, but it is also a form of socially responsible and ethical investing.
From a Shariah viewpoint, investing in shares is permissible as long as the activities of the businesses are within the Shariah parameters and guidelines. To ensure Shariah-compliant investing, two layers of screening are generally applied namely on the business activity (sector screening) and financial screening.
| Sector Screening | Financial Screening |
|---|---|
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With the sector screening, companies that operate businesses in violation of Shariah injunctions are excluded from the universe of investable stocks. Generally, stocks of companies whose primary business activities are in the following sectors would be deemed as Shariah non-compliant stocks:
- Conventional banking and finance (riba).
- Stockbroking or trading in non-Shariah-approved securities.
- Conventional insurance (gharar and riba).
- Gambling, gaming, casino operations and number forecasting (maysir).
- Production, trading, transporting or storage of prohibited goods and services such as pork, non-halal food, alcohol and pornography.
- Tobacco manufacturing or sale.
In addition, there are certain Shariah jurisdictions which also consider the following as Shariah non-compliant investment sectors: (1) Entertainment including cinemas, music and theme parks, (2) hospitality and resorts (3) weapons and defence.
Upon passing the sector screening, companies are then subjected to financial screening to further evaluate the extent of interest-based financing and interest-based income.
It has been reasoned that some portion of riba-based financing and revenue should be tolerated as the strict stipulation that Shariah-compliant companies must not have any form of interest-based financing nor have any interest-bearing investments or deposits would, at the present time, severely constrict the investment universe of investable stocks available to Muslim investors.
The financial ratios used to measure the quantum of interest-based financing and income depends on the index (or Shariah jurisdiction) relied on.
Leverage (the ratio of debt to total assets or to total market capitalization) is also examined to evaluate how much of the business is financed by interest-bearing debt instruments. If the leverage exceeds the cut-off point, the shares of the company do not qualify as Shariah-compliant investments.
What is Sustainable or Environmental, Social and Governance (ESG) Investing?
In recent years, investing has become more sophisticated, where considerations have gone beyond just looking at the returns in dollars and cents. Investment strategies now also entail other aspects such as the impact that the investment or the investee company has on the environment, ethical considerations as well as the reputation of the company.
ESG investing can simply be defined as the process of considering environmental, social and governance (ESG) factors, alongside the financial aspects, when making investment decisions. It is also similar to sustainable investing and earlier generational socially responsible investing approaches, where investment activities seek to contribute positively to the welfare of the community and environment.
To a certain extent, sustainable or ESG investing is in the same vein as Shariah investing as it is not focused solely on monetary returns, except that the former is not guided by religious requirements.
With this paradigm shift in investing, we have seen several emerging sustainable investment strategies in the investment sphere including exclusionary screening, thematic investing and integration of ESG in investment decisions.
Exclusionary screening involves identifying the sectors and companies to avoid based on traditional moral values or on the basis of norms and standards, for example, avoiding investments in products and services involving tobacco or alcohol due to the negative impact of such products on health. With thematic investing, there is a specific trend or objective to be addressed via investments such as food security, the pursuit of green technology, etc.
Amongst sustainable investment strategies, ESG integration has emerged as a strategy which involves the specific inclusion of ESG risks and opportunities in investment analysis. ESG integration also encompasses the development of policy, reporting standards and committees as well as processes to ensure that ESG considerations are integrated with investment decisions.
Shared principles and divergence between Shariah and sustainable investing
Shariah and sustainable/ESG investing share very similar principles and values including the promotion of stewardship, social responsibility, and responsible behaviour. The table below sets out what we believe to be the commonalities and differences between Shariah and ESG investing:
| Shariah Investing | Sustainable Investing | |
|---|---|---|
| Similarities | 1. Both aim to promote socially responsible and ethical values investment. 2. Both may pursue Maqasid Shariah, which is to promote the welfare of humankind and eliminate harm. |
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| Screening Methodologies | 100% based on Shariah screening criteria | Based on specific ESG screening metrics and scores |
| Concentration on Environmental and Social Issues | Indirect | Direct |
| Focus on Sustainability | Indirect | Direct |
Although Shariah and sustainable/ESG approaches to investing have developed independently, both have similarities vis-à-vis religious principles and both look to bias investing towards more sustainable outcomes. One observation is that many of the sectors which are excluded under Shariah law tend to score poorly on sustainability criteria, and are typically underweighted or excluded from sustainable portfolios as well.
For example, although the majority of sustainable funds do not object to pork-related products, some do, due to the carbon footprint of the industry. Others specifically exclude companies engaged in predatory lending. Notwithstanding certain similarities between sustainable/ESG and Shariah investing, it should be noted that although Shariah investing may qualify as a sustainable investment, the same could not be said for sustainable investment i.e., not every sustainable investing approach is Shariah-compliant.
The most visible impact of this is a notable reduction in leverage levels in Islamic portfolios compared with traditional benchmarks. This is also typically one of the main indicators used to assess the “quality” of a company, from a factor exposure perspective. Consequently, Shariah portfolios have a strong bias towards the “quality” factor.
Ultimately, Shariah and sustainable/ESG investments seek to generate attractive financial returns for Muslims and non-Muslim investors alike and potentially better outcomes for society and the environment.
With the onset of the COVID pandemic in 2020 contributing to heightened investor appetite to do good while investing, which Principal expect to continue going forward, we believe that Shariah investing, coupled with ESG integration, provides investors with an opportunity to not only pursue Shariah-compliant investments but also help achieve sustainability aims and improve the potential for risk-adjusted investment returns.
The information in this article has been derived from sources believed to be reliable, however, we do not independently verify or guarantee its accuracy or validity. It contains general information only on investment matters and should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The information it contains does not take account of any investor’s investment objectives, particular needs or financial situation. Investors should consider whether an investment fits their investment objectives, particular needs and financial situation before making any investment decision.
The data presented is for information purposes only and is not a recommendation to buy or sell any securities or adopt any investment strategy. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment.
All expressions of opinion and estimates in this article are subject to change without notice. This article is not intended to be, nor should it be relied upon in any way as a forecast or guarantee of future events or investment advice regarding a particular investment or the markets in general.
Environmental, social and governance responsible investing (ESG) is qualitative and subjective by nature, and there is no guarantee that the criteria utilized, or judgment exercised, will reflect the beliefs or values of any one particular investor. Information regarding responsible practices is obtained through voluntary or third-party reporting, which may or may not be accurate or complete, and such information is used to evaluate a company’s commitment to, or implementation of, responsible practices. Socially responsible norms differ by region. ESG, while a component of our investment analysis, is only one part of the overall assessment in our decision-making activities. ESG criteria may present additional advantages or risks and does not protect against market risks or volatility. You should not make any investment assumptions based solely on the information contained herein. There is no assurance that the socially responsible investing strategy and techniques employed will be successful.
