Sharia-compliant investing: how stock screening works worldwide

A sharia-compliant share passes two screens: the company's main business must be permissible, and its interest-bearing debt, interest-bearing cash and non-compliant income must stay under set limits, usually 30% to 33%. Small amounts of non-compliant income are then given away through purification. Standard-setters and index providers use different limits, so one company can pass one screen and fail another.

This guide explains how screening works. It does not give religious rulings. For a ruling on your own situation, ask a scholar you trust.

Why screening is needed

Islamic finance prohibits riba (interest), and investing in businesses such as alcohol, pork and gambling. The difficulty is that almost every listed company holds some bank deposits or loans.

The Muscat Stock Exchange's guide, based on AAOIFI standards, explains the common position. Dealing in shares of companies that sometimes use interest is forbidden in principle. An exception allows it when the main business is permissible and the interest-based amounts stay under set limits.

AAOIFI (the Accounting and Auditing Organization for Islamic Financial Institutions) is a standard-setter for Islamic finance. Some scholars accept only "pure" companies with no interest at all. Screening applies the more common "mixed company" view to listed shares.

Screen 1: what the company does

The first screen removes companies whose core business is not permitted. Lists differ, but share a core:

• conventional, interest-based banking, finance and insurance
• alcohol
• gambling
• pork and related products
• tobacco
• adult entertainment

Then the lists diverge. MSCI's October 2024 methodology also excludes weapons, music, hotels and cinema. FTSE's board opinion (February 2024) excludes weapons, forward currency deals and derivatives. S&P's 2012 Shariah methodology excludes advertising and media, and cloning.

Companies with small side activities are usually allowed. MSCI excludes a company if more than 5% of its total income, counted together, comes from prohibited activities and interest.

Screen 2: the financial ratios

A permissible business can still fail if it borrows or deposits too much at interest. Each provider compares these amounts with either the company's total assets or its market value (the share price times the number of shares), often averaged over months or years.

Most providers add a receivables test too. FTSE requires receivables plus cash under 50% of total assets. MSCI's main series uses 33.33%. S&P's 2012 rules used receivables under 49% of market value.

S&P Dow Jones Indices also runs the Dow Jones Islamic Market indices, with their own methodology. Providers update their rules from time to time, so always read the current document.

Worked example: one company, two answers

These figures are made up. Company B has total assets of USD 900 million and an average market value of USD 1,200 million. It owes USD 330 million in interest-bearing loans and holds USD 150 million in cash and interest-bearing deposits.

On debt, Company B fails FTSE's and MSCI's 33.33% total-assets limit. It passes AAOIFI's 30% and S&P's 33% market-value limits. Same company, same accounts, different results.

Now say the share price falls and the average market value drops to USD 1,000 million. Debt becomes 330 ÷ 1,000 = 33.0% of market value. Company B now fails both the 30% and the 33% limits, though its debt hasn't changed.

Purification: giving away the non-compliant part

Purification means giving the non-compliant share of your income to charity. The Muscat Stock Exchange's guide says you can't use that money in any way, even to pay taxes.

There are two common ways to work it out.

Method 1: a share of the dividend. MSCI applies a "dividend adjustment factor" to dividends in its indexes. It is total income minus prohibited revenue and interest income, divided by total income. The rest is purified.

Method 2: an amount per share. The Muscat Stock Exchange guide, based on AAOIFI standards, divides the company's non-compliant income by its number of shares, then multiplies by the shares you own.

Worked example: purifying USD 2,000 of dividends

These figures are made up. You own 1,000 shares of Company C. It pays a dividend of USD 2.00 a share, so you receive USD 2,000. Company C has 150 million shares. Its total income was USD 1,500 million, of which USD 45 million (3%) was interest income.

Check: 45 ÷ 1,500 = 3%, 2,000 × 0.03 = 60, and 0.30 × 1,000 = 300. Method 1 purifies only the part of the dividend you received. Method 2 assigns you your share of all the company's non-compliant income, paid out or not. Ask your scholar which method they follow.

Sharia-compliant funds and sukuk

Fund types

A sharia-compliant mutual fund is a pooled fund that only holds what its sharia board approves. Common types include:

• Equity funds that pick screened shares.
• Index funds and ETFs that track an Islamic stock index, such as one built on the MSCI, FTSE or S&P rules above.
• Sukuk funds that hold sukuk instead of conventional bonds.
• Cash-style funds that use trade-based or partnership contracts instead of interest-bearing deposits.

Each fund should name its sharia supervisory board, the standard it follows, its screens and how often it reviews holdings.

Sukuk, briefly

Sukuk are sharia-compliant certificates linked to assets or projects, used where conventional bonds would pay interest. Investors receive a share of the rent or profit from those assets, rather than interest on a loan.

Sukuk still carry risk. The issuer can default, prices can fall when market rates rise, and some sukuk are hard to sell quickly.

Why results differ, and change

• Different denominators. Total assets move slowly. Market value swings with the share price, so a falling price can push a company out.
• Different averaging periods. A 12-month average reacts faster than a 36-month one.
• Different limits. 30% under AAOIFI, about 33% under FTSE, MSCI and S&P.
• Different sector lists. Weapons, hotels or media are excluded by some providers, not others.
• Regular reviews. FTSE reviews quarterly, and MSCI's sharia advisors certify its lists quarterly. FTSE watches companies near the limit (31.667% to 35%) and changes their status after two consecutive quarters. MSCI uses a stricter 30% limit for new entrants.

A company that passed last year can fail this year, and vice versa.

Your plan

1. Decide which standard you follow. Ask a scholar you trust whether they accept mixed companies, and which limits and purification method they use.
2. Check a fund's sharia board and method. The prospectus should name the board, its standard, limits and review frequency, not just a label.
3. Compare costs. Look at the management fee and other charges, as for any fund.
4. Review periodically. Recheck holdings at least each quarter, or when a fund's or index's list changes.
5. Purify on time. Work out the amount when you receive dividends or sell, using your chosen method, and give it to charity.

What to watch out for

• Labels without a published method. "Halal" or "Islamic" on a product means little unless its sharia board and screens are disclosed.
• Concentration. Banks and insurers are excluded, and heavily indebted companies drop out. A sharia portfolio can lean on a few sectors, which can reduce diversification.
• Fees. Screening and sharia oversight cost money, and a higher fee compounds against you every year.

This guide is for education only. It is not a religious ruling or advice to buy or sell any security or fund.