Shariah-compliant finance and investments are structured in accordance with Islamic law. Shariah-compliant funds can be managed as mutual funds or hedge funds. In essence, they are common funds with ethical rules integrated into the policies - simply the Islamic form of socially responsible investment (SRI).
Types of Shariah-compliant fund
Commodities funds generate profits by buying and reselling halal commodities. Because of the restrictions on the use of derivatives, commodities funds make use of two types of Shariah-approved contracts: Istina'a, a contract where the buyer of an item funds the production of the item upfront. A detailed specification of the item is agreed before production starts and the cost of production has to be paid in full when the contract is agreed.
Bay al-salam are similar to a forward contract where a buyer pays in advance for the delivery of raw materials or goods at a given date. The delivery price of the contract is calculated at spot price minus a discount to compensate the buyer of the credit risk for the upfront payment.
Equity funds invest in common shares of companies engaged in Shariah-compliant activities. Companies are also screened in order to check for Shariah-compliant accounting principles.
Murabaha are similar to development funds, also referred to as ‘cost-plus' financing, where a fund will buy goods and resell them to a third party at a given price. The price is made of the cost of goods plus a profit margin. Cost and margin are agreed in advance.
Ijara funds acquire and keep ownership of an asset (real estate, machinery, vehicles or equipment) and then make profits by leasing it out in return for a rental payment. The fund is responsible for the management of the asset and will normally receive a management fee. The leased item must be used in a halal manner.
Riba - the payment or receipt of interest is considered unjust. Instead of borrowing and lending, Shariah-compliant finance is based on sharing the ownership of assets, business risk, and therefore the resulting profit or loss.
Haram - prohibited activities. These include the production and sale of alcoholic beverages (including pubs and restaurants), pork and tobacco products, adult-oriented media (video, magazines, etc), illicit trades (prostitution, drugs), and any other immoral activity.
Maisir - Islam forbids gambling of any form so derivatives, forwards, options and futures are prohibited. Other forbidden practices include short selling, margin, and scalping trading.
Gharar - uncertainty. The prohibition on gharar is often used as the grounds for criticism of conventional financial practices such as short selling, speculation, and derivatives.
Tayyab - the underlying principle associated with consumption of that which is ‘wholesome and more beneficial', not just ‘compliant'. In the context of finance and investment, tayyab ensures products are developed with a focus on holistic, equitable Islamic criteria of transparency, accountability, and fairness.