Islamic investment funds A general introduction Abu Dhabi April 2015

Agenda Role of Investment Funds Types of Investment Funds Key Principles of Islamic Investment Funds Islamic Fixed Income Funds Islamic Equity Funds Screening methodologies Purification approaches Islamic Real Estate Investment Funds

Benefits of Collective Investment Funds Alternative savings Economies of scale Diversification Liquidity Professionalism

Types of Investment Funds By investor’s cash-flow profile: Closed-ended funds Open-ended funds Interval funds Defined maturity funds Exchange Traded Funds (ETFs) By assets: Equity funds Money-market, fixed-income funds Balanced funds Real Estate Investment Funds/Trusts (REIFs/REITs)

Types of Investment Funds (cont’d) By style of management : Active management funds Index funds (passive) Special fund: Private Equity/Venture Capital Funds

Assets of Islamic Investment Funds Islamic Money Market Funds Money market sukuk (short-term) Deposits in Islamic banks Islamic Fixed Income Funds Sukuk Islamic Equity Funds Sharia-compliant equities Islamic Real Estate Funds (REITs) Sharia-compliant real estate investments Cash and liquidity must always be placed in Sharia-compliant manner (in Islamic banks, money market sukuk, or in conventional banks but without interest)

Key Principles of Islamic Investment Funds Established to invest only in Shariah-compliant securities  stipulated in fund prospectus or investment contract Consistently invest and operate in Sharia-compliant manner  regular certification for compliance is required No repo; no short selling; no derivatives; no borrowing Sharia compliance officer and Sharia Advisor Established approach to ‘purify’ itself from possible non-Sharia compliant investment Other principles for best practices for investment funds apply: e.g. professionalism/competence, management of conflict of interest, segregation of clients assets etc.

Typical Structure of Investment Funds Investors Investment Fund Investments (Securities) Custodian Fund Manager (Wakeel) Sharia Advisor Wakala structure The fund may take form as a Trust, Collective Investment Contract, or Company (Special Purpose Entity) Custodian needs not be Islamic bank, but conduct upon assets must be within Sharia (e.g. no interest on cash; no repo on securities)

Money Market and Fixed Income Funds Invest only in eligible fixed income instruments: sukuk , money market sukuk, deposits in Islamic banks Main challenge for Islamic money market and fixed-income funds: Availability of instruments Diversity of instruments/issuers Liquidity of instruments, thus liquidity of the funds Thus, development should starts with government sukuk Making instruments available at different maturities Regularity of issues ensure supply Creating benchmark for private securities

Islamic Equity Index List of eligible equities (members of an Islamic equity index) is fundamental in Islamic equity funds Prepared by the Exchange or other index providers; approved by a Sharia Advisory Board Screening methodology Core Business: must not be prohibited activities Prohibited businesses: Conventional financial services (based on riba ) Conventional insurance Gambling and gaming Manufacture or sale of tobacco products Production or sale of non-halal products (e.g. pork, liquor) Non-permissible entertainment businesses Weapon production and distribution Others non-permissible activities (including businesses that invest in or deal with non Sharia-compliant investments) Could be expanded and combined with other Social Responsibility features (e.g. environment, child protection)

Islamic Equity Index (cont’d) Screening methodology (cont’d) Non-core, ancillary, and other businesses may include activities that are common part of business (e.g. hotel selling liquor), unavoidable activities (managing cash in banks with interest), or even those strictly non-Sharia permissible, as long as they are small. Quantitative assessment of business: Single-limit approach (e.g. MSCI, DJI): for all non-permissible activities  no more than 5% of total business Multiple-benchmark approach: Strictly prohibited business (e.g. banks): 5% Rental from non-compliant activities; hotel operations; stockbroking: 20% Calculations based on (i) revenue; (ii) pre-tax profit.

Islamic Equity Index (cont’d) Screening methodology (cont’d) Financial Screening: Leverage: the use of debt to finance the company Liquidity: interest-generating assets (cash, securities) Calculations based on (i) assets; (ii) enterprise value. Monitoring Regular monitoring based on availability of information (annually, semi-annually, quarterly) Screening done not limited to the existing index members, but the whole universe (screen-in and screen-out) Rebalancing of index Information; disclosures Methodology must be transparent Immediate announcement of screening results Dividend information, for cleansing/purification purposes

Islamic Equity Index – Screening Approach Market Universe Eligible List - Core Eligible List Approved List Screening out companies with non-permissible core businesses Screening out companies with non-permissible activities within the business mix Financial screening of eligible companies: Financing composition (leverage) Financial asset composition

Purification/Cleansing Approaches Key principle: income received from the non-permissible portion of investment must be purified Purification at the Index level A portion of dividend representing non-permissible income should be deducted from the index’s return. E.g. from liquor sales of a supermarket; insurance business of a holding company Dividend to be deducted (purified) = Dividend x (Non-Permissible Revenue or Earnings* / Total Revenue or Earnings) Include interest income

Purification/Cleansing Approaches (cont’d) Purification at the Fund level For all funds: The portion of dividend coming from non-permissible activities should be given out for charitable purposes (clearly defined in prospectus) Use same calculation as a above Funds with active management: additional purification resulting from gain on sale of equities that are subsequently considered as non-compliant Key principle: If an equity drops from the compliant list, the funds cannot continue to hold it – thus: sell. If price > cost, and the sale is conducted immediately after announcement (on the same or immediate trading day), capital gain may be kept If price > cost on the announcement date or immediate trading day, and the sale is conducted after a period of lapse, only a portion of capital gain up to the announcement date/immediate trading day may be kept. Any gain left should be given out If price < cost on the announcement date/immediate trading day, sale may be postponed until equity price (+ any dividend paid) equal the cost.

Purification/Cleansing Approaches (cont’d) Cost: $5.00 Price: $7.00 Sell; Profit = $2.00 Sales price: $8.00 Max. allowed profit = $2.00 (Send to charity $1.00) Sales price: 6.50 Profit = $1.50 Price: $4.00 If sold, Loss = $1.00 May wait until price: $5.00 then sell (cannot assume profit) Example: After a period of lapse At the time of announcement on non-compliance At the time of purchase Notes: The fund cannot buy to reduce the average cost Common question: how long can the fund wait until it has to sell?

Purification/Cleansing Approaches (cont’d) Purification at the Fund level (cont’d) The fund cannot buy equities not listed in the compliant list: Any purchase in this nature is considered non-compliant, and thus subject to sanction (on the fund manager, not the fund) Still need a remedy: Must be sold immediately if cost is recoverable. Any gain (+dividend) should be given out If cost is not yet recoverable, sales may be postponed within a certain period (e.g. 1 month) Index (passive) funds do not have purification other than for dividends (like purification for the Index)

Islamic Real Estate Investment Funds Real estate is usually a debt-heavy investment Financing real estate construction using equity is extremely expensive Unless financing via sukuk, real estate equity investment is usually non Sharia-compliant Conventional REIT/REIF Originally established to: Mobilize savings (institutional and individual) for development Provide steady, long-term income from investment Exposure to improved property value Characteristics: Assets mostly (70%-90%) in income generating property Most income (>70%) after operations is distributed through dividends Eligible for tax breaks (corporate income tax, dividend tax, and others) Certificate (shares) tradable on stock exchanges

Islamic Real Estate Investment Funds (cont’d) Sharia Advisor Investors Trustee Management Company (Mudharib) Investment Fund (listed) Property Manager Real Estate

Islamic Real Estate Investment Funds – Key Issues Property development and its financing Fully operating property should be financed by equity. Debts can be refinanced by equity more cheaply – REIF can be issued for that purpose If Islamic REIF assets include property under construction, financing should be Sharia-compliant. Regulation should set limit on % of property under construction Use of real estate and tenancy Should be mainly for Sharia-permissible businesses. Tenancy for non-permissible businesses must be limited Limits can be differentiated based on: Existing tenants vs. new tenants (e.g. 20% and 100% permissible, respectively) Tenancy of newly acquired property (e.g. at least 80% permissible) Sub-tenancy (?)

Islamic Real Estate Investment Funds – Key Issues (cont’d) Purification Cash management Insurance

Closing Points Islamic investment funds – important part of the Islamic finance ecosystem Business foundations for Islamic investment funds: Availability of investible assets Presence of asset management business and its supportive enabling environment Government initiative in developing sukuk market is needed for Islamic funds (especially fixed-income funds) Different methodologies and approaches exist; policies should strike a balance between international acceptance and local context Some opportunities may exist today; but there are detailed works to do.

Annex Comparison in Islamic Equity Index Methodologies

Islamic Equity Index – Business Screening Guideline/Index Limit SC Malaysia 5% limit for strictly non-permissible businesses (conventional banking; conventional insurance; gambling; liquor; pork; non-permissible entertainment; interest income; tobacco) 20% limit for hotel/resort operations; stockbroking; rental received from non-permissible activities Dow Jones/S&P 5% limit for non-permissible business (based on revenues) MSCI FTSE 5% limit for non-permissible business including interest income (based on revenues); 5% purification recommended General guidelines; exception applies

Islamic Equity Index – Financial Screening Guideline/Index Limit SC Malaysia <33% for total cash & equivalents over total assets (excl. cash/instruments placed in Islamic accounts) <33% for total interest bearing debt (excl. Islamic instruments) to total assets Dow Jones/S&P <33% for total cash and interest-bearing securities divided by trailing 24-month average market capitalization <33% for total accounts receivables divided by trailing 24-month average market capitalization <33% for total debt divided by trailing 24-month average market capitalization MSCI 33.33% limit for total cash and interest‐bearing securities (excl. Islamic instruments) over total assets 33% limit for total accounts receivables and cash over total assets 33.33% limit for total debt (excl. Islamic instruments) over total assets FTSE <33.333% for cash and interest bearing items over total assets <50% for total accounts receivable and cash over total assets <33.333% for total debt over total assets General guidelines; exception applies

Ketut A. Kusuma; kkusuma@ifc.org; +1-202-458-4987 Thank You Ketut A. Kusuma; kkusuma@ifc.org; +1-202-458-4987