1. Islamic investment funds
A general introduction
Abu Dhabi
April 2015

2. 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

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

4. 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)

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

6. 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)

7. 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.

8. 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)

9. 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

10. 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)

11. 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.

12. 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

13. 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

14. 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

15. 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.

16. 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?

17. 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)

18. 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

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

20. 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 (?)

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

22. 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.

23. Annex
Comparison in Islamic Equity Index Methodologies

24. 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

25. 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

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