As the global financial market continues to evolve and diversify, the principles of Islamic finance play an increasingly vital role in providing ethical and transparent investment solutions. In the face of compliance challenges posed by conventional ETFs, the financial industry needs to adopt innovative approaches to develop new products and services that align with Shariah law. Here are some Shariah considerations and perspectives of Islamic finance on conventional index and (ETFs) funds.

Exchange-traded funds (ETFs) were launched in the early 1990s, combining the features of mutual funds and shares. In their 25-year history, ETFs have become one of the fastest-growing segments of the investment management business. However, conventional ETFs face some of the following Shariah compliance concerns which make conventional ETFs an inaccessible investment for Shariah-compliant seeking investors:

Non-Shariah compliant constituents

Conventional ETFs are composed of underlying assets which are not Shariah compliant. Unscreened equity constituents in an ETF portfolio could well fail at the business screening phase. Others may be prone to excessive leverage and interest-bearing debt, making them non-Shariah compliant in the financials screening. 

Bond ETFs are non-Shariah compliant assets as the debt security is essentially a loan with interest. A bond is a debt obligation for which the issuer pays a pre-determined rate of return to the bond holder. There is no investment in any underlying asset; rather, the issuer has a personal right and a liability on his legal personality. A repayment of debt with interest is due to the bond holder. The payment for the bond is effectively a loan (Qard) from a Shariah perspective. 

Tracking non-Shariah compliant indices

Strictly and legally speaking, tracking a non-Shariah compliant index is not unlawful and neither does it make the investment non-Shariah compliant, however, it might not be the optimal option for the Islamic finance industry.  For the Islamic finance industry to grow, it needs to develop a holistic, complete and independent system which has its own indices.

However, a number of Shariah boards have considered the tracking of non-Shariah compliant indices as non-compliant. This will assist the Islamic finance industry grow and disengage with any non-compliant element as a whole.

Failed Shariah screening

Many conventional ETFs fail either the business screening or financial screening for Shariah compliance. ETFs are invested in non-Shariah compliant financial instruments such as swaps, financial and unlawful beverage producing companies. Likewise, the financials of many equities in conventional ETFs are non-compliant with Shariah due to the excessive leveraging, interest bearing deposits, interest bearing debt and high proportion of unlawful income.

Derivatives

The constituents in commodity ETFs are composed of future and swap agreements. Such derivatives are non-Shariah compliant. In futures transactions, because neither counter-value, i.e., money or goods, is present at the time of contract, the sale is irregular (fasid). A normal sale cannot have both counter-values contractually deferred. Futures trading, where both counter-values are contractually deferred, is impermissible as it is an exchange of one debt for another, i.e., bay’ al-kali bil kali (a sale of two deferred counter-exchanges).

Securities lending

Another prominent issue in conventional ETFs is securities lending. Securities lending is a well-established activity where ETFs make short-term loans of the underlying stocks or bonds in the portfolio; this can incrementally increase the returns for shareholders[1].

Lending takes place in the following manner: First, a large financial institution asks to temporarily borrow a stock or bond from an ETF. To borrow the asset, the institution must compensate the fund and provide collateral, which must exceed the value of the loaned stock or bond. The fund company invests the collateral in low-risk money market funds, which can generate incremental returns until the borrowed stock or bonds are returned.

The ETF issuers receive cash collateral, they don’t just sit on it—they put it into money market securities to earn some small amount of interest on the cash[2]. 

Securities lending is rarely undertaken directly between a fund and a borrower. Fund managers usually employ intermediaries, such as custodian banks and third party specialists, as agents to lend their securities for them. These intermediaries benefit from economies of scale, expertise, technology, as well as borrower access which enables them to secure the most competitive pricing. In some cases, the lending agent may be a related party to the fund provider. 

Borrowers of securities include large financial institutions, such as investment banks, market makers and broker-dealers. Hedge funds are among the largest borrowers of securities, but they will typically borrow through the prime brokerage arms of investment banks, or broker-dealers, rather than directly from lending agents or fund managers. 

These financial institutions borrow securities for a variety of reasons, including ensuring the settlement of trades, as well as to facilitate market making and other trading activities, such as hedging and short selling[3].

ETF fund managers commonly place the collateral received into money market and gain interest for the fund. According to Islamic law, depositing funds in the money market is considered as a Qardh (loan). Any payment in lieu of such a deposit is Riba (interest). In Islam, a loan (qarḍ) is considered a gratuitous contract, and it is commendable for a lender to provide a loan to a borrower who is in need of money. Both the Qur’an and Sunnah promise reward to a lender who provides a loan to a person in need. The fact that the Shariah prohibits the lender to derive any conditional benefit from the loan further emphasises its gratuitous nature. It also implies that the loan contract should not be used for profiteering purposes. Thus, any profit or additional return in lieu of the loan is impermissible and non-Shariah compliant. Both the Qur’ān and the Sunnah have prohibited the lender from charging the borrower any additional amount. The Qur’an emphasises that the lender is entitled to receive the principal amount. It states: 

“O you who believe! Fear Allah, and give up what remains of your demand for usury, if you are indeed believers. If you do it not, take notice of war from Allah and His Messenger. But if you turn back, you shall have your capital sums: Deal not unjustly, and you shall not be dealt with unjustly” (al-Qur’an, 2:278-279).

A famous juristic maxim states: “Any loan which draws an increment is Riba” (Ibn Abi Shaybah).

Furthermore, the institution which borrows the securities pay fees to the ETF. This is also a form of Riba for the ETF.Therefore, for Shariah-compliant seeking investors, Islamic ETFs are a viable alternative.

ETFs, in their 25-year history, have become one of the fastest-growing segments of the investment management business. These funds provide liquid access to virtually every asset class and allow both large and small investors to build institutional-calibre portfolios. Thus, for Islamic financial institutions, ETFs are a lucrative form of investment. However, as shown above conventional ETFs fall short in a number of Shariah compliance issues. The equities held in a conventional ETF are not screened for Shariah compliance. Therefore, the core business activity as well as the financial ratios are at high risk of non-Shariah compliance. Conventional ETFs regularly practice securities lending, which accrue interest and are controversial due to the concept of lending securities and further trading them. Synthetic ETFs trade using conventional swap agreements which contravene Shariah principles from a number of angles. Thus, a Shariah compliant ETF must undergo Shariah screening of its business activity as well as its financial ratios. In terms of tracking, a Shariah compliant should only track a Shariah compliant index. In addition, the constituents of the ETF must be lawful assets. All this with a regular review and oversight of a Shariah supervisory board will ensure Shariah compliance.

As a conclusion, we believe that education and awareness are crucial to ensuring that investors and financial professionals understand these principles. Technological advancements, especially the application of blockchain and smart contracts, offer new possibilities for enhancing transparency and efficiency. Moreover, cooperation among global market participants is essential for promoting innovation and development in Islamic financial products. Ultimately, the universal value of Islamic finance lies in its commitment to fairness, transparency, and ethical investing, which is not only beneficial to the Muslim community but also important for the healthy development of the global financial market. Through collective efforts, we can look forward to a more inclusive, sustainable, and ethically sound financial future.

Reference

[1] iShares, Securities lending, Available from: https://www.ishares.com/us/education/securities-lending

[2] Bioy, H. & Rose, G. (2012), Securities Lending, Morningstar ETF Research, Available from:  https://media.morningstar.com/uk/media/ETF/SecuritiesLendinginPhysicalETFs.pdf 

[3] ETF.com, Understanding Securities Lending, Available from: http://www.etf.com/etf-education-center/21031-understanding-securities-lending.html?nopaging=1