The pros and cons of investing in Shariah-compliant funds

Ultimately, investors would need to weigh the pros and cons before investing in Shariah-compliant funds and ETFs

by IFAST RESEARCH TEAM

SHARIAH-COMPLIANT funds are collective investment funds that allow investors to invest in a diversified portfolio of Shariah-compliant stocks or sukuk.

Through funds, investors can leverage on the expertise of fund managers and their compliance teams and hence do need not go through the hassle of tracking the Shariah-compliant investments themselves.

For example, Shariah-compliant funds in Malaysia follow the list of Shariah-compliant stocks in Bursa Malaysia issued by the Shariah Advisory Council (SAC) of the Securities Commission Malaysia (SC) as mentioned in the previous episode, while for unlisted stocks and investment in foreign listed stocks, the screening methodology is determined by the funds’ respective Shariah board or the appointed Shariah Committee.

In addition, each Shariah-compliant fund will appoint a Shariah advisor to ensure that the fund continues to be managed and administered in accordance with Shariah principles.

The Pros

Due to the financial ratio screening, Shariah-compliant funds avoid companies that have high leverage. It is a known fact that companies with the less healthy financial positions are prone to fluctuate more during volatile markets.

Thus, the initial financial strength screening could indicate that Shariah-compliant companies tend to be more resilient during market uncertainties due to stronger balance sheets, lower debt-to-assets ratio and fewer risky investments.

At the same time, Shariah-compliant funds also have lower exposure to certain sectors such as financial or communication services. In particular, financial sector is typically considered as a cyclical sector and thus is more volatile than non-cyclical sectors.

As a result, Shariah-compliant funds tend to have lower volatility and drawdowns compared to conventional funds.

In order to have a comparison of how Shariah-compliant funds stack up against conventional funds, let’s use MSCI Inc’s All Country World Index (ACWI) and MSCI ACWI Islamic as comparison. As shown clearly in Table 1, MSCI ACWI Islamic had lower annualised volatility over the past 10 years.

The drawdown of funds during market downturns is also an indicator of resiliency. Shariah-compliant funds, that have lower weightage in cyclical sectors such as financial, are relatively less volatile compared to conventional funds especially during market downturns.

At the same time, MSCI ACWI Islamic also had lower drawdowns during market corrections such as during the sell-off in March 2020, the US-China trade war in the fourth quarter of 2018 (Figure 1).

The Cons

Due to the screening criteria, Shariah-compliant stocks tend to be a smaller subset of the investable stock universe.

ACWI Islamic has only 345 constituents, much lower compared to ACWI’s 1,507 constituents. Hence, fund managers could have a smaller number of stocks to choose from and also could miss out on certain opportunities that may be attractive but do not meet Shariah compliance.

As many financials, communication services or consumer discretionary companies do not meet the Shariah requirements, investors who buy Shariah-compliant funds could find themselves with less diversified funds that are missing out on certain sectors.

There is an additional risk that potential investors should take note of — the reclassification of Shariah status risk.

There is a risk that the stocks currently invested by the fund may be reclassified to Shariah non-compliant. In that case, the fund managers would need to dispose of the stocks, and the fund could miss out on the potential gains in the future or could suffer from losses if the stocks were sold at below-cost prices.

Due to the lack of exposure towards certain sectors such as financials, communication services and consumer discretionary (gaming and tobacco sectors), Shariah-compliant funds could be less diversified which may lead to overexposure to other sectors.

However, statistics have shown that the Shariah-compliant funds could be generally more resilient compared to their similar conventional counterparts, especially during market downturns.

Investors who have a lower risk appetite can consider investing in the generally less volatile and more resilient Shariah-compliant funds, while for those who are looking to reduce overall portfolio volatility also can consider adding/switching into some Shariah-compliant funds.

Shariah-compliant funds could be suitable for investors who are looking for ethical and responsible investments. Ultimately, investors would need to weigh the pros and cons before investing in Shariah-compliant funds and exchange-traded funds (ETFs).

The views expressed are of the research team and do not necessarily reflect the stand of the newspaper’s owners and editorial board.