Where do Shariah-compliant mutual funds stand in Bangladesh

Shariah-compliant mutual funds adhere to Shariah law and the principles of Islam. 

Associated mutual funds emerged in response to the needs of Muslim investors, who sought both returns and compliance. Despite its Muslim lineage, investors from any religion and faith can invest in Shariah-compliant funds. These funds also fall under the umbrella of socially responsible investments (SRI).

The concept of pooling funds and appointing a fund manager can be traced back to the pre-Islamic era. Prophet Mohammed (Peace be upon him) was known as Al-Amin (the trustworthy) and the people of Makkah preferred to keep their money with him. Trust (Amanah) plays a very important role in Islamic financial transactions and is present in every Islamic contract, be it a partnership (Mushraka), trust financing (Mudaraba), or agency (Wakala). By the virtues of this contract, the capital or property of the partnership is held in trust by one of the partners, on behalf of the other partners.

The popularisation of Shariah mutual funds is far more recent than its ancient roots. 

In 1984, Dr M Yaqub Mirza floated the idea of establishing the Amana Income Fund, the first US mutual fund managed according to Islamic principles. As an active Muslim investor, Dr Mirza found it difficult and time-consuming to hand-pick 'halal' securities for his personal portfolios. He realised that a professional investment advisory firm, with greater collective expertise and resources, would be better equipped to carry out the complex and demanding Shariah-based screening process. He also felt a mutual fund would be the ideal investment vehicle because it ensures broader participation and that investors share in profits and losses.

According to a 2011 report by PricewaterhouseCoopers (PwC), the number of Shariah-compliant funds grew at an annualized rate of 26% in the first decade of this century. The report further states that "an inflection point" occurred between 2002 and 2003, when petrodollar liquidity improved and capital markets in the Gulf Cooperation Council (GCC) countries matured to fuel investments.

S&P Dow Jones Indices has created many Shariah-compliant indices for Muslim investors. 

The S&P 500 Shariah index was launched in December 2006 and is comprised of all of the Shariah-compliant names in the S&P 500. As of October 2017, it had 235 constituents with information technology accounting for the largest portion of the index at 38%. 

Other Shariah-compliant indices maintained by S&P Dow Jones include: S&P Global Healthcare Shariah, S&P Global Infrastructure Shariah, S&P Developed Large and Mid-Cap Shariah, S&P Developed Small-Cap Shariah, and the S&P Developed BMI Shariah Index.

Chief components of Shariah screening

Managing a Shariah fund involves greater complexities than a conventional fund. Rules and regulations are often ill-defined and gaps in the legal framework translate to variances in Shariah rulings and other legal decisions. 

Prerequisites to managing a Shariah fund include adequate knowledge regarding Shariah laws, the processes involved in appointing a Shariah board, and a number of other matters including prescribed investments, carrying out an audit, the purification of income (adjusting reported income for non-permissible components), and asset screening.

Although consensus is not commonplace among contemporary Shariah scholars regarding the prohibition of companies, most Shariah boards have advised against companies involved in conventional banking, insurance, leasing, alcohol, pork-related products, tobacco, weapons, casinos/gambling, hotels, cinema, pornography, music, etc. Beyond these categories, the financial ratios of eligible companies must not exceed prescribed thresholds.

For uninvested cash, non-interest-bearing deposits or other vehicles compliant with Islamic principles are prescribed. Fund managers of Shariah mutual funds are required to evaluate the portfolio securities on a regular basis to ensure that their financial ratios do not violate Islamic parameters. Funds are accountable to investors with regard to maintaining Shariah compliance.

A Shariah supervisory board can play a critical role in ensuring efficient management and compliance. Board members are typically Shariah scholars who have extensive domain knowledge and experience, built up through years of working with different banks and financial institutions engaged in Shariah-based operations. 

The Bangladesh story

Bangladesh's Shariah-compliant asset pool is fairly modest compared to the population share of Muslims (around 91%). In line with broader economic growth, savings of the general people have increased and this has led to a situation where Shariah-focused investors often struggle to identify appropriate investments. 

The journey of Islamic mutual funds in Bangladesh started in 2010 with Islamic Finance and Investment Limited's "IFIL Islamic Mutual Fund-1"; this was a closed-end mutual fund. Investment Corporation of Bangladesh (ICB) served as the trustee and custodian of the Mutual Fund, while ICB Asset Management Company Limited managed the fund. 

In the same year, Al-Arafah Islami Bank Limited sponsored another closed-end Shariah Mutual fund, named "AIBL 1st Islamic Mutual Fund." Open-end Shariah mutual funds entered the fray in 2016 with Asian Tiger Capital Partners Investments Limited's "ATC Shariah Unit Fund"; ICB served as the trustee and the custodian of the fund. A list of Shariah funds and their recent performances are presented in this report.

How have Shariah mutual funds fared in Bangladesh?

Since the key tenet for Shariah investors is compliance, the DSE Shariah Index (or DSES) has been used as the benchmark index. However, market returns (DSEX Index) have also been presented to facilitate broader comparisons.

Outperformance is more prominent during bear market runs (DSEX posted negative returns in 2019 and 2022), evidenced by the number of Shariah funds that beat both the Shariah (DSES) and broad market (DSEX) indices in those years. In periods where the broad market rallied (2020 and 2021), fewer Shariah funds were able to outpace the market but the presence of superior returns among select funds means there is merit to investing in Shariah funds, even from a purely returns perspective.

Returns of best-performing funds over the period in review (2019-2022 YTD) support the idea that top funds, even with a Shariah mandate, can not only outperform the Shariah universe but the broader market as well.  

The way forward: A functional ecosystem is key to proliferation of Islamic finance

While performance metrics make a case for investments in Shariah mutual funds, a caveat is that Shariah compliance in Bangladesh is not always airtight. Regulatory oversight and enforcement are intermittent while on the fund side, a fairly limited investment universe often gives way to screening liberties. 

Investors are unlikely to catch on to these liberties due to knowledge gaps surrounding Shariah-based screening. This means that companies and sukuks greenlit by regulators are unlikely to come under further scrutiny. It follows that greater awareness among investors (via educational sessions by finance professionals) coupled with a more hands-on approach from key stakeholders (eg regulator and custodians) are crucial stepping stones to ensuring a more compliant fund management industry.

For a wider investment universe to emerge, there needs to be a tide that floats the entire Islamic Finance system in Bangladesh. Foremost is the credibility of Islamic banks, which is imperative to the prosperity of Shariah mutual funds. 

Recent media reports regarding solvency of certain Islamic banks in Bangladesh highlight existing hurdles. Well-governed and managed Islamic banks would represent deposit havens for both mutual funds and their underlying portfolio companies. Due to the lack of such banks, Shariah fund managers face a much narrower universe with regard to both fixed income and equity investments— the latter is essentially a second order effect. 

A business may boast the right margins and valuation, but it may not be Shariah-compliant due to the business allocating 'cash and equivalent' balances (above a certain threshold) to non-Islamic banks; this may not have been the case had there been Islamic banks performing at par with non-Islamic counterparts. 

Beyond Islamic banks, a bigger basket of well-governed and well-managed businesses naturally broadens the Shariah investment universe. The blue-chip universe of Bangladesh's stock market is quite small and it shrinks further when Shariah filters are applied, leading to the aforementioned 'limited investment universe'. Typically, Shariah mutual funds lean towards non-financials, with a view towards long-term capital accumulation. There is, therefore, a need for more quality initial public offerings (IPOs) for these types of businesses; needless to say, regulatory participation is vital here as well. 

Sadikur Rahman, CSAA (Certified Shari'ah Advisor and Auditor) is the head of growth and business development at IFA Consultancy (IFAC) and Mustavi Zaman Khan, CFA (Chartered Financial Analyst) is a senior investment analyst at EDGE Research and Consulting Limited.