ANALYSIS
Patching holes in the net Automated Shariah screening can miss non-compliant business activities. Mohamed Donia and Shehab Marzban explain why in-depth manual research is critical
C
ompanies are subjected to analysis by Shar iah-compliant fund screening to identify their involvement in Shariah non-compliant business and financial activities. This enables the exclusion of businesses that are not truly Shariah-compliant. Business activity screening eliminates companies whose primary business activity does not comply with the Shariah, such as conventional banks, bars and casinos. Financial screens, on
MOHAMED DONIA Evaluate adequacy of compliance
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SHEHAB MARZBAN Analyse financial figures
the other hand, measure businesses’ involvement in Shariah non-compliant financing activities, such as interest earnings and debt financing. Dow Jones Islamic Indexes, for example, employs a financial screen in which the debt of the company divided by its trailing 12-month average market capitalisation value must be less than 33%. In general, business activity screening is accomplished by standardised industry classification codes, such as GICS (general industry classification system) or ICB (industry classification benchmark). Companies are assigned a single, specific industry code based on the business segment that generates its revenue. As companies can operate in multiple business segments, a business may be assigned to a Shariah-compliant industry but still generate revenue from non-compliant activities. Using Dow Jones Islamic Indexes as an example, its rulebook states “…if the company has business activities in any one of the following sectors defined by the ICB, it is considered inappropriate for Islamic investment purposes.” These sectors include distillers and vintners, food products, and food retailers and wholesalers. The Shariah non-compliance of distillers and vintners is obvious. But food products, food retailers and wholesalers should not be generalised as being non-compliant, since not all food products sold by retailers and wholesalers include pork or alcohol. If
Islamic Banking & Finance Volume Six Issue Four Number 19
The screening guidelines can exclude entire industries without researching whether they operate compliantly
these industries are to be eliminated without analysing the companies case-by-case, the alternative is automated screening. But this has drawbacks. The screening guidelines defined can exclude entire industries without researching whether the companies themselves operate Shariah-compliantly. If a hotel chain is operating Shariah-compliantly or a food retailer is not selling pork or alcohol, they would still be considered inappropriate. A company may have raised Shariah-compliant debt, as is the case with many companies in the GCC, which is ignored and all the debt is considered non-compliant. The inappropriate business segments mentioned are clearly those with non-compliant elements. But there may be companies whose primary revenue is generated from a compliant business segment and yet a proportion of revenue is generated from a non-compliant activity. These companies would not be identified using the described Shariah screen. This facilitates automated screening systems but results in a smaller asset universe of compliant companies. A company such as Louis Vuitton (LVMH) is categorised under the ICB subsector “clothing and accessories”. Businesses belonging to this subsector are described as “manufacturers and distributors of clothing, jewellery, watches or textiles”. Based on the sector description and Shariah guidelines, Louis Vuitton is considered Shariah-compliant.
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But if we investigate the business operations and financial figures of Louis Vuitton, we can see that a remarkable share of the revenue generated stems from the sales of wine and spirits. For the first quarter in 2008, the total reported revenue of LVMH has been 4002m euros of which 16% (640m euros) comes from wines and spirits. Since most Shariah scholars have agreed on a maximum of 5% for noncompliant revenue, LVMH should be classified as non-compliant. However, the automated screen of industry classification codes classifies LVMH as Shariah-compliant. An adequate compliance evaluation, such as the one described for LVMH, can only be obtained through in-depth research. Companies assigned to a clearly non-compliant industry (such as brewing) can be considered directly non-compliant.
Automated screens classify Louis Vuitton as Shariah-compliant, despite non-compliant business operations
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ANALYSIS
Companies that are generally compliant but operate in multiple business segments need to be analysed in detail by looking at their financial statements, company websites and news, as well as materials provided by their investor relations departments. Companies originating from Islamic countries need to be researched differently. These companies may already operate partially or completely Shariah-compliantly and different financial figures need to be analysed. Companies may operate partially compliantly when, for instance, a proportion of their debt is financed Shariah-compliantly. If that is the case, the Shariah debt should be identified and separated from the conventional debt, which can help to measure the company’s leverage. By contrast, some companies in MENA state in their financial statements that their business operations and financial transactions all adhere to the Shariah. Such companies should be classified directly as being “Shariah-compliant by law”. As the global asset universe is large, screening cannot be handled manually. Interactive screening—combining automated and manual research— needs to be applied to overcome the shortcomings iinherent in automation. Such a combined screening is adopted by IdealRatings, a financial firm that identifies the
Shariah-compliant services available, scanning a global asset universe covering more than 95% of capital markets in more than 90 nations. Automated and manual analysis, and research techniques are combined so that end-users can define their own Shariah guidelines and execute them on the most accurate data relevant for Shariah screening. Purification is the act of cleansing investments from non-compliant earnings and makes in-depth research crucial in screening.. The amount to be purified is valued using the proportion of non-permissible revenue generated—in the case of Louis Vuitton, this is 16%. If investments are made in Louis Vuitton and dividend purification is followed by the fund, 16% of the dividends received must be purified. Without a detailed analysis, investors would have invested not only in a noncompliant activity, but also they would not have purified earnings. Quality Shariah screening requires defining adequate Shariah screens and properly categorising companies as compliant or non-compliant. n
Interactive screening— automated and manual research—will overcome the shortcomings of automation
Mohamed Donia is co-founder and managing partner at IdealRatings Inc, which services Shariah compliant funds in the USA, Europe and Middle East. E:
[email protected]. Shehab Marzban is a product manager at IdealRatings Inc, following a post as researcher and project manager at the University of Cologne. E:
[email protected]
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Islamic Banking & Finance Volume Six Issue Four Number 19
