Whether you follow Islam or not, it pays to be well-versed in the particulars of Islamic finance. Islamic finance, which covers all financial institutions, practices, assets, and vehicles that are organised under Islamic principles and laws, is now worth a record $1.2 trillion, or about 1% of the global financial market.
As Muslim-majority markets continue to grow and constitute a larger share of the global economy, the importance of Islamic asset management is also set to grow in the years ahead. But what is Islamic finance, and how does it work? One of the first things you need to know is one of the central and defining principles of Sharia investing, which concerns interest, or riba.
Put simply, Islamic laws governing usury, which aim to prevent inequality and unfair wealth hoarding, explicitly forbid investors and lenders from earning interest on their investments. This is because to do so would be to collect unearned wealth and enrich oneself at the expense of others.
In this way, Islamic finance is very similar to many increasingly popular “social responsibility investments”, or SRIs. So, how can Muslim investors and lenders make money if they are not allowed to earn interest? Read on to find out.
1. Islamic Finance: The Basics
First off, it is worth covering the basics of halal finance. This will give you a better idea of why it is not possible to collect interest on Sharia investments and which kind of profitable investments are acceptable. Much like how other investment markets are governed by a raft of regulations and standards, Halal investments are governed by principles of Sharia law.
As the Quran explains, Allah is the sole owner of all wealth in the material world and humans are merely trustees of that wealth, who must use it and manage it responsibly and for the betterment of all. Muslims are permitted to enjoy any wealth they have earned and to grow their own wealth, but they must do so in a socially responsible manner. When it comes to Islamic investing, the main goal is to achieve social justice through the market and the economy. This means several things, such as:
This is probably the defining aspect of halal finance that makes it different from other forms of investing. As in many other religions, usury is forbidden, due to the insidious social impact and indebtedness, it can cause. That is why the collection of interest, or riba, is expressly forbidden under Islamic Finance. If financial activities do generate interest, this money should be reinvested immediately into socially worthwhile activities and causes.
Put simply, gambling in any form is forbidden under Sharia law. Many forms of investment and financial activity that may be common in some markets can be considered to be gambling in Islamic Finance, as profit may be based on total chance or may involve the lazy acquisition of unearned wealth. There are some key terms here that are worth understanding, which we will get into later.
Ensuring the Government is Responsible
A central tenet of Islamic finance is that the state holds obligations to its citizenry and is responsible for ensuring that everyone’s basic needs are met. This means that governments must practice sound fiscal policies and avoid gambling state funds or otherwise using them in ways that are not halal and may not help secure social justice.
Encouraging Investors to Share Risk
A core component of Islamic finance is that of shared risk. This means that, in any financial transaction or investment, the risk stemming from that investment is split between parties as evenly as possible. This is designed to prevent exploitation and ensure that one party is not shouldering the burden of any investment.
The redistribution of wealth is the end-goal of many of the principles behind modern Islamic finance. If you grow wealth from Islamic investments, you should be willing and able to redistribute some of that wealth to those less fortunate than yourself. This is primarily achieved through the imposition of zakat, which we will discuss below.
2. Halal Investments: Terms You Need to Know
There are a number of key terms and phrases that will come up in any discussion with a halal asset manager. Here is what you absolutely need to know:
Riba: As mentioned, Riba describes any form of interest that may be derived from an investment, the collection of which is haram, or forbidden.
Zakat: This describes a kind of tax or levy that is imposed on Muslims to ensure the fair distribution of wealth. It is often the role of the state to impose zakat on those who can afford to pay it, although some investments may also impose a zakat charge to help redistribute some of the wealth to those in need.
Maysir: This is essentially the acquisition of unearned wealth, without any effort involved. It is tantamount to gambling and is very much haram.
Qimar: Like the above, Qimar is forbidden, as it described any game of chance in which there is money to be won.
Ijara: This is a term used in Islamic mortgage lending. Ijara specifies a process in which an Islamic bank purchases a property and then leases it to the homeowner, who will repay the cost in fixed installments, without paying additional interest.
Sukuk: This one is very important. Sukuk is the word for an Islamically acceptable bond. They can be asset-backed or asset-based, and are the cornerstone of any halal investment portfolio.
3. Business Transactions That Are Haram
As you might have guessed, a certain range of business investments and transactions are expressly forbidden under Sharia investing. These are:
Investments in Prohibited Products & Industries
Any Islamic asset management fund will ensure that certain products and industries are excluded altogether. These are typically products and industries which profit from harmful or haram activities and primarily include:
Investments into Heavily Indebted Companies
In order to avoid activities that involve the collection of riba, any company that has interest-bearing debt equal to more than 33% of its total value cannot be invested in. Some halal asset managers and investors will try to avoid investing in a company with any interest-bearing debt at all, but this is generally very difficult to do.
All parties should be fully aware of the risks of an investment and that risk should be evenly and proportionally distributed. Investments that are secretive and opaque are forbidden.
4. How Can Sharia Investments Make Money if They Can’t Earn Interest?
So, with all of these activities and common features of the market being excluded from Islamic finance, how can one actually make money from a halal investment? There are actually many ways for investments to be profitable without the need to earn interest. This includes ‘standard’ non-Islamic investment vehicles and investments that have been specifically designed to make money in a way that is halal. Here are some examples:
- Murabaha: This is best described in English as ‘cost-plus selling’. This is when a lender, bank, or asset manager might purchase an asset or property and then agree to sell it to another property for a higher price in a transparent manner. The buyer would then pay this higher price through interest-free installments and the seller would pocket the difference as profit.
- Wakala: These are essentially fees paid to asset managers and banks for the role that they play in facilitating investments. Wakala helps to increase profits and overall value.
- Stocks and Bonds: As we shall explain shortly, stocks and bonds are acceptable as they typically do not earn interest, but rather gain in value on the free market. This is a common way for an investor anywhere in the world to make money from investments in a way that is halal.
5. Common Types of Acceptable Sharia Investments
Now that you know how halal investments can make money without having to rely on interest payments, it is worth getting a clearer picture of the kinds of investments that are acceptable. This includes investments that Wall Street banks would make, as well as specialty Islamic investment groups in major markets such as the UAE.
- Sukuk: As we have explained, these are a form of halal bonds that allow investors to put their money into a project or asset in which the profits will be realized at a later date, usually deriving from the sale of that asset or rents derived from it.
- Stocks: Stocks are an acceptable form of halal investment, as their value does not derive from interest. As long as the company you are investing in is not haram, you are all good to go.
- Real Estate: Real estate is invested in because it is hoped that its value will increase over time and it can later be sold at a profit. This is why many of the world’s largest Islamic funds are dominated by high-profile real estate investments.
- Istisna: This is an Arabic word describing a process in which an Islamic fund will purchase a project that is under construction but will be delivered to the buyer at a later date.
- Venture Capital: This is simply the process of investment in promising young companies that will hopefully become successful and deliver profits further down the line.
Join Australia’s Only Islamic Super Fund Today
If you are ready to make smart, halal investments that do not require you to earn interest, you have come to the right place. By joining Australia’s largest and only Islamic super fund, you can begin making socially-conscious, halal investments today. Make sure to get in touch with our friendly, professional, and experienced team today to find out how you can become a member.
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Ethical Finance and Innovation
Dr. Sayd Farook is the Executive Director of Crescent Foundation. He is Group Chief Operating Officer of Crescent Wealth and Managing Director of Crescent Finance. He previously served as Advisor to the Executive Office of the Vice President and Prime Minister of the UAE and Ruler of Dubai. In this capacity, he envisioned and executed strategic / transformation initiatives for Dubai and the UAE. Prior to that, he was the Global Head Islamic Capital Markets at Thomson Reuters, where he advised and served large corporates, multilaterals and governments in the Middle East, North Africa and South East Asia.