Understanding Islamic Unit Trusts

The rising affluence of investors who are keen to invest in Islamic financial products and the expansion of Islamic Capital Market products will underpin the growth prospects of the Islamic unit trust industry over the longer term. In Malaysia, growing demand for Islamic unit trusts is evident. From a mere two Islamic funds in 1993, the number of Islamic funds in Malaysia’s private unit trust industry has increased to 146 today. As at June 30, 2010, the Islamic fund sector has a net asset value (NAV) of RM26.37 billion, which is about 31 percent of the private unit trust industry in Malaysia1.

Characteristics of Islamic Unit Trusts

The primary characteristic that distinguishes Islamic fund management from conventional investing is its compliance with Shariah law. Islamic funds must adhere to Shariah-compliant economic activities and invest only in companies that fulfill Shariah requirements. In addition, Islamic funds cannot invest in conventional banks that offer products with fixed interest rates but can invest in Islamic securities and Islamic financial institutions. The funds must also avoid making investments in companies that are involved in products restricted by Islamic laws, such as alcohol, tobacco, pork, gambling or pornography.

After eliminating companies with non-Shariah primary business activities, the quantitative filter, in the form of financial ratios, are used to ensure that a Shariah-compliant company makes its income with adequate financial resources and without excessive debt. In addition, an Islamic fund may only engage in leverage through the use of Islamic financing instruments and may not obtain or provide conventional loans nor invest in conventional interest-bearing products, including conventional debt securities. Cash held by a fund may only be invested in Shariah-compliant, short-term investment products, such as Islamic money market instruments.

Resiliency of Islamic Funds

As such, Islamic funds have been known to be more resilient than conventional unit trusts as their returns are generally less volatile. Meanwhile, there are also other advantages to "ethical" investing. For instance, Islamic funds were little affected by scandals afflicting companies such as Enron and WorldCom several years ago, as these companies' highly leveraged balance sheets kept Islamic funds from buying them. Moreover, the quantitative filter adds to the resilient nature of Islamic funds because if interest rates were to increase in a rising inflationary environment, investments in non-leveraged companies are expected to outperform.

Purification of Profits

There will also be times when certain Shariah-compliant securities are reclassified to be
Shariah non-compliant. This may be due to a company changing or expanding its
operations which can lead to an unacceptable level of activities prohibited by Shariah laws.
For instance, a restaurant or hotel may decide to start serving alcohol or pork. In this case,
the Shariah Adviser will render the securities to be disposed should their market value
exceed the original investment cost on the announcement day.

The fund management company is then supposed to purify or cleanse the profits made by
its Islamic funds by identifying the profits generated by non-permissible activities and
channel the amount to charitable bodies approved by the Shariah Adviser. Investors can
find out how fund managers purify earnings from their Islamic funds in the respective
prospectuses.

Shariah Advisory Council

In order to protect the interest of investors, the SC has set up a Shariah Advisory Council
(SACSC) to regulate Islamic funds in Malaysia. The SACSC is responsible for attending to
inquiries and proposals related to the field as well as making pronouncements to encourage
innovation in the industry.

In addition, the SC also allows the registration of both local and foreign advisers for unit
trust funds and Islamic securities to ensure that fund managers are able to tap into their
own Shariah expertise. Besides ensuring that the operations and investments of the funds
are in compliance with Shariah requirements, Shariah advisers also occasionally meet with
the fund managers to answer enquires and offer advice.
For more information, please contact me or visit www.lancerlim.com or www.facebook.com/LancerLimUTC.