How Does The Current Economic Uncertainty Impact Shariah-Compliant Funds?

There’s a lot to like about Shariah-compliant funds, even if you aren’t Muslim. They focus on socially responsible investing, which can also appeal to investors who don’t want to participate in harmful or unethical industries.

That’s not all: investing in Shariah-compliant funds may perform better than conventional ones during volatile times, such as the present. Here’s how the current economic uncertainty has impacted Shariah-compliant funds, and why you may want to consider them in your portfolio.

But first, what is a Shariah-compliant fund?

A Shariah-compliant unit trust fund adheres to the principles of Islamic finance. Like a conventional unit trust fund, it pools together many investors’ money to buy a group of investments. It can invest using a particular strategy (such as investing in growth stocks or focusing on investments that give consistent income). A fund can also be structured in a way to focus on short-term, medium-term or long-term returns.

What do Shariah-compliant funds invest in?

Shariah-compliant funds differ from conventional ones in terms of investment holdings. While conventional funds can invest in any industry, Shariah-compliant funds undergo an additional level of screening to filter out industries that are not Shariah-compliant. This involves industries that are considered unethical, such as those involving liquor, firearms, adult entertainment and gambling. They may also be evaluated based on whether they are maslahah (serving public interest).

Shariah law also prohibits interest, uncertainty or excessive risk. As such, Shariah-compliant funds cannot perform transactions that involve short selling, speculative trading or conventional insurance. This also applies to most banking stocks, which are not deemed Shariah-compliant, as banks derive their income from riba (interest)

Each investment must also meet certain requirements. For example, a stock cannot be considered Shariah if it holds more than 33% in debt instruments compared to its total assets, as Islamic law prohibits having excessive debts.

What economic challenges have they faced this year?

The COVID-19 pandemic has majorly affected businesses and livelihoods. The unemployment rate went up to 5% in April, the highest it’s been in 30 years (source: https://www.theedgemarkets.com/article/malaysia-unemployment-rate-spiked-5-april). More than 30,000 small- and medium-sized enterprises (SMEs) have ceased operations since the movement control order was first implemented in March.

This economic recession has affected both Islamic and conventional investments. According to a recent study that examined the stock market from December 31, 2019 to April 18 this year, the COVID-19 pandemic had a big negative effect on the KLCI, as well as all sectors, except for the plantation sector (source: https://www.ijbs.unimas.my/images/repository/pdf/Vol21-no2-paper7.pdf). Back in March, the KLCI sunk to its lowest point in a decade, although it has since risen (source: https://www.theedgemarkets.com/article/klci-sinks-below-1300-mark-its-lowest-decade).

We’re not out of the woods yet, either. The COVID-19 pandemic is still affecting our everyday life, while there are political uncertainties both locally and abroad. These factors make it hard to predict how the stock market will act in the short term.

Are Shariah-compliant funds more stable than conventional funds?

Although the economic recessions have affected both Islamic and conventional funds, the effects are not the same. During periods of uncertainty, such as the present, Islamic funds have historically performed better than their conventional counterparts (source: https://www.theedgemarkets.com/article/islamic-investments-more-stable-choice-uncertain-times.

Let’s look at how equities performed during the SARS outbreak in 2003 and the 2008-2009 global financial crisis. From January 2002 to July 2012, the Dow Jones Islamic Market Index (which tracks the performance of Shariah-compliant equities in the US) outperformed its conventional counterpart, the Dow Jones Industrial Average Index, by 14.26% (source: https://www.theedgemarkets.com/article/islamic-investments-more-stable-choice-uncertain-times).

Closer to home, here’s how the FBM KLCI, which tracks the 30 largest companies in the Malaysian stock market, performed against the Principal Islamic Malaysia Opportunities Fund, which invests in Shariah-compliant equities and sukuk.

So why do Shariah-compliant funds tend to perform better during times of economic instability? Well, due to Shariah screening requirements, they generally aren’t exposed to volatile stocks like banking. On the other hand, conventional funds are exposed to banking stocks, which have been badly affected during the recession. The reduction of the Overnight Policy Rate (OPR) and introduction of loan moratoriums meant lower profit margins for banks, which in turn affected their stock prices. Stock prices of financial services fell 21% from the start of the year until November 9 (source: https://www.bursamalaysia.com/trade/trading_resources/listing_directory/indices-profile?stock_code=0010I).

However, this isn’t to say that Shariah-compliant funds always perform better than conventional ones. During uncertain times, Shariah-compliant funds can provide more stability as they tend to be less volatile. But besides that, Shariah-compliant and conventional funds generally provide similar returns. For example, here’s how the Principal Islamic Lifetime Balanced Fund compared to its conventional counterpart in the past five years:

Choosing the right funds matters in the long term

In short, Shariah-compliant funds can be a good investment choice for Muslims or for those who value an emphasis on socially responsible investing. During periods of uncertainty, they can also perform better than conventional funds.

While Shariah-compliant funds can help provide more stability in the short-term, it’s also important to choose the right funds to grow your money over the long-term. This means choosing funds that can perform well, as well as those that suit your risk profile.

Principal Islamic Asset Management, one of Malaysia’s largest Islamic asset managers, has global experience and expertise. You can choose from a wide range of Shariah-compliant funds that span different asset classes, geographic regions and risk ratings – this means being able to build a Shariah portfolio that meets your needs and helps you reach long-term investing goals.

Looking for Shariah-compliant investments? Find out more about investing in Shariah-compliant funds with Principal.