Guide to islamic equity markets: Shariah stock screening methodologies

In-Depth Analysis

The question of whether Muslims can invest in publicly traded stocks is one of the most practically important questions in Islamic finance. Unlike Sukuk, which are designed from the ground up to be Shariah-compliant, conventional equities (stocks) represent ownership in companies that may engage in a mix of permissible and impermissible activities. Shariah stock screening methodologies have been developed to systematically evaluate which stocks are permissible for Muslim investors and which must be excluded. The screening process operates on two levels: qualitative (sector/business activity) screening and quantitative (financial ratio) screening. Both must be passed for a stock to be deemed Shariah-compliant. The qualitative or sector screen examines the company's primary business activities. Companies whose core business involves any of the following are excluded outright: conventional financial services (banking, insurance that involves Riba), alcohol production or distribution, pork and pork products, gambling and gaming, tobacco, weapons and defense (in some interpretations), adult entertainment, and conventional media that promotes values contrary to Islam. If a company's primary business is permissible but it earns a small portion of revenue from impermissible activities, many scholars permit investment provided the impermissible revenue does not exceed a threshold (typically 5% of total revenue), and the impermissible income is purified by donating that proportion of any dividends received to charity. The quantitative or financial ratio screen examines the company's financial structure, specifically its level of debt, interest income, and cash/receivables. The logic is that even if a company's business is permissible, excessive reliance on interest-bearing debt or interest income taints the investment. The specific ratios and thresholds vary between screening methodologies, but the most widely followed standards include: The Dow Jones Islamic Market (DJIM) Index, launched in 1999, was the first major Shariah-compliant equity index. The DJIM screening methodology, developed by its Shariah Board chaired initially by Sheikh Nizam Yaquby, applies the following financial ratio screens: total debt divided by trailing 24-month average market capitalization must be less than 33%; the sum of cash and interest-bearing securities divided by trailing 24-month average market capitalization must be less than 33%; and accounts receivables divided by trailing 24-month average market capitalization must be less than 33%. The S&P Shariah Index Series, developed in collaboration with Rating Intelligence Partners, applies broadly similar sector screens but uses a slightly different financial ratio methodology. S&P uses total debt to market capitalization (less than 33%), cash and interest-bearing items to market capitalization (less than 33%), and accounts receivables to total assets (less than 49%). The differences in denominator (market capitalization vs total assets) and thresholds create divergences between the DJIM and S&P Shariah universes. The AAOIFI Shariah Standard No 21 provides guidance on equity screening that is referenced by many Islamic funds and Shariah advisors globally. AAOIFI's standard is broadly consistent with the DJIM and S&P methodologies but uses total assets as the denominator for financial ratios: total interest-bearing debt to total assets must be less than 30%, and interest income must be less than 5% of total income. MSCI also publishes Islamic index series with its own screening methodology, as does FTSE Russell (FTSE Shariah Index). While the general principles are consistent, the specific thresholds and calculation methods differ, meaning that a stock may pass one screen but fail another. This has led to calls for greater harmonization of screening standards, though some scholars argue that methodological diversity reflects legitimate differences of scholarly opinion (Ikhtilaf) and is healthy for the market.