THE

2009 GROSSMAN SENIOR RESEARCH PRIZE:

“Investing the Islamic Way”
A Thesis presented to the Department of Economics at Trinity College
in partial fulfillment of the requirements for the Bachelor of Arts
Degree

May 2009
by
Verdell Walker

This Thesis won the 2009 Kenneth S. Grossman Senior Research Prize for Global Studies,
administered by the Center for Urban and Global Studies. The Kenneth S. Grossman ’78
Global Studies Fund was established in honor of Professor Eugene Leach in support of
student investigations of global issues that will confront mankind collectively in the 21st
century.
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ABSTRACT

The objective of this thesis is to analyze the performance of Islamic equity funds versus
their conventional, interest-based counterparts. This was accomplished by calculating and
comparing the returns for four Islamic equity funds and two conventional funds for specified
time periods. Chapter one will provide a brief historical background on the evolution of Islamic
law (“Sharia”). Chapter two will provide a quick review of the literature surrounding portfolio
theory, as developed by Markowitz, Tobin, Sharpe and others, and its application to “real world”
portfolios. Chapter three will treat the constraints Sharia imposes on investing, which include
prohibitions on certain lines of business, restrictions on allowable amounts of debt, and
inhibitions to the development of Islamic investment management funds. Chapter four will
examine the performance of Islamic funds. Chapter five will deal with other investment options
for Muslim investors. Chapter six will discuss the dangers of Sharia arbitrage and the prospects
for greater expression of Muslim principles in Islamic finance. The findings presented in chapter
five indicate that Muslims may not necessarily have to pay an opportunity cost for adhering to
their faith in their financial affairs. While of course longer time horizons are needed to make
more certain judgments, the Islamic funds have charted excellent performance over the time
horizons considered and have performed well versus their conventional counterparts. Indeed, the
superior returns of the Amana funds have attracted the attention and funds of non-Muslim
investors as well.
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ACKNOWLEDGEMENTS

This thesis could not have happened without the guidance, support, and expertise of the
following:

Above all, God

My mother

Professors Curran, Antrim, Grossberg, Prashad, Hayes, and Ahmed

Chaplain Marwa Aly

Rachel Barlow

Marlene Barzana
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TABLE OF CONTENTS

I. Introduction

II. The History and Evolution of Islamic Law

III. A Review of Modern Portfolio Theory and Ethical Investment

IV. Sharia Constraints on Muslim Investors

V. An Investigation of the Performance of Islamic Funds

VI. Other Islamic Asset Classes and Investment Alternatives

VII. Sharia Arbitrage

VIII. Conclusions

IX. List of References

X. Appendices
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LIST OF TABLES

Table 1. The Good Money Industrial Average vs the Dow Jones Industrial Average, 1976-2000
....................................................................................................................................................... 90
Table 2. The Good Money Utility Average vs The Dow Jones Utility Average, 1976-2000 ...... 91
Table 3. AMAGX During Last Stock Market Downturn ........................................................... 109
Table 4. AMANX During the Last Stock Market Downturn ..................................................... 110
Table 5. IMANX During the Last Stock Market Downturn ....................................................... 111
Table 6. Number of Securities - Islamic Portfolios .................................................................... 112
Table 7. Industry Allocation - Highest Percentages ................................................................... 113

LIST OF FIGURES

Figure 1. The Efficient Frontier.................................................................................................... 40

Figure 2. The Capital Market Line ............................................................................................... 42
Figure 3. The Capital Market Line with Lending or Borrowing at the Risk Free Rate ............... 43
Figure 4. The Security Market Line .............................................................................................. 45
Figure 5. Dow Jones Islamic Market Screening Criteria ............................................................ 85
Figure 6. The GMIA vs. DJIA - Cumulative Value Change ......................................................... 91
Figure 7. The GMUA vs. DJUA - Cumulative Value Change ...................................................... 92
Figure 8. The AEIFX and VEIPX Compared.............................................................................. 102
Figure 9....................................................................................................................................... 103
Figure 10. AMANX and VEIPX Compared ................................................................................ 104
Figure 11..................................................................................................................................... 105
Figure 12. IMANX and VWUSX Compared ............................................................................... 106
Figure 13..................................................................................................................................... 106
Figure 14. AMAGX and VWUSX Compared .............................................................................. 107
Figure 15..................................................................................................................................... 108
Figure 16................................................................................................................................................... 114
Figure 17.................................................................................................................................................. 115
Figure 18................................................................................................................................................... 116
Figure 19................................................................................................................................................... 128

Special Note: References to individual hadith and/or hadith collections in this thesis will be
found in footnotes.
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CHAPTER I. INTRODUCTION

Since 2001, the Islamic finance industry has grown by an astonishing 20% to 30%,

making it the fastest growing segment of the global financial industry (Carruthers and Colangelo,

2008). Islamic finance has long had a foothold in the Middle East and other countries with large

Muslim populations, and now it is expanding in the United States and Europe. The rise of this

industry has tracked the concurrent growth in the western Muslim population. Particularly in the

US and the UK, immigration and conversion to Islam are fueling the growth of the Muslim

demographic. These Muslims tend to be well-educated and middle class, and many of them are

demanding more Islamic financial products. Western financial institutions, such as HSBC and

Citibank, have been striving to acquiesce to this new source of customers. The growing demand

for Islamic financial products and services as well as the recent increased focus upon the Islamic

world highlights the rising influence of Islam and Muslims in global political, economic, and

social arenas.

Contemporary Islamic finance is the product of centuries of development of Islamic law.

The contracts used today in the industry are based on the intellectual and juristic efforts of some

of Islam’s greatest scholars and jurists. Taking the contracts those jurists devised as a foundation,

industry practitioners construct contracts and instruments to meet the financial needs of Muslims

seeking liquidity and financing, as well as enabling them to conform to the letter and spirit of

their religious obligations. Contrary to popular belief, Islamic law is not a rigid system of rules

and regulations devised in the 8th Century C.E. In practice, Sharia is dynamic, fluid, and open to

interpretations by Muslim jurists who strive constantly to adapt Islamic law to meet new

challenges to the Muslim way of life. Guided by the Quran, Muhammad’s example, these jurists

exercise a certain degree of independent reason but always do so within the boundaries set down
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by their faith. Their objective is to refine and expand the law and, by extension, Islam itself, as a

means to adaptation in a changing world.

The development of the Islamic financial industry holds great promise for Muslims and

non-Muslims alike. Muslims will gain an industry dedicated to meeting their business and

financial needs while at the same time affording them the opportunity to adhere to their religious

beliefs if they so choose. And since Islamic finance and investment shares many of the same

standards and principles as the modern ethical investment movement, non-Muslim investors will

gain an avenue through which they can find expression for their ethical and social values while

also pursuing and protecting their own financial wealth and gain. Moreover, it seems that

Muslims may not necessarily have to sacrifice financial gain for their principles. One of the

central aims of this thesis is to investigate and analyze the performance of Islamic equity

portfolios relative to conventional (i.e. not subject to the restrictions and guidelines of Islamic

law) equity portfolios. The results indicate that Islamic funds perform better or at least as well as

conventional funds. This is a positive validation for the Islamic financial industry in particular

and ethical investment in general.

However, in order to move forward, the Islamic financial industry must overcome

significant challenges. The most serious obstacle the industry currently faces is its present

reliance on prohibitions, the most famous of which is the prohibition on paying and receiving

interest. The Islamic financial industry is now a prohibition driven industry. Unfortunately, many

Islamic financial institutions focus on crafting products and services that simply mimic

conventional financial products. These “Islamic” products differ from their conventional

counterparts only in name. The mechanisms through which they are created, such as adding

degrees of separation and incorporating special purpose entities, only impose added costs and
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economic inefficiencies on a captive market of Muslims who wish to follow the precepts of their

faith. This phenomenon is known as Sharia arbitrage, and as we shall see in the following

chapters it has the potential to cause serious and lasting damage to the nascent Islamic financial

industry before it even has the chance to mature.

The prohibition-focused nature of the industry as it currently is poses the danger that

practitioners will become more focused on adhering to religio-legal form rather than on

promoting the moral substance of the Sharia. Helping Muslims avoid those actions that are

impermissible in Islam is only half the battle. The industry should also strive to allow Muslims to

further the aim of Islam itself: to promote and protect the welfare of humankind while bringing it

closer to God. Furthermore, the same intellectual vitality that characterizes other spheres of

Islamic law must be applied with the same vigor in Islamic finance. While there is nothing

wrong with using medieval contracts as a starting point for formulating new financial

instruments – indeed, modern Islamic bankers would be remiss if they did not take advantage of

the rich legacy and achievements left behind by the brilliant scholar-jurists of old – the industry

should endeavor to reduce their reliance on religious forms and instead find new ways to meet

contemporary financial challenges. This is precisely how jurists of the classical and medieval

periods of Islamic history formulated these contracts in the first place! If the industry continues

along its current path, it risks losing the innovative quality so characteristic of Islamic

jurisprudence itself, falling into stagnation, and worst of all, failing to realize its full potential.
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CHAPTER II. THE HISTORY AND EVOLUTION OF ISLAMIC LAW

The main purpose of this work is to examine a subset of Islamic finance, namely Islamic

investing. However, Islamic investing and finance cannot be fully understood without a working

knowledge of the broader canopy under which it rests – Islamic law. The rules that govern

Islamic finance and contractual obligations as they relate to business and commerce are an

important component of the wider body of Islamic law. Muslims believe that in order to direct

their business and financial dealings God has laid down guidelines to which they must adhere.

Some are explicit, while others require elucidation from qualified religio-legal specialists. To

help the reader better understand these religious requirements, this chapter is devoted to offering

a brief sketch of the history and evolution of this body of legal thought.

What is Islamic Law?

Joseph Schacht (1964) describes Islamic law as the “epitome of Islamic thought, the most

typical manifestation of the Islamic way of life, the core and kernel of Islam itself” (p. 1). Islamic

law is aimed at guiding the footsteps of Muslims in this world and the next, regulating their

religious and secular conduct. One of its key goals is to educate humans in how to maintain the

correct relationship with both God and other human beings. Islamic law is often equated with the

Arabic word “Sharia.” In its narrowest sense, Islamic law comprises legal rules. But the term

Sharia connotes more than legal rules; it refers to the method of conduct that Muslims must

employ in their lives, religiously, ethically, and legally (Zahraa, 2000, p. 169; Mahmassani, 1961,

pp.10-11). Many Muslims believe that the Sharia has a defined set of objectives, known as the

maqasid al-Sharia. These objectives center on protecting and preserving a set of key elements:

1. Life, human and otherwise (within reason)

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2. Religion

3. Wealth

4. Intellect

5. Progeny/lineage (taking care of widows, orphans, and the elderly falls into this

category) (Haneef, 2002, p. 254)

6. Honor (debated by scholars) (Marwa Aly, personal communication, January 29, 2009;

Llewellyn, 2003, pp. 193-194)

Anything that promotes or protects these elements should be supported and/or allowed. The

Islamic legal system that can be seen as the articulation of the Sharia and its aforementioned

goals can be divided into two main spheres: ibadat and muamalat. Ibadat, which means

“rituals,” refers to matters of religion, such as prayers, the hajj (pilgrimage to Mecca), paying

zakat (charitable donations), and other obligations incumbent upon Muslims. Muamalat, which

means “transactions,” describes social, political, and economic practices and issues that are most

akin to the subject matter of other legal systems. This second part is further divided into three

spheres: criminal law, family law, and transactions (the purview of Islamic finance) (Badr, 1978,

p. 188).

So how do Muslim jurists (the fuqaha) derive the rules and regulations that make up the

Sharia? This is achieved through the science of fiqh, or Islamic jurisprudence. Meaning

“knowledge,” fiqh is the methodological process through which qualified individuals have

shaped the development, interpretation and derivation of the Sharia throughout history. Islamic

law is not static, even in this present age. Through the methodologies of fiqh, jurists continue to

respond to the legal questions that arise and shape daily life for Muslims. The Sharia and its

attendant legal rules are based upon a set of both primary (i.e. divine and passed from God to
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humankind through the prophets) and secondary sources, discussed in the next chapter.

The Sources of the Law: The Primary Sources

To deduce the substance of Islamic law, Muslim jurists rely on two primary sources: the

Quran and the Sunna. The Quran is the holy book of Islam, while the Sunna can best be

described as the example of Muhammad to which Muslims can look for guidance as to how to

live the most pious and authentically Islamic life possible. Whenever a jurist is trying to find the

answer to some religious or legal question, it is to these sources that he looks first.

The Quran

Without a doubt, the Quran is the most important source of Islamic law. For all Muslim

jurists past and present, regardless of their differences in opinion on innumerable legal issues, the

Quran is the backbone of Islamic law. Muslims believe that the Quran was revealed to

Muhammad by God over a period of approximately twenty years in the cities of Mecca and

Medina. The Meccan chapters, or suras as they are known in Arabic, are typically shorter,

emotionally powerful, and deal with matters of religion and faith. The Medinan suras are usually

longer and provide the most detailed legal guidelines. The Quran was not written down during

Muhammad’s lifetime. After his death his companions began the process of transcribing the holy

book. During his reign from 644 to 656, the third caliph Uthman ordered that the Quran be

compiled into one definitive version and distributed to the provinces of the growing Muslim

empire (Mahmassani, 1961, pp.66-67).

The subject matter of Islamic law is ubiquitously Quranic in origin; all works of fiqh

throughout Islamic history touch on the same subjects – such as prayer, divorce, making alms,

the hajj, etc. – because these subjects were initially raised in the Quran. If a subject is not
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directly dealt with in the Quran, it usually has some Quranic inspiration. For instance, the Quran

makes no mention of many of the various business contracts used in Islamic finance. However,

when formulating these contracts, jurists were expressly concerned with structuring the contract

in such a way that Muslims could avoid riba and gharar, both expressly forbidden in the Quran

(and discussed in the next chapter). 1 The verses that deal with licit and illicit acts and behaviors,

as opposed to those concerned with ritual duties, are few in number in proportion to the Quran’s

total verses, usually 6236 in most modern editions. However, as opposed to other verses, the

legal verses are often longer in length and rarely repeated (Dutton, 1999, pp.157-161). The

Quran offers the most comprehensive legal rulings in personal law, such as issues of divorce,

marriage, inheritance, and the treatment of slaves (Schacht, 1964, p. 12).

Muslim jurists are convinced of the primacy of the holy book, especially in light of such

verses as Quran 6:38 (“…Nothing have we omitted from the book….,” )and Quran 16:89 (“…We

have sent down to thee a Book explaining all things, a guide, a mercy and glad tidings to

Muslims”). These verses led many Muslim jurists to believe that the Quran is a complete guide

to the proper Islamic life and the answer to every possible question, and thus it was up to them to

research the Quran and identify the answers contained therein, the real intentions of God, and the

proof to support their legal arguments. Yet as mentioned above the Quran contains very few

explicit legal rulings, so many scholars divide the Quran’s verses into two classes. First, there are

verses which have clear meanings, and second, there are verses whose subtle nuances of meaning

and connotation must be extracted by rational deduction and subject to interpretation (Zahraa,

2000, p.190). For this reason, jurists rely on the second most important source for the Sharia: the

Sunna.

1
Riba is unjustified enrichment through the exploitation of others or through the appropriation of other’s property
for one’s own use without a legitimate reason. It is dealt with numerous times in the Quran. Gharar is excessive risk
and uncertainty in business and finance. Riba and gharar will be treated extensively in chapter III.
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The Sunna

To the adherents of Islam, Muhammad is considered the perfect Muslim, the embodiment

of all that is good in man and an infallible example. Muslims attach great importance to his

words, deeds, and personal attributes, as well his acceptance of others’ actions, both tacit and

explicit. The sayings and actions of Muhammad are collectively known as the Sunna of the

Prophet (Mahmassani, 1961, pp. 71-73). The Sunna can be viewed as a natural extension of the

Quran; the dictates contained within the Book, according to early jurists, were personified and

put into action by Muhammad. Muhammad created a model for living the proper Muslim

lifestyle by demonstrating to his disciples, through his own life, how to fulfill the obligations laid

down in the Quran, such as prayer, paying zakat, and so forth. Symbolically the Sunna will never

usurp the primacy of the Quran, but it is undoubtedly a necessary complement to the Book itself

(Dutton, 1999, pp. 161-164). In practice, it is referred to much more often than the Quran in fiqh.

Throughout the centuries, the prophetic Sunna has been recorded in collections of the

traditions of Muhammad, the Hadith. A hadith is essentially a report from one or more of the

Companions of what Muhammad said or did. The Companions were those early Muslims who

saw or spoke with Muhammad, the most prominent of which were his close associates. The

reports of the Companion(s) were passed down through time through a chain of narrators, or

isnad. The credibility of the isnad was of vital importance, as only the reports of the most

trustworthy narrators were accepted by Muslims. In the eighth century, hadiths began to be

collected, authenticated, and compiled into complete collections. Thus hadiths can be considered

the textual building blocks of the Sunna. There have been numerous compilations of hadith

throughout Islamic history, but the two best known collections are referred to as the Sahih

(Arabic for ‘authentic’) books, written by Abu Abdullah Muhammad ibn Ismail al-Bukhari (d.
 14

870) and Abu al-Husayn Muslim al-Nisaburi (d. 875). Both Bukhari and Muslim searched

throughout the Muslim provinces for their traditions, painstakingly asserting the accuracy and

authenticity of the narratives and their isnads (Mahmassani, 1961, pp. 71-72).

The Secondary Sources

As mentioned earlier, the revealed sources of the Quran and the Sunna are the foundation

of Islamic law. While they do provide specific rulings on some legal issues, for the most part,

jurists must engage in the processes of deduction to derive the law from these sources. This is

done using the two secondary sources: ijma (consensus of opinion) and ijtihad (deductive

reasoning).

Ijma

Ijma, the consensus of the Muslim community on a hukm (regulation of God), is regarded

as the third most important source of Islamic law. In practice it is often thought of as the

unanimous opinion of jurists at a specific time about a particular legal question. Its primary

function was to determine whether a jurist’s opinion was valid or weak. This doctrine is based on

the well known prophetic hadith, “My people shall not agree in error” (Saleh, 1998, p. 260). In

the early days of Islam, consensus referred to the unanimous agreement of the Muslim

community. Later, as Islam spread from the Hijaz across the Near East and the Mediterranean,

consensus came to be thought of as the agreement in opinion of Muslim jurists in any particular

point in time, which represented the Muslim public, or those who were involved in the

discussion of a particular legal issue. Consensus may be an explicit corroboration of opinion or a

tacit acquiescence on the part of jurists. Shiite jurists held different views on ijma than Sunnis.

Shiites only accept the consensus of Muhammad’s family, Ahl al-Bayt, or an endorsement by one
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of Shiite Islam’s infallible Imams, instead of the mere consensus of the ulama (the community of

legal/religious scholars who were well versed in Islam and the Sharia) (Kamali, 1996, p. 24;

Mahmassani, 1961, p. 77-78).

Despite a vast treatment in works of fiqh, as yet there is no generally accepted view about

what ijma truly is. Scholars have debated the scope, form, and proper application of ijma since

the 8th century, when it became formalized along with the other methodologies of fiqh. Some

scholars, like Hanafis (adherents to one of the major schools of Islamic law discussed later), felt

that ijma should include all Muslims in order to be valid, while others, such as eleventh century

scholar Ibn Hazm, believed that only the consensus of the Companions mattered. In addition,

there is wide disagreement on the authority of tacit ijma. Some schools of law (again the Hanafis)

allowed tacit ijma, other schools did not (like the now extinct Zahiri school), and still others trod

a middle road like the Shafiis, who only allowed tacit ijma if certain guidelines were met (for

example, there must be indications of approval by the silent parties). Scholars even disagreed on

what types of questions ijma could answer. The great Islamic scholar al-Ghazzali (d. 1111) felt

ijma could answer all questions, while others felt that ijma could only be used for questions that

had not already been answered in the Quran (“Idjma,” 1971, pp. 1023-1026).

In addition to ijma, a lesser degree of consensus known as al-jamhur, or the majority of

jurists, also exists. Al-jamhur is attained when a majority of jurists agrees on a specific ruling,

thus lending the ruling a higher degree of probability of being truly Islamic. The individual

opinion of a jurist is challengeable until it is supported by other jurists, through either ijma or

jamhur (Zahraa, 2000, p. 183). Before this occurs, a ruling is considered to be probable. The

approval of other jurists transforms the ruling into one of certainty. Furthermore, the case

establishes a precedent that can be followed by later jurists in similar cases. In its capacity as a
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precedent-forming process, consensus has been a powerful force in the development of Islamic

law, and it has important implications for the rise of taqlid, or imitation, which will be discussed

in greater detail below (Hallaq, 1986, pp. 427-450).

On a practical level, the possibilities for ascertaining consensus on a particular issue

dramatically waned as the Muslim world grew. If it exists at all today, it is usually on minor

points of legal detail. Some have even gone so far as to suggest that in modern times ijma should

not be limited to Muslim jurists but should consist of all Muslims (Weiss, 1978, p. 209; Kamali,

1996, pp. 23-24). This is obviously impractical in modern times where Muslims reside in every

corner of the inhabited world and obtaining the opinion of each one of them is at the height of

infeasibility.

Ijtihad

Ijtihad is perhaps one of the most – if not the most – important concepts in the study of

Islamic jurisprudence. Simply put, ijtihad is the process in which a mujtahid (one who practices

ijtihad) uses his own reasoning to deduce the answer to a legal question; he extracts this answer

from the Quran and Sunna, his source material. Ijtihad, which literally means “endeavor” or

“self-exertion,” is the opposite of taqlid, or imitation. Taqlid is the acceptance of a rule based on

the authority of past jurists and/or previously settled legal cases. In general, Muslims do not

believe that a mujtahid creates Islamic law; rather he “discovers” that which was already

implicitly present in the Quran and the Sunna (Weiss, 1978, pp. 200-206).

Muslims generally regard ijtihad with great reverence. A tradition attributed to

Muhammad describes the rewards awaiting the jurist who practices ijtihad in the next life. Even

if his judgment is incorrect, he would still receive a reward. If the jurist had reasoned correctly

he would be doubly rewarded. In ijtihad, the jurist must apply himself to the utmost and
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sincerely seek God’s pleasure to receive the favor; if not, he is doomed to burn in hellfire

(Zahraa, 2000, pp. 192-193; Makdisi, 1979, p.1). Theoretically the opinions of a jurist should be

objective, not subjective. If personal preferences or other subjective whims infiltrate a juristic

decision, it is rejected as bida, or improper innovation (Weiss, 1978, p. 206). Keep in mind bida

does not mean innovation in the sense that we now know it; indeed ijtihad is used precisely to

innovate in an appropriate way and find new solutions to problems!

Ijtihad has numerous sub-varieties, each geared toward applying the general guidelines of

Islamic law to new legal cases (Kamali, 1996, p. 21). One of the most widely used modes of

ijtihad is qiyas (analogy). Qiyas is used to discover the solution to a new legal quandary, except

if that case has already been addressed in the Quran and the Sunna. Analogy consists of two

types: the analogy of similarities and the analogy of opposites.

The more prevalent of the two, the analogy of similarities, is used when a case in

question bears marked similarities to a case that has already been decided. Muslim jurists

developed this doctrine on the premise that rules are made to fulfill various objectives and

interests. These objectives and interests are the impetus for the rules. Thus, they could apply the

same rule to another problem which shared the same cause (illa) (Mahmassani, 1961, p. 79;

Hallaq, 1986, p. 427). Once a new case is found to share the same illa with a previous case, the

judgment of the original case is transferred to the new, ensuring consistency and continuity in

Islamic law. Scholars of fiqh have laid down strict parameters for the isolation of the illa, since

the illa was the key factor in analogies of similarities. Misusing the illa was tantamount to

flouting God’s law (Hallaq, 1984, p. 680).

The analogy of opposites was slightly more straightforward, if not used so often as its

counterpart. Jurists simply did not apply a rule that had been established in an earlier case to a
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new case if it was determined that the new case did not share the same illa with the old. Hence, a

new rule would have to be developed through some other mode of ijtihad (Mahmassani, 1961, p.

79).

The Requirements of a Mujtahid and the Process of Ijtihad

In order to qualify as a mujtahid, a Muslim jurist first had to acquire a lofty set of

prerequisites and qualifications. Besides a deep understanding of the Quran and the Sunna, a

mujtahid must also have a firm grasp of Quranic Arabic language and grammar, the

circumstances of the revelation of the Quran (asbab al-nuzul), the wording of verses, the

multiple meanings of different words, and al-naskh, the doctrine of abrogation (discussed briefly

later in the chapter) (Zahraa, 2000, p. 190). These rigorous standards have led some to believe

that not everyone is qualified to perform ijtihad. Therefore, most Muslims are simply taught to

follow the guidelines set by mujtahids.

The authority of the results of a jurist’s ijtihad rests only in the fact that what he has

derived is based upon the Quran and the Sunna, not on his personal merit, however great it may

be. Even if the ruling is issued by a learned and talented jurist, it is still an opinion (unless of

course it is corroborated by ijma or jamhur) (Weiss, 1978, p. 203). It is the pursuit of this ilm, or

knowledge, in which jurists are so entangled. Since each ruling is by nature fallible opinion

created by humans, Sunni jurists acknowledge the possibility of error, which is evidenced in the

occurrence of ikhtilaf (disagreement among jurists). However, it is incumbent upon Muslims to

obey even erroneous rulings, provided that jurists derived them from the texts in good faith and

sincerity.

The Dynamism of the Law

The Quran, Sunna, ijma, and ijtihad are the four main sources of Islamic law. They are
 19

widely accepted and applied by nearly all Muslim jurists. While disputes over the authenticity of

hadith, the conditions for ijma, and the methods of qiyas did arise, greater differences also arose

among groups of jurists who favored other strategies for adapting Islamic law to new situations.

Some jurists accepted new methods while others rejected them. These controversies were some

of the main points of division among the madhhabs, or “schools” of Islamic law, which emerged

in the tenth and eleventh centuries. This chapter will deal with a few of these principles.

Maslaha and Istislah

Maslaha is the Islamic concept of public interest or welfare. It is the direct opposite of

madarra and mafsada, which both denote “injury.” Anything which prevents or mitigates

mafsada and promotes the overall welfare of humanity can be termed maslaha. Legally, maslaha

is to be distinguished from istislah, which is a mode of legal reasoning that uses maslaha as

grounds for making a legal decision. The great eighth- century scholar Malik ibn Anas is

traditionally thought to be the first jurist to have used maslaha as a basis for legal reasoning, and

it is accepted as a valid legal source by the madhhab, or school of jurisprudence, that bears his

name. Other jurists and madhhabs typically reject it. 2 Istislah was developed by later jurists who

claimed Malik had been first to use the method. Before Malik, the concept of public welfare had

been used to decide numerous legal matters during the time of the seventh century even though

the term maslaha had yet to be coined.

It was not until the time of the esteemed eleventh century scholar Abd al-Hamid al-

Ghazzali that maslaha emerged as a mature principle. Al-Ghazzali insisted that maslaha was

about more than just averting mafsada; instead, it was actually the ultimate purpose of the Sharia

itself. Al-Ghazzali reasoned that maslaha was anything that furthered the aims of the Sharia,

2
However, no indisputable evidence has demonstrated that Malik ever used maslaha as a basis of reasoning, and
other jurists have also been said to be the first to consider it.
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namely the maqasid al-Sharia. Anything that hampered this goal was mafsada. According to al-

Ghazzali, the achievement of maslaha was paramount and necessary, and qiyas was the

appropriate tool to use to reach that end. To al-Ghazzali, maslaha is divided into al-darurat

(necessities), al-hajiyyat (needs), and al-tahsinat (improvements). The second and third

categories require a textual reference from the Quran, the Sunna, or the precedent of ijma be

found through qiyas. Alternatively, al-Ghazzali considered the al-darurat to be enough for a

legal decision, even without employing qiyas on the first three sources of the law, because al-

darurat constitutes the ultimate aim of the Sharia itself. Essentially al-Ghazzali argued that

maslaha was a source of law unto itself, irrespective of the other sources.

The thirteenth-century jurist Nadim al-Din al-Tawfi took al-Ghazzali’s reasoning a step

further. He believed that if maslaha contradicted one of the primary sources, it should overrule

the source because maslaha was God’s primary goal, and the Sharia was meant to promote it. He

cites passages from the Quran and the prophetic traditions to support his argument, particularly

the hadith la darar wa-la dirar (“no injury should be imposed nor an injury to be inflicted as a

penalty for another injury”). Al-Tawfi thus promoted the principle of maslaha in all aspects of

legal transactions (muamalat) but not in religious matters (ibadat). Underlying both al-

Ghazzali’s and al-Tawfi’s reasoning are the overarching objectives of the maqasid al-Sharia i.e.

the need to promote and protect life, religion, wealth, intellect, and progeny. Today, the principle

of maslaha has been enjoying renewed interest from Muslim jurists, including those involved in

Islamic finance, where it is used to argue that in order to prevent undue hardship Muslims should

be allowed to pursue certain modern financial instruments and processes that may not be strictly

Islamic (Mahmassani, 1961, pp. 87-89; “Maslaha,” n.d., pp.738-739).

 21

Al-Naskh

As we have seen, maslaha can be used as a justification for allowing Muslims to engage

in activities that may not have a basis in the Quran, Sunna or precedents of ijma, or that might

even contravene these texts, provided that compelling evidence of the need to do so exists.

Maslaha, as envisioned by al-Tawfi and others, is itself related to al-naskh, the concept of

abrogation. It means that one Sharia rule can supplant an earlier one in order to enable the Sharia

to adapt to changing times. There are several brands of naskh, the primary three being the Quran

being supplanted by itself, the Sunna being superseded by it, and the supplanting of the Quran by

the Sunna (Schacht, 1964, p. 115). Needless to say, naskh has always been a controversial

subject in Islamic jurisprudence. While the majority of jurists recognized the supersession of the

Quran by itself (e.g. a later verse of the Quran superseding an earlier one), it was usually only

accepted in regards to those Medinan verses which discussed transactions and not the Meccan

verses which tended to deal with matters of religion. In addition, instances of the Sunna

supplanting the Sunna occurred often, i.e. a later hadith contradicted an earlier one.

However, it was the supersession of the Quran by the Sunna that raised the most

disagreement among jurists. While jurists generally agreed on the authority of a prophetic

tradition when it supported the Quran or elucidated it, many jurists found it impossible to accept

that the Sunna could contradict and overrule the holy book of Islam. The foremost among these

were al-Shafii and Ahmad ibn Hanbal, the revered eponyms of two of the extant madhhabs,

active in the eighth and ninth centuries respectively. They cited several Quranic verses and

prophetic traditions which affirm the primacy of the Quran.

Some jurists who felt that the Sunna could supersede the Quran, including Malik, some

jurists from the extinct Zahiri madhhab, and the disciples of Abu Hanifa, another great jurist and
 22

madhhab namesake. They reached this conclusion through reason and actual historical precedent.

Quran 2:180 says:

“It is prescribed for you when one of you approacheth death, if he leaves wealth, that he
bequeath unto parents and near relatives in kindness. This is the duty of the devout.”

However, these jurists felt that this verse was supplanted by a saying attributed to Muhammad:

“No bequest is to be made to an heir.”

Today, most jurists fall into the camp of Ibn Hanbal and al-Shafii and hold that a law can

only be repealed by the authority that made it (Mahmassani, 1961, pp. 64-66). Essentially, only

Muhammad can repeal himself, and even Muhammad cannot repeal God.

Classification of Human Deeds

The rulings of the Sharia, drawn from the primary sources using the methods described

above, are intended to guide the behavior of Muslims in the temporal world. They are divided

into five categories, based on whether performing an action or not performing it are rewarded,

not rewarded, punished, or not punished.

1. Deeds that are incumbent upon Muslims to perform are wajib. Making the hajj,

performing prayers (salat), and paying alms (zakat) fall into this category.

2. Deeds that are recommended but not mandatory are mandub. The remembrance of

God (zikr) is an example.

3. Deeds that are permissible but neither rewarded nor punished are mubah.

4. Deeds that are frowned upon but not expressly prohibited and punished are makruh.

A Muslim is rewarded if he or she refrains for committing makruh deeds.

5. Deeds that are expressly forbidden are considered to be haram. Like makruh deeds, a

Muslim is rewarded if he or she refrains for committing haram actions. Charging or

 23

paying interest is considered haram under the prohibition of riba. Engaging in

something that is haram is subject to divine penalty (Saleh, 1998, p. 262).

Another important term is halal, which simply refers to something that is permissible under

Islamic law. The system above is a perfect example of the flexibility of Islamic law. Jurists can

and do disagree about the nuances between each of the categories. Furthermore, Muslim jurists

recognize the broad range of human behavior and the complexities of the human condition. Thus,

we see yet again that different human actions seldom can be classified as unequivocally bad or

unequivocally good in Islamic law.

Historical Foundations of the Sharia and Islamic Law

Jahiliyya

Muslim historians refer to the period before the advent of Islam as Jahiliyya, or the Time

of Ignorance, meaning that humankind was ignorant of God’s true religion and His law before

Muhammad’s revelations. Despite this designation, the legal institutions, traditions, and

structures of pre-Islamic Arabia had a profound influence on the development of Islamic law.

The early inhabitants of the Arabian Peninsula, the Bedouin, had a very complex system of law

that was rigorous in the application of its rules. The cities of Mecca and Medina, which were

destined to play a key role in the coming religion, were already bustling centers of commerce

and trade, as were other cities and towns in the area. The people of this region, therefore, had a

well developed system of commercial law with which Muhammad was no doubt familiar in his

position as a caravan leader for his wife Khadija’s Mecca-based mercantile business.

Family law, criminal law, and laws of personal status were also well developed in the

Arabian Peninsula before the advent of Islam. These laws were dominated by the tribal system,
 24

a social force that still wields much power and influence in the Arab world today. The individual

was only understood in terms of his or her tribe; the tribe provided legitimacy and protection to

its members. The features of tribal law were affected in no small way by Islam, but they have

still left indelible fingerprints on Islamic law.

The Arabs of this period relied extensively on mediation through arbitrators known as

hakam. The importance of the hakams lied in the fact that whatever judgments they issued in

legal disputes became an authoritative explanation of what the law was or ought to be. Thus, the

hakam’s role as arbitrator also developed into that of a lawmaker. Through his statements, the

hakam explained what constituted the sunna, or normative custom (to be distinguished from the

prophetic Sunna of Muhammad). The hakams applied and developed this sunna, which became

one of the most important concepts in what would become Islamic law (Schacht, 1964, pp. 6-8).

Due to his status as the Messenger of God and a man of unblemished character,

Muhammad was considered by his followers to be a hakam. Moreover, his military and political

successes extended his influence beyond that of a mere arbitrator. As a prophet, Muhammad was

concerned with laying down a moral code by which man could lead a life that was most pleasing

to God. Nevertheless, Muhammad had to work within and apply Islam’s religious and ethical

guidelines to the legal institutions of his day. The legal rules and prohibitions that are found in

the Quran and the Sunna do not exist solely for their own sake. Instead, they can be seen as

establishing, upholding and maintaining the moral norms that characterize a proper Islamic

lifestyle. For instance, the Quranic prohibitions of riba and gharar were meant to further the

ends of Islamic justice, such as preventing the exploitation of the poor. Though these

prohibitions concern certain kinds of commercial and legal transactions, the Quran does not
 25

concern itself with regulating the form and substance of these transactions (Schacht, 1964, pp.

11-12).

The Formative Era of Islamic Jurisprudence

The Umayyad and Abbasid Caliphates

After the death of Muhammad in 632 and the reign of the Medinan caliphs between 632

and 661, the rule of the Muslim community was transferred into the hands of the Damascus-

based Umayyad dynasty. While the Umayyads tended to focus more on temporal matters of state

and administration, Islamic law, justice, and jurisprudence began to solidify and emerge during

their rule. As the Umayyads concentrated on the territorial expansion of the Muslim empire,

Umayyad governors also took steps that advanced the development of Islamic fiqh. As the

empire grew, the system of arbitration that prevailed in the era of Jahiliyya and the first decades

of Islam no longer met the legal needs of Muslims. The governors met these needs by appointing

qadis, Islamic judges. The qadis used their own reasoning to reach their decisions, thus forming

the base from which Islamic law would spring. Under the qadis, a trend toward greater

Islamization of local laws began in earnest.

Toward the beginning of the eighth century, more and more ‘specialists’ were appointed

to the post of qadi. A specialist was not someone who was trained in a dedicated educational

institution. Rather he was one who spent time studying the injunctions and legal directives of the

Quran. These individuals were not merely concerned with legal points, but with the wider

application and implementation of Islam in the lives of Muslims. Thus it is during the Umayyad

period that we see the emergence of the ulama, the body of religious/legal scholars which

responded to the prevailing practice of adopting local laws in the acquired territories of the
 26

Islamic empire. The ulama came to dominate the qadis and coalesced into a separate,

independent group (Z. Antrim, personal communication, February 2, 2009).

After the Abbasid dynasty overthrew the Umayyads in the middle of the eighth century,

the Islamicization of the law proceeded even further. The Abbasids maintained that Islamic law

was the only legitimate law and elevated the status of the ulama, with whom they consulted on a

variety of issues. The early Abbasid rulers sought to shape the articulation of Islamic law from

theory into practice, but later rulers were less assiduous in their commitment to this goal and

were more concerned with preserving and extending their own power.

Thus, gradually during the Abbasid period, the Sharia and its interpretation became the

exclusive domain of the ulama. Although in theory the ulama operated outside of the influence

of the government, in practice they were far less independent, especially those employed as qadis

who were subject to dismissal and dependent upon executive power to enforce their rulings

(Schacht, 1964, pp. 49-56).

The Rise of the Madhhabs

Thanks to their newfound independence, the ulama were free to immerse themselves in

the articulation of Islamic law, and jurists actively began to develop a rich corpus of legal

thought. During the 9th-11th centuries, fiqh reached its apex, as did so many other sciences in the

capable hands of Muslim scholars. It was also during this time that one of the most important

features of Islamic law began to emerge – the madhhabs, or ‘schools’ of law (Mahmassani, 1961,

p. 17). These madhhabs and the scholars who inspired them hold great significance in the history

of Islamic law in particular and Islam in general.

The term “school” is often used in the literature for the lack of a better word. Throughout

the history of Islamic law, there were numerous such schools, only four of which survive to the
 27

present day. The madhhabs were not formal educational institutions. They were merely groups

of jurists who adhered to certain legal doctrines that can be traced back to a pioneer in Muslim

law for which the school was named. Even so, a strict conformity to said doctrines did not exist

in each madhhab, as jurists who belonged to the school were free to differ in opinion from the

‘official’ line. Many often did. Even though a jurist may identify himself as belonging to a

specific madhhab, he is by no means bound by that school’s doctrines. He is free to pick and

choose the doctrines that he feels are best in formulating his legal opinion. It is highly likely that

this freedom of choice has always existed for jurists (Hallaq, 2001, p. 21).

There were hundreds of schools that did not survive the test of time. Only four madhhabs

survive to this day in Sunni Islam: the Hanafi school, the Maliki school, the Hanbali school, and

the Shafii school. The scholars for whom these madhhabs were named did not “found” a school

in any sense of the word; rather their followers and students retroactively applied their names to

the madhhabs that were established around their teachings and doctrines (Hallaq, 2001, p. 25).

The Maliki School

In the Arabian Peninsula, the city of Medina became a seat of Islamic jurisprudence. As

Medina was the destination of Muhammad’s flight from Mecca in 622 and the site from where

he regulated the affairs of the community for the last decade of his life, it is no small wonder

then that the school of Medina came to be associated with those who placed great importance on

the traditions of Muhammad. A number of jurists emerged in Medina who received renown

across the Muslim world for their brilliance. The most famous is Malik ibn Anas al-Asbahi (b.

711 – d. 795). Malik was considered to be a leading authority on prophetic traditions because of

the meticulous diligence he displayed in finding and authenticating hadith. Malik was also a

major proponent of ijma; he relied extensively on the consensus of the scholar-jurists of Medina
 28

when he could find no answer to a legal question in the Quran or the Sunna (Dutton, 1999, p. 13;

Mahmassani, 1961, pp. 24-25). Malik was clear in his assertion of the superiority of the Medinan

rulings over those of other cities’ ulama. He cites the Medinese jurists’ greater experience and

knowledge of Islam due to their city being the City of the Prophet (Dutton, 1999, p. 38). Only in

the absence of the Quran, Sunna, and the ijma of the Medinan jurists did Malik employ his

formidable intellect in ijtihad.

From its home in Medina, the Maliki madhhab spread through the rest of the Hijaz, the

Maghrib (North Africa), and Andalusia (Muslim Spain). The school also reached Upper Egypt,

Sudan, Bahrain, Kuwait, and other Islamic nations. It also spread across Muslim Central and

West Africa (Mahmassani, 1961, pp.26-27; Schacht, 1964, p. 65).

The Hanafi School

The eponym of the Hanafi school, Abu Hanifa Numan ibn Thabit of Kufa, Iraq, was

known for his scholarly and legal brilliance. His school was established around 805, at the time

of the death of his famous student al-Shaybani, approximately forty years after Abu Hanifa’s

death. A significant characteristic of Abu Hanifa’s juristic work is his willingness to develop and

extend the Sharia through personal reasoning. Along with the Quran, Sunna, and the opinions of

the Companions, Abu Hanifa considered personal opinion, obtained through the rigorous use of

ijtihad, an important source of the law. This confidence in personal opinion characterized his

school and his followers. Abu Hanifa was also a diligent analyst of the hadith (Mahmassani,

1961, pp. 19-20).

From its home in Iraq, the Hanafi school spread wide across the Muslim world. One

third of the world’s Muslims are adherents of the Hanafi school. Hanafi jurisprudence was the

basis for the Majallah, the official legal code of the Ottoman Empire. Besides being the official
 29

school of Lebanon, Syria, and Egypt, it is also widely accepted in Turkey, the Balkans, the

Caucasus, China, India, Pakistan, and Afghanistan (Schacht, 1964, p. 65; Mahmassani, 1961, p.

24).

The Shafii School

The Shafii school revolves around the teachings of the great jurist Muhammad ibn Idris

al-Shafii. Al-Shafii was well traveled, and his sophistication, intellect, oral and written eloquence,

and proficiency in jurisprudence made him a scholar of exceptional ability. These personal

qualities allowed him to create the foundations of his own madhhab, which synchronized the

Maliki school and the Hanafi school. Al-Shafii was heavily influenced by Abu Hanifa and his

teacher Malik; thus his madhhab is an effective melding of the characteristics of these two

influences: reliance on opinion and reliance on tradition, respectively. Thus, the importance of

al-Shafii’s synthesis in the history and evolution of Islamic law cannot be overestimated

(Mahmassani, 1961, p. 27). Because of his articulation of such a synthesis, al-Shafii is

traditionally regarded as the founder of fiqh. Other scholars had contemplated issues of

jurisprudence long before his time, but al-Shafii laid the foundations for the basic structures of a

methodology.

Egypt is home to many adherents of the madhhab, especially in rural areas. Palestine,

Jordan, Syria, Lebanon, Iraq, Pakistan, and India have many adherents as well. Nearly all the

Muslims of Southeast Asia, including Indonesia and Malaysia, follow the Shafii madhhab. The

school also has followers among the Sunni Muslims of Iran and Yemen (Mahmassani, 1961, p.

29; Schacht, 1964, p. 66).

The Hanbali School

 30

The smallest of the madhhabs, the Hanbali school began around 855, the date of the

death of its namesake, the Baghdadi jurist Ahmad ibn Hanbal. Ibn Hanbal disliked the use of

personal reasoning even more so than Malik. He advocated the strict adherence to a literal

understanding of the primary sources of the Quran and the Sunna. Ibn Hanbal was said to be

unyielding in his own personal faith and his unwillingness to compromise on his views of true

Islam often led to his persecution and punishment.

Throughout its history, the Hanbali madhhab has seen two periods of rejuvenation. The

first came during the thirteenth and fourteenth centuries with the advent of Ibn Taymiyya and his

student Ibn Qayyim ibn Jawziyya. Ibn Taymiyya consistently denounced what he considered to

be bida, or improper innovation, such as cults of saints, some prevalent Sufi doctrines such as

esotericism, and certain rituals he observed during his pilgrimage to Mecca in 1292. Like Ibn

Hanbal, Ibn Taymiyya was totally committed to the primacy of the textual sources of the Quran

and Hadith. Ibn Taymiyya, and indeed most if not all Hanbalis, attached relatively little

importance to ijma. Also like most Hanbalis, qiyas never took precedence over the text for him.

Nevertheless, he supported the disciplined use of ijtihad, believing that ijtihad was an integral

component of the continual interpretation of the Law (“Ibn Taymiyya,” 1971, pp.951-955).

Ibn Taymiyya’s teachings and legacy directly inspired the second renewal of Hanbalism

that occurred during the eighteenth century in the person of Muhammad ibn Abd al-Wahhab. His

fiery, puritanical form of reformism, today known as Wahhabism, swept through the central

Arabian Peninsula. Ibn Abd al-Wahhab rejected the blind imitation of ancestors and argued for a

return to the pure Islam of the time of Muhammad. By the same token, he too rejected what he

considered to be religious deviations such as the worship of tombs and saints.

 31

The Hanbali school is the official madhhab of Saudi Arabia and has adherents in other

parts of the Arabian Peninsula, Palestine, Syria, Iraq, and other Islamic nations (Mahmassani,

1964, pp. 30-33).The school is often called the most conservative of the madhhabs. However,

this is erroneous. For one, the Hanbalis reject ijma; the schools which accept and rely extensively

on ijma tend to be the most conservative since they are thus more prone to adhere to the

precedents set by earlier scholars. In addition, Hanbali jurists have been some of the most

frequent users of ijtihad, such as Ibn Taymiyya (whose work on gharar has important

implications for modern Islamic finance, as we shall see) (Z. Antrim, personal communication,

February 2, 2009).

The Evolution of the Madhhabs

The madhhabs can be seen as the intellectual and structural basis of Islamic law. But it

would be a mistake to think that the madhhabs became rigid entities after the deaths of their

eponyms. The madhhabs evolved and changed to respond to the needs of Muslims in each and

every age. Indeed, although the disciples of the four scholars preserved their work and legacies

and referred to them often, later jurists also used their own intellect and ijtihad to further refine

and develop fiqh and each madhhab’s legal corpus. In short, at no point in time did Islamic law

become stagnant.

In 1950, Joseph Schacht published his landmark work The Origins of Muhammadan

Jurisprudence. One of the key points of this book is that the madhhabs began their existence in

the eighth century when jurists began to cluster around geographical centers. Jurists were thus

identified by their regional affiliations. Schacht called these geographical centers the ‘ancient

schools of law’ (Hallaq, 2001, p.1), the most important of which were Kufa and Basra (the Iraqi

school), Mecca and Medina (the Hijaz school), and Syria. In the early Abbasid period, these
 32

geographical schools transformed themselves into personal schools that focused on the doctrine

of an individual master-jurist, whose work and teachings disciples carried forward. According to

Schacht, this process was completed by the middle of the ninth century. Schacht maintains that

this transformation was largely due to the efforts of al-Shafii. Since al-Shafii’s teachings and

rulings were an amalgamation of Maliki and Hanafi doctrine, al-Shafii thus created a new

personal doctrine all his own. Thus, Schacht asserts, anyone who adhered to al-Shafii’s teachings

became a follower of al-Shafii. Because of this, Schacht contends that al-Shafii was the founder

of the first truly personal school, and his actions were the catalyst that led to the creation of other

personal schools, including the other three orthodox madhhabs and those which eventually died

out (Schacht, 1964, p. 57-59).

The historian Wael Hallaq disagrees with this thesis, however. According to his theory,

the madhhabs did undergo a transformation, but they evolved from personal schools based on

individual doctrines to doctrinal schools; the geographical schools never existed. Hallaq (2001)

argues that all madhhabs in Islamic history developed a regional character, but this regional

variation was due to the environment in which a particular corpus of law developed, and was not

representative of a distinct geographical doctrine (p. 19). He cites examples in works of fiqh and

history of certain jurists having followings of their own during the period of the geographical

schools, as well as instances of jurists being classified as members of geographical schools even

after 870 CE, the date which Schacht specified as the end of the transformation from

geographical to personal schools (Hallaq, 2001, p.15). Hallaq also finds instances of

geographically defined schools from much later periods of Islamic history, even as late as the

thirteenth century. In addition, there is evidence that the later schools also developed a distinctive

regional character for their doctrine; Hallaq cites Andalusian Malikism, Transoxanian Hanafism,
 33

and Syrian Shafiism as examples (Hallaq, 2001, p.18). Furthermore, Hallaq maintains that jurists

who worked in the same geographical area, such as Iraq, did not necessarily share a uniform

doctrine; it was merely convenient for historians to designate jurists by their location (Hallaq,

2001, p.16). Hallaq points to the schools of al-Shafii and the Damascene scholar al-Awzai (d.

774) as examples of scholars considered to be jurists of their own accord and with their own

personal madhhabs that had no association with a particular geographic location before the end

of the eighth century (Hallaq, 2001, p. 17).

As for the transformation from personal to doctrinal schools, Hallaq cites the emergence

of taqlid in the latter half of the ninth century and the tenth century. Taqlid, meaning “imitation,”

is characteristic of a madhhab reaching the final stages of its evolutional maturity. It refers to the

fact that jurists of each madhhab looked to past jurists, especially the four eponyms, for guidance

as to their legal decisions. The prevalence of taqlid, according to Hallaq’s theory, allowed

madhhab jurists to develop a cohesive and substantive body of doctrine and legal theory for their

particular school. Thus, on the macro-level, the later madhhabs were well-integrated entities, and

possessed an organized unity in their doctrinal orientation. Due to the highly individualistic

nature of ijtihad, each jurist within a madhhab had the right to form his own opinions. So on the

micro level, jurists had to control the vast assortment of opinions. To address this need, jurists

developed what Hallaq calls the madhhab-opinion, which was the authoritative doctrine of a

particular school, announced by fatwa (a non-binding religious opinion issued by a religious

scholar or scholars), and determined by the agreement of the madhhab’s jurists. The madhhab-

opinion also need not be that of the eponym of the school (Hallaq, 2001, pp. 21-24).

Due to the many instances that Hallaq presents of madhhabs not following the trajectory

espoused by Schacht, Hallaq’s arguments are more compelling than the Schachtian theory. The
 34

importance of the madhhabs in the history and evolution of Islamic law is undeniable. In its final

form, the madhhab is the representative of a corpus of legal doctrine of its founder. Later jurists

both refined and elaborated that doctrine through their own reasoning. From the very beginning,

Islamic law has been a highly individualistic discipline. The madhhab at its developmental

height was intended to control this individualistic spirit, not curb it. Ijtihad is highly revered in

Islam for a reason. Islamic law owes its dynamic character, and indeed its very development, to

those efforts.

The Gate of Ijtihad

Ijtihad is the lifeblood and catalyst of Islamic law. For centuries, Muslim jurists have

developed the law and addressed the issues that affected the temporal and spiritual lives of

Muslims. A long held theory, again advanced by Joseph Schacht, was that the so-called “gate of

ijtihad” closed forever in the tenth century. Schacht and other scholars hold that during the early

Abbasid period, scholars began to feel that Islamic law had reached its ultimate maturity; all the

questions that mankind could ever raise had been answered through the Quran, Sunna, and the

ijtihad of brilliant jurists of old. Furthermore, the infallibility of ijma also led to the solidification

of doctrine and later to the restriction of jurists’ ability to exercise ijtihad. The question arose as

to who was qualified to practice ijtihad and who was not qualified to do so. Schacht posited that

jurists of the ninth century began to feel that no contemporary jurist had the qualifications that

the earlier scholars had possessed, and thus were not fit to exercise independent reasoning. From

that point on, scholars felt that jurists should limit themselves to the explanation and

interpretation of the doctrine laid down by their forebears. In short, this was a call for the era of

taqlid to begin. After this point, Schacht argues that Islamic law became rigid and extremely

conservative, and despite the opposition of a number of independent jurists and collective
 35

movements, taqlid became the guiding principle of the law (Schacht, 1964, pp. 69-75; Weiss,

1978, p. 208).

However, later scholars have challenged Schacht’s theory and argued that no such

closure of the gate of ijtihad ever occurred. Bernard Weiss points out that there was never a point

in time in which a permanent barrier to ijtihad was formally erected, and disagrees with

Schacht’s proposition that ijma is the primary reason behind the conservatism of Islamic law

(Weiss, 1978, p. 208).

Again, it is Wael Hallaq who offers a compelling argument against the prevailing

Schachtian theory. Hallaq (1986) contends that scholars did not debate the necessity of ijtihad;

rather they raised questions about whether or not any era could persist without mujtahids. On one

side, the Hanbalis and a significant number of Shafiis held that mujtahids must exist at all times.

The Hanafis and other Shafiis believed that the mujtahids would eventually cease to exist

(pp.129-130). Hallaq bolsters his argument by pointing out that the search for ilm, or knowledge,

is a fundamental concept of Islamic culture. To Sunni jurists, ilm signified the knowledge of

what would please God. Ilm and fiqh are often equated by Muslim jurists in that fiqh is the

knowledge of God’s law. Ijtihad, along with other methods treated in works on fiqh, is meant to

extract and interpret God’s law from the primary sources. Consequently, it is only through ijtihad

that the Sharia can survive and flourish; closing the gate of ijtihad would prevent the continual

search for ilm and thus render the Sharia and Islam incomplete (Hallaq, 1986, pp. 131-132).

Thus jurists did not question whether the gate of ijtihad should be closed; rather they

were concerned with the existence or nonexistence of mujtahids. The ulama played a key role in

Islamic society, and the mujtahids were at the pinnacle of ulama hierarchy, regarded as the

guardians and expounders of the Sharia. Nevertheless around the tenth and eleventh centuries,
 36

the dearth of highly gifted mujtahids like al-Shafii and Abu Hanifa led many Muslims to believe

that mujtahids were a dying breed and were being replaced by lesser mujtahids who could only

operate within the confines of the madhhabs. This belief led many to consider the possible future

extinction of the mujtahids (Hallaq (1986) pp. 135-136). The debate over the existence and

possible extinction of the mujtahids carried eschatological significance. In Islamic eschatology,

the disappearance of ilm is a sign of the Day of Judgment. Ilm could only disappear if the

mujtahids did as well. Thus, the decreasing number of mujtahids was a sign of the coming Day

(Hallaq, 1986, pp. 137-139).

Conclusion

Islamic law is a product of both revelation and reason. These two forces have had a

complex relationship throughout the entirety of Islamic history. After reading this chapter, it

should be clear to the reader that Islamic law is not a static thing. Rather, it is a dynamic, mutable

entity that benefits from and encourages the active participation of Muslim jurists and scholars. It

is further characterized by a wide range of disagreement and variance of opinion on innumerable

legal issues. What is halal (permissible) for one jurist is not necessarily so for others. This point

is especially relevant for the study of modern Islamic finance. One will find a wide range of

opinions on what is Islamic or un-Islamic. However, the same kind of debate and rigorous

intellectual grappling that has shaped, defined, and developed Islamic law over the centuries is

still very much at work in modern Islamic finance, and will continue to be so far into the future.

Furthermore, it is important to study the medieval era of Islamic history because it was in this
 37

epoch that the contracts on which modern Islamic finance is based were first created and

developed. 3

3
This chapter has dealt with the dominant Sunni tradition. While much of the material also applies to the Shiite
tradition, there are many differences and a full study of Shiite law is beyond the scope of this thesis. Indeed, even a
broad study of Shiite legal traditions would constitute a thesis on its own. For those interested in Shiite law, the
writer recommends that they should start with pages 35-39 of the Mahmassani’s Falsafat al-Tashri fi al-Islam, cited
in this chapter. For an excellent summary of the Shiite traditions of ijtihad, see Weiss pp. 210-212.
 38

CHAPTER III. A REVIEW OF MODERN PORTFOLIO THEORY AND ETHICAL

INVESTMENT

Introduction

We have just explored the history and evolution of Islamic fiqh, or jurisprudence. The

reader should now have a clear picture of how Islamic legal theory has developed, and how it

continues to be employed to this day. Later we will discuss how the contracts developed in the

classical and medieval periods of Islamic history provided the foundation for modern Islamic

finance. We will also examine the unique considerations that confront Muslim investors as they

make their investment decisions. But it is important to remember that Muslims, like all investors,

must make those decisions based on their individual risk profiles and expected/desired rates of

return. The purpose of this chapter is to provide a brief review of modern portfolio theory as it

has developed in the United States and the Western world.

The Pioneering Work of Harry Markowitz

Portfolio theory as we know it began with the work of Harry Markowitz, who developed

the basic portfolio model during the 1950s. Markowitz derived a model that could yield the

expected holding period return for a portfolio. He also identified an appropriate measure of risk

for the holding period by showing that the standard deviation/variance, a well known statistical

measure, was an excellent way to quantify the measure of risk for a portfolio. At the same time,

his portfolio variance formula demonstrated the importance of diversification in order to reduce

the total risk of a portfolio. By diversification, it is meant that an investor can invest in a number

of asset classes, from stocks and bonds to art and real estate. Markowitz also stressed that

diversification could not eliminate all variance from a portfolio, and that a portfolio with the

maximum expected return will not always be the one with minimum variance. In terms of the
 39

variance and standard deviation, it is important to remember that investors do not want

variability - whether it is above or if it is below - about the mean expected return.

Markowitz argued that having a high number of securities in a portfolio does not imply

adequate diversification. Rather, it is important for investors to diversify their asset holdings

across a wide range of industries, simply because firms in the same industry are more likely to

post concurrent poor performances than are firms in different industries. Investing in many

securities also is not guaranteed to ensure a small variance. The standard deviation/variance of

portfolio is a function of the standard deviations of individual securities and of the covariance of

rates of return for all pairs of assets in the portfolio. It is this covariance that is the most

significant determinant of adequate diversification and management of risk. The returns of two

firms in different industries will have a lower covariance than two firms that are in the same

industry. The concept of covariance applies equally to all asset classes, be they stocks, bonds,

real estate, etc. These simple yet profound observations form the basis of modern portfolio

theory, and are employed by portfolio managers and knowledgeable individual investors to this

day (Markowitz, 1952, pp. 77-91; Reilly and Brown, 2006, p. 202).

If one examined all of the two asset combinations that exist in a typical portfolio, we

would derive a multitude of curves that represent those combinations. The envelope curve that

contains the best of those possible combinations is referred to as the efficient frontier. Every

portfolio that has the maximum rate of return for a given level of risk or the minimum amount of

risk for every return is represented along the efficient frontier (see Figure 1). Every portfolio on

the frontier has higher return for equal risk than some portfolio beneath the frontier, or it can

have equal return for lower risk. For example, both portfolio A and B dominate portfolio C

because they lie on the efficient frontier. Portfolio A is preferable to portfolio C because it offers
 40

the same rate of return as portfolio C but contains less risk. Portfolio B is preferable to C because

it offers a higher rate of return for the same level of risk. Risk and return are intimately related;

an investor can be rewarded with a higher return for accepting higher risk.

E(R)

E(σport)
Figure 1. The Efficient Frontier

It is important to keep in mind that neither portfolio A nor B is better than the other is. An

investor will choose either portfolio A or B based on their individual risk/reward preference. All

investors seek to find a suitable location on the efficient frontier based on their utility function,

which captures their risk tolerance. For instance, an investor that has an appetite for risk will

choose portfolio B over portfolio A. Conversely, a risk-averse investor will choose A. Based on

his or her utility function, an investor will seek to find the optimal portfolio, a combination of

investments that matches the investor’s risk-return profile.

In summary, the Markowitz model is based on five key assumptions:

 41

1. Investors believe each investment is represented by a probability distribution of

expected returns over a defined holding period.

2. Investors seek to maximize their expected utility. Their individual utility curves show

diminishing marginal utility of wealth.

3. Investors estimate the risk of a portfolio based on the variability of expected returns,

as measured by standard deviation/variance.

4. Investors’ investment decisions are solely a function of expected return and expected

risk, as measured by standard deviation/variance.

5. For a given level of risk, investors expect higher returns. For a given rate of expected

return, investors prefer less risk to more risk.

Keeping these assumptions in mind, the optimal portfolio for any investor is one that offers the

maximum expected rate of return for the same or lower level of risk, or one that offers lower risk

for the same or higher expected rate of return, relative to another portfolio(s) (Reilly and Brown,

2006, pp. 202-223).

The Development of Capital Market Theory

Building on Markowitz’s portfolio theory, capital market theory emerged in order to

tackle the issue of valuing risky assets. Two major theories developed for this purpose are the

capital asset pricing model (CAPM) and the arbitrage pricing theory (APT).

A major innovation in the development of capital market theory is the concept of a risk

free asset. Such an asset would have zero variance, as well as zero correlation with other assets

in the portfolio. Thus, the risk free asset provides the pivotal risk free rate of return. It also

allows us to see how capital assets can be priced under conditions of uncertainty. Thanks to the

development of the risk free asset, James Tobin was able to take Markowitz’s work one step
 42

further and derive the capital market line. The riskless asset’s expected rate of return was the

pure interest rate.

E(Rport)
CML

Point of
Tangency

Efficient
Frontier
M

RFR

σport

Figure 2. The Capital Market Line

At this pure rate of interest, investors can either lend or borrow. At point M in Figure 2,

the capital market line is tangent to the efficient frontier. Point M represents the risky market

portfolio. Below point M, an investor will be investing in the market portfolio and lending at the

risk free rate (i.e. investing part of your portfolio in the risk free asset). In addition to investing in

a portfolio beyond M on the efficient frontier, an investor may also add leverage to his or her

portfolio under the assumption that one can borrow money at the RFR and invest in risky

securities. 4 As seen in Figure 2, both risk and return increase in a linear fashion along the capital

market line. This simple linear relationship between the expected return and the standard

deviation of the portfolio represents equilibrium (Sharpe, 1964, pp.425-442). It was Tobin who
4
It should be noted by the reader that the lending and borrowing rates may differ, which would lead to a
discontinuity in the capital market line.
 43

carried the CML to the market portfolio; others, especially John Lintner, extended the concept to

distinguish between the lending and borrowing portfolios, as seen in Figure 3.

Another important development in the evolution of capital market theory is James

Tobin’s separation theorem, which describes the separation of the investment decision from the

financing decision. Since the market portfolio represents the best investment opportunity, all

investors will want to invest their money in it. Investors differ only in the position that they

desire on the capital market line, which depends on their risk preferences. How an investor

obtains the desired position on the CML is a function of their investment decision based on their

risk tolerance, i.e. whether they want to lend (for more risk averse investors) or borrow (for more

risk tolerant investors) at the risk free rate (Tobin, 1958, pp. 65-86).

E(Rport)
Borrowing

Point of CML
Tangency
Lending

RFR

σport

Figure 3. The Capital Market Line with Lending or Borrowing at the Risk Free Rate
 44

The market portfolio includes all risky assets, such as stocks, bonds, foreign securities,

art, real estate, antiques, etc. Because of the tremendous diversity of its holdings, the market

portfolio is regarded as completely diversified, meaning that all of its diversifiable risk is no

longer present. Specifically, this diversifiable risk is unique to each individual asset; it is known

as unsystematic risk. The unsystematic risk of each asset is offset by the variability of all other

assets in the market portfolio. After all the unsystematic risk has been diversified away, only

systematic risk is left. Systematic or market risk, measured by the standard deviation of a

portfolio’s returns, is influenced by macroeconomic variables such as changes in interest rates,

inflation, the money supply, and variability in factors like industrial production. To eliminate

unsystematic risk through diversification, one must add securities to the portfolio. A study by

Statman (1987) showed that a well diversified stock portfolio should contain at least 30 stocks

for a borrowing investor and 40 for a lending investor, after transactions costs. While adding

stocks with low correlations to each other will diversify away the unsystematic risk in a portfolio,

it will not eliminate the systematic risk (Reilly and Brown, 2006, pp.236-237).

The Capital Asset Pricing Model and Arbitrage Pricing Theory

The Capital Asset Pricing Model (CAPM)

Developed by William Sharpe, John Lintner, and Jack Treynor, the traditional capital

asset pricing model (CAPM) determines what should be the expected rate of return on a risky

asset. The formula for the model is usually given as follows:

E(Ri) = RFR + βi (RM – RFR)

In the equation,

E(Ri) = the expected return on asset i

 45

RFR = risk free rate

βi = the beta (a measure of standardized risk) of asset i

RM = the return on the market

RM – RFR = market risk premium

In addition, if an analyst or investor has already determined the expected rate of return on an

asset, he/she can use the CAPM to calculate a required rate of return. By comparing the expected

rate of return to the rate indicated by the CAPM, one can determine if an asset is properly valued,

overvalued, or undervalued.

Determining if an asset is properly valued or not requires the derivation of a security

market line (SML) for that asset, which represents the relationship between an asset’s expected

or required rate of return and its systematic risk.

E(Ri)

SML

RM

RFR

CoviM
σ2 M

Figure 4. The Security Market Line

 46

Figure 4 presents a security market line for an asset i, depicting its risk/return profile. In terms of

the CAPM and the SML, the most important variable is the beta, which measures systematic risk

(the type that cannot be diversified away). The beta measures a risky asset’s covariance with the

market portfolio as it relates to the variance of the market portfolio:

βi = CoviM/ σ
2
M
Here,

CoviM = covariance of asset i with the market portfolio

σ2M = variance of the market portfolio

The market portfolio’s beta is 1. If an asset has a beta that is higher than 1, this signifies that the

asset has a higher systematic risk than the market. In other words, it is more volatile than the

market portfolio. Conversely, if an asset has a beta less than 1, this signifies that it has lower

systematic risk than the market and is thus less volatile.

As shown in the equation for the CAPM, the expected rate of return for a risky asset is

calculated by adding the RFR and the risk premium. The risk premium itself is calculated by

multiplying the beta and the market risk premium (Reilly and Brown, 2006, pp. 239-241).

Arbitrage Pricing Theory (APT)

While the CAPM has been one of the most useful and revolutionary concepts developed

in financial economics, it also has a number of shortcomings. Many academicians were not

convinced of a perfectly linear relationship between risk and return. Others questioned the

CAPM’s dependence on a market portfolio not currently available and thus its usefulness in

portfolio evaluation. Anomalies such as the small firm effect – where small capitalization stocks

tended to outperform large capitalization stocks on a risk-adjusted basis – also cast a shadow on

the efficacy of the CAPM and other single factor models. Thus financial economists began to
 47

search for a model that overcame these deficiencies and permitted multiple expressions of risk.

Arbitrage pricing theory, developed by Stephen Ross during the 1970s, was the result of this

search. APT is a multifactor model that allows investors and analysts to quantify and identify

risk factors in the valuation of an asset (Reilly and Brown, 2006, pp. 270-271).

The APT is usually represented mathematically as follows:

Ri = E(Ri) + bi1δ1 + bi2δ2 + …+ bikδk + εi (i = 1 to n)

In the equation,

Ri = the actual return on asset i during a specific time period

E(Ri) = expected return on asset i provided risk factors do not change

bij = the reaction in asset i’s returns to movements in risk factor j

δk = common factor or indexes with a zero mean that affect returns on all assets

(macroeconomic variables like interest rates, GDP growth, and political events)

εi = a random error term with a mean of zero and that is completely diversifiable in a

large portfolio

n = number of assets

The bij terms measure the magnitude of how an asset reaches to a specific factor. For instance,

export-oriented firms will be more sensitive to changes in exchange rates than firms who conduct

most or all of their business domestically. So the export-oriented firm may have a bij of 5, while

the domestically oriented firm would have a bij of 1.

In the APT, when unique factors – εi – are diversified away, the return on a zero beta

portfolio is zero. Thus, the expected return on an asset is found through the equation:

E(Ri) = λ0 + λ1b i1 + λ2b i2 + … λkb ik

Where:
 48

λ0 = expected return on asset i with zero beta

λ1 = risk premium attached to risk factor j

b ij = the factor beta – measures responsiveness of asset i to changes in risk factor j

Through this equation, the investor can calculate the expected rate of return on a risky asset

using the APT.

The CAPM and APT are both static linear models that attempt to represent the investor’s

investing activity – risking capital to obtain a financial reward. The key difference between the

two models is how they represent systematic risk. The CAPM relies on a single representation of

that systematic risk, namely beta. The APT on the other hand employs multiple factors to express

and capture market-wide systematic risk (Reilly and Brown, 2006, pp. 270-272).

While the ability to choose multiple common risk factors in the valuation of a security is

a definite advantage of the APT, the theory unfortunately does not indicate what those factors are

or how many factors there are. Some financial economists have recommended and employed

with success common macroeconomic variables that affect all securities to be used as factors in

the APT model – inflation rates, interest rates, changes in real GDP, etc. These are generally

known as macroeconomic risk factor models. Others have suggested using microeconomic risk

factor models, which use the characteristics of the securities themselves to define the relationship

between risk and return. An example of this approach is the Fama and French model which used

three different risk factors:

1. excess return to the stock market portfolio

2. the return differential associated with firm size (i.e. large capitalization vs. small

capitalization)
 49

3. the return differential associated with book-to-market valuation (i.e. “value” stocks vs.

“growth” stocks) (Reilly and Brown, 2006, p. 292)

Ethical Investment

Ethical investment, also called conscience investing, can be defined as the use of ethical

and social parameters of selecting and managing a portfolio. It has its roots in the efforts of

religious institutions to avoid investing in morally dubious industries. Some of the earliest

examples of ethical investing in the US were church groups that found it morally repugnant to

invest in the so called “sin” stocks of companies that were engaged in producing alcohol and

tobacco and gambling. The Pioneer Fund, launched in 1928, was the first mutual fund created to

serve the social interest of these religious groups. Later, several social movements in the United

States, including the women’s rights movement, the civil rights movement, the environmental

movement, and national/international issues, such as the Vietnam War and apartheid in South

Africa, compelled more investors to combine their moral/ethical beliefs with their investment

strategies. The most visible example of ethical investing came during the 1980s as anti-apartheid

activists led a campaign against investing in South African companies in an effort to show their

displeasure with a racist regime and to encourage the end of apartheid. College endowments and

pension funds (most notably TIAA-CREF and the California Public Employees’ Retirement

System) led the way in divestment of South Africa related investments. The boycott received a

great deal of international publicity and a wave of portfolio managers rushed to accommodate the

wishes of their clients who wished to rid their portfolios of companies that had any South

African operations (Judd, 1990, pp. 9-11). The recent move to divest from Chinese companies

that have operations in the Darfur region of the Sudan is a modern day equivalent of the South

Africa boycott.
 50

The ethical investing sector can be subdivided into four broad categories: environmental,

political, social, and religious. The demand for ethical investing has grown steadily over the past

few years and the trend is projected to continue (Atta, 2000, p. 10). In their landmark guide,

Ethical Investing, Amy Domini and Peter Kinder (1984) identified three approaches to ethical

investing (here, “institution” can be substituted for “investor” to account for institutional

investors such as pension funds, endowments, mutual funds, banks, etc.):

1. Avoidance – an investor avoids investing in companies that offend his or her

ethical sensibilities (modern Islamic finance most frequently uses this approach).

2. Positive choice – an investor places his or her funds with companies that meet

their social/ethical goals, such as companies that hire and promote minorities,

make products and services that improve the environment, treat their workers well,

etc.

3. Activism – an investor uses his or her clout as a shareholder to induce company

management to policy changes.

Domini, a leader in the field of socially responsible/ethical investment, believes that while

avoidance and positive choice complement each other, activism requires a greater degree of

dedication by an investor (not to mention enough capital to buy and hold blocks of shares large

enough to carry sufficient influence to challenge management) (pp. 2-12).

Key Characteristics of Ethical Funds

There are several key traits that ethical funds 5 share in common. First, most ethical unit

trusts utilize some type of screening criteria to select investments. While these screens can be

positive or negative, negative screens tend to be more widely used due to the ease with which

5
An ethical fund is a fund that consists of investments that are chosen in regard to a specific set of ethical guidelines
and standards established by an investor and/or an asset manager.
 51

they can be described and monitored. Negative screens also tend to be less subjective than

positive screens. On the whole, the process of deciding what is an ethical investment is

subjective and by no means universal. The disparity in the ethical definitions of different ethical

funds can make comparison and evaluation difficult to attribute to any common ethical

standard(s).

Ethical investment units have also been found to have a bias toward small capitalization

stocks. Studies conducted on ethical funds in the UK have demonstrated this bias. This may have

important implications for the returns of ethical funds, including Islamic funds. There is a well

documented stock market phenomenon called the small company effect; over long periods of

time, small cap stocks tend to have higher returns than large cap stocks. To be sure, the level of

risk involved in investing in small cap stocks is larger than for large cap stocks. This effect has

been documented in many markets, including US and UK stock markets.

Ethical unit trusts also tend to differ in terms of the international exposures of their

holdings. Choosing ethical companies may lead to the exclusion of certain nations. Global asset

allocation may become more a function of ethical standards than that of evaluations of market

fundamentals. As aforementioned, during the era of apartheid many investors did not invest in

South Africa. 6 More recently, many investors withdrew money from Chinese oil companies that

did business in the Darfur region of the Sudan. International diversification has been shown to

have positive effects for a portfolio’s returns because foreign stocks tend to have historically low

or negative correlations with US stocks. Many foreign securities also offer higher risk-adjusted

6
The impact of this boycott on South African financial markets has been debated. A 1999 study by Teoh, Welch,
and Wazzan found that divestment had little to no significant impact on its targets. The team found that total
corporate participation in South Africa was so limited that in spite of the large number of divesting companies and
pressure from legislators and investors, the boycott had little noticeable effect on South African financial markets or
the valuations of South African firms. (Please see Teoh, Siew Hong, Ivo Welch, & C. Paul Wazzan. (1999). The
Effect of Socially Activist Investment Policies on the Financial Markets: Evidence from the South African Boycotts.
Journal of Business, 72, pp. 35-89.)
 52

returns than US securities (Reilly and Brown, 2006, p. 97). If an ethical fund is circumvented

from investing in foreign securities, its returns may be negatively impacted (Atta, 2000, pp.9-13).

Ethical vs. Socially Responsible Investing

In everyday parlance, “ethical investing” and “socially responsible investing” are terms

that are used interchangeably to describe investing money with a conscience. However, ethical

investing is only a subcategory of socially responsible investing (SRI), according to social

responsibility proponent Ritchie P. Lowry. Under the broad umbrella of SRI, Lowry (1991)

identifies three distinct types of SRI. Ethical investing, which is a passive approach to social

responsibility, is the simplest form of SRI; individual and institutional investors make their

investment decisions using their own subjective ethical judgment. Domini’s avoidance and

positive choice approaches are most commonly used in this type of SRI. Social investing

involves using the activist approach; social investors use their position as shareholders in

company to influence and coerce management to change their policies. Alternative investing is

the process of investing in ventures that contribute to the public good, such as land trusts and low

income housing developments.

Ethics and morality are highly subjective issues, open to the interpretation of the

individual. With such divergent views on what constitutes ethical behavior, there is no consensus

on what role, if any, social responsibility should play in investment management (not unlike the

debates over which Islamic financial contracts are permissible under the Sharia and which ones

are not!) (pp. 19-36).

Conclusion

In this chapter, we have reviewed the history and evolution of modern portfolio theory

and, briefly, ethical investing. The question of risk and return is one that every investor,
 53

regardless of his or her religious persuasion, must face when making their investment decisions.

But for Muslims who choose to adhere to the Sharia, there are other, spiritual considerations as

well. For these Muslims, the Sharia does not stop at the door of the mosque. As we have seen in

chapter II, the Sharia is a way of life and a code of conduct. It has as much influence on earthly

matters like investing as it does on spiritual and religious obligations. We will now turn our

attention toward one of the most prominent forms of ethical investing – Islamic investment.
 54

CHAPTER IV. SHARIA CONSTRAINTS ON MUSLIM INVESTORS

Introduction

We have just reviewed the history and evolution of modern portfolio theory. As we have

seen, every investor follows (or at least should) the profit maximization-loss minimization rule

taught in every introductory economics course and adapted to portfolio selections. Every investor,

from conservative individuals with low risk appetites who seek to build and protect their wealth

to hedge fund managers who are willing to accept high risk for the possibility of huge return,

wants to achieve the maximum return for the least amount of risk. In other words, investors

optimize between risk and return based on their individual preferences. Muslim investors are no

exception.

However, beyond these considerations some Muslims choose to answer to the strictures

of their faith. Indeed, the investment requirements imposed by the Quran and the Sharia

constitute one of the earliest examples of what is now called socially responsible investing. The

Muslim investor has the same goal as any other investor – to maximize returns relative to risk –

but he or she also has the religious obligation to put his or her money into business ventures and

firms that are compatible with Islam and the Sharia. For the pious, not to do so entails a worse

punishment than losing money – it means disgrace in the eyes of God.

The purpose of this chapter is to examine the restrictions that the Sharia imposes on

Muslim investors. It will detail accepted and prohibited lines of business, as well as the financial

characteristics of a halal (legally sanctioned) investment. The classical prohibitions of riba,

gharar, and maysir will also be examined. The chapter will also look at the development of

Islamic investment funds, and the issues that they face. (Islamic equity funds will be the key

focus of this chapter and the next; other investment alternatives for Muslims will be discussed in
 55

a later chapter.) The issues explored in this chapter are integral for understanding the

considerations and obligations that pious Muslim investors face every day, and for understanding

what makes Islamic investing truly Islamic.

The Philosophy of Islamic Investing

Omer Ahmed (2000), president of Crescent Capital Management, detailed five key

components of what he considers the “philosophical mandate” of Islamic finance:

1. Wealth must be deployed productively.

2. The hoarding of wealth is haram (forbidden).

3. Money is not an asset.

4. Islam recognizes a separation between ownership and control.

5. Capitalists cannot take advantage of their position.

These five guidelines provide a useful framework for understanding the philosophy of Islamic

finance and economics.

As referred to in chapter II, Islam, through its sacred text, the Quran, provides, at least in

theory, a comprehensive set of principles and requirements for the daily lives of Muslims. Islam

is thus deeply involved in social, political, cultural, and economic matters. The ideal Islamic

economic and financial system differs markedly from the Western interest-based model. It is

important to appreciate that this system is defined and best understood in the context of an

Islamic society.

Ahmed reminds us that in Islam, justice, equality, and fairness are the ends to which all

Muslims must strive. Those involved in business, trade, and finance are no exception and must

endeavor to reach these goals in addition to making a profit or achieving a high rate of return.

Most Muslims do not regard the presence or absence of wealth as vice or virtue.
 56

Muslims believe that all wealth belongs to God, and that man only serves as a steward

over whatsoever portion of wealth that God has allotted to him. The Quran places great

significance on how Muslims create, use, and consume their wealth. According to Ahmed,

wealth in Islam is defined in terms of assets, not monetary value. Money is seen as merely a

medium of exchange, with no intrinsic value of its own. The commoditization of money is not an

accepted concept in Islamic economics. Money is at best a potential asset. It only attains a

nominal sense of value when it is deployed productively.

Islam stresses modesty, the avoidance of wasteful consumption, and self-reliance, and

enjoins Muslims to deploy their wealth productively. The hoarding of wealth is expressly

forbidden (Quran 9:33-34). Taking advantage of one’s wealth is also haram. In the context of

business and financial dealings, wealthy owners of capital should not supersede or enjoy any

advantage over the possessors of other factors of production, such as labor. This would violate

Islam’s insistence upon fairness and equality.

Ahmed stresses that profit and loss sharing, or equity based, financing is the most favored

way to conduct financial and business transactions in Islam. Providers of capital and providers of

labor are considered to be equal partners in any contract or transaction; therefore both have the

right to enjoy the fruits of any venture, in addition to bearing the weight of any losses. Providers

of capital cannot protect their capital or demand forms of guarantees for a pre-specified capital

return. This would be a form of the forbidden riba (discussed below). This condition reflects

Islam’s preoccupation with justice and fairness (“Islamic Investing,” 2000.)

The Three Major Prohibitions of Islamic Finance: Riba, Gharar, and Maysir

Modern Islamic finance is a prohibition driven industry. Namely, there is a great deal of

time spent elucidating what Muslims cannot do, or what is haram. While that list is a long one,
 57

three main prohibitions must be highlighted in order for the reader to understand the key

foundations of Islamic finance: riba, gharar, and maysir.

Riba

Those who charge riba are in the same position as those controlled by the devil's
influence. This is because they claim that riba is the same as commerce. However, God permits
commerce, and prohibits riba. Thus, whoever heeds this commandment from his Lord, and
refrains from riba, he may keep his past earnings, and his judgment rests with God. As for those
who persist in riba, they incur Hell, wherein they abide forever.
-Quran 2:275

O you who believe, you shall observe God and refrain from all kinds of riba, if you are
believers. If you do not, then expect a war from God and His messenger. But if you repent, you
may keep your capitals, without inflicting injustice, or incurring injustice. If the debtor is unable
to pay, wait for a better time. If you give up the loan as a charity, it would be better for you, if
you only knew.
-Quran 2:277-280

Every loan (qard) that attracts a benefit is riba. 7

Probably the most distinguishing (or at least the most widely known among non-Muslims)

feature of Islamic finance is the prohibition of the payment and receipt of interest. This

prohibition is known by the Arabic word riba, which literally means “increase.” Generally, riba

constitutes any increase in capital for which no compensation is given. Islam forbids the lending

of credit for profit. The Quran fervently denounces riba, and both it and the Sunna list riba as

one of the most grievous sins. The least of the forms of riba are equated with incest, for instance.

All who take part in riba are accursed, both in this world and in the next, where they are

threatened with hellfire. The Quran regards it as a practice of true unbelievers. Indeed, as a test

of Muslims’ belief, it demands that riba should be abandoned, and threatens dire punishment if it

is not abandoned (Schacht, 1995, pp. 491-493). Despite the rancor with which the Quran regards

riba, it provides little explanation of what the term means. This has led to wide misconceptions

7
See Vogel p. 73, footnote 7.
 58

of what riba truly is. In English, riba is most commonly translated as “interest” or “usury,” but

these are simplistic and misleading.

The one explicit example of riba comes from the Quran and is known as riba al-jahiliyya,

so known because it was practiced in pre-Islamic Arabia. When a debtor could not repay a loan

(of money or goods) with the accompanying interest, the creditor granted a time extension.

However, the principal was increased concurrently, often by fifty percent. This practice is

referred to in Quran 3:130 and 30:39. This form of riba also includes assigning a penalty to a

debtor for failing to pay at the loan maturity date (analogous to modern late payment fees)

(Schacht, 1995, pp. 491-493; Vogel and Hayes, 1998, pp. 72-73). However, the Quranic verses

and the hadith mentioned above indicate that the nature of riba is much more expansive than the

“pay or increase” form.

As mentioned earlier, the prohibition of interest is the most famous feature of Islamic

finance. This common conception is an oversimplification of the nature of riba. In general,

jurists have defined riba as “trading two goods of the same kind in different quantities.”

Numerous studies have shown that premodern and contemporary Islamic jurists have expanded

riba’s definition beyond its original demarcations (i.e. riba al-jahiliyya) (El-Gamal, 2006, p. 49).

This is precisely the type of articulation of legal thought described in chapter II. However, no

one can argue that charging interest on a loan is not a form of riba, as shown by the “loan”

hadith above.

There are also forms of modern “interest” in the Western sense that Islamic jurists have

allowed. Take for instance the murabaha contract, or a cost-plus or credit sale. Suppose that a

Muslim landscaper wishes to buy a lawnmower for his business. He does not currently have the

funds to do so, but he wishes to conduct this transaction in the Islamic fashion. He then
 59

approaches a Muslim financial institution who buys the lawnmower on his behalf. The institution

then sells the lawnmower to the landscaper; the total (deferred) price that the landscaper will end

up paying is a combination of the retail price of the lawnmower, plus a profit markup for the

Islamic financial institution. Clearly, an implicit interest rate can be calculated in this transaction.

However, this transaction is considered halal because the institution is compensated for the cost

of deferring the landscaper’s payment, the risk of destruction of the good prior to its delivery,

and the risk that the lawnmower may be returned if a defect is found therein, as well as credit

risk. In his research, one scholar, Mahmoud El-Gamal, has defined riba as “the sale of credit”

(El-Gamal, 2006, pp. 67-68; El-Gamal, 1999).

Today, Islamic scholars recognize and prohibit two types of riba. The first is riba al-

qurud, or interest on loans. The second is riba al-buyu, or interest in trade. For riba al-qurud, no

amount over and above the loan may be given or received by the borrower and lender. Riba al-

jahiliyya falls into this category. This prohibition is not only limited to giving additional money;

gifts, goods, and services are also included.

Riba al-buyu, interest in trade, is further divided into categories. The first is riba al-nasa,

the interest in forward transactions. If two parties engage in a forward transaction for the delivery

of same type of commodity, neither side can defer delivery of the commodity. The second type is

referred to as riba al-fadl, or the interest in inequality; it occurs when two parties exchange the

same commodity but in different quantities.

It is hard to conceive of such transactions that could lead to either riba al-nasa or riba al-

fadl occurring in the present day. They can arise quite easily in barter, however. The prohibitions

thus discourage barter and encourage cash transactions, which are more efficient (Hardie and

Rabooy, 1991, p. 58).

 60

Common Misperceptions concerning Riba

1. Riba is prohibited to prevent the exploitation of the poor.

a. While this assertion is partly true, it does not tell the complete story. Many

scholars insist that the prohibition was put in place to prevent rich creditors from

taking advantage of poor debtors. However the Muslim scholar Ibn Rushd (a

twelfth-century Maliki jurist known in the West as Averroes) demonstrated that

the respective wealth of either party in a transaction is of no consequence as

regards to the prohibition of riba; rather, the focus is on the lent sum. Examine

Quran 2:278-279 (reproduced above). Some Muslim scholars hold that the

meaning of verse 279 (If you do not…incurring injustice) is best explained as “if

you repent, then you should collect your principal, without increase or

diminution.” This refers to the fact that both an increase and a decrease in the sum

of money that is returned to the creditor relative to the amount lent is considered

an injustice.

2. All interest is Riba.

a. This too is a misconception. As seen above in the example of a murabaha

transaction, not all forms of interest constitute the forbidden riba. Jurists maintain

that it is perfectly permissible for a deferred price of an asset to be higher than the

spot price. The “interest” is embedded in the credit price of the sale. Another

example of this phenomenon is ijara (lease) financing. 8

3. All Riba is interest.

8
Ijara means lease, rent or wage. In general, it refers to selling benefit, use, or service for a fixed price or wage. An
Islamic financial institution leases to a customer an asset/piece of equipment for a fixed price and period. The fixed
price generally includes the principal amount plus a profit markup for the Islamic financial institution.
 61

Abu Sa'id al-Khudri (Allah be pleased with him) reported Allah's Messenger (may peace
be upon him) as saying: Gold is to be paid for by gold, silver by silver, wheat by wheat,
barley by barley, dates by dates, salt by salt, like by like, payment being made hand to
hand. He who made an addition to it, or asked for an addition, in fact dealt in usury. The
receiver and the giver are equally guilty. 9

a. This is one of the most famous and oft-quoted hadiths concerning riba. In

particular, it prohibits riba al-fadl. All sales within a genus with inequality with or

without a time factor constitute riba al-fadl. As per this hadith, it is impermissible

to trade goods of the same genus and kind in different quantities. Jurists have

agreed that prohibition is not limited to the six goods listed in the hadith, called

ribawi goods. Hanafi jurists also include all fungible goods measured by weight

and volume. However, Shafii and Maliki jurists restricted it to monetary

commodities, such as gold and silver, and storable foodstuffs.

4. Riba is return without the risk.

a. The return on a permissible credit sale carries the same risk as the return on a loan

with interest – credit risk. In both transactions, the lender faces the risk that the

borrower cannot repay what is owed at the contract’s maturity.

5. Riba is “usury.”

a. This fallacy is due to the faulty yet unfortunately common translation of riba as

“usury.” The modern understanding of usury is exorbitant interest. In Islam,

charging interest on a loan is forbidden, regardless of the percentage rate, be it 1%

or 20% (Vogel and Hayes, 2006, pp. 72-77; El-Gamal, 1999; El-Gamal, 2000).

Gharar

The Messenger of God forbade the ‘sale of the pebble’ (hasah, the sales of an object
determined by throwing a pebble), and the sale of gharar. 10

9
Muslim. Book 10 – The Book of Transactions (Kitab al-Buyu), Number 3854.
10
Muslim. Quoted in Vogel and Hayes p. 87
 62

The Messenger of God forbade the sale of the copulation of the stallion. 11

Whoever buys foodstuffs, let him not sell them until he has possession of them. 12

In English, gharar can be translated as “risk” or “uncertainty.” Islamic jurists know that

all financial contracts and transactions entail a certain degree of risk and uncertainty that is

unavoidable. Jurists seek to determine whether the risk present in a contract is major or excessive

gharar, which would invalidate a contract, or minor gharar, which is tolerated. It is important to

keep in mind that risk and uncertainty are not haram in and of themselves. Instead, it is the sale

of gharar (bay al-gharar in Arabic) that has been expressly forbidden by Muhammad. Another

important point is that unbundled risk is also forbidden (El-Gamal, 2000, pp. 148-149). Suppose

that a customer buys an expensive crystal vase for $500. As she is paying for the vase, the

salesperson offers an extended warranty plan at an additional cost of $75. It would be

impermissible for her to buy the plan, because this is the sale of risk through insurance, which is

prohibited. However, if the vase were offered for $575, the price of the vase and the cost of the

warranty plan bundled together, it would be perfectly acceptable for her to purchase the vase.

Jurists allow risk sharing by bundling the insurance cost with the purchase price.

In order for a sale to be valid (i.e. binding on both parties), jurists agree that all parties

must have full knowledge of all aspects of the contract, and that the object of the contract must

be in existence at the time of the contract (however, the Malikis and Hanbalis allow sales of

absent/nonexistent goods provided that they are described in minute detail in the contract). The

absence of one does not compensate for the presence of the other, and price is not considered to

be sufficient for the absence of either knowledge or existence. Generally, gharar is considered to

11
Bukhari. Quoted in Vogel and Hayes p. 88
12
Bukhari. Quoted in Vogel and Hayes p. 88
 63

be present when there is incomplete information and/or fraud, as well as uncertainty about the

intrinsic nature of the objects in question in a contract (Vogel and Hayes, 2006, p. 90).

There are four instances of transactions that involve unacceptable risk to some extent, all

of which are expressly prohibited in various hadiths.

1. Pure speculation. A few examples of this type of transaction are forms of gambling

that pre-Islamic merchants engaged in, such as selling for a fixed price whatever

unexamined goods that a buyer touched. Little is known of these contracts besides

their names, however.

2. Uncertain outcome. This includes contracts where the object has an uncertain value

and may not be realized at all. Examples include selling fish that have not yet been

caught. The sale of goods not yet in one’s possession also falls into this category.

(Notice the implications that this has for the short selling of stocks, and indeed all

options.)

3. Unknowable future benefit. This encompasses contracts in which the benefits to the

buyer are known, but the future benefits are unknown. An example of this is buying a

pregnant cow. Such transactions can feature considerable gharar, especially if the

buyer paid too much for the object of sale or had false hopes as to its benefits.

4. Inexactitude. These hadiths are concerned with inexactitude, such as selling someone

grain before it is weighed (Vogel and Hayes, 2006, pp. 88-89).

There are four conditions that must be met if gharar is to invalidate a contract:

1. The gharar must be major or excessive to invalidate a contract. Instances of minor

gharar, such as if the exact weight of the object of sale is not known to the nearest

ounce, are not sufficient for invalidating a contract.

 64

2. The contract must be one in which property changes hands (e.g. a sale). Gifts are

thereby excluded from the rules of gharar. A majority of jurists permit uncertainty in

a gift contract. But selling an item that has major gharar is not permissible.

3. The present gharar must affect the principal components of a contract, namely price

and object of sale. For example, it is permissible to sell a pregnant mare, but it is

haram to sell the unborn foal due to the risk that it may be stillborn.

4. If a contract with major gharar meets a need that cannot otherwise be fulfilled, then it

is tolerated. A perfect example of this condition is the salam contract, where an

advance payment is made for goods to be delivered later. Without this contract,

financing for various agricultural and industrial activities could not be completed.

Thus a salam contract is thus deemed to be expedient, regardless of the level of

gharar (El-Gamal, 2006, pp. 58-59). This is an example of the application of maslaha.

Liberal Voices on Gharar: Ibn Taymiyya

As seen above, the limits on gharar can be quite restrictive on some contracts. The four

major madhhabs feature a number of such restrictions that can hamper some transactions. It is

for this reason that modern practitioners of Islamic finance often turn to the rulings of the

medieval Hanbali jurist Ibn Taymiyya (d. 1328). Ibn Taymiyya sought to return the meaning of

gharar to “risk” and believed that the rules prohibiting lack of knowledge and non-existence

were detrimental to the effective utilization of contracts. As we have seen above, traditional rules

of gharar are antithetical to modern forms of finance, such as short selling. However, even Ibn

Taymiyya’s views would regard modern developments such as derivatives and commercial

insurance as untenable (Vogel and Hayes, 2006, pp. 92-93.)

Maysir
 65

Maysir is actually the severest form of gharar – gambling. The Quran prohibits maysir in

no uncertain terms in verse 5:90, calling it an “abomination,” and “Satan’s handiwork.” The

verse goes further in claiming that maysir, as well as alcohol, were tools that the Devil uses to

“sow enmity and hatred” among Muslims, and prevent them “from the remembrance of God and

prayer.”

Economic Rationale for the Prohibition of Riba and Gharar

Of the three major prohibitions, riba and gharar are the most frequently encountered.

Mahmoud El-Gamal characterizes riba and gharar as the trading in unbundled credit and risk,

respectively. In their bundled forms, which classical jurists strove to develop, both credit and risk

can be made acceptable under traditional Islamic protocol. El-Gamal offers two economic

explanations for the prohibitions on gharar and riba.

Gharar - Loss Aversion

The prohibition on gharar can be interpreted as Islam’s attempt to protect its followers

from exposure to excessive financial risk and the payment of inefficiently priced premiums to

reduce or eliminate risk. The aforementioned human tendencies drive people to take too much

risk in their financial and commercial dealings, and then pay too much for insurance to protect

them as a result. Return to the previous example of the woman buying a vase who is offered an

extended warranty plan. The salesperson offers the plan at the point of purchase, when the

woman has begun to consider the vase her own. This tactic is used to exploit her tendency for

loss-aversion. If the insurance was bundled into the total price of the vase, she would probably

have thought twice before purchasing. Yet since the warranty was offered after she had bought

the vase (when she considered it her own property) the instinct to protect that property was

triggered. The human tendency of loss aversion compelled her to pay more for insurance than
 66

she otherwise would have. Thus El-Gamal argues that the Islamic prohibition of gharar can help

insulate consumers from the detrimental effects of this behavior (El-Gamal, 2000, pp. 60-61).

Riba - Market Efficiency and Pre-commitment

The economic substance of the prohibition of riba was first articulated centuries ago by

Ibn Rushd. Even though he was of the Maliki school, Ibn Rushd adopted the Hanafi line of

thought in his discussion of the underlying economic basis of the riba prohibition. Hanafis

generally extend the rules of riba dictated for the six ribawi goods to all fungible commodities.

Ibn Rushd felt that the Hanafis’ reasoning for the prohibition of riba was the most compelling:

It is thus apparent from the law that what is targeted by the prohibition of riba is the

excessive inequity that it entails. In this regard, equity in certain transactions is achieved

through equality. Since the attainment of equality in exchange of items of different kinds is

difficult, we use their values in monetary terms. Thus, equity may be ensured through

proportionality of value for goods that are not measured by weight and volume. Thus, the ratio

of exchanged quantities will be determined by the ratio of the values of the different types of

goods traded. For example, if a person sells a horse in exchange for clothes…if the value of the

horse is fifty, then value of the clothes should be fifty. If the value of each piece of clothing is five,

then the horse should be exchanged for 10 pieces of clothing.

As for fungible goods measured by weight or volume, equity requires equality, since they

are relatively homogenous, and thus have similar benefits. Since it is not necessary for a person

owning one of the those goods to exchange it for goods of the same type, justice in this case is

achieved by equating volume or weight, since the benefits are very similar. 13

It is easy to recognize the conditions for efficiency of exchange in the previous selection.

Even though he wrote centuries before the advent of calculus and modern economic theory, Ibn
13
This is the translation of El-Gamal 2006 pp.52-53
 67

Rushd articulated one of the key concepts of modern economics. Efficiency in exchange is

achieved when the ratio of the prices are equal to the ratio of marginal utilities. Justice is

achieved by “marking to market.”

Another key example of this notion is found in a well known hadith. One day an

unnamed man whom Muhammad had appointed as governor of Khaybar approached

Muhammad. He had with him some dates he had brought from Khaybar. Muhammad inquired

where the governor had obtained the dates. The governor responded that he had traded two

volumes of lower quality dates for one volume of the high quality variety. Muhammad replied

angrily that his actions constituted the forbidden riba. Instead, Muhammad declared, he should

have sold the lower quality dates and used the proceeds to buy the high quality dates. 14

This too is yet another example of economic efficiency. By selling the low quality dates

(at the highest possible market price) and buying the high quality dates (at the lowest possible

market price), exchange occurs at the ratio dictated by market prices. As the law of diminishing

utility will be at work, buyers and sellers of the dates will trade until the ratio of the marginal

utilities is equated to the ratio of market prices. Efficiency in exchange is then achieved. Thus it

can be argued that the aim of the prohibition of riba is to ensure equity in exchange in markets.

This logic can also be extended to credit sales and leases, the classical contracts used to

avoid riba in financing. Here, the appropriate “price” would be the market determined interest

rate. Ironically, conventional finance does a service to Islamic finance in that it determines the

appropriate interest rate for borrowers based on their creditworthiness and the security of the

collateral. Some argue that benchmarking the implicit interest rate in Islamic credit sales to

conventional interest rate tables is appropriate. Suppose that the market interest rate is 6% for a

particular borrower and his or her collateral, but an Islamic financial institution charges this same
14
Bukhari. Volume 3, Book 34 – Sales and Trade, Number 404.
 68

borrower 10% implied interest. This is clearly inefficient and contravenes the Islamic spirit of

equity and fairness, even if it uses an accepted Islamic financial contract (Vogel and Hayes, 2006,

pp. 62-93; El-Gamal, 2006, pp. 46-63).

The Time Value of Money in Islamic Finance

A common misconception about Islamic finance is that Islam does not recognize the time

value of money. This is a falsehood that is no doubt derived from the promulgation of the

improper translation of riba as “interest” or “usury.” Jurists not only accept the concept of the

time value of money, but also consider it to be a natural and completely permissible tendency

among humans, who after all tend to exhibit a positive time preference. We can see this in the

case of murabaha, or credit sales. Nearly all scholars agree that the credit price of a commodity

or good can and should be more than its cash or spot price, so long as the credit price is settled

beforehand in a binding contract between the two parties. Jurists accept that both time and place

have an influence on price. A good that is worth $100 in the morning can be worth $10 at night.

Similarly, a good that is worth $500 in New York can be worth $100 in Hatchechubbee,

Alabama. This is acceptable provided that these differences in price arise due to market forces

(Ayub, 2007, pp. 89-90).

Islamic Investment Funds: Development and Practice

Islamic equity investment funds began as simple mutual funds that invested in a limited

universe of stocks, applying standard portfolio management techniques as well as Sharia

guidelines. Islamic investment funds generally revolve around equity investment. The reason for

this is obvious; since Islam forbids the payment and receipt of interest, Muslim investors cannot

buy the conventional bonds and other debt-based securities of companies. Likewise, Muslim
 69

investors are prohibited from investing in preferred shares of stock. Preferred shares give holders

priority claims to assets in the event of a bankruptcy, a guaranteed rate of profit, and so on.

Therefore, common stocks are the preferred and permissible way to invest in companies.

Islamic finance values equity partnership as the ideal method of investment. Various jurists have

ruled that it is permissible to invest in and trade common stocks of companies that operate

acceptable primary businesses that conform to Islamic protocol. Owning shares of a company’s

stock is deemed to be equivalent to being a silent partner who has partial ownership of that

company’s assets. Jurists also view mutual funds as permissible modes of investment. The

mutual fund manager is seen as the agent of the fund’s shareholders, who are seen as investors in

the underlying stocks (El-Gamal, 2006, pp.123-124).

Islamic equity funds have experienced tremendous growth. In 1996, there were 29 such

funds with $800 million in assets. By 2000, this number had increased to 98, with nearly $5

billion in assets. Today there are over 100 Islamic equity funds catering to a large variety of

investors.

Asset Management of Equity Funds

Fund management is most often carried out by investment banks and specialized fund

providers in Islamic finance. Most Islamic funds are operated in Saudi Arabia, UAE, Britain, UK,

USA, Canada, Bahrain, Kuwait, Pakistan, Malaysia, Brunei, and Singapore. The steadily rising

demand for Islamic investing options is now spurring growth across the globe. Managers of

Islamic equity funds select stocks based on their lines of business and their financial

characteristics. An Islamic equity fund must carry a pro rata profit actually earned by the fund.

Based on investor risk profiles and management strategy, these equity funds are divided into four

subcategories:
 70

1. Regular income funds – objective is to earn profits through steady dividends

2. Capital gain funds – objective is to earn profits from the capital gains

accumulated through the frequent purchase and sale of Sharia compliant equities

3. Aggressive funds – objective is to invest in high risk securities in the hopes of

generating above average returns for investors

4. Balanced funds – objective is to invest in high quality securities and to distribute

profits to investors from dividends and capital gains (Ayub, 2007, p. 201)

Other Asset Classes

Equity investment is the most common form of investment in Islamic finance. However,

there are other Sharia compliant products that are available to Muslim investors. Sheikh

Muhammad Taqi Usmani, a preeminent Hanafi jurist from Pakistan, has identified five

categories of Islamic investment funds:

1. Equity funds

2. Ijara funds (funds from subscribers are used to finance the purchase of assets

through ijara or Islamic leases. Rentals from the user of the asset are distributed

to investors in the fund)

3. Commodity funds (funds are used to purchase commodities that are later resold at

a profit; profits are later distributed among subscribers)

4. Murabaha funds (funds are used to finance murabahas; proceeds from these

credit sales are then distributed to the funds investors)

5. Hybrid, or mixed funds (funds are used in different types of investing, such as in

equities, leasing, or commodities) (Ayub, 2007, pp. 201-203)

Sharia Advisory Boards

 71

One of the most distinguishing characteristics of Islamic equity funds are professional

Sharia advisory boards. While not all funds retain such boards, having a Sharia advisory board is

a sign of legitimacy to many investors. The presence of a Sharia board is a comfort for many

Muslim investors; they are assured that their money is being invested in a manner that conforms

to the rigid standards of traditional Islamic business practice; this is all because the board is there

to ensure that outcome. A Sharia board serves many functions. It is primarily responsible for

certifying the permissibility of the stocks that comprise an Islamic equity fund. Besides

monitoring the portfolio, the Sharia board also is responsible for monitoring the management of

the fund to ensure that the managers always act in accordance with the Sharia. This is especially

important when fund managers are not Muslims. The board is also expected to help management

prepare investor reports and SEC filings. Those who serve on Sharia boards must be well versed

in both Islamic law and modern financial instruments and practices.

An important caveat to keep in mind is that Islamic funds have different Sharia boards.

As seen in chapter II, rulings on a given financial topic may differ jurist to jurist and board to

board. Sharia boards are often hired and compensated by the financial institutions for which they

consult. Thus, these boards may suffer from a lack of independence in their rulings. On a wider

scale, the industry currently lacks a broad regulatory framework. While there are a number of

influential bodies in Islamic finance, such as the Fiqh Council of the Organization of the Islamic

Conference, there is no single, universal Sharia supervisory board, nor has there ever been. The

call for such a board has arisen numerous times in the past. It has been argued that a central

Sharia board would be impractical because it could not perform all the functions required for

Sharia supervision for the hundreds of Islamic financial institutions in existence. Another reason

put forward is that since there are a wide variety of Islamic financial institutions, from mutual
 72

funds to commercial banks, a central Sharia board could not possibly provide the specialized

consultation and advisory services for each subsector of the Islamic financial industry

(DeLorenzo, 2000). The various schools of law and their different interpretations no doubt also

play a role.

Creating a central body to regulate Islamic finance would be a daunting task. But in order

for the Islamic financial industry to move forward, to attract new customers, and to retain current

customers, it needs some sort of regulatory framework. The credit crisis has demonstrated

unequivocally what can happen when the market is allowed to run freely with inadequate

supervision. While the industry’s built-in adherence to the theoretically fair and equitable system

of Islamic financial law is a definite advantage, this does not exempt the industry from the need

to have cohesive regulations. A centralized Sharia supervisory organization should be created to

enact a standard set of regulations for the industry. To counter the arguments presented above,

the agency could have numerous internal departments dedicated to regulating different sectors of

the industry. To fund its operations, a fee could be charged to Islamic financial institutions who

apply for membership in the organization. Membership in the organization could be seen as a

seal of approval and sign of legitimacy in the eyes of Muslim investors. A conference of Muslim

jurists, scholars, and Islamic finance professionals could be convened to choose the governors

who would run such an organization, as well as hammer out other details. Representation from

each madhhab would be paramount. Such an organization would also be in the best interest of

Muslim investors, who would then have greater assurance that the financial products they use are

in accordance with the Sharia. 15

15
In addition, there would probably have to be another organization for Shiites. While Sunni and Shiite doctrine on
some financial and business issues overlap, many others do not.
 73

Fortunately, there have been steps in the right direction. There are a number of different

bodies that attempt to provide regulatory standards for members and the industry. The three most

important are the Accounting and Auditing Organization for Islamic Financial Institutions

(AAOIFI), the Islamic Financial Services Board (IFSB), and the Organization of the Islamic

Conference (OIC) Fiqh Academy.

The AAOIFI, founded February 26, 1990 in Algiers, is a nonprofit organization whose

mission it is to formulate accounting, auditing, governance, ethical, and Sharia guidelines for the

Islamic finance industry. The organization is supported by 155 institutional members, such as

Islamic financial institutions (IFIs) and other players in the Islamic finance industry. The

AAOIFI has also garnered the support of national governments. Some countries, such as Bahrain,

Jordan, and Sudan, have implemented its standards, while others like Pakistan, Saudi Arabia,

Malaysia (the leader in Islamic finance), and Australia have issued regulatory guidelines based

on AAOIFI standards for IFIs in their jurisdiction. Most notably, AAOIFI also issues

professional certifications for participants in Islamic finance; these are the Certified Islamic

Professional Accountant (CIPA) and Certified Sharia Adviser and Auditor (CSAA) designations

(Accounting and Auditing Organization for Islamic Financial Institutions, 2009). The AAOIFI

can effectively be thought of as a combination of the Financial Accounting Standards Board and

the CFA Institute.

Based in Kuala Lumpur, the Islamic Financial Services Board (IFSB) also issues

standards for the Islamic finance industry, including Islamic insurance companies. The IFSB

conducts research and facilitates the discussion of issues that affect the industry as a whole by

organizing conferences and seminars. The IFSB currently has 178 members, including the
 74

International Monetary Fund, World Bank, Islamic Development Bank, and Saudi Arabia

(Islamic Financial Services Board, 2009).

The Fiqh Academy is a subsidiary of the Organization of Islamic Conference. Established

September 25, 1969, the OIC, the second largest inter-governmental organization after the

United Nations, is comprised of 57 member nations from across the Muslim world (Organization

of the Islamic Conference, 2009). Muslim scholars from across the world, primarily scholars of

fiqh but also including experts in other fields, constitute the membership of the Fiqh Academy.

The goal of the Academy is to investigate and find solutions to the problems that confront

Muslims in the modern era. To this end, the Academy issues fatwas on a number of subjects,

including questions concerning Islamic finance and the economic lives of Muslims (Islamic Fiqh

Academy, 2009).

Sovereign nations have also made concerted efforts to regulate Islamic finance and

banking within their borders. Bahrain has a detailed set of guidelines for listing, offering, and

issuing debt securities, including Islamic bonds, or sukuk. Malaysia has set forth more stringent

requirements for Islamic bonds, such as mandating more frequent/detailed financial reports and

disclosures and requiring financiers involved in Islamic finance to be Sharia literate. However,

Islamic banks have encountered opposition from some governments, particularly those of North

Africa. The governments of countries like Egypt, Morocco, and Algeria are very leery of Islamic

financial institutions (IFIs), believing them to be linked to Islamic political parties. Some of these

countries allow Islamic banks to exist but provide little regulatory support, while others ban IFIs

outright (Modi, 2007). This is probably due to the history of political struggle between more

secular Middle Eastern governments and Islamist movements that has been waged in the region

for decades. Other nations that have experienced tension and conflict between Muslims and non-
 75

Muslims also outlaw IFIs (Modi, 2007). At any rate, the varying levels of governmental support

for IFIs presents a hurdle in the way of greater integration and regulation of the industry.

By the very nature of Islamic law, a wide diversity of opinion concerning the

acceptability of Islamic financial products will always exist. As seen in chapter II, the

geographically decentralized and highly personal nature of fiqh may preclude the establishment

of a single regulatory body which can definitively rule on products’ adherence to Sharia

guidelines. However, it is imperative that regulators ensure that Muslim customers have

unfettered access to full disclosures about the risks of Islamic financial products, and that the

process of determining whether an Islamic investment is Sharia compatible is as transparent as

possible.

Other pressing regulatory challenges also confront the Islamic investment funds and the

Islamic finance industry. First, Islamic financial firms should and must continually monitor their

products for Sharia compliance before and after launch to maintain investor confidence and firm

reputation. Second, the shortage of qualified Sharia scholars often means that scholars hold

positions at multiple firms. This obviously can result in numerous conflicts of interest, plus a

possible decline in quality of oversight as scholars are stretched thin across many firms. Third, a

simultaneous dearth of professionals versed in both finance and the Sharia means that the

industry will lack the qualified personnel it needs to sustain its growth. Education, training and

development programs, and time are all needed to allow a large enough pool of Sharia scholars

and financial professionals to emerge (Carruthers and Colangelo, 2008).

The issue of regulation of the Islamic finance industry will be taken up and further

explored in the context of Sharia arbitrage in chapter VII.

The Dow Jones Islamic Market Index

 76

In the development of Islamic funds, particularly equity funds, the problem of finding a

suitable benchmark against which managers and investors could measure performance arose.

Millions of Muslims were determined to adhere to their religious principles in their financial and

economic dealings, and fund managers were eager to acquiesce to this new demand. The Dow

Jones Company, sensing an opportunity, stepped in to create an index that would become the

standard benchmark for Islamic investing.

The Dow Jones Islamic Market (DJIM) Indexes were introduced in 1999 as the first

benchmarks to represent Islamic-compliant portfolios. Today the series encompasses more than

70 indexes and is arguably the most comprehensive family of Islamic market measures. The

company has put together a Sharia board to guide its operations, and to judge the Sharia

compliance of the components of its indexes. The board consists of some of the most respected

and well known names in Islamic finance today, including Yusuf Talal DeLorenzo, Nizam

Yaquby, and Dr. Mohamed Elgari. This board was instrumental in developing the screening

parameters that Dow Jones uses to select stocks for its universe.

Over time, the company has launched several subindexes, such as the DJ Islamic US

Index, which covers US companies only, the DJ Europe Index, which is dedicated solely to

European stocks, and even the DJ Islamic BRIC Index, which features companies from Brazil,

Russia, India, and China. The company expects to launch more subindexes in the future.

The Dow Jones Islamic Market Indexes include only easily accessible, actively traded

stocks. The selection universe for the family is the Dow Jones World Index. The components of

DJIM Indexes represent a broad range of stocks from different countries, regions, market cap

ranges and Sharia-compliant industries. Subindexes allow the individual tracking of these

various market segments. Stocks are only selected for membership in the DJIM Indexes if they
 77

pass a rigorous set of quantitative and qualitative measures. These screens are developed and

continuously evaluated by the Sharia board. The composition of each subindex is reviewed

quarterly every March, June, September and December. The indexes also are reviewed on an

ongoing basis to evaluate for corporate actions such as mergers and acquisitions, de-listings or

bankruptcies (Moran, 1999; Dow Jones Indexes, 2008).

Acceptable Lines of Business for Islamic Investing

In the never-ending quest for superior portfolio returns and performance, most

contemporary investors are limited only by their tolerance for risk and supply of personal capital.

Some investors, as mentioned above, choose to place their money into firms whose operations

closely match their own personal guidelines and ethics. However, the only restraint that most

investors face on investment decisions is derived from their own self-imposed constraints.

This is not so for the Muslim investor. Muslim investors who choose to conduct their

business and financial dealings according to their religion not only must consider the expected

return of an investment, but also how that investment affects his or her standing in the eyes of

God.

The Sharia forbids Muslims from participating in several activities; thus it is also

forbidden for Muslims to invest in firms engaged in these activities. Fund managers and

individual investors who are concerned with remaining true to the precepts of Islam steer clear of

providing startup financing to companies whose primary business activities fall within the

forbidden categories and purchasing the equity of such firms. Sharia boards have identified

several lines of prohibited business for Muslim investors. The standards that have been

incorporated into the industry screen of the Dow Jones Islamic Market index are as follows 16:

16
Keep in mind that all Islamic funds may not adhere to these same business screens. However, the screens used in
the DJIM are often referred to and used by Islamic funds.
 78

1. Alcohol. Alcohol and other intoxicants are strongly opposed in Islam, just as they are

in the Judeo-Christian tradition. The basis of this is the following verse of the Quran:

They ask you concerning alcohol and gambling. Say: "In them is a great sin, and

some benefits for men, but the sin is far greater than the benefit." (Quran 2:219)

2. Tobacco. There is no explicit ban on tobacco in the Quran. Nevertheless due to the

harmful physical effects of nicotine, many Muslims consider tobacco to be an illicit

good (even though smoking is very popular throughout many nations in the Islamic

world). Muhammad al-Jibaly of the Al-Quran was-Sunna Society of North America

cites Quranic commands against suicide and willfully harming the body (Quran 4:29,

2:195) in his denunciation of tobacco products and smoking (Al-Jibaly, 2008).

3. Pork related products. One of the most well known prohibitions in Islam is the

injunction against the consumption of pork products. This prohibition is based upon

Quran 5:4: Forbidden to you for food are: dead meat, blood, and the flesh of swine….

4. Financial services. Since most financial services companies having dealings with

interest – both paying and receiving – it is forbidden for Muslims to invest in them.

Insurance companies also fall within this category. 17

5. Defense/weapons. Many Muslims are averse to investing in companies that produce

weapons and other equipment used in war and defense.

6. Entertainment. Although entertainment products are widely consumed in the Islamic

world (for example, Egypt has a successful and influential film industry), many

17
Conventional commercial insurance as we know here in the West is deemed haram by many Islamic legal experts.
This stance was formally decided at the second session of the Fiqh Academy of the Organization of Islamic
Conference. The Academy felt that paying a fixed insurance premium contains substantial gharar, invalidating the
contract. Most jurists lean towards the forms of mutual insurance and social (state-organized) insurance. A viable
and Islamically permissible mode of insurance known as takaful has been approved by many jurists in that it is
based on the cooperative insurance model (with variations from mutual insurance as it is known here in the West).
However, there are also scholars who deem commercial insurance to be permissible under the Sharia. The debate on
the permissibility of insurance continues, but it is beyond the scope of this paper.
 79

scholars agree that it is haram to invest in companies that produce such products.

These forbidden items include films, music, and other recreational products. Casinos

are also off limits due to the prohibition, noted above, of gambling (which is known

in Arabic as maysir). Hotels also generally fall into this category, as many serve

alcohol and provide various forms of entertainment. Lastly, pornography is also

included in this category.

7. Food wholesalers and retailers. Many such companies offer non-halal foodstuffs,

hence the prohibition on this industry.

In addition to the aforementioned businesses, other companies/industries recommended

against include companies who treat their workers poorly, cause negative environmental effects,

and biotech companies that are involved in projects that use aborted embryos and pursue human

cloning. It is important to keep in mind that not all activities associated with these industries are

unequivocally haram; some jurists may classify them as makruh or even mubah (see chapter II),

but even then some would still argue against investing in companies that engage in them.

If a company is engaged in any of these industries, then Muslim investors tend to shy

away from them. However, for many companies, even though their primary line of business is

acceptable, part of their operations are involved in haram activities. Still more have subsidiaries

or minority interests in companies that are involved in impermissible activities.

Sharia scholars differ in their approaches to investments in these types of companies. The

most conservative scholars hold that investing in the equity of a company that is engaged in a

haram activity in any degree is impermissible. Clearly, this narrow view vastly restricts the

number of equities in which Muslims can invest, especially as regards to companies that pay or

receive interest; debt financing is prevalent among companies in all areas of the world. It is
 80

nearly impossible for most firms to maintain and grow their operations without accessing short

term credit at the very least. In the case of such companies, some jurists invoke the Maliki

principle of maslaha, or public interest. In this context, it is held that requiring Muslims to

adhere to the strictest forms of Sharia compliance (i.e. investing in companies that are not

involved in haram activities to any extent and that have no short or long term debt) would cause

undue hardship on the faithful. This is especially true for Muslims living in the West, where few

companies completely fit the stringent guidelines of Islamic jurisprudence. Some scholars permit

Muslims to invest in such companies provided that the illicit ventures are not their main line of

business. Others have relaxed the guidelines on the level of financial leverage that a company

may have (discussed in the next chapter). In general, the principle of maslaha allows some

degree of flexibility in the investment choices of Muslims.

Purification

In a perfect world, Sharia scholars’ ideal publicly traded company would exist; all of its

operations would be halal and it would be free from every questionable source of income,

including borrowing and lending at interest. Since this ideal is rarely encountered in the

contemporary world, the issue of purification of returns (covering both dividends and capital

gains) arises. Generally, purification is deducting from total investment gains earnings obtained

through means that are in violation of the dictates of Islam. For equity earnings, this primarily

includes interest earnings and income from haram operations (other than primary operations

which should of course be halal). While this seems simple in theory, it is rarely so in practice.

While many jurists and Islamic finance professionals agree about the importance of

purification, a number of controversial issues surround the procedure of purification. Scholars

disagree about whether Islamic funds should purify returns for investors, or if investors should
 81

be responsible for this function. Another issue is whether interest earnings and impure income

should be attributed to revenue or net income. Yet another issue revolves around what is to be

purified: dividends, capital gains, or assets. Purification can also create a comparison problem

between Islamic funds (purified vs. unpurified returns) or distortion of optimal portfolio

selection (pre-purified vs. post-purified returns).

There are three common methods for Islamic equity fund purification. In all formulas, P

equals the purification factor through which impure income can be estimated. Impure income

encompasses both interest income and income from haram operations.

Method 1

In a portfolio of shares on at time period t1, we have companies (c) earning interest i.

Interest income is equal to ic1 + i c2 …+ i cn = a. If net operating income for any company is y,

then total net operating income for the portfolio is equal to: yc1 + y c2 …+ y cn = b. Net asset value

for the fund at time period t1 is NAVt1. Then we must calculate Z, which is equal to: NAVt2 -

NAVt1. If H is equal to H = a/b then purification factor P is equal to ZH=P. For every dollar

invested, the investor must multiply by P and donate this amount to charity. So for example, if P

= 0.009 and the investor’s Z is $3000, then she must give $27 to charity.

Method 2

We have a portfolio of n securities. (S1, S2,… Sn). Compute the dividend yield where:

D = dividend / market value

The annual portfolio dividend yield will be D1 + D2…+ Dn. Interest income for each company

will be:

I = interest income / net operating income

 82

For the entire portfolio, total interest income will be ic1 + i c2 …+ i cn. The purification factor P

can be calculated as (D)(I) = P. For every dollar invested, $P must be donated to charity.

Method 3

Let us assume the following:

Interest income for each stock in the portfolio is X. X1 …Xn denotes each company.

T = tax rate for each company

A = percentage of total shares of each company owned by the fund

M = number of months a share is held in the portfolio

Interest income of the portfolio is then: ∑ X (1-T) (X) (A) (M) (Elgari, 2000)

Many jurists and Sharia board advisors agree that the funds winnowed away during

purification should be set aside for charitable purposes. Some funds distribute these amounts

among a variety of charities, while others set up a charitable fund or foundation under the

auspices of the fund manager.

It is interesting to note that while these mechanisms are meant for cleansing returns of

interest income, no such requirement is in place for income derived from haram secondary

operations. However, one could easily substitute “haram income” wherever “interest income”

appears in the formulas listed above. It is also not clear how “Islamized” debt (that which is

collected or paid through murabaha or ijara transactions) should be treated.

Acceptable Financial Characteristics

The Sharia lays down specific principles that govern the economic and financial decision

making of the faithful. One of the main tenets of Islamic financial theory is the superiority of

profit-and-loss sharing in ownership rather than debt financing. In other words, equity is looked

upon more favorably than debt in a company’s capital structure. However, debt financing is
 83

widely used across the world, as is investing in interest bearing securities. For Muslims who

wish to adhere to the strictest interpretation of this prohibition, the universe of companies in

which they may invest is severely circumscribed.

The financial screens that are used to select halal investments are not clear cut and vary

with each Sharia board. The Dow Jones Sharia board has instituted three financial screens that

are used to winnow out unacceptably leveraged companies. Stocks are considered ineligible for

investment if:

1. Total debt divided by trailing 12-month average market capitalization is 33% or

more.

a. Total debt = short term debt + long term debt + current portion of long term

debt

2. Cash plus interest-bearing securities divided by trailing 12-month average market

capitalization is 33% or more.

a. It is an established maxim in the Sharia that debt cannot be sold to a third

party, i.e. securitized. Thus, investing in all types of collateralized debt

obligations (CDOs) is impermissible. Selling cash for cash must comply with

the currency exchange (sarf) rules set forth in the Sharia. Modern scholars

traditionally stipulate that cash and debts cannot exceed real assets on a

company’s balance sheet in order for it to be permissible to invest in that

company’s equity. Scholars differ on the percentage of cash and debt that is

allowable, but most agree that this number cannot exceed 50%.

3. Accounts receivables divided by 12-month average market capitalization is 33% or

more.
 84

a. Accounts receivables = current receivables + long term receivables

Some might wonder what is so significant about the 33% number. It is based on a well known

saying of Muhammad: “One third, and one third is too much.” 18 In consequence, amounts of one

third or less have been the criterion for a small percentage.

In addition to the three screens specifically used by the DJIM indexes, other financial

screens are also vetted by numerous Sharia boards.

1. Companies with debt-to-equity ratios over 30% are often considered impermissible to

invest in. This criterion is also based on the “one-third” hadith.

2. It is impermissible to invest in the equities of companies whose interest income or

unlawful gains exceed 5-15%. However, the opinion that such earnings should not

exceed 5% is now widely accepted and considered the norm. The DJIM index also

follows this stipulation.

18
Bukhari. Volume 4, Book 51 – Wills and Testaments (Wasaayaa), Number 5.
 85

Sharia
Compliant
Companies

Primary Business
Screens

Financial Screens

Figure 5. Dow Jones Islamic Market Screening Criteria

Shortcomings of the Dow Jones Islamic Market Index

In terms of the stringency of their guidelines for primary business activities, the DJIM

does a remarkably good job of staying in keeping with the strictures of the Sharia. It is easy to

understand that companies that produce pork or alcohol would be excluded from an Islamic

portfolio, whereas for certain other industries, such as hotels and food providers, it may seem

akin to throwing the wheat out with the chaff. Certainly there are some hotels that do not serve

alcohol. However, for an index provider such as Dow Jones, the cost of scouring prohibited

industries for companies that are indeed Sharia compliant far outweigh the benefits. The

conservatism that the DJIM exhibits is reflective of this fact. It has been suggested that

companies that do not pass the business screen due to their industry but who are themselves
 86

Sharia compliant could provide information to Dow Jones that indicates their compliant status. If

index managers and the Sharia board approve, then the company could be included in the index,

provided that they also pass the financial screens. This could possibly be of great benefit to the

DJIM in that it would remove the onus of collecting such information from the provider, would

allow the DJIM to provide a wider snapshot of the broader market, and would provide more

investment choices for Islamic funds and individual Muslim investors. In addition, there is also

an illogical omission from the list of prohibited industries – air and sea transportation. Both

airlines and cruise lines are known to serve alcohol and provide entertainment for their

passengers, in addition to being highly leveraged.

Another shortcoming of the DJIM is that it does not take into account off-balance sheet

liabilities and assets in the computation of the financial ratios. Taking these items into account

will result in a truer picture of the financial status of a company, and be truer to Islamic

principles.

Using market capitalization as the denominator in the financial screens is also

problematic. Sudden large market movements can cause a company to be Sharia compliant one

hour, then out of compliance in the next. Since Islamic investors are more concerned with the

assets and liabilities of a company, total assets or total capitalization is a more appropriate

measure for financial compliance (Dow Jones Indexes, 2008; Khatkhatay and Nisar, 2007, pp. 1-

18; Yaquby, 2000).

Conclusion

Two things should be abundantly clear. First, Islamic finance is just as fluid and dynamic

as Islamic law. While there are some issues that enjoy wide agreement, there are others that do

not. Numerous attempts to create an autonomous regulatory body that can govern Islamic finance
 87

across the globe have been made. The individualistic nature of fiqh that was first encountered in

chapter II may make this goal impossible. Nevertheless, the industry should still strive to create

and adopt cohesive regulatory standards that can be applied by Islamic financial institutions from

New York to Dubai to Jakarta, for the good of both customers and the industry’s long term

growth. Second, the Islamic finance industry is currently driven by prohibitions. It is

undoubtedly important to keep these prohibitions in mind during the development of Islamic

financial products and services. But a single minded focus on these prohibitions may at best

drastically limit the potential of the industry and at worst promote inefficiency, creative

stagnation, and the elevation of legal form over religious substance. These dangers will be

elucidated in chapter VII, but now we turn to the performance of Islamic equity funds.
 88

CHAPTER V. AN INVESTIGATION OF THE PERFORMANCE OF ISLAMIC

FUNDS

Introduction

We now turn our attention to the performance of Islamic equity funds. Four mutual funds

that conform to the precepts of the Sharia will be examined. The performance of these funds vis-

à-vis the performance of conventional equity funds will be compared. The ultimate purpose of

the following analysis is to answer the following four questions:

1. How do the returns on an Islamic portfolio compare to those of a conventional fund?

2. How does an Islamic fund perform during a market downturn?

3. Can sufficient diversification be achieved in an Islamic portfolio?

4. How have the Islamic funds performed in the recent market downturn and broader

global financial crisis?

To provide background, we will begin with an examination of the literature surrounding

the performance of socially responsible/ethical investing.

Ethical Investment Performance

Ethical mutual funds have been in existence for a number of years, but only recently has

their performance been seriously analyzed. As more and more investors show a marked interest

in ethical investing, and more funds are channeled into the sector, attempts have been made to

analyze their returns as compared to conventional funds. Wall Street purists have consistently

argued that investors who employ ethical restrictions when making their financial decisions will

suffer from a lack of sufficient diversification and sacrifice returns. Proponents of socially

responsible investing have countered that investors can indeed achieve outstanding returns as

well as follow their conscience.

 89

The Good Money Indexes

In the late 1970s, GOOD MONEY Publications created its Good Money Industrial

Average (GMIA) and Good Money Utility Average (GMUA). Both stock indexes, the brainchild

of Ritchie Lowry, were designed to be the ethical equivalents of the Dow Jones Industrial

Average and the Dow Jones Utility Average respectively, and were developed to provide an easy

way for investors to track and compare the performance of SRI versus traditional investment

over time. For the GMIA, the industries of the DJIA were examined to select socially acceptable

companies. While acceptable companies existed in some sectors such as computers and

pharmaceuticals, other sectors had no acceptable companies. Nuclear weaponry production and

other defense related business disqualified companies in the aerospace and defense industry.

Companies with poor track records in particular social indicators, such as environmental

protection and labor relations, were also excluded. Like the GMIA, the GMUA was designed to

replicate its Dow Jones counterpart. The index was comprised of utility companies that did not

produce nuclear power, developed and/or used alternative energy sources, and enacted

conservation programs. Companies that used traditional fossil fuels but nevertheless had good

environmental records were also included. Like the Dow Jones indexes, the Good Money

indexes replaced components if a company went private, declared bankruptcy, or merged with

another company. While no company in either Good Money index was replaced because of

negative performance, companies were dropped if they ceased to meet social guidelines. If

possible, the offending company was then replaced with a socially acceptable alternative from

the same industry.

 90

Table 1. The Good Money Industrial Average vs the Dow Jones Industrial Average, 1976-2000

Good Money Industrial Average Dow Jones Industrial Average

Cumulative YOY Cumulative
Year Value YOY Change Change Value Change Change
1976 27.74 --- --- 1004.65 --- ---
1977 30.16 8.7% 8.7% 831.17 -17.3% -17.3%
1978 33.62 11.5% 21.2% 805.01 -3.2% -19.9%
1979 40.41 20.2% 45.7% 838.74 4.2% -16.5%
1980 49.01 21.2% 76.7% 963.99 14.9% -4.1%
1981 57.83 18.0% 108.5% 875.00 -9.2% -12.9%
1982 68.17 17.9% 145.8% 1066.54 21.9% 6.2%
1983 88.20 29.4% 218.0% 1258.64 18.0% 25.3%
1984 84.10 -4.7% 203.2% 1211.57 -3.7% 20.6%
1985 127.75 51.9% 360.5% 1546.67 27.7% 54.0%
1986 137.60 7.7% 396.0% 1895.95 22.6% 88.7%
1987 144.04 4.7% 419.3% 1938.83 2.3% 93.0%
1988 161.79 12.3% 483.2% 2168.57 11.9% 115.9%
1989 207.11 28.0% 646.6% 2753.20 27.0% 174.1%
1990 170.20 -17.8% 513.6% 2633.66 -4.3% 162.2%
1991 218.84 28.6% 688.9% 3168.83 20.3% 215.4%
1992 227.87 4.1% 721.5% 3301.11 4.2% 228.6%
1993 240.67 5.6% 767.6% 3754.09 13.7% 273.7%
1994 226.95 -5.7% 718.1% 3834.44 2.1% 281.7%
1995 277.36 22.2% 899.8% 5117.12 33.5% 409.3%
1996 328.91 18.6% 1085.7% 6448.27 26.0% 541.8%
1997 443.63 34.9% 1499.2% 7908.25 22.6% 687.2%
1998 559.69 26.2% 1917.6% 9181.40 16.1% 813.9%
1999 595.07 6.3% 2045.2% 11497.12 25.2% 1044.4%
2000 586.06 -1.5% 2012.7% 10786.85 -6.2% 973.7%
Source: http://www.goodmoney.com/gmiaraw.htm

From its inception in 1976, the GMIA performed admirably. Indeed, the GMIA often

outperformed the DJIA. Over a 25 year period, the GMIA climbed over 2000% in value, while

the DJIA increased 973%. This impressive performance is even more evident in figure 4, which

graphs the cumulative change in both the GMIA and the DJIA from 1977 to 2000. The GMIA

was up 20 years out of the 25 year period, and down four. The DJIA, in contrast, was up 18 years

and down six. The GMIA outperformed the DJIA 14 years during the period, while the DJIA

outperformed the GMIA only 10.

 91

Figure 6. The GMIA vs. DJIA - Cumulative Value Change

2500%

2000%
GMIA

1500%

1000%

DJIA

500%

0%
1977
1978
1979

1980
1981
1982

1983
1984
1985
1986
1987
1988
1989
1990
1991

1992
1993
1994

1995
1996
1997

1998
1999
2000
-500%

Table 2. The Good Money Utility Average vs The Dow Jones Utility Average, 1976-2000

Good Money Utility Average Dow Jones Utility Average

Cumulative Cumulative
Year Value YOY Change Change Value YOY Change Change
1976 22.89 ---- ---- 108.38 ---- ----
1977 25.33 10.7% 10.7% 111.28 2.7% 2.7%
1978 21.45 -15.4% -6.3% 98.24 -11.7% -9.4%
1979 22.36 4.2% -2.3% 106.60 8.5% -1.6%
1980 23.46 4.9% 2.5% 114.42 7.3% 5.6%
1981 24.87 6.0% 8.7% 109.02 -4.7% 0.6%
1982 34.51 38.8% 50.8% 119.46 9.6% 10.2%
1983 45.34 31.4% 98.1% 131.80 10.3% 21.6%
1984 43.52 -4.0% 90.1% 149.52 13.5% 38.0%
1985 51.74 18.9% 126.0% 174.81 16.9% 61.3%
1986 71.71 38.6% 213.3% 206.01 17.5% 90.1%
1987 63.44 -11.5% 177.2% 175.08 -15.0% 61.5%
1988 67.87 7.0% 196.5% 186.28 6.4% 71.9%
1989 74.54 9.8% 225.6% 235.04 26.2% 116.9%
1990 66.63 -10.6% 191.1% 209.70 -10.8% 93.5%
1991 78.88 18.4% 244.6% 226.15 7.8% 108.7%
1992 75.70 -4.0% 230.7% 221.01 -2.3% 103.9%
1993 80.60 6.5% 252.1% 229.30 1.4% 111.6%
1994 70.73 -12.2% 209.0% 181.52 -20.8% 67.5%
1995 84.51 19.5% 269.2% 225.40 24.2% 108.0%
1996 90.53 7.1% 295.5% 232.53 4.5% 114.6%
1997 107.35 18.6% 369.0% 273.07 17.4% 152.0%
1998 114.90 7.0% 402.0% 312.30 14.4% 188.2%
1999 104.93 -8.7% 358.5% 283.36 -9.3% 161.5%
2000 126.96 21.0% 454.7% 412.16 45.5% 280.3%
Source: http://www.goodmoney.com/gmuaraw.htm
 92

Likewise, the GMUA also performed well, often outperforming its Dow Jones

counterpart. The GMUA outperformed the DJUA 15 years to nine during the period. The value

of the GMUA rose 454% compared to the DJUA’s 280% rise. In addition, when utility stocks

fell out of favor with equity investors during early 1987, the GMUA lost 11.5% of its value

while the DJUA fell 15%.

Figure 7. The GMUA vs. DJUA - Cumulative Value Change

500%

400%
GMUA

300%

200%

DJUA
100%

0%
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
-100%

GOOD MONEY decided to stop tracking their averages in 2002, citing market volatility

and the increasing difficulty in finding socially acceptable companies in which to invest. On this

latter point, GOOD MONEY referred to a study that found two thirds of CEOs interviewed

revealed that they had felt the need to falsify earnings and performance in an effort to placate

shareholders and analysts (Lowry, 1991, pp. 41-49; Good Money, 2002). In spite of this, the

Good Money averages’ long track record does provide important insight into the performance of

SRI over the time period covered. The GMIA and GMUA both demonstrate that an investor may

not have to sacrifice return and financial gain in order to remain true to their moral principles. At
 93

the same time, a few caveats must be kept in mind. While the DJIA tends to focus on large cap

companies and not high growth small firms, the GMIA has a broader representation of the entire

economy. This could explain why it has performed in such an impressive fashion. Likewise,

Grossman and Sharpe once compared the performance of the NYSE to that of a value weighted

NYSE portfolio that screened for companies involved in South Africa. To this portfolio they

added Treasury bills, creating a portfolio whose standard deviation was equivalent to the

NYSE’s. While the risk adjusted South Africa free portfolio outperformed the NYSE from 1960

to 1983, this was due to the fact that the portfolio’s companies were smaller than those of the

NYSE, on average (Hamilton, Hoje, and Statman, 1993, pp. 62-66).

Doing Well While Doing Good

In addition to indexes, several ethically screened funds have also performed well. The

1980s saw many socially managed funds outperform their traditional peers. The Calvert Social

Investment Fund, part of Washington, D.C.’s Calvert Group rose 6.8% in 1984 as many

unscreened funds lost value. That same year, the Pax World Fund 19 gained 6.5%, and the New

Alternatives Fund 20 lost a mere 0.6%. In 1987, 848 mutual funds selected by Lipper Analytical

Services that were at least one year old were ranked in the Financial Services Directory; three of

the most recognizable socially screened funds – New Alternatives, Calvert, and Parnassus 21 –

each handily outperformed the industry average for performance in 1986 of 27.7%. During the

bloodletting of the 1987 stock market crash, Lipper found that nine socially screened mutual

funds had actually outperformed or stayed in line with their unscreened peers. Despite the

19
The Pax World Fund was started by Quakers and Methodists. The fund employed both the avoidance and positive
choice approaches. The fund especially sought out companies with excellent environmental records and those who
were dedicated to being equal opportunity employers. (Lowry, 1991, p. 23)
20
The New Alternatives Fund sought companies that had a positive impact on the environment, especially those that
were involved with alternative and renewable energies. (Ritchie p. 52)
21
Parnassus is a socially screened fund that uses a contrarian approach to selecting companies, i.e. choosing firms
that are currently out of favor with other investors. (Ritchie p. 52)
 94

damage inflicted by the crash, Lipper also declared the Calvert-managed Ariel Growth Fund as

1987’s top small company growth fund with assets of less than $25 million, and the second best

of all small company growth funds irrespective of size. Ariel screened for companies engaged in

business in South Africa, weapons manufacturing, nuclear energy and/or nuclear equipment

production (Lowry, 1991, pp. 51-53). 22

The Opposing Point of View

As dedicated as the adherents of SRI have and continue to be, there remain many

investing purists and financial professionals who remain unconvinced that socially responsible

investing can yield the same financial rewards as more conventional styles. They believe that

investors should only be focused on risk and return; a person’s subjective set of moral principles

has no place in the investment decision. The arguments against social investing are numerous.

One popularly held belief is that imposing moral/social restrictions on the kinds of companies

that may be invested in unnecessarily limits one’s potential universe of investments, thus

dampening the benefits achieved by diversification. Blanket prohibitions on certain sectors deny

these funds and their investors the opportunity to invest in high performing stocks. In addition,

such funds often have a higher cost of operation due to the extra research needed to identify

investments. In the case of Islamic funds, hiring and maintaining a Sharia board also imposes

added costs.

Just as there have been studies that seem to indicate stronger performance from socially

screened funds vis-à-vis their more traditionally managed counterparts, there have also been

empirical analyses that substantiate the claims of those who oppose using social criteria to make

22
Not discussed in this section is the TIAA-CREF Social Choice Equity Fund. TIAA CREF is one of the largest
defined contribution pension plans in the world. Like many of the ethical funds discussed here, the Social Choice
Equity Fund has offered consistently strong performance, both against other funds of its class and its benchmark
index, the Russell 3000.
 95

investment decisions. These analyses find that socially screened portfolios perform worse than or,

at best, in line with conventional portfolios. In a study by Hamilton, Jo, and Statman calculated

the monthly excess returns of 17 socially responsible mutual funds established in or before 1985,

and 15 socially responsible mutual funds established in or after 1986. These returns were

compared to those of two groups of conventional mutual funds from the same time periods. The

returns of the SRI mutual funds were not statistically different from those of the conventional

funds, indicating that investors can expect to neither lose nor gain from investing socially

screened funds. They found that adopting social responsibility principles affect neither expected

stock returns nor firms’ cost of capital (Hamilton et al., 1993, pp. 62-66).

Going a step further, Samuel Mueller of the University of Akron identified in 1991 what

he called the “opportunity cost of discipleship,” a theory which holds that adherents of moral or

ethical systems that are different from the prevalent, mainstream social environment will face

negative consequences as a result of their observance. Mueller’s theory builds upon the work of

sociologists, most notably Dietrich Bonhoeffer, who advanced the concept of costly grace. 23 The

costs experienced by such adherents include both indirect costs such as missed opportunities and

more direct costs such as lower incomes. According to Mueller, sect members’ social networks

often consist primarily of other sect members, reducing the opportunity for networking and other

economic benefits. Also, adhering to a sect’s particular set of ethical guidelines may also prevent

members from participating in and taking advantage of profitable economic enterprises such as

owning a liquor store or operating a casino. Like Hamilton and her colleagues, Mueller also

23
The concept of costly grace was developed by Bonhoeffer in 1963. He posits that adherents to sectarian religions
will experience social costs associated with their belief. In 1988, Laurence Iannaccone took Bonhoeffer’s work a
step farther by developing a formal microeconomic model in which participants in sectarian groups suffer real
economic costs as a result of their actions. See Bonhoeffer, Dietrich. (1963). The Cost of Discipleship. New York:
Macmillan and Iannaccone, Laurence R. (1988). “A formal model of church and sect.” American Journal of
Sociology, 94: S241-68.
 96

compared the returns of several ethical funds 24 against relevant fund indices during the 1980s.

He found that the funds yielded lower returns than their unrestricted peers, while also exposing

investors to a somewhat higher level of risk (Mueller, 1991, pp. 111-124).

The examples presented above provide a glimpse into the ongoing controversy

surrounding ethical mutual funds. A definite conclusion about the efficiency and performance of

such funds has not yet been reached. While by no means offering a definitive conclusion as to

ethical funds’ performance, this study will attempt to answer such questions regarding the

Islamic subsector of the ethical investing world.

The Advantage of Social Investing

No matter what one thinks of including social criteria in the investment decision, social

investing has a definite advantage, one that has increasingly been highlighted in the wake of the

financial crisis of 2008. The causes of the financial crisis are manifold, but an important root is

speculation in risky mortgage backed securities and the chase for short term profits (which

existed even before the mortgage crisis). The credit crunch that nearly strangled the global

financial system to death highlighted the dangers of excessive leverage. Socially responsible

investing, including Islamic investing, discourages just this sort of behavior because it can lead

to the volatility and uncertainty witnessed over the course of 2008.

By its very nature, socially responsible investing is conservative. Socially conscious

investors seldom chase after short term gains, instead focusing on long term return and gain.

They favor companies with excellent track records, financial strength, superior valuation, and a

sound business model. Socially responsible investors’ insistence on steering clear of companies

that engage in what they (and others) consider to be morally suspect behavior, such as polluting

24
The funds were: Working Assets, Calvert Money Market fund, Calvert Managed fund, Pax World fund, Pioneer,
Pioneer II, Pioneer Three, Dreyfus Third Century, Parnassus, and New Alternatives.
 97

the environment or not doing enough to promote and retain female and minority employees, may

seem overly fastidious to many more traditionally minded investors. But that approach seems

wise, even prescient, when such companies are penalized for their behavior through lawsuits,

punitive legislation, and the like. Islamic funds were spared much of the damage that

conventional funds suffered in the early stages of the financial crisis as they did not own

financial stocks. The Sharia’s ban on interest saved many of these funds from the rapid declines

in value that weakened some conventional funds and felled others.

The Four Islamic Equity Funds

In order to gauge the performance of an Islamic fund, suitable representations of Sharia

compliant funds were necessary. Generally speaking, investors seek either growth or regular

income from equity investments; Islamic funds that focused on these goals were needed. Four

Islamic mutual funds were selected to represent the Islamic equity portfolio in this analysis.

Azzad Ethical Income Fund (AEIFX)

The Azzad Ethical Income Fund is provided by Azzad Asset Management, a Virginia

based asset management firm that specializes in ethical investing. Benchmarked to the S&P 500,

the fund’s managers seek to obtain current income for investors by investing at least 80% of its

assets in dividend paying companies, as well as achieving long term capital appreciation. The

fund’s holdings are primarily distributed across a number of large cap dividend yielding

companies. Though the fund’s focus is on large cap companies, the fund may invest up to 25%

of its assets in small and midcap companies. The fund does not invest more than 5% of its assets

in one company, nor does it devote more than 25% of assets to a single sector. Managers also

employ business and financial screens to select securities for inclusion in the fund. Like most

Islamic funds, this fund does not invest in companies that deal with alcohol, tobacco, financial
 98

services, and unethical entertainment like pornography and gambling. The fund uses proprietary

software, which uses financial data provided by sources such as Thomson Financial, to screen for

companies that meet its ethical criteria (Manal Fouz, personal communication, December 9,

2008). Interestingly, the fund also does not invest in companies that are primarily involved in

the production of all meat products, and not solely pork products, citing the fact that many

people are vegetarians or abstain from eating meat due to religious reasons. The fund also

employs the following financial screens to select permissible securities for inclusion:

A. Debt Screen
i. Total debt = short term debt + current portion of long-term debt + long-term
debt
ii. Total debt/trailing 12-month average market capitalization ≤ 33%
iii. Total debt/assets ≤ 33%

B. Accounts Receivable Screen

i. Accounts receivables = current receivables + long-term receivables
ii. Accounts receivables/total assets ≤ 45%

C. Interest Income Screen

i. Interest income/total sales ≤ 5%

The fund also does not invest in interest based securities, assets that are deemed interest-

equivalent securities, and derivative and hybrid securities (i.e. swaps and futures contracts) (The

Azzad Funds 2008 Prospectus).

Amana Income Fund (AMANX) and Amana Growth Fund (AMAGX)

Like the Azzad Ethical Income Fund, the Amana Income Fund is dedicated to generating

current income for investors by investing only in dividend paying stocks, as well as preserving

capital. This fund is managed by the Amana Mutual Funds Trust, which is part of Saturna

Capital. Also like the Azzad fund, the Amana Income Fund is benchmarked to the S&P 500. The

fund does not invest in instruments that pay interest, nor does it invest in companies whose

primary lines of business are inconsistent with Sharia guidelines. At least 80% of the fund’s
 99

assets are invested in income producing equity securities, and the fund is biased toward large cap

companies.

Also managed by Saturna’s Amana Mutual Funds Trust, the Amana Growth Fund is

focused on providing shareholders with long term capital appreciation. Benchmarked to the

Russell 2000, the Growth Fund is biased toward large cap growth stocks. At least 80% of the

assets of the Growth Fund are invested in common stock. Along with Sharia guidelines, stocks

are selected for inclusion in the fund based on past earnings and growth rates, as well as

managers’ expectations of future share price appreciation.

The funds’ managers are true long term value investors; they tend to seek out companies

with strong balance sheets, established and sound business models, and attractive valuation. In

keeping with many mutual funds, managers actively strive to limit the amount of income taxes

paid by shareholders by infrequently trading securities and selling high tax cost lots first (The

Amana Funds 2008 Prospectus).

The Iman Fund (IMANX)

The fourth Islamic fund is the Iman Fund, distributed by Quasar Distributors and advised

by Allied Asset Advisors, a subsidiary of the North American Islamic Trust (NAIT), which also

owns approximately 72% of the outstanding shares of the fund. The Iman Fund is benchmarked

to the S&P 500, the Russell 3000, and the Dow Jones Islamic Market US Index. The fund’s

managers refrain from investing in interest bearing securities, companies that generate large

amounts of interest income, and companies that have impermissible lines of business. The fund

is advised by a three member Board of Trustees – Shaykh Abdalla Idris Ali, Mohammed

Kaiseruddin, PhD., and Bassam Osman, MD – none of whom receive compensation from the
 100

fund. These trustees meet throughout the year to discuss and decide upon issues of policy and to

supervise the operations of the Fund (The Iman Fund, 2008).

The “Conventional” Comparison Funds

In order to effectively judge the performance of Islamic funds, funds that do not face

Sharia guidelines are needed for comparison. Two conventional mutual funds were chosen for

comparison to the Islamic funds, both provided by Vanguard. “Conventional” funds are those

which do not face restrictions in the types of companies they may invest in. Unlike Islamic funds,

which cannot deploy their uninvested cash in interest bearing accounts, these conventional equity

funds may place their excess capital in interest bearing accounts and instruments.

Vanguard Equity Income Fund (VEIPX)

Due to its focus on obtaining current income for investors, this fund was selected for

comparison to the Azzad Ethical Income Fund and the Amana Income Fund. The fund primarily

invests in large cap stocks with high dividend yields. The fund, which maintains a number of

advisors, looks for companies that have demonstrated a commitment to consistently paying

dividends. Normally the fund invests at least 80% of its assets in stocks. Though the fund may

invest up to 20% of its assets in foreign securities, its primary focus is on U.S. equity securities.

The fund also invests a small portion of its assets in exchange traded funds (ETFs), including

those of Vanguard. The fund can participate in futures contracts, but avoids utilizing more than

20% of its assets for this purpose. The fund does not use futures or any other derivative

instrument to speculate (The Vanguard Group, 2008, Vanguard Equity Income Fund Investor

Shares – VEIPX).

Vanguard U.S. Growth Fund (VWUSX)

The Vanguard U.S. Growth Fund is dedicated to providing investors with long term
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capital appreciation, making it a suitable conventional comparison to the Amana Growth Fund

and the Iman Fund. The fund’s portfolio holdings typically include large cap U.S. companies that

have experienced and are expected to continue to experience high rates of growth. In addition to

focusing on firms that have above average expected rates of growth, the fund’s managers also

search for companies that maintain positions of strength within their particular industry, and are

financially sound. Unlike the Vanguard Equity Income Fund, this fund may use futures, options

contracts, or other derivative instruments. However it too does not use such contracts for

speculative purposes (The Vanguard Group, 2008, Vanguard U.S. Growth Fund - VWUSX).

The Vanguard 500 Index Fund (VFINX)

The Vanguard 500 Index Fund was created to track the S&P 500. Generally, it contains

the 500 stocks included in the S&P 500. The fund also maintains approximately the same levels

of sector diversification as the S&P 500. Naturally, the fund has a beta of 1.00 (meaning that it is

as volatile as the market) (The Vanguard Group, 2009, Vanguard 500 Index Fund – VFINX). The

VFINX makes a perfect benchmark to measure the performance of the Islamic funds and the

conventional funds because it is basically a cost-adjusted version of the real S&P 500. With the

fund, management costs and fees are taken into account, making for a more realistic comparison

of returns.

The Islamic Funds versus Their Conventional Counterparts

How does an Islamic fund compare to a conventional fund? Can Muslim investors expect

the same or better levels of performance? Or are they penalized for adhering to their religious

beliefs, as theorized by Dietrich Bonhoeffer and Samuel Mueller? To conduct this analysis, the

quarterly holding period returns for each portfolio were calculated for its entire time span, from

date of inception to December 2008. The Islamic income funds, AEIFX and AMANX, were
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compared to the VEIPX. Likewise, the Islamic growth funds, IMANX and AMAGX, were

compared to the VWUSX.

Figure 8. The AEIFX and VEIPX Compared

During most of its history, the AEIFX has been outperformed by its conventional

counterpart, the VEIPX. Roughly from 2002 to 2007, the AEIFX only outperformed the VEIPX

four times. However, beginning in last 2007, we can observe an interesting reversal. The Islamic

fund began to consistently outperform its conventional rival over the five quarter ranging from

December 2007 to December 2008. This can be seen even more clearly in the Figure 9, which

depicts the basis point difference between the returns of AEIFX and VEIPX; anything above the

reference line at 0% represents a quarter when the AEIFX outperformed the VEIPX.
 103

Figure 9.

The timing of this reversal is most likely no coincidence. This time period coincides with

the emergence of the global liquidity crisis and the resulting upheaval in the broader economy.

Financial stocks, which represented nearly 20% of the VEIPX’s holdings at the end of 2008,

suffered tremendous declines. AEIFX’s Islamic restrictions no doubt helped spare the fund from

the same level of pain experienced by its conventional counterpart.

AMANX, the other Islamic income fund, tells nearly the same story. AMANX has often

outperformed the VEIPX, even in its earlier years. And it too also posted superior performance

relative to the conventional fund (with the exception of the quarter ended September 30, 2008).
 104

Figure 10. AMANX and VEIPX Compared

 105

Figure 11

The Islamic growth funds have also fared well against their conventional

counterpart, the VWUSX. Throughout its eight year history, IMANX has often outperformed the

conventional growth fund, as seen in Figures 12 and 13. And until the end of the third quarter of

2008, IMANX maintained strong performance in the midst of the fallout from the financial crisis.

AMAGX, the second of the Islamic growth funds, delivered a strong performance during

the difficult second half of 2008, as well as an admirable overall performance throughout its

history, as seen in Figures 14 and 15.

 106

Figure 12. IMANX and VWUSX Compared

Figure 13
 107

Figure 14. AMAGX and VWUSX Compared

Like the other Islamic funds, AMAGX offered investors a welcome measure of relief

from the dizzying downward spiral in the financial markets in the last months of 2008.

On the whole, the Sharia restrictions of the four Islamic funds protected investors from

the more overwhelming declines faced by conventional funds as the credit crunch deepened. The

ban on interest-based financial companies was a major part of the funds’ consistency and

resilience. As the financial crisis began to punish those companies that had accumulated large

and onerous debt loads, the Islamic funds were largely spared the fallout from the credit crunch

during the latter half of 2008. In addition, Muslim investors

 108

Figure 15

should be comforted by the fact that the Islamic funds also charted great performance during

good times as well. These results suggest that Muslims may not suffer from “costly grace” if

they choose to adhere to their religious beliefs in their financial dealings and investments.

The Islamic Funds’ Bear Market Performance

In recent years, there have been three bear markets (aside from the current and ongoing
 109

market downturn precipitated by the financial crisis): the 1987 bear market, which lasted from

July 1987 to December 1987, the 1990 bear market, which lasted from June 1990 to November

1990, and the stock market downturn of 2002, which actually really began in February 2000 and

lasted until October 2002. This downturn is generally associated with the “Internet bubble”

bursting 25, and was exacerbated by the September 11, 2001 terrorist attacks. The oldest of the

Islamic funds, the Amana Funds, were incepted in 1996, whereas the Iman Fund and the Azzad

Ethical Income Fund were incepted in 2000 and 2002, respectively. Therefore, three of the

Islamic funds’ strength and performance have only been tested by the stock market downturn of

2002. The Azzad Ethical Income Fund missed the brunt of the downturn, which came prior to its

inception.

Table 3. AMAGX During Last Stock Market Downturn

Date AMAGX VWUSX VFINX

March 2000 7.76% 5.09% 3.24%
June 2000 -11.29% 1.42% -3.11%
September 2000 -2.21% 0.70% -1.95%
December 2000 -6.34% -24.62% -7.78%
March 2001 -13.29% -25.37% -9.36%
June 2001 8.61% 10.37% 7.14%
September 2001 -17.28% -23.76% -15.57%
December 2001 21.14% 20.21% 10.91%
March 2002 0.08% -8.45% -0.35%
June 2002 -16.78% -21.08% -13.38%
September 2002 -16.60% -13.66% -15.42%
Mean Quarterly -4.20% -7.20% -4.15%
HPY
*Bold - outperformed VFINX; Italics - outperformed conventional fund

25
The Internet, or dot-com, bubble was a nearly six year speculative bubble that occurred when Western stock
markets saw their valuations increase exponentially. The bubble’s growth was led by Internet and technology
companies. The rise of the dot-com stocks was accompanied by rapidly increasing stock prices, a rush of venture
capital, speculation, and Malkielian “irrational exuberance.” This environment led many tech ventures to abandon
standard business models and focus more on stock price appreciation. But like all bubbles before it, the tech bubble
also proved untenable and resulted in a devastating stock market crash in 2001 and many tech and Internet
companies went bankrupt.
 110

Table 3 compares the quarterly returns of AMAGX, VWUSX, and the benchmark VFINX

during the stock market downturn of 2002. AMAGX often outperformed the VFINX and

actually nearly always outperformed the conventional VWUSX. Its average quarterly holding

period return of -4.20% also outperformed that of the VWUSX.

Table 4. AMANX During the Last Stock Market Downturn

Date AMANX VEIPX VFINX

March 2000 2.42% 0.38% 3.24%
June 2000 0.06% -2.26% -3.11%
September 2000 0.00% 5.12% -1.95%
December 2000 0.34% 6.94% -7.78%
March 2001 -7.28% -3.87% -9.36%
June 2001 3.14% 4.40% 7.14%
September 2001 -8.05% -6.99% -15.57%
December 2001 4.33% 5.91% 10.91%
March 2002 2.06% 3.31% -0.35%
June 2002 -8.76% -8.42% -13.38%
September 2002 -15.63% -16.92% -15.42%
Mean Quarterly -2.49% -1.13% -4.15%
HPY
*Bold - outperformed VFINX; Italics - outperformed conventional fund

In contrast, AMAGX’s sister fund performed slightly worse, as seen in Table 4. While it often

outperformed the benchmark fund, it seldom did better than its conventional rival VEIPX did.

The reason for this was that AMANX was heavily weighted with utility and energy companies

during much of the period; weakness in those industries overcame the relatively good

performance of other sectors.

 111

Table 5. IMANX During the Last Stock Market Downturn

Date IMANX VWUSX VFINX

December 2000 -10.12% -24.62% -7.78%
March 2001 -15.21% -25.37% -9.36%
June 2001 7.85% 10.37% 7.14%
September 2001 -17.87% -23.76% -15.57%
December 2001 15.50% 20.21% 10.91%
March 2002 -2.44% -8.45% -0.35%
June 2002 -16.52% -21.08% -13.38%
September 2002 -15.11% -13.66% -15.42%
Mean Quarterly -6.74% -10.80% -5.48%
HPY
*Bold - outperformed VFINX; Italics - outperformed conventional fund

The Iman Fund rarely outperformed the benchmark fund VFINX during this period, but nearly

always outperformed its conventional counterpart VWUSX, much like the other Islamic growth

fund AMAGX.

The Question of Diversification

One of the most common charges against Islamic portfolios – and ethical funds in general

– is that by reducing the number of sectors in which an individual may invest, the investor will

pay a price for losing the benefits of diversification. Diversification has been an important tenet

of portfolio selection ever since Markowitz introduced the idea in the 1950s (see chapter III).

According to theory, an investor can virtually eliminate all unsystematic risk in a portfolio

through diversification. This depends on reducing the covariances between assets in the portfolio

to their minimum level. While investing in many securities does not guarantee the smallest

variance for a portfolio, it is generally accepted that adequate diversification can be achieved by

investing in a large number of securities across different industries. The question lies in how

many stocks are necessary to reach an adequate level of diversification (i.e. when unsystematic

risk in the portfolio has been reduced to the lowest possible level).
 112

In 1968, John Evans and Stephen Archer investigated how many securities were

necessary to achieve diversification in a portfolio. Through their analysis, Evans and Archer

found that the marginal benefits (i.e. risk reduction) of adding securities to a portfolio declined

rapidly as more and more securities were added, or in technical terms displayed a diminishing

marginal effect. Their study indicated that only eight to ten securities were needed to attain the

full economic benefits of diversification; adding any more was not economically justified due to

marginal costs (primarily transactions costs) outweighing marginal benefit (Evans and Archer,

1968, pp. 761-767). However, this position was refuted by the work of Meir Statman in the late

1980s. Statman’s analysis yielded surprising and substantially different results from the Evans

and Archer study. Statman demonstrated that no less than 30 stocks are needed for a well

diversified portfolio. Specifically, Statman showed that a well diversified equity portfolio must

contain at least 30 stocks for a borrowing investor, and no less than 40 stocks for a lending

investor (Statman, 1987, pp. 353-363).

Even with Statman’s drastically larger required number of stocks, Islamic equity

portfolios are in no danger of not meeting his criteria, as can be seen in the table below:

Table 6. Number of Securities - Islamic Portfolios

Islamic Portfolio # of Securities

IMANX 158

AEIFX 48

AMANX 82

AMAGX 84

Source: Latest SEC filing

The sector weights in each portfolio are just as important as the total number of securities.

The sector weight represents the portfolio’s exposure to a specific industry. After a thorough
 113

analysis of each of the Islamic funds’ SEC filings, the Islamic funds demonstrated good sector

diversification. The figures in the right hand column of Table 7 represent the highest industry

allocations throughout each fund’s history. None exceeds a quarter of the portfolio’s value. The

Islamic portfolios have thus maintained sufficient industry diversification, overweighting sectors

which the managers have been “bullish” on at different points in time.

Table 7. Industry Allocation - Highest Percentages

Fund Highest Percentage

AEIFX 19.61%

IMANX 17.70%

AMAGX 21.60%

AMANX 22.10%

Source: Historic N-CSRs and N-CSRSs

Recent Market Turmoil – The Role of Financial Stocks

In the midst of the recent turmoil in the US stock market, nearly every stock has suffered

declines as this global financial and economic crisis has proved that no industry is recession

proof. The financial industry was the worst hit. After the global liquidity crisis emerged in late

2007, one financial institution after another fell in a staggering domino-like fashion. Bear Stearns,

Fannie Mae, Freddie Mac, and Lehman Brothers were all felled by the crisis sweeping the

financial markets and enveloping the broader economy. Portfolios that held significant amounts

of financial stocks were pummeled. In light of their lack of financial stocks, 26 a significant

question about the recent performance of Islamic funds immediately emerges. Did Islamic

26
The reader should keep in mind that when we say “financial stocks”, this is not just limited to banks and other
lending institutions. This generally includes all companies that are involved in the financial industry. The companies
that are excluded are: insurance companies, credit services companies, banks (commercial and investment),
brokerages, savings and loans, non-Islamic mortgage companies, asset management companies, and REITS that
invest in conventional interest-based mortgages and/or properties used for non-halal enterprises such as casinos.
 114

restrictions on investing in financial companies and companies with high debt loads actually

shield the Islamic funds somewhat from the carnage in the markets? The answer is a qualified

yes.

In the current global financial crisis, there have been three important watermarks for US

markets. The first occurred around August/September 2007 when the liquidity crisis began to

emerge. The “credit crunch”, as it came to be called, was marked by financial and debt markets

seizing up, blocking off lifelines of credit and funding for large and small businesses alike.

Turmoil in the home-loan and mortgage markets gradually began to seep out into the rest of the

lending world. Stock markets across the world were sent into a tailspin, dragging the returns and

value of many portfolios down with them.

Figure 16. Holding Period Return, Post September 2007

10%

0%
AEIFX IMANX VFINX VWUSX VEIPX AMAGX AMANX
-10%

-20%

-24.16%
-30%
-31.15%
-34.68%
-40%
-39.66% -39.55%
-41.08%
-44.21%
-50%
Source:

Author's Calculations

Figure 16 depicts the holding period returns of all seven portfolios after September 2007

(the holding period is September 2007 to December 2008). VFINX, shaded purple, represents the

benchmark for comparison. The results of this analysis are very interesting. Two of the Islamic

portfolios, AEIFX and IMANX, underperformed the benchmark fund, down 44% and 41%
 115

respectively. At the other end of the spectrum, the other two Islamic portfolios, AMANX and

AMAGX, performed relatively well during the holding period.

The first quarter of 2008 was another watershed moment in the current crisis. The quarter

began with extremely high market volatility, both in the US and abroad. The pain did not stop

there; March 2008 saw both the collapse of fabled investment bank Bear Stearns and the

government takeover of Fannie Mae and Freddie Mac. These events sent further shockwaves

through the markets and financial stocks were among the most severely affected. The pattern

shown above again plays out below in Figure 17. AMANX and AMAGX performed well against

their peers during 2008, despite the unprecedented upheaval in the financial markets and the

broader economy.

Figure 17. Holding Period Return, 2008

10%

0%
AEIFX IMANX VWUSX VFINX VEIPX AMAGX AMANX
-10%

-20%

-23.14%
-30%
-29.31%
-31.20%

-40% -37.58% -36.66%

-41.52%
-43.63%
-50%

Source: Author's Calculations

The third shoe to drop in the course of the crisis came in September 2008, which

witnessed the fall of another Wall Street pillar, Lehman Brothers. Unlike Bear Stearns, which

was acquired in the eleventh hour by rival JP Morgan Chase with the backing of the federal

government, Lehman Brothers was forced into bankruptcy. The bankruptcy filing sent already

fragile markets into a vicious, breakneck freefall, which eventually led Congress to enact the
 116

Troubled Asset Relief Program (TARP), administered by then Secretary of the Treasury Henry

Paulson.

Figure 18 shows the holding period returns for each of the portfolios from September

2008 to December 2008. After this third shock, AMAGX and AMANX yet again displayed good

performance. No portfolio was spared in the carnage that ensued after the fall of Lehman

Brothers, but these two funds performed arguably well and caused their shareholders much less

anxiety that most other funds.

In this recent environment, a lack of financial stocks was a definite advantage for the

Islamic funds. In the midst of fears about mortgage related securities and other toxic assets,

shares of banks, brokerages, and other financial companies were hit hard. The restrictions of the

Sharia did provide a degree of insulation from the market turmoil.

Figure 18. Holding Period Return, Post September 2008

10%

0%
IMANX AEIFX VFINX VWUSX VEIPX AMAGX AMANX

-10%

-12.67%

-20% -18.68%
-19.42%
-22.61% -22.45%
-25.92%
-30% -27.22%

Source: Author's Calculations

However, only the Amana funds seemed to be the beneficiaries of this protection, while

the Iman Fund and the Azzad Ethical Income Fund suffered even worse than the conventional
 117

funds. So while the lack of financial companies does seem to explain a part of the Amana Funds

excellent performance, it does not tell the whole story.

The other factor that probably helped the Amana funds perform so well was the fact that

their managers began to build strong cash positions in August 2007. New investors’ funds were

not placed into equities, and cash levels subsequently rose to around 30% of assets (obviously

these were not held in interest bearing securities) (Mamudi, 2009). These cash positions helped

to mitigate the impact of the havoc raging in the markets on the funds’ performance. In contrast,

the other two Islamic funds kept the majority of their assets in equities.

The Strength of the Amana Funds

The strong and consistent performance of the Amana Funds comes as no surprise. While

the funds are not widely known to most investors, both have consistently been top performers

and their managers at Saturna Capital are also well regarded. Most importantly, the funds belie

the criticisms leveled against socially conscious and faith based funds discussed earlier in the

chapter. Both funds have been continually ranked among the best performing funds in their

respective categories for years.

The Amana funds’ Islamic restrictions and investment rules have also contributed to their

performance, even before the current crisis hit. The low debt requirement has led managers to

some profitable investments. Nicholas Kaiser, the funds’ manager, bought shares of construction

company Washington Group International after research revealed that it had zero debt. The firm

bought the shares at $55; they later sold the position at $91.50 after a takeover offer caused the

stock to rise. The restriction on investing in companies whose debt levels exceed 33% also

helped the funds escape from some potentially disastrous choices. For example, Enron

Corporation met the other criteria for inclusion in AMAGX, but its debt level prevented the fund
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from investing. In addition, the Amana funds’ low turnover rate (which measures how often

stocks are bought and sold) is around the very low level of 10% annually; this strengthens

performance and cuts costs associated with frequent trading, such as capital gains taxes and

trading fees (the frequent trading of stocks is seen as a form of maysir). On the whole, these

guidelines also make the Amana funds appealing choices for long term minded investors, both

Muslim and non-Muslim (Cui, 2007, pp. C1-C2). The performance of the Amana funds within

the period studied provide strong evidence that investors in socially conscious funds need not

fear being penalized for adhering to their beliefs.

Conclusion

Islamic investment is, at its core, a subset of ethical investment in that it is guided by a set

of essential, intrinsic beliefs, values, and social standards. Both Islamic investment and ethical

investment in general have faced a barrage of criticism from “traditionalists” who cling steadfast

to the principle that emotions and other subjective criteria should be divorced from the

investment decision. Indeed, some studies have pointed to the existence of an opportunity cost

associated with investing according to one’s ethical or religious principles. It is true that ethical

investment and Islamic investment in particular can result in a very restricted investment

universe, as well additional costs of operation. At the same time there have been numerous other

studies, including this one, that suggest positive benefits. A key advantage of social investing is

that it tends to be conservative, favoring a value oriented strategy that focuses on long term

return and gain. Furthermore, the restrictions maintained by some social funds have helped their

investors steer clear from stocks that eventually came to be severely punished in the market, as

we have seen in the case of Islamic stocks and their fortunate exclusion of financial firms and

debt laden companies in the wake of the credit crunch. The results of the foregoing analysis offer
 119

compelling evidence that Muslims need not necessarily fear being penalized for attempting to

adhere to the precepts of the Sharia. Indeed, the Islamic funds, especially the Amana Funds,

often offered superior performance relative to their conventional rivals.

One should not think that equity portfolios are the only investment vehicles available to

Muslims who choose to adhere to the Sharia in their financial decisions. There are several other

Islamic asset classes and investment alternatives that they may choose from, as we shall see.
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CHAPTER VI. OTHER ISLAMIC ASSET CLASSES AND INVESTMENT

ALTERNATIVES

Introduction

With all the restrictions imposed by the Sharia, it would seem that Muslim investors are

limited to investing in equities and not much else. However, this is not the case. The focus of this

work may be on equity portfolios, but there are a number of different Sharia compliant asset

classes that are available to Muslims. In addition to other special classes of valuable assets that

can comprise a portfolio, such as fine art, jewelry, antiques, and the like, there are many new

types of Islamic securities and financial vehicles that are being developed to suit the needs of

Muslims. Depending on their level of individual wealth, Muslims can deploy their financial

capital in a variety of contracts and assets that are acceptable to Islamic protocol. The purpose of

this chapter is to explore these investment alternatives in greater detail. We will begin with a

brief discussion about the process of securitization in Islamic finance.

Securitization in Islamic Finance

Even before the recent meltdown in the mortgage market, securitization had become a

standard process in contemporary Western finance. It allows financial institutions to originate

tradable, liquid financial instruments from a wide variety of other financial assets, not only

mortgages, but also receivables and loans. This process, which can only take place with assets

which have an associated cash flow, leads to the creation of an asset backed security. It has

become a powerful tool in modern finance. Presumably, the recent mortgage collapse will only

be a temporary setback in the continued use of securitization in the financial world.

However, from the advent of collateralized debt obligations in the 1980s, securitization

has been greeted with an unfriendly reception by many Muslim jurists, who are keenly averse to

new financial instruments secured by debt. This is due to the fact that the sale of debt is strictly
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prohibited in Islam. Likewise, contemporary jurists – some in Malaysia are notable exceptions –

have also prohibited trading in debts and liabilities. General trading of one liability for another

has been forbidden due to gharar, which would arise from uncertainty about the delivery of

either compensation. However, classical jurists ruled that it is permissible to cancel one debt

against another of equal amount and maturity (maqassa). Forwarding a debt to a third party –

hawala – is also permitted. Most modern jurists hold that selling a liability to the debtor was

halal, with the qualification that the debt must be sold at or below face value to the debtor

himself (El-Gamal, 2006, pp. 102-106).

Real Estate

Buying, maintaining, leasing, and selling real estate is fundamentally a permissible

business in the eyes of the Sharia. Real estate is one of the most widely used methods of

investment in the West (even though it has been associated with some spectacular bubbles and

panics, such as the current financial crisis which, as noted, was precipitated by flawed mortgages

and mortgage-backed securities). Real estate and property development is a key industry in the

Middle East, the Arab world, and the Muslim world. However, investing in real estate generally

requires having a substantial amount of capital readily available with which to purchase and

develop properties. Few individual investors have the financial resources to invest in real estate

on a wide scale. Even for those who do possess the financial wherewithal to do so, it may not be

feasible or efficient for a number of reasons. Consequently, investing in a real estate investment

trust, or REIT, is usually a more suitable option.

A REIT is an entity that invests in different kinds of real estate or real estate related

assets. The properties can be of a residential nature, or be commercial real estate properties, such
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as offices, hotels, and malls. Many REITs specialize in one type of property. REITs can also

invest in mortgages secured by real estate. There are three principal types of REITs:

1. Equity REITs are the most common type of REIT. They invest in, or own real estate

and distribute profits to their investors from the rents they collect.

2. Mortgage REITs provide funds to real estate owners and developers. In addition,

they invest in financial instruments that are secured by mortgages on real estate.

3. Hybrid REITs are a combination of equity and mortgage REITs, as their name

suggests.

In order to be classified as a REIT, an entity must conform to several specific guidelines enacted

by the IRS. A company must pay 90% of its income to investors annually. The firm must also

invest at least 75% of its total assets in real estate. Lastly, the company has to earn 75% or more

of its gross income from investments in real property and/or mortgages tied to real property

(Securities and Exchange Commission, 2004).

Equity REITs represent the most permissible option for Muslims (unless of course a firm

invests in Islamic mortgages), which hold the majority of their assets in the form of real estate.

The majority of their income also comes from rent. And because REITs are legally required to

pass much of their income on to investors in the form of dividends, REITs are an excellent

investment option for Muslims looking for reliable, stable sources of income. Furthermore,

REITs have exhibited low correlations with other asset classes – which means that they are

suitable for diversification, thus making them useful additions to any equity portfolio.

However, in terms of Sharia compliance, REITs do have an Achilles heel; they are

usually highly leveraged. The optimal level of debt for the average REIT is somewhere in the

40% to 60% range, well above the commonly accepted cutoff of approximately 33%. Since
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REITs offer such desirable benefits to investors, two approaches have been suggested that would

allow Muslim investors to reap the benefits of these securities. First, the principle of maslaha is

often invoked; since REITs offer such clear advantages to investors, a higher debt benchmark

should be used to screen them. A debt to asset ratio of 50% is considered a reasonable

benchmark. The second approach, offered by Mahmoud El-Gamal, is to consider only non-

mortgage or unsecured debt when computing debt to asset or debt to market capitalization ratios

during screening. All secured or mortgage debt can easily be “Islamized” through a number of

Islamic contractual forms. In a recent study, El-Gamal examined thirteen REITs, and found that

when unsecured debt-to-assets ratios were employed, ten of those REITs actually passed the

33% screen (El-Gamal, 2006, pp. 129-132).

Private Equity and Venture Capital – Mudaraba and Musharaka

Profit and loss sharing (PLS) is the ideal business form in Islamic finance in that it

promotes equity and the sharing of risk and reward between parties. The partnership is the

primary expression of this principle, and is highly regarded in Islamic financial fiqh. The use of

partnerships in Arabia predates the Islamic period, and is highly revered in the Arab and Muslim

worlds. Many of Muhammad’s Companions entered into partnerships during and after his

lifetime. Forms of partnership are recognized and legalized in both the Quran and the Hadith.

Christians who lived in Muslim controlled areas of Europe were likely thus inspired by the Arabs

and Muslims to adopt the practice and spread it to other parts of the Continent. Partnerships have

a long and rich tradition in classical Islamic jurisprudence (Ayub, 2007, pp. 307-311).

This chapter will focus on the two main forms of partnerships in use in contemporary

Islamic finance: mudaraba and musharaka. These two forms are considered by many jurists and

scholars to be the workhorse of true Islamic finance, and the two forms that contribute the most
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to Islamic finance’s goals of productivity, equity, and PLS. In many jurists’ opinion, mudaraba

and musharaka constitute the axis on which modern Islamic finance is supposed to turn.

Mudaraba

A mudaraba (also known as a qirad and muqarada by the Shafii and Maliki schools

respectively) is a silent partnership between an investor or investors, or sleeping partners (known

as the rabb al-mal) who provide capital to an agent (the mudarib) who acts on their behalf. The

mudarib invests the capital on behalf of the investors. The investors and the agent share the

profits of a venture, if there are any, according to a pre-determined ratio. For example, the

contract may specify that the investors receive 60% of the profits while the mudarib receives

40%. Capital losses are borne strictly by the investor, while the agent loses his or her time and

any profit he or she would have realized had the venture been successful. The mudarib may only

use the funds for purposes that are explicitly defined in the contract. At the conclusion of the

mudaraba transaction, the mudarib must return the principal and the predetermined share of

profit to the investors.

In terms of the business of the mudaraba, the mudaraba can be either restricted or

unrestricted. In a restricted mudaraba, the mudarib may only engage in the business or

businesses specified by the rabb al-mal. In the unrestricted mudaraba the rabb al-mal leaves it to

the discretion of the mudarib to engage in whatever businesses he or she wishes. In both types of

mudaraba, the business must of course conform to the religious litmus test in order to be deemed

acceptable.

The capital of a mudaraba must be currency and not any other form of real property; this

injunction exists in order to prevent gharar in that the price of the real property may fluctuate

before it is converted to cash. It is also impermissible to use a debt owed by the mudarib or
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anyone else to the rabb al-mal as capital. This stipulation is clearly meant to prevent the rabb al-

mal from guaranteeing the return of his principal and an illegitimate return on the loan, namely

the forbidden riba.

The rabb al-mal may impose restrictions on the mudarib, but the mudarib is afforded a

great deal of flexibility and freedom in deciding how to conduct business and earn profits. Every

madhhab with the exception of the Hanbalis does not permit the mudarib to use his own capital

in the venture. It is the duty of the mudarib to liquidate the mudaraba; however each madhhab

differs as to which party has the final say over the proper time of dissolution. The Hanbali and

Hanafi schools allow a mudaraba contract to specify a pre-determined duration, after which

mudarib may no longer conduct business on behalf of the investor(s) (Wakin, 1993, pp. 284-285;

Ayub, 2007, pp. 320-327; Warde, 1999).

Musharaka

The traditional musharaka is a full contractual partnership formed to pursue a specific

line of business or project. The project can be a new venture or an existing one that requires

additional capital. Each partner in the musharaka receives an equity stake in the venture – this is

the primary difference between the mudaraba and the musharaka. In contrast to the mudaraba, a

musharaka allows each partner to contribute capital and to jointly share in the profits and losses

of the venture. Another key difference between the two contracts is that in the musharaka each

partner not only contributes capital, but also contributes some amount of labor. Musharaka can

also include non-Muslims provided that the guidelines of the Sharia are observed. As in the

mudaraba, the capital infused in a musharaka must be a liquid asset i.e. money.

The musharaka is the modern Islamic contract that conforms most closely to the ideals of

Islamic finance in that it is true profit-and-loss sharing. Each partner receives profits or bears
 126

losses in proportion to the share of capital he or she provided. Some jurists argue that a partner

can receive more than the ratio of his or her investment as compensation for supplying more

labor to the musharaka. This view is held on the basis that labor is also an important factor in the

success of the venture and the generation of profit. Regardless of disagreements about the share

of profit, there is universal consensus on the point that losses must be shared in accordance with

the amount of capital invested by each partner (Latham, 1993, pp. 671-672; Ayub, 2007, pp.

312-318; Warde, 1999).

The Link to Modern Private Equity and Venture Capital

Even the most casual observer can appreciate the similarities that exist between

conventional Western private equity and venture capital structures and the two main forms of

Islamic PLS, mudaraba and musharaka. Both focus on creating a partnership between lender and

borrower, with financiers actively involved in the management of the venture and ensuring that it

is as profitable as possible. Islamic PLS and venture capital feature long term commitments on

the part of financiers to entrepreneurs and their ventures, rather than the short term focus of

conventional, interest-based lenders.

This type of investment is not limited to very wealthy Muslims or Islamic institutional

investors. There are two avenues through which middle class Muslims can also participate in

mudarabas and musharakas. First, there is the “double mudaraba”, a contract endorsed by Frank

Vogel, the director of Harvard Law School’s Islamic Legal Studies Program. The structure of the

double mudaraba is simple. Investors place their capital with an Islamic financial institution in a

primary mudaraba, thereby making the institution a mudarib. The institution then invests those

funds, as well as its own capital, with entrepreneurs in a number of secondary mudarabas. The

institution then can redistribute its profits from these secondary ventures to its own primary
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investors. Second, Islamic PLS offers the potential to develop a secondary market of mudaraba

and musharaka certificates in which both Muslims and non-Muslims alike could invest. Indeed,

mudaraba certificates have been in use since the early 1980s (Warde, 1999; Ayub, 2007, p. 389).

Islamic Bonds – Sukuk

Muslims are prohibited from investing in conventional bonds, but they do have an

Islamic alternative. This alternative is known as a sakk (plural: sukuk), the Arabic term for bond

or certificate. Before the advent of sukuk, it was widely held than an Islamic debt market could

not be developed due to the Sharia prohibition on the sale of debt. But the materialization of

different types of sukuk has demonstrated that some feature and benefits of a debt market can be

made available to Islamic firms and investors.

Many participants are involved in a typical sukuk issuance, but there are always four key

players:

1. The originator or issuer

2. The special purpose vehicle (SPV), which is incorporated specifically for the

securitization process, managing the issue, and purchasing the underlying assets from the

issuer

3. Investment banks

4. Subscribers to the issuance, which are usually central banks, Islamic banks, and

individuals (Ayub, 2007, p. 393)

Sukuk can be issued on the basis of Islamic contracts such as ijara. They can be either

variable return sukuk or fixed return sukuk. There are various categories of sukuk that are based

on Islamic financial contracts, such as mudaraba, musharaka, and ijara (Ayub, 2007, p. 396).
 128

Since lease backed sukuk are some of the most popular in contemporary Islamic finance, we will

use that structure as an example for a typical sukuk transaction.

Tabreed

2. Leases assets of the 3. Lease payments and

trust (sold back at exercise price on
maturity) dissolution event

4. Periodic payments
and/or dissolution
payments
1. Sells trust shares

Tabreed SPV Sukuk

Holders
1. Sale price = 1. Sukuk
$100 M proceeds =
$100M

Figure 19. Tabreed Sukuk Transaction Structure 27

In March 2004, Tabreed Financing Corporation, an SPV of the National Central Cooling

Company (United Arab Emirates) issued $100 million in corporate sukuk. At first glance, the

diagram above seems complex. However, the transaction was completed in a rather simple,

straightforward manner. Tabreed held trust assets – in the form of central cooling plants – in trust

for the sukuk holders. These plants were purchased by Tabreed with the proceeds of the sale of

the sukuk. Tabreed leased the plants back to NCCC, which subsequently made rental payments to

Tabreed. In turn, Tabreed redistributed these rental payments to the holders of the sukuk. When

the sukuk matured, NCCC would purchase the plant from Tabreed. In addition, if any

27
Diagram from El-Gamal 2006 p. 7
 129

“dissolution event” such as the destruction of the plants or anything else that would stop the flow

of rental payments, had occurred, then payments would have continued in the form of a

repurchase price (El-Gamal, 2006, pp. 5-7).

Sukuk hold an enormous amount of potential for the Islamic financial industry. They can

be used for liquidity and fund management as well as for monetary policy. Indeed, Sudan uses

them to control liquidity in its economy. In addition to Middle Eastern and Muslim majority

countries and firms, corporations in Europe and Japan are beginning to tap the sukuk market in

order to raise short term and long term funds. Sukuk also promise to be instrumental in raising

the huge amounts of funds needed for infrastructure development in the Muslim world (Ayub,

2007, pp. 389-415; El-Gamal, 2006, pp. 102-116).

Call and Put Options

While call and put options, which are equity derivatives, may be exotic for some

investors in the West, they are nevertheless popular investment instruments and constitute an

important part of many investment strategies. Simply put, an option is the right to buy (call

option) or sell (put option) shares of common stock at a specific price during a specified time

period. In a call option contract, a party (not the company in question) issues the call option to

buy a company’s common stock within a certain time frame for a certain strike price, which may

then be bought by another investor. Conversely, an investor who holds a put option has the right

to sell shares of a company’s stock at a designated strike price within a certain time period. Put

options are an excellent tool for investors who believe that a stock price will decline in the future,

or for someone who owns shares of a certain company and want to protect themselves from a

price decline (Reilly and Brown, 2006, p. 86). If the price of the stock moves in the holder’s
 130

favor, the holder can exercise his or her right to buy or sell the stock at the strike price. The

holder can simply abandon the options contract if the price moves unfavorably.

As useful as they may be, options are considered impermissible under the Sharia by many

Islamic scholars to be. This is because delivery of a good (in this case a stock) must be given and

taken in accordance with a contract regardless of price movements. Because an option grants the

right, not the obligation, to purchase or sell a stock on or before a date of expiration, many

Islamic scholars feel that options are thus not compliant with the Sharia.

However, as in nearly all issues relating to the interpretation of the Sharia, there are some

scholars who feel that call and put options may be made permissible through the use of arbun. In

an arbun contract, a buyer agrees to purchase some asset and makes an advance payment, which

is less than the full purchase price. If the buyer decides to accept the asset, then she will pay the

purchase price less the amount of the advance. If she decides not to take the asset, then the seller

keeps the advance. Interestingly, classical law does not require a time limit to be fixed to this

contract. The arbun is Islamic finance’s closest answer to the call option. The Organization of

the Islamic Conference (OIC) Academy endorsed arbun with the stipulation that a time limit be

specified in the contract. 28

Many (if not most) scholars feel that arbun is a void contract. The lack of a time limit

requirement makes the contract unacceptably indefinite. If the buyer decides not to take the

assets, the seller still gets to keep the advance or down payment, which many scholars consider

to be an unjust enrichment (akl al-mal bi al-batil). Also, some scholars also cite a hadith in

28
A put option, however, is another story. The most analogous Islamic financial contract to a put option is the third
party guarantee (TPG), which are usually provided by Islamic banks. The TPG is used to guarantee the installment
payments of customers who have bought goods through murabahas. Thus the TPG can be seen as the Islamic
alternative to the default penalty used in conventional finance. The bank is paid an administrative fee, which cannot
be expressed as a percentage of the contract’s value, by the customer who buys the good or goods. The TPG is a sort
of put option for the purchaser; if they decide to stop paying the balance of the installment payments for the good for
whatever reason, they can theoretically surrender the asset to the bank. This acts as a put option where the strike
price is equal to the unpaid installment payments. (Vogel and Hayes, 2006, pp. 228-229).
 131

which Muhammad forbade the contract. The Hanbalis are the only madhhab that endorses arbun,

citing other hadiths and stories from early Islam they feel lends credence to the contract. Some

Hanbalis insist that a time limit be placed in the arbun contract, while most do not (Ayub, 2007,

pp.209-210; Vogel and Hayes, 2006, pp. 156-164).

Preferred Stock

Preferred shares are another popular investment option in conventional finance.

Sometimes used to meet the long term equity needs of an established company, preferred shares

of stocks often carry distinct benefits that common shares do not. Although they usually do not

have voting rights, preferred shares typically are senior to common shares in the payment of

dividends and other payouts and in the event of bankruptcy liquidation. Preferred shareholders

are paid after bond holders and before common shareholders in a bankruptcy. Almost all

preferred shares have some sort of fixed dividend amount, negotiated with the corporation. There

is no consensus on whether or not preferred stocks are Sharia compliant. It is accepted that while

one group of shareholders cannot receive a higher/more senior fixed dividend than other

investors, they can have a higher payout ratio. Ideally, the owners of the class of stock with the

higher payout ratio would pay a premium for this privilege, or would forego other advantages,

such as voting rights (Vogel and Hayes, 2006, pp. 196-197).

Interest on Bank Deposits

In the West, deposits in a bank are liabilities as they are considered to be loans from

depositors to the institution. Islamic financial theory views deposits in much the same way, and

thus the Islamic rules regarding loans apply to them. Contemporary Muslim scholars

consequently view the interest paid on conventional bank deposits to be forbidden. This view

was endorsed in 1965 at a conference of Islamic scholars in Cairo (Hardie and Rabooy, 1991, p.
 132

59). Likewise, depositors may not receive free services while they hold accounts at a bank

because the services are considered a form of return. Muslims are forbidden to receive interest,

no matter if it is in the form of money or services. The bank would also be in the wrong if they

could easily repay the depositors’ funds, which are considered loans (Hardie and Rabooy, 1991,

p. 64).

Zero Coupon Bonds and Islamic Certificates of Deposit

Zero Coupon Bonds

Zero coupon bonds by definition yield no interest. So at first glance, it seems like these

instruments would be perfect investment choices for Muslims. However, such bonds are issued

at a discount to buyers relative to other bonds and debt instruments available in the marketplace.

It can be argued that this means that the discount can be influenced by or even determined by the

interest rates on other securities. Samuel Hayes, a professor of the Harvard Business School who

has written prolifically on issues in Islamic finance, sees no point at which interest is not built

into the price of a zero coupon bond (S. Hayes, personal communication, November 4, 2008).

Islamic Certificates of Deposit

Traditional CDs are riba based, and are thus unacceptable for Muslim investors. However,

certificates based on murabaha deposits are a Sharia compliant option, and can even be tradable

in a secondary market. These certificates will undoubtedly be much riskier than traditional CDs.

First, the returns on such investments’ underlying deposits are only known ex post facto rather

than ex ante, which may cause their market value to fluctuate and vary from the redemption price.

This risk can be mitigated somewhat by the shorter the time to maturity. Unlike conventional

CDs whose returns are determined largely by macroeconomic variables, the returns on Islamic
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CDs would be influenced primarily by microeconomic conditions, because it is the profits of the

Islamic bank or company that determine the return (Wilson, 1991, pp. 205-214).

Conclusion

Despite the number of restrictions that Muslim investors face, there are a number of

investment alternatives available for their use. Islamic financial institutions and increasingly,

Western financial institutions, are in the process of developing and engineering new Sharia

compliant products and services designed to meet the needs of their clientele.

But the industry is currently prohibition driven. Most practitioners of Islamic finance

focus solely on replicating conventional, interest based financial products using medieval Islamic

contracts such as murabahas. This preoccupation invariably leads to the formulation of hiyal, or

legal ruses, to circumvent these prohibitions. The prohibition-focused nature of the Islamic

financial industry has caused some Islamic financial institutions to lose sight of the broader aims

of Islam and the Sharia. Unfortunately, it also provides a fertile breeding ground for

manifestations of the phenomenon known as Sharia arbitrage.

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CHAPTER VII. SHARIA ARBITRAGE

Introduction

Islam is the world’s fastest growing religion, and it is no surprise that this growth is

accompanied by a concurrent rise in demand for financial and business products that fit within

the confines imposed by ubiquitous Islamic religious restrictions. This represents a major source

of opportunity for financial institutions seeking new customers and business.

Many of the products developed for the nascent Islamic finance industry are based upon

nominate contracts developed during the early centuries of Islamic jurisprudence, as discussed in

chapter IV. While this backwards-looking approach has provided a strong foundation for the

industry, it can also lead to a phenomenon known as Sharia arbitrage. As we shall see, Sharia

arbitrage is a severe handicap for the industry, in terms of both innovation and reputation.

What is Sharia Arbitrage?

In finance, there are two kinds of arbitrage. The first type is the textbook definition of

arbitrage. When the fundamental “law of one price” 29 breaks down in practice, opportunities to

engage in arbitrage arise. A specific tangible good has different prices in different markets. An

arbitrageur can purchase the good in market A, where it has a lower price, and resell it in market

B, where it has a higher price. Minus transactions costs, the difference between market B’s price

and market A’s price represents the arbitrageur’s profit. The second type of financial arbitrage is

regulatory arbitrage. When a financial product or service is banned in country A, but allowed in

country B, financial professionals can synthesize a new product that mimics the attributes of the

disallowed product for use in country A.

29
This theory states that in an efficient market all identical goods must have only one price. This also applies to
services but since services are not easily transferred across borders, most economists focus on tangible goods.
 135

Sharia arbitrage, a term coined by Mahmoud El-Gamal, is a form of regulatory arbitrage.

Simply put, Sharia arbitrage occurs when Islamic financial institutions create and sell Islamic

versions of conventional financial products, usually at a premium. The term ‘Sharia arbitrage’

may be new, but the phenomenon itself has existed for centuries. In Medina, during the time of

the jurist Malik, various hiyal were being used to skirt the prohibition on riba (Hassan and Lewis,

2007).

Sharia arbitrage can occur because Islamic finance is currently a prohibition-driven

industry which serves a captive market of Muslims who must adhere to those prohibitions and

would rather not use conventional financial products. But the Islamic finance industry uses those

conventional financial products as the inspiration for its own products, and seeks to create

alternatives that closely mirror the properties of conventional products while still being deemed

permissible (El-Gamal, 2006, p. 175; El-Gamal, 2005, pp. 117-119). Furthermore the diversity of

juristic opinion espoused by different madhhabs and Sharia boards can also engender

opportunities for Sharia arbitrage (Aktar, 2007).

How Sharia Arbitrage Works

As currently practiced, Sharia arbitrage occurs primarily through two main methods. The

first method is dual characterization of financial contracts, and the second method is through

using degrees of separation in financial contracts.

Dual characterization refers to the use of two sets of terms, one for jurists and one for

regulators, in Islamic financial contracts. An example of this method is murabaha financing of

home buying (i.e. a bank buys a home, and then sells it to a Muslim customer for the price plus a

credit markup). Regulators see this as secured lending (which is un-Islamic) and customers view

the contract as safe, because it does not violate the rigid restrictions of Islamic law and in fact
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has the approval of the Sharia board. The mortgage documents often feature terms like loan,

interest, and borrower, but Sharia boards of US Islamic home finance providers assure Muslims

that these terms are only included to meet US regulatory requirements. Customers can even

deduct the “markup” component of the mortgage on their annual taxes (El-Gamal, 2005, pp. 120-

122).

The second major method of Sharia arbitrage is the use of degrees of separation. With

this technique, different segments of a financial contract are viewed individually rather than as a

whole. By using multiple degrees of separation, an otherwise impermissible transaction can be

made Sharia compliant. Consider the following telling examples provided by El-Gamal (2005):

1. B sells a stapler to A, for the cash price of $100. A turns around and sells the
stapler to B for a credit price of $105 payable in one year. This practice is called
“bay` al-`ina” (same item sale-resale). Some jurists (e.g. the Hanbalis) forbade it
based on Prophetic traditions, while others (e.g. the Malikis) forbade it based on
the principle of sadd al-dhara’i` (prevention of stratagems to achieve illegal ends
through legal means). However, some others (e.g. the Hanafi jurist Abu Yusuf
and Al-Shafi`i) allowed the contract, ruling on each of the two separate valid sales
separately. Provided that the second sale is not stipulated in the first, they
reasoned, one cannot forbid the practice based on speculation about the
contracting parties’ unobservable intentions.
2. C sells a stapler to A, for the cash price of $100. A sells the stapler to B for the
credit price of $105 payable in one year. B sells stapler to C for the cash price of
$100. This practice is called Tawarruq (literally, monetization – of the stapler in
this example). Abu Hanifa contemplated this contract as a variation on the previous one,
with a third party serving as intermediary (muhallil). While he forbade the simple `inah
(without a third party), he was more accommodative of Tawarruq. Most jurists
considered Tawarruq invalid, defective or reprehensible. However, there were two
reports on ibn Hanbal’s opinion on this contract, thus allowing a faction of the Hanbali
school to approve the contract, which is quickly replacing Murabaha as the favorite mode
of financing in the GCC.

3. C sells stapler to A, for the cash price of $100. A sells stapler to B for credit price of $105
payable in one year. B sells stapler to D for cash price of $100. D sells stapler to C for
cash price of $100. Now, we have added two intermediary entities (C and D) between
lender (A in all examples) and borrower (B). Contracts with larger numbers of
intermediaries do not have explicit names in classical jurisprudence, and were not
discussed in their writings (pp. 123-124).
 137

Adding multiple degrees of separation to a contract allows Sharia arbitrageurs to circumvent

Islamic prohibitions and replicate conventional financial products. Since adding many degrees of

separation can be expensive in terms of transactions costs, bankers tend to keep them to a

minimum (El- Gamal, 2005, pp. 123-124).

The Dangers and Consequences of Sharia Arbitrage

Sharia arbitrage poses a number of dangers to the long term development of Islamic

finance, and its effects could have far-reaching consequences for the nascent industry.

First of all, Sharia arbitrage leads to higher transactions costs and economic inefficiency.

As evidenced by the degrees of separation approached described above, Sharia arbitrage usually

adds extra costs to contracts due to superfluous and unnecessary transactions. Another example

of this is the incorporation of special purpose vehicles (SPVs) to conduct parts of certain

transactions. And of course there are the fees associated with hiring lawyers and jurists to

structure and package products and certify their permissibility (El-Gamal, 2005, p. 127).

The methods of Sharia arbitrage also bear a striking and disturbing resemblance to

methods of financing criminal activities. The use of SPVs, which can be used in tax evasion, and

the numerous degrees of separation, which divide funds from their final destinations, can both be

used in money laundering and other criminal activities. In addition, because Sharia arbitrage uses

many of the same strategies, this may expose the industry to abuse by criminals who wish to use

Islamic financial contracts to conceal their financing activity and fund their illegal operations.

This possibility is especially troublesome in a post 9/11 world where Muslim movements are

often viewed with suspicion (El-Gamal, 2006, pp. 176-177; El-Gamal, 2005, pp. 128-130).

The deleterious effects of Sharia arbitrage’s nature also pose a significant threat to the

overall health of the Islamic finance industry. Sharia arbitrage is quite lucrative in its early stages;
 138

even after accounting for added transactions costs from inefficient contracts and products, profit

margins are still attractive. Like any competitive industry, the existence of profit leads other

firms to enter the market. The proliferation of competition forces existing players to seek out

new avenues of business and find ways to cut costs. This drive to cost-cutting may lead some

firms - especially those who do not have the size, scope, and economies of scale enjoyed by

mammoth players like HSBC - to sacrifice quality in their operations, such as by incorporating

SPVs in less reputable areas. This can lead to Enron-like scandals and loss of confidence in the

Islamic financial industry (El-Gamal, 2006, pp. 181-183).

Sharia arbitrage in Islamic finance is preoccupied with manipulating medieval

jurisprudence contracts to replicate conventional financial products. Through complex financial

engineering, new products can be created that follow the form of Islamic law but not its spirit

and allow users to engage in speculation (Yashpal, 2008). This mere imitation of conventional

products lends credence to the argument that many firms’ products adhere to the Sharia in form

but not substance. The focus on imitation rather than on innovation to meet the needs of Muslims

is a serious defect of IFIs which practice Sharia arbitrage in the opinion of many scholars and

experts. Thus Sharia arbitrage can damage the credibility of the industry in the eyes of Muslims

(El-Gamal, 2006, pp. 183-184). When “Islamic” products differ from conventional products only

in minute details, both potential and existing customers may feel alienated from the industry.

Some may even turn to conventional financial products and services.

Moving Forward

As it exists now, Islamic finance is a prohibition driven industry. In everything from

scholarly literature to newspaper and magazine articles, the main interest is clear; IFIs, Sharia

boards, ordinary Muslims, and outside observers continually fixate on the haram. As we have
 139

seen, this single minded focus provides a fertile breeding ground for the growth and proliferation

of Sharia arbitrage. We have also seen the destructive attributes of Sharia arbitrage that pose a

real danger to the industry’s long term growth, stability, and reputation.

Sharia arbitrage’s most harmful effect however is that it can and most likely will lead to

stagnation in this small yet growing industry. Islamic finance is developing at a rapid pace, but it

is still a niche market. If those in the industry hope to maintain this rate of growth so that Islamic

finance becomes a viable, attractive alternative to conventional finance, it must drop this current

mode of imitation. Bankers and jurists should focus on creating and innovating unique products

of their own rather than simply replicating conventional financial products. On a deeper level,

the industry must move away from trying to satisfy form to delivering true substance, namely by

seeking and embodying the aims of Islam. Only in this way can the industry retain its current

customers and attract new ones.

It has been acknowledged that the Islamic financial industry currently tends to serve high

net worth Muslims who are looking for “Islamic” products that mimic conventional ones and are

satisfied with these products’ Sharia-board certifications.

However, it is not this relatively small group that will provide the basis for sustained, long term

growth of the industry. Rather, it is middle class Muslims, and poor Muslims who aim to reach

that socioeconomic status, who will constitute the largest and most important consumer segment

for the industry. The Islamic finance industry cannot afford to ignore this already large and

growing middle class. Furthermore, this class of Muslims tends to be well-educated and not as

complacent in their acceptance of Sharia board pronouncements (El-Gamal, 2006, p. 176;

Wharton School of Business, 2004). Muslims are not unintelligent; they are well aware that

many products offered by the Islamic finance industry are Islamic in name only. They are not
 140

fooled by Arabic names and dual characterization; indeed these attributes of Sharia arbitrage are

more likely to disenchant them than earn their business and trust. Attracting this class of

customers will require that the industry shift away from Sharia arbitrage to products that offer

economic efficiency and represent a sincere effort to adhere to the ideals of the Sharia and Islam

as closely as possible.

It is not enough to focus on prohibitions and negative screens like those discussed in

chapter IV. In order to move forward, Islamic finance must also seek, support, and promote that

which is positive. In numerous places in the Quran, Muslims are commanded to enjoin what is

good and forbid what is wrong. 30 Ergo, Muslims must not only refrain from sin and push others

to do so as well, but they must also actively do the things that are good, i.e. the things that are

wajib and mandub. The overarching aim of the Sharia after all is to promote and protect the

welfare of man while bringing him closer to God. Specifically, the maqasid al-Sharia, previously

mentioned in chapter II, are the goals that the Sharia was designed to protect. Anything that

furthers and promotes these goals should be pursued and supported by Muslims in general and

the Islamic finance industry in particular. Islamic culture has a number of institutions and

features that are well suited to promoting the positive goals of the Sharia, such as waqf 31 and

zakat 32. The industry should try to develop and promote products that serve not just economic

goals, but further social and spiritual goals as well. It is only in this fashion that Islamic finance

can truly be called Islamic and differentiate itself from the conventional financial industry.

Conclusion

Islamic finance is an industry that holds enormous potential for both Muslims and non-

30
See Quran 3:110, 3:104, and 9:71
31
Waqf is a religious endowment, similar to a common law trust, which is exclusively dedicated to religious and/or
charitable purposes.
32
Zakat, one of the well known five pillars of Islam, is alms given to the poor. It is incumbent upon every Muslim to
set aside a specific portion of their income for zakat payments.
 141

Muslims alike across the world. Its guiding light – the Sharia – was meant to protect and promote

the best interest of humankind. The Sharia itself is imbued with a strong sense of fairness, justice,

equality, and social responsibility.

The current prohibition-focused nature of the Islamic financial industry is a handicap and

a hindrance that may prevent it from reaching that full potential. Furthermore, the phenomenon

of Sharia arbitrage poses a clear threat to the industry’s development, innovation, and reputation.

In order to move forward, practitioners of Islamic finance must loosen themselves from

the overzealous adherence to juristic form and the tendency to merely replicate conventional

financial products. If the industry ever wishes to emerge as a viable alternative to conventional

finance, it must abandon these propensities and recommit to the rich legacy of innovation and

originality that has characterized Islamic law for centuries. In doing so it will not just attract

Muslim customers, but also non-Muslims who are looking for a financially and morally

satisfying way to pursue their financial and business dealings.

 142

CHAPTER VIII. CONCLUSIONS

Due to the heightened interest that has surrounded Islam and the Middle East in recent

years, it is no small wonder that Islamic finance has received such an intense amount of attention.

This attention has led scholars and financial professionals alike to devote themselves to further

study of this exciting and fascinating field. Muslims too have turned to Islamic finance in

increasing numbers for the opportunity to exercise their faith in their financial dealings. This

swell of interest was a catalyst for this study. Specifically, the aim of this work has been to

investigate the performance of Islamic equity funds versus their conventional counterparts. On a

broader level, an analysis of Islamic law and the juristic underpinnings of modern Islamic

finance has been made in order to gain a deeper appreciation for its historical, theological, and

philosophical roots.

Islamic finance sits under the canopy of Islamic law. Indeed, Islamic finance cannot be

fully understood without first understanding Islamic law. And Islamic law in turn is a part of the

wider body of the Sharia, the true and righteous method of conduct for Muslims. Islamic law has

a rich history of innovation and healthy (oftentimes sharp) debate. It is fluid and changing,

nothing at all like the hardened monolith that it is often incorrectly assumed to be. While the

current era of Islamic law is characterized by a high degree of taqlid, it still can, should, and does

adapt to ever changing times. It rises to the challenges presented by the modern age, ones that

were never even conceived of during the time of Muhammad, with the same spirit possessed by

the jurists of old. The growth and development of Islamic finance, which uses the contracts and
 143

forms devised in Islam’s classical and medieval ages to construct financial products to meet the

needs of Muslims, is a testament to that spirit of adaptability.

The results obtained in chapter V indicate that Muslims may not necessarily have to pay

an opportunity cost for adhering to their faith in their financial affairs. While of course longer

time horizons are needed to make more certain judgments, the Islamic funds have charted

excellent performance over the time horizons considered and have performed well versus their

conventional counterparts. Indeed, the superior returns of the Amana funds have attracted the

attention and funds of non-Muslim investors as well.

That has important implications for global investors, both Muslim and non-Muslim. The

analysis of chapter V suggests that combining moral/ethical considerations with the traditional

risk vs. return standard may not lead to financial loss. Islamic investing and all socially

responsible investing are conservative by nature. It involves and encourages examining company

fundamentals and rewards corporate responsibility. This can help socially conscious investors

avoid being dragged down by companies penalized for unethical behavior and/or engaged in

businesses that do not comply with their specific standards. For example, the Islamic funds were

partly insulated from the turmoil in the markets during the last quarter of 2008 because of their

lack of financial stocks. Socially responsible investing is value investing, and can offer long term

gain and capital appreciation, rather than short term profits. Islamic investing in particular is

averse to speculation, which can lead to financial and economic instability, as this recent global

credit crisis and economic slowdown has shown us.

This study’s conclusions open up a multitude of opportunities for further research. First,

the future performance of the Islamic funds should be closely tracked and monitored. Longer
 144

time horizons will provide us with more information about their performance and quality of

management.

Second, as discussed above, the TIE’s positive screens could benefit from more debate

and input from Sharia specialists and individual Muslim investors. Furthermore, separate TIE’s

could be developed for each industry. For instance, the “proper treatment of animals” screen may

be better suited to companies in the clothing, health, and beauty industries than, say,

telecommunications companies. Each industry has different and idiosyncratic concerns that may

be better accounted for with its own TIE.

Above all, it is the author’s hope that this work inspires the creation and development of

new, innovative Sharia-compliant products with an equal focus on Sharia prohibitions and

positive benefits. While Islamic financial products should not solely mimic conventional

instruments, it is important to remember that Islamic finance and conventional, interest-based

finance are not always antagonistic, mutually exclusive spheres. Indeed, they can inform and

inspire each other. There are numerous conventional financial constructions that can be easily

adapted to Islamic standards. Search funds are an excellent example of the potential synergies

that exist between Islamic and conventional finance.

Created and developed over 25 years ago, a search fund is little known business model

that can offer outstanding long term return. In a typical search fund, entrepreneur(s) with little to

no practical, managerial experience (mostly graduates of elite business schools) are financially

backed by a small group of investors. The investors provide money for the entrepreneur(s) to

search for an attractive acquisition target – a promising business with revenue of $10 million to

$30 million dollars. Once the entrepreneur(s) find a desirable business, the investors finance the

company’s purchase. The entrepreneur(s) become managers of the company, where they can
 145

gain from the expertise and knowledge of the investors, who join the newly acquired company’s

board of directors. Studies have shown that the search fund investors can receive an average

annual return of 30 percent or higher (Bowers, 2009, p. B5). The search fund model can easily be

replicated through the mudaraba contract discussed in chapter VI.

The implications of this study reach far beyond the Muslim world. Islamic financial

products and contracts can be attractive to non-Muslim markets as well. Islamic finance is

buttressed by ethical principles that have broad-based appeal to Muslims and non-Muslims alike.

These same principles can help us create a more ethical financial system and illustrate the

similarities and common values that are present across the globe. As globalization and

technology tighten the linkages between us, long held assumptions about so-called barriers

between Muslims and non-Muslims begin to break down. Islam is a powerful force the world

over, and will undoubtedly remain so. Globally, Islamic finance is well suited to help accomplish

this paradigm shift. It has already taken root in the US financial system, as evidenced by the

Islamic equity funds profiled in this study, and is on track to gain market share in the foreseeable

future. Islamic finance can be used as a tool to introduce non-Muslims to Islam as a positive,

beneficial, and ethically-driven entity that seeks only the best interests of humanity and the

planet.
 146

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CHAPTER X. LIST OF APPENDICES

Appendix A. Portfolio Holdings of the Iman Fund

Appendix B. Portfolio Holdings of the Amana Income Fund

Appendix C. Portfolio Holdings of the Amana Growth Fund

Appendix D. Portfolio Holdings of the Azzad Ethical Income Fund

Appendix E. Portfolio Holdings of the Vanguard US Growth Index Fund

Appendix F. Portfolio Holdings of the Vanguard Equity Income Fund

Appendix G. The Good Money Indexes

a. Good Money and Dow Jones Industrial Averages

b. Good Money and Dow Jones Utility Averages

Appendix H. Dow Jones US Islamic Market Index Components

Appendix I. Glossary

Appendix J. TIE Example Rationale

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APPENDIX A. Portfolio Holdings of the Iman Fund – November 30, 2008

Company Quantity Market Value

United Technologies Corp. 3,500 169, 855
FedEx Corp 5,500 388,575
United Parcel Service, Inc.- Class B 6,200 357,120
Magna International Inc.-Class A (b) 1,500 42,165
Harley-Davidson, Inc. 1,200 20,412
Thor Industries, Inc 6000 93,840
PepsiCo, Inc. 3,600 204,120
Alexion Pharmaceuticals, Inc. (a) 9,000 302,940
Amgen, Inc. (a) 8,000 444,320
Genentech, Inc. (a) 5,500 421,300
Gilead Sciences, Inc. (a) 5,700 255,303
Seattle Genetics, Inc. (a) 10,000 86,600
Vertex Pharmaceuticals Inc. (a) 6,000 147,540
Agrium Inc. (b) 4,100 128,822
Ashland Inc 5,000 47,750
Monsanto Co. 1,000 79,200
Mosaic Co. 1,200 36,420
Syngenta AG - ADR (b) 2,300 82,846
Terra Industries Inc. 4,400 64,724
Zoltek Companies, Inc. (a) 8,000 64,400
Career Education Corp. (a) 5,000 92,400
The Brink’s Co. 5,500 119,735
CoStar Group Inc. (a) 2,000 65,240
Layne Christensen Co. (a) 3,000 67,740
Cisco Systems, Inc. (a) 13,500 223,290
Corning Inc. 13,300 119,833
EchoStar Corp. - Class A (a) 7,000 119,490
Harris Corp. 7,500 261,600
Infinera Corp. (a) 9,000 87,840
Juniper Networks, Inc. (a) 5,500 95,590
QUALCOMM, Inc. 8,200 275,274
Research In Motion Ltd. (a)(b) 1,100 46,717
Apple Inc. (a) 1,500 139,005
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Aecom Technology Corp. (a) 7,000 185,430

Chicago Bridge & Iron Co N.V. (b) 15,700 159,669
Foster Wheeler Ltd. (a)(b) 6,100 135,786
Granite Construction Inc. 7,500 321,675
Jacobs Engineering Group Inc. (a) 3,000 134,310
McDermott International, Inc. (a)(b) 5,300 51,675
Quanta Services, Inc. (a) 9,000 146,340
Vulcan Materials Co. 500 29,990
Ivanhoe Mines Ltd. (a) 15,500 36,580
Genuine Parts Co. 1,100 43,065
Brink’s Home Security Holdings, Inc. (a) 5,500 110,000
Chunghwa Telecom Co. Ltd. - ADR (b) 9,075 141,933
Pioneer Drilling Co. (a) 19,500 143,130
Acuity Brands, Inc. 8,000 215,680
AZZ Inc. (a) 5,000 120,300
Baldor Electric Co. 9,000 148,320
Rockwell Automation, Inc. 700 21,805
SunPower Corp. (a) 6,033 156,979
Agilent Technologies, Inc. (a) 3,300 62,139
Amphenol Corp. - Class A 3,000 69,660
FLIR Systems, Inc. (a) 3,000 93,060
NIDEC CORPORATION - ADR (b) 8,300 102,754
ScanSource, Inc. (a) 3,000 51,030
Trimble Navigation Ltd. (a) 2,000 40,720
Core Laboratories N.V. (b) 2,000 133,220
Diamond Offshore Drilling, Inc. 1,700 125,460
FMC Technologies, Inc. (a) 1,300 35,711
Natural Gas Services Group (a) 8,000 82,400
Noble Corp. (b) 1,000 26,790
Patterson-UTI Energy, Inc. 21,500 268,535
Rowan Companies, Inc. 13,000 225,550
Schlumberger Ltd. (b) 6,600 334,884
Superior Well Services, Inc. (a) 10,000 102,500
Lance, Inc. 4,000 78,120
Nestle SA - ADR (b) 4,415 159,712
Peet’s Coffee & Tea Inc. (a) 4,000 90,280
 154

FNX Mining Co. Inc. (a)(b) 3,000 7,407

Teck Cominco Ltd.-Class B (b) 5,000 24,600
Becton, Dickinson & Co. 2,100 133,413
C.R. Bard, Inc. 6,000 492,180
DENTSPLY International, Inc. 1,000 26,080
Illumina, Inc. (a) 10,000 220,100
Medtronic, Inc. 3,700 112,924
Zimmer Holdings, Inc. (a) 7,500 279,900
Fresenius Medical Care AG & Co. KGaA -
ADR (b) 3,000 131,850
PSS World Medical, Inc. (a) 7,000 121,730
Panasonic Corp. - ADR (b) 2,800 33,432
3M Co. 2,000 133,860
VistaPrint Ltd. (a)(b) 3,000 49,050
Google Inc. (a) 750 219,720
Accenture Ltd. - Class A (b) 8,000 247,840
Automatic Data Processing, Inc. 9,500 390,070
Infosys Technologies Ltd. - ADR (b) 2,500 62,875
Ampco-Pittsburgh Corp. 5,000 83,250
Bucyrus International, Inc. - Class A 4,000 78,120
CIRCOR International, Inc. 7,500 163,725
Illinois Tool Works, Inc. 7,000 238,840
Joy Global Inc. 3,500 81,515
Kaydon Corp. 7,000 215,950
L.B. Foster Co.- Class A (a) 5,000 159,350
The Manitowoc Co., Inc. 7,500 59,100
Parker Hannifin Corp. 6,000 246,480
Robbins & Myers, Inc. 8,500 191,250
Sun Hydraulics Corp. 4,500 68,490
Michael Baker Corp. (a) 7,200 236,880
Skyline Corp. 4,600 106,122
Novo-Nordisk A/S - ADR (b) 7,300 373,030
Agnico-Eagle Mines Ltd. (b) 2,100 79,086
Brush Engineered Materials Inc. (a) 7,500 86,850
Haynes International, Inc. (a) 3,500 63,805
Kaiser Aluminum Corp. 5,000 105,550
Newmont Mining Corp. 5,500 185,075
 155

Nucor Corp. 1,500 53,520

Randgold Resources Ltd. - ADR (b) 6,000 229,380
Schnitzer Steel Industries, Inc. 3,000 81,000
Sims Group Ltd. - ADR (b) 12,500 115,250
Universal Stainless & Alloy Products, Inc. (a) 3,500 42,700
CANON Inc. - ADR (b) 10,000 297,600
BG Group PLC - ADR (b) 2,500 176,461
Contango Oil & Gas Co. (a) 3,500 183,890
EOG Resources, Inc. 6,100 518,622
Imperial Oil Ltd. (b) 3,500 117,810
Occidental Petroleum Corp. 3,000 162,420
Royal Dutch Shell PLC - Class A - ADR (b) 7,400 395,530
StatoilHydro ASA - ADR (b) 20,300 345,506
Stone Energy Corp. (a) 1,980 32,908
Tesco Corp. (a)(b) 11,500 79,350
Total SA - ADR - ADR (b) 1,000 52,750
Ultra Petroleum Corp. (a)(b) 2,500 101,575
Deltic Timber Corp. 2,500 119,800
Avon Products, Inc. 1,600 33,760
Abbott Laboratories 5,000 261,950
Alcon, Inc. (b) 1,200 95,748
Amylin Pharmaceuticals, Inc. (a) 15,000 111,150
Auxilium Pharmaceuticals Inc. (a) 3,500 76,230
Eli Lilly & Co. 4,500 153,675
Forest Laboratories, Inc. (a) 2,000 48,360
Genzyme Corp. (a) 1,000 64,020
Johnson & Johnson 6,000 351,480
Providence and Worcester Railroad Co. 2,000 21,980
Applied Materials, Inc. 8,300 79,514
Atheros Communications (a) 5,500 80,300
Broadcom Corp. - Class A (a) 3,800 58,178
Cree, Inc. (a) 15,500 246,140
Cymer, Inc. (a) 9,500 223,155
Cypress Semiconductor Corp. (a) 22,000 82,060
Intel Corp. 7,500 103,500
Rambus, Inc. (a) 14,000 144,340
 156

Adobe Systems, Inc. (a) 9,000 208,440

Microsoft Corp. 18,900 382,158
Nintendo Co., Ltd - ADR (a)(b) 2,000 77,747
Salesforce.com, Inc. (a) 13,500 386,370
Synopsys, Inc. (a) 7,000 112,210
Teradata Corp. (a) 10,000 134,300
VMware Inc.- Class A (a) 8,400 162,540
Bed Bath & Beyond, Inc. (a) 10,000 202,900
Best Buy Co., Inc. 12,000 248,520
Foot Locker, Inc. 3,200 21,536
O’Reilly Automotive, Inc. (a) 4,000 104,280
Staples, Inc. 15,100 262,136
Nike, Inc. - Class B 5,700 303,525
Pure Cycle Corporation (a) 12,500 33,875
China Mobile Ltd. - ADR (b) 2,500 114,575
NTT DoCoMo, Inc. - ADR (b) 2,500 41,925
Total Investments: $23,315,486
 157

APPENDIX B. Portfolio Holdings of the Amana Income Fund – December 31, 2008

Company Quantity Market Value

AT&T 300,000 $8,550,000
Abbott Laboratories 170,000 $9,072,900
Air Products & Chemicals 110,000 $5,529,700
Alcoa 400,000 $4,504,000
Arch Coal 200,000 $3,258,000
Archer-Daniels-Midland 80,000 $2,306,400
AstraZeneca PLC ADS 190,000 $7,795,700
Autoliv 60,000 $1,287,600
Avery Dennison 60,000 $1,963,800
BASF SE ADS 90,000 $3,445,371
BP PLC ADS 100,000 $4,674,000
BHP Billiton ADS 85,000 $3,646,500
Black & Decker 43,000 $1,797,830
Burlington Northern Santa Fe 100,000 $7,571,000
Canadian National Railway 110,000 $4,043,600
Canadian Pacific Railway 90,000 $3,025,800
Carlisle 220,000 $4,554,000
Chunghwa Telecom ADR 241,922 $3,773,983
Colgate-Palmolive 90,000 $6,168,600
ConocoPhillips 140,000 $7,252,000
EI Du Pont de Nemours 140,000 $3,542,000
Duke Energy 70,000 $1,050,700
E.ON AG ADS 85,000 $3,310,674
Emerson Electric 180,000 $6,589,800
EnCana 200,000 $9,296,000
Exxon Mobil 110,000 $8,781,300
FPL 150,000 $7,549,500
Freeport-McMoRan Copper & Gold 100,000 $2,444,000
General Mills 150,000 $9,112,500
Genuine Parts 200,000 $7,572,000
GlaxoSmithKline PLC ADS 100,000 $3,727,000
Honeywell International 225,000 $7,386,750
Idacorp 90,000 $2,650,500
 158

Illinois Tool Works 100,000 $3,505,000

Intel 200,000 $2,932,000
Johnson & Johnson 150,000 $8,974,500
Kellogg 140,000 $6,139,000
Kimberly-Clark 130,000 $6,856,200
Eli Lilly 210,000 $8,456,700
Manitowoc 250,000 $2,165,000
McGraw-Hill 150,000 $3,478,500
Methanex 200,000 $2,248,000
Microsoft 300,000 $5,832,000
Microchip Technology 200,000 $3,906,000
National Fuel Gas 130,000 $4,072,900
Nike 150,000 $7,650,000
Novartis AG ADR 150,000 $7,464,000
Nucor 140,000 $6,468,000
Parker Hannifin 80,000 $3,403,200
Pearson PLC ADS 300,000 $2,862,000
PepsiCo 100,000 $5,477,000
Pfizer 500,000 $8,855,000
Piedmont Natural Gas 60,000 $1,900,200
Plum Creek Timber 50,000 $1,737,000
Praxair 120,000 $7,123,200
Procter & Gamble 120,000 $7,418,400
RPM International 180,000 $2,392,200
Regal-Beloit 100,000 $3,799,000
Rio Tinto PLC ADS 14,000 $1,244,740
Rockwell Automation 150,000 $4,836,000
SK Telecom ADR 50,000 $909,000
Sempra Energy 40,000 $1,705,200
JM Smucker 120,000 $5,203,200
Spectra Energy 35,000 $550,900
Taiwan Semiconductor ADS 450,019 $3,555,150
Teleflex 60,000 $3,006,000
Telefónica SA ADS 100,000 $6,739,000
Telstra ADR 100,000 $1,335,140
Telus 100,000 $2,842,000
 159

Tenaris SA ADR 50,000 $1,049,000

3M 115,000 $6,617,100
Tomkins PLC ADS 100,000 $731,000
Total SA ADS 75,000 $4,147,500
Unilever PLC ADS 250,000 $5,755,000
United Parcel Service 120,000 $6,619,200
United States Steel 60,000 $2,232,000
United Technologies 130,000 $6,968,000
University Bank Certificate of Dep 1,000,000 $1,000,000
Valspar 40,000 $723,600
Vodafone Group PLC ADS 150,000 $3,066,000
Weyerhaeuser 20,000 $612,200
Wyeth 160,000 $6,001,600
Total Investments: $369,797,038
 160

APPENDIX C. Portfolio Holdings of the Amana Growth Fund – December 31, 2008

Company Quantity Market Value

Adobe Systems 460,000 $9,793,400
Agilent Technologies 500,000 $7,815,000
Akamai Technologies 300,000 $4,527,000
Amazon.com 200,000 $10,256,000
América Móvil SAB de CV ADS 230,000 $7,127,700
American Eagle Outfitters 450,000 $4,212,000
American Tower 60,000 $1,759,200
Amgen 200,000 $11,550,000
Anglo American PLC ADR 350,000 $4,067,000
Apple 200,000 $17,070,000
Bed Bath & Beyond 150,000 $3,813,000
Best Buy 350,000 $9,838,500
BP PLC ADS 105,000 $4,907,700
Canadian Pacific Railway 175,000 $5,883,500
Canon ADS 220,000 $6,908,000
China Mobile ADS 150,000 $7,627,500
Cisco Systems 500,000 $8,150,000
Clorox 175,000 $9,723,000
Coach 240,000 $4,984,800
Convergys 400,000 $2,564,000
Crane 210,000 $3,620,400
Cree 160,000 $2,539,200
CVS/Caremark 200,000 $5,748,000
Dentsply International 325,000 $9,178,000
Dr Pepper Snapple 150,000 $2,437,500
Eli Lilly 140,000 $5,637,800
EMCOR 275,000 $6,168,250
EnCana 150,000 $6,972,000
Express Scripts, Cl A 50,000 $2,749,000
Fastenal 155,000 $5,401,750
Gartner 100,000 $1,783,000
Genentech 140,000 $11,607,400
Genuine Parts 125,000 $4,732,500
 161

Genzyme 130,000 $8,628,100

Groupe Danone ADS 380,000 $4,561,672
Hansen Natural 325,000 $10,897,250
Harris 230,000 $8,751,500
Hewlett-Packard 270,000 $9,798,300
Humana 250,000 $9,320,000
IMS Health 300,000 $4,548,000
Infosys ADS 150,000 $3,685,500
Intel 650,000 $9,529,000
International Business Machines 110,000 $9,257,600
Intuit 400,000 $9,516,000
John Wiley & Sons 100,000 $3,558,000
Johnson & Johnson 180,000 $10,769,400
LAN Airlines SA ADS 350,000 $2,817,500
Lincoln Electric Holdings 96,500 $4,914,745
Lowe's 225,000 $4,842,000
Manitowoc 300,000 $2,598,000
McGraw-Hill 220,000 $5,101,800
Noble 200,000 $4,412,000
Norfolk Southern 270,000 $12,703,500
Novartis AG ADR 150,000 $7,464,000
Novo Nordisk A/S ADS 180,000 $9,250,200
Oracle 550,000 $9,751,500
PepsiCo 200,000 $10,954,000
Petro-Canada 80,000 $1,751,200
PetSmart 305,171 $5,630,405
Pharmaceutical Product Development 250,000 $7,252,500
Potash Corp of Saskatchewan 170,000 $12,447,400
Qualcomm 300,000 $10,749,000
Quantum 400,000 $144,000
Regal-Beloit 145,000 $5,508,550
Rio Tinto PLC ADS 33,000 $2,934,030
Ritchie Bros Auctioneers 97,800 $2,094,876
Rogers Communications 200,000 $6,016,000
SanDisk 135,000 $1,296,000
Seagate Technology 250,000 $1,107,500
 162

Sony ADS 120,000 $2,624,400

Staples 250,000 $4,480,000
SumTotal Systems 50,000 $142,000
Taiwan Semiconductor ADS 738,107 $5,831,045
Teck Cominco 100,000 $492,000
Teva Pharmaceutical Industries ADR 100,352 $4,271,985
Trimble Navigation 400,000 $8,644,000
Turkcell Iletisim Hizmetleri ADR 200,000 $2,916,000
United Parcel Service 200,000 $11,032,000
University Bank Certificate of Dep 1,000,000 $1,000,000
VCA Antech 302,000 $6,003,760
Verigy 180,000 $1,731,600
Wyeth 200,000 $7,502,000
Xilinx 200,000 $3,564,000
Zimmer 225,000 $9,094,500
Total Investments: $515,042,418
 163

APPENDIX D. Portfolio Holdings of the Azzad Ethical Income Fund – September 30, 2008

Company Quantity Market Value

Syngenta AG (Switzerland) ADR 2,200 93,104
Gymboree Corp. 2,500 88,750
Fomento Economico Mexicano S.A.B DE
C.V. 4,000 152,560
FMC Corp 2,900 149,031
Questar Corp. 2,500 102,300
Sasol Ltd. 2,300 97,727
Southwestern Energy Co. 4,400 134,376
Diana Shipping, Inc. 4,100 80,729
CPFL Energy, Inc. 1,750 97,755
Emerson Electric Co. 2,800 114,212
Lindsay Corp 1,100 80,025
Unilever PLC 3,300 89,793
Hasbro, Inc. 3,900 135,408
General Mills, Inc. 2,200 151,184
SPX Corp. 1,250 96,250
Joy Global, Inc. 1,700 76,738
Eaton Corp. 1,500 84,270
Autoliv, Inc. 2,200 74,250
Borg Warner 2,600 85,202
Baldor Electric Co. 4,000 115,240
Equitable Resources, Inc. 2,000 73,360
Luxottica Group 4,600 105,754
Greif, Inc. 1,600 104,992
Celgene Corp. * 1,700 107,576
Johnson & Johnson 2,000 138,560
Wyeth 2,900 107,126
Chunghwa Telecom Co. Ltd. (Taiwan) 4,300 101,781
Vodafone Group Public Ltd. 4,150 91,715
Canon, Inc. 2,500 94,375
Wabtec Corp 3,000 153,690
CSX Corp 2,300 125,511
Republic Services, Inc. 4,200 125,916
 164

Fastenal Co. 2,400 118,536

CVS Caremark Corp. 2,700 90,882
Buckle, Inc 2,300 127,742
Ruddick Corp. 3,600 116,820
Signet Group PLC 4,750 111,055
Intel Corp. 5,750 107,698
Monolithic Power Systems, Inc. * 5,000 86,850
Aixtron AG 7,100 42,600
Asml Holding NV 4,600 81,006
Universal Health Services, Inc. Class-B 2,100 117,663
Nuance Communications, Inc 8,300 101,177
Church & Dwight Co., Inc. 2,100 130,389
AK Steel Holding Corp. 2,800 72,576
J.B. Hunt Transport Services, Inc. 3,400 113,458
Kirby Corp. 2,700 102,438
W.W. Grainger 1,550 134,803
Total Investments: $5,084,953
 165

APPENDIX E. Portfolio Holdings of the Vanguard US Growth Index – November 30, 2008

Shares Mkt Val

Consumer Discretionary (7.3%)

McDonald's Corp. 1,546,590 90,862
*
Kohl's Corp. 1,545,791 50,485
The Walt Disney Co. 1,240,800 27,943
Omnicom Group Inc. 723,330 20,463
*
Apollo Group, Inc. Class A 234,280 18,002
Lowe's Cos., Inc. 742,960 15,350
NIKE, Inc. Class B 216,710 11,540
234,645
Consumer Staples (14.1%)
Wal-Mart Stores, Inc. 1,943,550 108,606
The Procter & Gamble Co. 863,820 55,587
PepsiCo, Inc. 737,800 41,833
The Coca-Cola Co. 888,550 41,646
Colgate-Palmolive Co. 620,100 40,350
Philip Morris International Inc. 933,700 39,365
Costco Wholesale Corp. 608,200 31,304
Campbell Soup Co. 605,650 19,411
Kellogg Co. 439,100 19,070
CVS/Caremark Corp. 619,340 17,917
The Kroger Co. 643,140 17,789
Molson Coors Brewing Co. Class B 282,800 12,576
General Mills, Inc. 175,600 11,093
456,547
Energy (7.5%)
Schlumberger Ltd. 2,243,270 113,824
EOG Resources, Inc. 931,890 79,229
Apache Corp. 431,350 33,343
XTO Energy, Inc. 162,000 6,195
Cameron International Corp. 242,640 5,120
National Oilwell Varco Inc. 162,600 4,600
242,311
Exchange-Traded Fund (0.0%)
1
Vanguard Growth ETF 3,100 122

Financials (7.2%)
CME Group, Inc. 379,485 80,432
Charles Schwab Corp. 2,849,585 52,233
The Goldman Sachs Group, Inc. 511,100 40,372
JPMorgan Chase & Co. 1,248,300 39,521
Franklin Resources Corp. 360,900 21,924
234,482
Health Care (23.4%)
Gilead Sciences, Inc. 3,355,360 150,287
Abbott Laboratories 2,191,000 114,787
Celgene Corp. 1,911,660 99,597
Genentech, Inc. 1,269,200 97,221
Teva Pharmaceutical Industries Ltd. Sponsored ADR 1,934,260 83,463
Medco Health Solutions, Inc. 1,116,400 46,889
Baxter International, Inc. 728,100 38,516
Alcon, Inc. 469,540 37,465
 166

Becton, Dickinson & Co. 513,510 32,623

St. Jude Medical, Inc. 783,280 21,955
*
Thermo Fisher Scientific, Inc. 556,720 19,864
Allergan, Inc. 414,235 15,608
758,275
Industrials (5.4%)
Danaher Corp. 557,015 30,992
Emerson Electric Co. 821,770 29,493
Lockheed Martin Corp. 377,000 29,070
Fastenal Co. 662,540 25,514
Roper Industries Inc. 551,190 25,228
J.B. Hunt Transport Services, Inc. 571,610 15,325
Expeditors International of Washington, Inc. 360,320 12,046
Honeywell International Inc. 154,800 4,313
Union Pacific Corp. 71,600 3,583
175,564
Information Technology (25.2%)
Google Inc. 533,195 156,205
Apple Inc. 1,681,506 155,825
Hewlett-Packard Co. 3,902,800 137,691
Cisco Systems, Inc. 7,140,773 118,109
QUALCOMM Inc. 3,096,495 103,949
Microsoft Corp. 2,441,895 49,375
Activision Blizzard, Inc. 1,797,700 21,033
Adobe Systems, Inc. 825,039 19,108
FLIR Systems, Inc. 568,270 17,628
Intel Corp. 1,011,010 13,952
salesforce.com, inc. 377,370 10,800
Electronic Arts Inc. 525,760 10,021
813,696
Materials (4.2%)
Monsanto Co. 1,279,575 101,342
Praxair, Inc. 342,040 20,198
Air Products & Chemicals, Inc. 147,430 7,041
Ecolab, Inc. 162,720 6,247
134,828
Telecommunication Services (0.1%)
America Movil SA de CV Series L ADR 137,300 4,119
Total Common Stocks (Cost $3,938,862) 3,054,589
 167

APPENDIX F. Portfolio Holdings of the Vanguard Equity Income Fund – December 31, 2008

Shares Mkt Val

Consumer Discretionary (6.1%)
Home Depot, Inc. 2,553,100 58,773
Genuine Parts Co. 1,221,800 46,257
McDonald's Corp. 433,805 26,978
Sherwin-Williams Co. 395,200 23,613
Fortune Brands, Inc. 228,800 9,445
H & R Block, Inc. 326,900 7,427
Macy's Inc. 574,900 5,950
VF Corp. 108,000 5,915
Hasbro, Inc. 194,800 5,682
Nordstrom, Inc. 384,500 5,118
Black & Decker Corp. 107,300 4,486
The McGraw-Hill Cos., Inc. 146,500 3,397
Limited Brands, Inc. 309,800 3,111
CBS Corp. 289,300 2,370
Lennar Corp. Class A 233,000 2,020
Johnson Controls, Inc. 103,300 1,876
Autoliv, Inc. 64,600 1,386
Cracker Barrel Old Country Store Inc. 54,700 1,126
ArvinMeritor, Inc. 368,700 1,051
Oxford Industries, Inc. 116,800 1,024
Modine Manufacturing Co. 201,600 982
Jones Apparel Group, Inc. 94,100 552
National Presto Industries, Inc. 6,000 462
The Stanley Works 10,300 351
Whirlpool Corp. 7,200 298
219,650
Consumer Staples (11.5%)
Philip Morris International Inc. 1,770,855 77,050
Nestle SA ADR 1,514,200 59,962
Kimberly-Clark Corp. 913,675 48,187
Altria Group, Inc. 2,668,755 40,192
The Coca-Cola Co. 735,082 33,277
PepsiCo, Inc. 530,700 29,067
Unilever NV ADR 809,300 19,868
Kraft Foods Inc. 585,189 15,712
Diageo PLC ADR 270,450 15,345
ConAgra Foods, Inc. 792,600 13,078
Sysco Corp. 550,188 12,621
Lorillard, Inc. 203,700 11,479
SuperValu Inc. 714,700 10,435
H.J. Heinz Co. 219,200 8,242

The Hershey Co. 161,500 5,611

Avon Products, Inc. 191,300 4,597
The Procter & Gamble Co. 73,860 4,566
Reynolds American Inc. 74,200 2,991
J.M. Smucker Co. 25,425 1,102
Kellogg Co. 22,700 995
414,377
Energy (8.5%)
 168

Chevron Corp. 1,903,000 140,765

ConocoPhillips Co. 977,900 50,655
Total SA ADR 801,100 44,301
BP PLC ADR 879,500 41,108
Marathon Oil Corp. 603,400 16,509
Valero Energy Corp. 335,000 7,249
Sunoco, Inc. 57,300 2,490
Knightsbridge Tankers Ltd. 128,210 1,878
Spectra Energy Corp. 67,700 1,066
306,021
Exchange-Traded Fund (1.1%)
1
Vanguard Value ETF 963,400 39,654

Financials (19.4%)
JPMorgan Chase & Co. 3,708,100 116,916
Wells Fargo & Co. 3,905,520 115,135
Bank of America Corp. 4,845,563 68,226
U.S. Bancorp 2,165,879 54,169
The Chubb Corp. 955,062 48,708
PNC Financial Services Group 845,182 41,414
Bank of New York Mellon Corp. 1,308,970 37,083
Ace Ltd. 670,900 35,504
The Allstate Corp. 811,700 26,591
The Travelers Cos., Inc. 310,800 14,048
Citigroup Inc. 1,534,700 10,298
BB&T Corp. 347,700 9,548
Kimco Realty Corp. REIT 438,809 8,021
SunTrust Banks, Inc. 263,200 7,775
T. Rowe Price Group Inc. 214,000 7,584
Hudson City Bancorp, Inc. 435,400 6,949
NYSE Euronext 231,100 6,327
Lincoln National Corp. 322,800 6,082
MetLife, Inc. 166,700 5,811
Cincinnati Financial Corp. 187,300 5,445
Wachovia Corp. 963,100 5,336
IPC Holdings Ltd. 173,100 5,176
First BanCorp Puerto Rico 451,700 5,032
Huntington Bancshares Inc. 647,400 4,959
Bank of Hawaii Corp. 107,100 4,838
Morgan Stanley 290,700 4,663

Marshall & Ilsley Corp. 332,900 4,541

FirstMerit Corp. 218,600 4,501
Merrill Lynch & Co., Inc. 339,077 3,947
American Express Co. 186,900 3,467
Fifth Third Bancorp 404,712 3,343
NBT Bancorp, Inc. 118,058 3,301
Ameriprise Financial, Inc. 133,500 3,119
Safety Insurance Group, Inc. 70,600 2,687
Pacific Capital Bancorp 141,548 2,389
National City Corp. 1,316,800 2,383
Aspen Insurance Holdings Ltd. 66,300 1,608
Popular, Inc. 293,361 1,514
Federated Investors, Inc. 46,257 784
Protective Life Corp. 48,600 697
 169

Regions Financial Corp. 75,900 604

Marsh & McLennan Cos., Inc. 12,300 298
700,821

Health Care (11.1%)

Pfizer Inc. 6,750,731 119,555
Johnson & Johnson 1,040,605 62,259
Bristol-Myers Squibb Co. 2,596,432 60,367
Merck & Co., Inc. 1,730,214 52,599
Wyeth 1,082,498 40,605
Eli Lilly & Co. 901,049 36,285
GlaxoSmithKline PLC ADR 761,800 28,392
400,062
Industrials (13.6%)
General Electric Co. 7,283,172 117,987
Waste Management, Inc. 1,620,300 53,697
Caterpillar, Inc. 838,100 37,438
Republic Services, Inc. Class A 1,430,100 35,452
Eaton Corp. 652,300 32,426
3M Co. 510,000 29,345
Illinois Tool Works, Inc. 795,700 27,889
Schneider Electric SA 309,673 23,056
PACCAR, Inc. 780,800 22,331
Norfolk Southern Corp. 450,300 21,187
Honeywell International Inc. 402,462 13,213
Emerson Electric Co. 287,000 10,507
Northrop Grumman Corp. 213,713 9,626
United Parcel Service, Inc. 162,900 8,985
The Boeing Co. 155,900 6,652
Dover Corp. 194,100 6,390
The Timken Co. 269,400 5,288
GATX Corp. 156,176 4,837
Briggs & Stratton Corp. 273,700 4,814
Raytheon Co. 89,100 4,548
Federal Signal Corp. 375,115 3,080

R.R. Donnelley & Sons Co. 201,600 2,738

Pacer International, Inc. 250,611 2,614
^
Genco Shipping and Trading Ltd. 151,300 2,239
Tyco International, Ltd. 94,000 2,030
Deere & Co. 40,200 1,540
TAL International Group, Inc. 73,525 1,037
The Standard Register Co. 109,700 980
491,926
Information Technology (4.0%)
Intel Corp. 4,272,700 62,638
Microsoft Corp. 2,757,000 53,596
Automatic Data Processing, Inc. 279,800 11,007
Diebold, Inc. 170,300 4,784
Analog Devices, Inc. 206,400 3,926
Xilinx, Inc. 189,300 3,373
Motorola, Inc. 607,600 2,692
Jabil Circuit, Inc. 71,200 480
142,496
 170

Materials (3.7%)
E.I. du Pont de Nemours & Co. 878,027 22,214
Packaging Corp. of America 1,384,500 18,635
PPG Industries, Inc. 409,700 17,384
Air Products & Chemicals, Inc. 313,800 15,775
International Paper Co. 906,900 10,702
Dow Chemical Co. 528,900 7,981
United States Steel Corp. 143,100 5,323
Eastman Chemical Co. 166,600 5,283
Olin Corp. 274,400 4,961
Compass Minerals International, Inc. 78,200 4,587
Southern Copper Corp. (U.S. Shares) 276,300 4,437
Glatfelter 472,000 4,390
Stepan Co. 74,000 3,477
Worthington Industries, Inc. 273,200 3,011
Nucor Corp. 52,900 2,444
Bemis Co., Inc. 82,800 1,961
Lubrizol Corp. 14,100 513
Innophos Holdings Inc. 3,337 66
133,144
Telecommunication Services (6.7%)
AT&T Inc. 5,058,105 144,156
Verizon Communications Inc. 2,731,428 92,596
Embarq Corp. 138,355 4,975
Windstream Corp. 30,100 277
242,004
Utilities (9.9%)
FPL Group, Inc. 1,361,066 68,502
Dominion Resources, Inc. 1,320,930 47,342
Consolidated Edison Inc. 813,400 31,666

PG&E Corp. 805,000 31,162

Entergy Corp. 339,800 28,248
American Electric Power Co., Inc. 799,800 26,617
Exelon Corp. 304,900 16,956
SCANA Corp. 406,800 14,482
Southern Co. 382,400 14,149
Duke Energy Corp. 702,534 10,545
Public Service Enterprise Group, Inc. 318,820 9,300
Edison International 243,000 7,805
Sempra Energy 179,500 7,652
DTE Energy Co. 174,500 6,224
CenterPoint Energy Inc. 443,800 5,601
Progress Energy, Inc. 128,300 5,113
Alliant Energy Corp. 171,900 5,016
TECO Energy, Inc. 402,800 4,975
ONEOK, Inc. 162,100 4,720
Atmos Energy Corp. 197,900 4,690
Avista Corp. 154,300 2,990
FirstEnergy Corp. 36,800 1,788
UGI Corp. Holding Co. 28,600 698
356,241
Total Common Stocks (Cost $4,089,454) 3,446,396
 171

Appendix G. GOOD MONEY AND DOW JONES INDUSTRIAL AVERAGES

GOOD MONEY INDUSTRIAL AVERAGE* VS. DOW JONES INDUSTRIAL

AVERAGE

INDUSTRY GMIA DJIA

AEROSPACE BE Aerospace The Boeing Company

APPAREL Hartmarx None
AUTOMOTIVE General Motors
H. B. Fuller and DuPont,
CHEMICALS
Minnesota Mining & Manfacturing Minnesota Mining & Manufacturing
International Business Machines
COMPUTERS Intel
Intel, Microsoft, Hewlett-Packard
& SOFTWARE Microsoft
and Honeywell
Avon Products,
CONSUMER Home Depot
Callaway Golf,
PRODUCTS and General Electric
Home Depot and Maytag
American Express,
FINANCIAL Fannie Mae
J. P. Morgan
SERVICES and First Virginia Banks
and Citigroup
FOOD & Hershey Foods Coca-Cola
RESTAURANTS and McDonald's and McDonald's
FOREST
Stora Enso International Paper
PRODUCTS
HOUSEHOLD
Procter & Gamble Procter & Gamble
PRODUCTS
MACHINERY &
Ametek and
INDUSTRIAL Caterpillar
Cummins Engine
EQUIPMENT
MEDICAL & HEALTH Baxter International None
METALS & Aluminum Company
None
MINING of America
MULTIFORM
None United Technologies
& CONGLOMERATE

OFFICE
Herman Miller
EQUIPMENT None
and Pitney Bowes
& SUPPLIES
PETROLEUM
Chevron ExxonMobil
PRODUCTS
Johnson & Johnson Johnson & Johnson
PHARMACEUTICALS
and Merck & Company and Merck & Company
PRECISION
None Eastman Kodak
INSTRUMENTS
PUBLISHING Washington Post None
 172

REAL ESTATE
The Rouse Company None
DEVELOPMENT
RECREATION None Walt Disney
RETAIL Target Stores
Wal-Mart Stores
STORES and Nordstrom
STEEL Worthington Industries None
AT&T Corp. and
TELECOMMUNICATIONS US West Communications
SBC Communications
TOBACCO None Philip Morris Companies

*GMIA last updated January 10, 2001.

Source: Good Money website
 173

Appendix G (Cont.). GOOD MONEY AND DOW JONES UTILITY AVERAGES

GOOD MONEY UTILITY AVERAGE* VS. DOW JONES UTILITY AVERAGE

INDUSTRY
GMUA DJUA
CATEGORY

DIVERSIFIED
Citizens Communications None
SERVICES
AES Corp,
Dominion Resources,
Hawaiian Electric Industries,
IDACORP,
LG&E Energy,
NONNUCLEAR ELECTRIC MidAmerican Energy,
AND/OR GAS Montana Power, None
UTILITIES NiSource,
OGE Energy,
Otter Tail Power,
Southwest Gas,
UtiliCorp
and Xcel Energy,
American Electric Power,
AES Corp.,
Consolidated Edison,
Dominion Resources,
Duke Energy Corp.,
Edison International,
Enron Corp.,
NONNUCLEAR & NUCLEAR
Excelon,
ELECTRIC AND/OR None
NiSource,
GAS UTILITIES
PG&E Corp.,
PECO Corp.,
Public Service Enterprise Group,
Reliant Energy,
Southern Company,
TXU
and Williams Companies
WATER
American Water Works None
SERVICES

*GMUA last updated January 10, 2001.

Source: Good Money website
 174

Appendix H. Dow Jones US Islamic Market Index Components – January 21, 2009

Market
Company Ticker Capitalization
Agilent Technologies Inc. A LRG
Alcoa Inc. AA LRG
Advance Auto Parts Inc. AAP MID
Arkansas Best Corp. ABFS SML
Abbott Laboratories ABT LRG
Autodesk Inc. ADSK MID
Arch Coal Inc. ACI MID
Alcon Inc. ACL LRG
Alberto-Culver Co. ACV MID
Adobe Systems Inc. ADBE LRG
Analog Devices Inc. ADI MID
Alliance Data Systems Corp. ADS MID
Adtran Inc. ADTN SML
American Eagle Outfitters Inc. AEO MID
AGCO Corp. AG MID
Allergan Inc. AGN LRG
American Greetings Corp. Cl A AM SML
Skyworks Solutions Inc. SWKS SML
Hess Corp. HES LRG
Wyeth WYE LRG
Akamai Technologies Inc. AKAM MID
AK Steel Holding Corp. AKS MID
Albemarle Corp. ALB MID
Honeywell International Inc. HON LRG
Alkermes Inc. ALKS SML
Allegheny Technologies Inc. ATI MID
Altera Corp. ALTR MID
Alexion Pharmaceuticals Inc. ALXN SML
Applied Materials Inc. AMAT LRG
Applied Micro Circuits Corp. AMCC SML
Ametek Inc. AME MID
Amedisys Inc. AMED SML
Amgen Inc. AMGN LRG
Healthways Inc. HWAY SML
Amylin Pharmaceuticals Inc. AMLN MID
American Tower Corp. Cl A AMT LRG
Abercrombie & Fitch Co. ANF MID
Ann Taylor Stores Corp. ANN SML
Alpha Natural Resources Inc. ANR MID
Ansys Inc. ANSS SML
Arris Group Inc. ARRS SML
Apache Corp. APA LRG
Air Products & Chemicals Inc. APD LRG
Avocent Corp. AVCT SML
Amphenol Corp. Cl A APH MID
 175

Apollo Group Inc. Cl A APOL MID

Ariba Inc. ARBA SML
Arena Resources Inc. ARD SML
Aeropostale Inc. ARO SML
MPS Group Inc. MPS SML
Astec Industries Inc. ASTE SML
Atheros Communications Inc. ATHR SML
ATMI Inc. ATMI SML
Atmel Corp. ATML SML
Aptargroup Inc. ATR SML
Atwood Oceanics Inc. ATW SML
Automatic Data Processing Inc. ADP LRG
Auxilium Pharmaceuticals Inc. AUXL SML
Avon Products Inc. AVP LRG
AVX Corp. AVX MID
Acuity Brands Inc. AYI SML
AutoZone Inc. AZO MID
Baxter International Inc. BAX LRG
Bed Bath & Beyond Inc. BBBY MID
Bill Barrett Corp. BBG SML
C.R. Bard Inc. BCR MID
Becton Dickinson & Co. BDX LRG
BE Aerospace Inc. BEAV SML
Beckman Coulter Inc. BEC MID
Verizon Communications Inc. VZ LRG
Christopher & Banks Corp. CBK SML
Baker Hughes Inc. BHI LRG
BJ Services Co. BJS MID
Immucor Inc. BLUD SML
BMC Software Inc. BMC MID
BioMarin Pharmaceutical Inc. BMRN SML
Bemis Co. Inc. BMS MID
Bristol-Myers Squibb Co. BMY LRG
Burlington Northern Santa Fe Corp. BNI LRG
Brady Corp. Cl A BRC SML
Brocade Communications Systems Inc. BRCD MID
Broadcom Corp. BRCM LRG
Brooks Automation Inc. BRKS SML
Berry Petroleum Co. Cl A BRY SML
Savient Pharmaceuticals Inc. SVNT SML
BLYTH Inc. BTH SML
Peabody Energy Corp. BTU LRG
Bucyrus International Inc. BUCY MID
BorgWarner Inc. BWA MID
Brown Shoe Co. Inc. BWS SML
CA Inc. CA LRG
Cato Corp. Cl A CTR SML
Cameron International Corp. CAM MID
Cooper Industries Inc. Cl A CBE MID
Cubist Pharmaceuticals Inc. CBST SML
 176

Cabot Microelectronics Corp. CCMP SML

Coeur d'Alene Mines Corp. CDE SML
Cardinal Health Inc. CAH LRG
Belden Inc. BDC SML
Career Education Corp. CECO SML
Celgene Corp. CELG LRG
Century Aluminum Co. CENX SML
Cephalon Inc. CEPH MID
Cerner Corp. CERN MID
CF Industries Holdings Inc. CF MID
Cognex Corp. CGNX SML
Chico's Fas Inc. CHS SML
Church & Dwight Co. CHD MID
Chemed Corp. CHE SML
Check Point Software Technologies Ltd. CHKP MID
C.H. Robinson Worldwide Inc. CHRW MID
Chevron Corp. CVX LRG
Checkpoint Systems Inc. CKP SML
Colgate-Palmolive Co. CL LRG
Core Laboratories N.V. CLB SML
Clarcor Inc. CLC SML
Cliffs Natural Resources Inc. CLF MID
Clean Harbors Inc. CLH SML
Big Lots Inc. BIG SML
Centene Corp. CNC SML
Consol Energy Inc. CNX LRG
Corinthian Colleges Inc. COCO SML
Cabot Oil & Gas Corp. COG MID
Coach Inc. COH LRG
Cepheid CPHD SML
Copart Inc. CPRT MID
Compuware Corp. CPWR MID
Crane Co. CR SML
Celera Corp. CRA SML
Cree Inc. CREE SML
Carters Inc. CRI SML
Charles River Laboratories International Inc. CRL MID
Crocs Inc. CROX SML
Carpenter Technology Corp. CRS SML
Cirrus Logic Inc. CRUS SML
Carrizo Oil & Gas Inc. CRZO SML
Cisco Systems Inc. CSCO LRG
Carlisle Cos. CSL SML
Cintas Corp. CTAS MID
CTS Corp. CTS SML
Citrix Systems Inc. CTXS MID
Cummins Inc. CMI MID
Covance Inc. CVD MID
Convergys Corp. CVG MID
Coventry Health Care Inc. CVH MID
 177

Eagle Materials Inc. EXP SML

Diebold Inc. DBD MID
Dress Barn Inc. DBRN SML
Donaldson Co. Inc. DCI SML
E.I. DuPont de Nemours & Co. DD LRG
Deckers Outdoor Corp. DECK SML
Dell Inc. DELL LRG
Danaher Corp. DHR LRG
Dick's Sporting Goods Inc. DKS SML
Viad Corp. VVI SML
Dollar Tree Inc. DLTR MID
Genentech Inc. DNA LRG
Dionex Corp. DNEX SML
Denbury Resources Inc. DNR MID
Diamond Offshore Drilling Inc. DO LRG
Dover Corp. DOV MID
Dow Chemical Co. DOW LRG
Amdocs Ltd. DOX MID
Delta Petroleum Corp. DPTR SML
Dresser-Rand Group Inc. DRC MID
Dril-Quip Inc. DRQ SML
Datascope Corp. DSCP SML
DeVry Inc. DV MID
Devon Energy Corp. DVN LRG
Dycom Industries Inc. DY SML
eBay Inc. EBAY LRG
Ecolab Inc. ECL MID
Energen Corp. EGN MID
Estee Lauder Cos. Inc. EL MID
Callaway Golf Co. ELY SML
EMC Corp. EMC LRG
Emulex Corp. ELX SML
Eastman Chemical Co. EMN MID
Emerson Electric Co. EMR LRG
Endo Pharmaceuticals Holdings Inc. ENDP MID
Energy Conversion Devices Inc. ENER SML
Energizer Holdings Inc. ENR MID
Entegris Inc. ENTG SML
Enzo Biochem Inc. ENZ SML
EOG Resources Inc. EOG LRG
Equitable Resources Inc. EQT MID
ESCO Technologies Inc. ESE SML
ITT Educational Services Inc. ESI MID
Evergreen Solar Inc. ESLR SML
Express Scripts Inc. ESRX LRG
ENSCO International Inc. ESV MID
Ethan Allen Interiors Inc. ETH SML
Eaton Corp. ETN MID
Edwards Lifesciences Corp. EW SML
Corporate Executive Board Co. EXBD SML
 178

Expeditors International of Washington Inc. EXPD MID

Expedia Inc. EXPE MID
Extreme Networks Inc. EXTR SML
Fastenal Co. FAST MID
Foundation Coal Holdings Inc. FCL SML
Freeport-McMoRan Copper & Gold Inc. FCX LRG
FactSet Research Systems Inc. FDS MID
FedEx Corp. FDX LRG
F5 Networks Inc. FFIV SML
Health Net Inc. HNT MID
Massey Energy Co. MEE MID
Fluor Corp. FLR LRG
Flowserve Corp. FLS MID
FMC Corp. FMC MID
Fossil Inc. FOSL SML
Forest Laboratories Inc. FRX LRG
First Solar Inc. FSLR LRG
FMC Technologies Inc. FTI MID
Frontier Oil Corp. FTO SML
H.B. Fuller Co. FUL SML
Foster Wheeler Ltd. FWLT MID
Forward Air Corp. FWRD SML
Gartner Inc. IT MID
Genesco Inc. GCO SML
Gardner Denver Inc. GDI SML
Goodrich Petroleum Corp. GDP SML
Genzyme Corp. GENZ LRG
Guess? Inc. GES MID
Graco Inc. GGG MID
Gilead Sciences Inc. GILD LRG
Corning Inc. GLW LRG
Gentex Corp. GNTX MID
Genesee & Wyoming Inc. Cl A GWR SML
Google Inc. Cl A GOOG LRG
Genuine Parts Co. GPC MID
Global Payments Inc. GPN MID
Gen-Probe Inc. GPRO SML
Gap Inc. GPS LRG
Garmin Ltd. GRMN MID
Chart Industries Inc. GTLS SML
Granite Construction Inc. GVA SML
W.W. Grainger Inc. GWW MID
Gymboree Corp. GYMB SML
Haemonetics Corp. HAE SML
Halliburton Co. HAL LRG
Hansen Natural Corp. HANS MID
Harman International Industries Inc. HAR MID
Hill-Rom Holdings Inc. HRC SML
Home Depot Inc. HD LRG
Harley-Davidson Inc. HOG MID
 179

Hewitt Associates Inc. Cl A HEW MID

Harmonic Inc. HLIT SML
HNI Corp. HNI SML
Holly Corp. HOC SML
Hologic Inc. HOLX MID
Helmerich & Payne Inc. HP MID
Harris Corp. HRS MID
Harsco Corp. HSC MID
Henry Schein Inc. HSIC MID
Hubbell Inc. Cl B HUB/B MID
Hewlett-Packard Co. HPQ LRG
Hexcel Corp. HXL SML
International Business Machines Corp. IBM LRG
InterDigital Inc. IDCC SML
Biogen Idec Inc. BIIB LRG
Integrated Device Technology Inc. IDTI SML
IDEXX Laboratories Inc. IDXX SML
IDEX Corp. IEX SML
Mosaic Co. MOS LRG
IHS Inc. Cl A IHS MID
ITT Corp. ITT MID
Illumina Inc. ILMN MID
Informatica Corp. INFA SML
Insituform Technologies Inc. Cl A INSU SML
Intel Corp. INTC LRG
Intuit Inc. INTU MID
ION Geophysical Corp. IO SML
International Rectifier Corp. IRF SML
Intersil Corp. Cl A ISIL MID
Isis Pharmaceuticals Inc. ISIS SML
Intuitive Surgical Inc. ISRG MID
Illinois Tool Works Inc. ITW LRG
Life Technologies Corp. LIFE MID
Interwoven Inc. IWOV SML
J.B. Hunt Transport Services Inc. JBHT MID
J. Crew Group Inc. JCG SML
JDA Software Group Inc. JDAS SML
Jacobs Engineering Group Inc. JEC MID
j2 Global Communications Inc. JCOM SML
Johnson & Johnson JNJ LRG
Juniper Networks Inc. JNPR LRG
Joy Global Inc. JOYG MID
Kaiser Aluminum Corp. KALU SML
Kaman Corp. KAMN SML
Kinetic Concepts Inc. KCI MID
Kaydon Corp. KDN SML
Kirby Corp. KEX MID
King Pharmaceuticals Inc. KG MID
KLA-Tencor Corp. KLAC MID
Kimberly-Clark Corp. KMB LRG
 180

Sears Holdings Corp. SHLD LRG

Kennametal Inc. KMT SML
CarMax Inc. KMX MID
Coca-Cola Co. KO LRG
Kohl's Corp. KSS LRG
Quicksilver Resources Inc. KWK MID
Lincoln Electric Holdings Inc. LECO SML
Littelfuse Inc. LFUS SML
Laboratory Corp. of America Holdings LH MID
Lennox International Inc. LII SML
LKQ Corp. LKQX MID
Linear Technology Corp. LLTC MID
Eli Lilly & Co. LLY LRG
Lowe's Cos. LOW LRG
Lam Research Corp. LRCX MID
TrueBlue Inc. TBI SML
Lattice Semiconductor Corp. LSCC SML
Landstar System Inc. LSTR SML
Southwest Airlines Co. LUV LRG
Lexmark International Inc. LXK MID
St. Mary Land & Exploration Co. SM SML
Mattel Inc. MAT MID
Matthews International Corp. Cl A MATW SML
Microchip Technology Inc. MCHP MID
Micrel Inc. MCRL SML
Micros Systems Inc. MCRS SML
Medicines Co. MDCO SML
McDermott International Inc. MDR MID
Medtronic Inc. MDT LRG
MDU Resources Group Inc. MDU MID
Medarex Inc. MEDX SML
CVS Caremark Corp. CVS LRG
Methode Electronics Inc. MEI SML
Magellan Health Services Inc. MGLN SML
Medco Health Solutions Inc. MHS LRG
Herman Miller Inc. MLHR SML
Mueller Industries Inc. MLI SML
Martin Marietta Materials Inc. MLM MID
3M Co. MMM LRG
Mentor Corp. MNT SML
Molex Inc. MOLX MID
Monsanto Co. MON LRG
Motorola Inc. MOT LRG
Merck & Co. Inc. MRK LRG
Marathon Oil Corp. MRO LRG
Marvell Technology Group Ltd. MRVL MID
Mine Safety Appliances Co. MSA SML
Microsemi Corp. MSCC SML
Microsoft Corp. MSFT LRG
MSC Industrial Direct Co. MSM SML
 181

EarthLink Inc. ELNK SML

Mettler-Toledo International Inc. MTD MID
Manitowoc Co. MTW MID
Minerals Technologies Inc. MTX SML
Murphy Oil Corp. MUR LRG
Myriad Genetics Inc. MYGN SML
National Instruments Corp. NATI SML
Noble Energy Inc. NBL LRG
Navigant Consulting Inc. NCI SML
NCR Corp. NCR MID
99 Cents Only Stores NDN SML
Nordson Corp. NDSN SML
Noble Corp. NE LRG
Newmont Mining Corp. NEM LRG
McAfee Inc. MFE MID
National Fuel Gas Co. NFG MID
Newfield Exploration Co. NFX MID
NII Holdings Inc. NIHD MID
Nike Inc. Cl B NKE LRG
National Oilwell Varco Inc. NOV LRG
Norfolk Southern Corp. NSC LRG
National Semiconductor Corp. NSM MID
NeuStar Inc. Cl A NSR MID
NetApp Inc. NTAP MID
Nucor Corp. NUE LRG
NuVasive Inc. NUVA SML
NVIDIA Corp. NVDA MID
Novellus Systems Inc. NVLS MID
NVR Inc. NVR MID
Newell Rubbermaid Inc. NWL MID
United Online Inc. UNTD SML
Old Dominion Freight Line Inc. ODFL SML
Odyssey HealthCare Inc. ODSY SML
Oceaneering International Inc. OII MID
Oil States International Inc. OIS SML
Olin Corp. OLN SML
Owens & Minor Inc. OMI SML
OM Group Inc. OMG SML
Omniture Inc. OMTR SML
Onyx Pharmaceuticals Inc. ONXX SML
Oracle Corp. ORCL LRG
O'Reilly Automotive Inc. ORLY MID
OSI Pharmaceuticals Inc. OSIP MID
OmniVision Technologies Inc. OVTI SML
Occidental Petroleum Corp. OXY LRG
ConocoPhillips COP LRG
Paychex Inc. PAYX LRG
Potlatch Corp. REIT PCH SML
Plum Creek Timber Co. Inc. REIT PCL MID
priceline.com Inc. PCLN MID
 182

Precision Castparts Corp. PCP LRG

Southern Copper Corp. PCU LRG
Patterson Cos. Inc. PDCO MID
Pride International Inc. PDE MID
Mednax Inc. MD SML
Exelon Corp. EXC LRG
Perot Systems Corp. PER SML
PETsMART Inc. PETM MID
Pfizer Inc. PFE LRG
Procter & Gamble Co. PG LRG
Stillwater Mining Co. SWC SML
Parker Hannifin Corp. PH MID
Polaris Industries Inc. PII SML
Packaging Corp. of America PKG MID
PerkinElmer Inc. PKI SML
Children's Place Retail Stores Inc. PLCE SML
Polycom Inc. PLCM MID
Pall Corp. PLL MID
Plantronics Inc. PLT SML
Plexus Corp. PLXS SML
PMC-Sierra Inc. PMCS SML
Parametric Technology Corp. PMTC SML
Pentair Inc. PNR MID
Pre-Paid Legal Services Inc. PPD SML
Pharmaceutical Product Development Inc. PPDI MID
PPG Industries Inc. PPG LRG
Perrigo Co. PRGO SML
Progress Software Corp. PRGS SML
Public Storage PSA LRG
PSS World Medical Inc. PSSI SML
Pacific Sunwear of California Inc. PSUN SML
Patterson-UTI Energy Inc. PTEN MID
Phillips-Van Heusen Corp. PVH SML
Quanta Services Inc. PWR MID
Praxair Inc. PX LRG
Corrections Corp. of America CXW SML
Brink's Co. BCO SML
Qualcomm Inc. QCOM LRG
QLogic Corp. QLGC MID
Quest Software Inc. QSFT SML
RCN Corp. RCNI SML
Rowan Cos. Inc. RDC MID
Red Hat Inc. RHT MID
Robert Half International Inc. RHI MID
Polo Ralph Lauren Corp. RL MID
Rambus Inc. RMBS SML
ResMed Inc. RMD MID
Rohm & Haas Co. ROH LRG
Rockwell Automation Corp. ROK MID
Roper Industries Inc. ROP MID
 183

Ross Stores Inc. ROST MID

Range Resources Corp. RRC MID
Reliance Steel & Aluminum Co. RS MID
Republic Services Inc. RSG MID
RTI International Metals Inc. RTI SML
IMS Health Inc. RX MID
Rayonier Inc. REIT RYN MID
AT&T Inc. T LRG
Schnitzer Steel Industries Inc. SCHN SML
Sepracor Inc. SEPR MID
Superior Energy Services Inc. SPN MID
Salesforce.com Inc. CRM MID
Schering-Plough Corp. SGP LRG
Shaw Group Inc. SGR MID
Sherwin-Williams Co. SHW MID
Sigma-Aldrich Corp. SIAL MID
Smith International Inc. SII LRG
Saks Inc. SKS SML
Silicon Laboratories Inc. SLAB SML
Schlumberger Ltd. SLB LRG
Semtech Corp. SMTC SML
Snap-On Inc. SNA SML
SanDisk Corp. SNDK MID
Senior Housing Properties Trust SNH SML
Synopsys Inc. SNPS MID
Sonoco Products Co. SON MID
Sonus Networks Inc. SONS SML
Staples Inc. SPLS LRG
Spirit AeroSystems Hldgs Inc. Cl A SPR SML
SPX Corp. SPW MID
SunPower Corp. Cl A SPWRA MID
Stericycle Inc. SRCL MID
SRA International Inc. Cl A SRX SML
Simpson Manufacturing Co. SSD SML
Nuance Communications Inc. NUAN MID
Steris Corp. STE SML
St. Jude Medical Inc. STJ LRG
Questar Corp. STR MID
Strayer Education Inc. STRA SML
Stryker Corp. SYK LRG
Seagate Technology Inc. STX MID
Men's Wearhouse Inc. MW SML
Sun Microsystems Inc. JAVA MID
Southwestern Energy Co. SWN LRG
Sybase Inc. SY SML
Symantec Corp. SYMC LRG
RadioShack Corp. RSH MID
Timberland Co. TBL SML
Tidewater Inc. TDW MID
Teledyne Technologies Inc. TDY SML
 184

Techne Corp. TECH SML

Teradyne Inc. TER SML
Terex Corp. TEX MID
Tredegar Corp. TG SML
Thor Industries Inc. THO SML
Theravance Inc. THRX SML
TIBCO Software Inc. TIBX SML
Titanium Metals Corp. TIE MID
Tiffany & Co. TIF MID
TJX Cos. TJX LRG
Timken Co. TKR MID
Thermo Fisher Scientific Inc. TMO LRG
Monster Worldwide Inc. MWW MID
Technitrol Inc. TNL SML
Triquint Semiconductor Inc. TQNT SML
Terra Industries Inc. TRA MID
Trimble Navigation Ltd. TRMB MID
ACI Worldwide Inc. ACIW SML
Tractor Supply Co. TSCO SML
Tessera Technologies Inc. TSRA SML
Total System Services Inc. TSS MID
Toro Co. TTC SML
Teletech Holdings Inc. TTEC SML
Tetra Technologies Inc. TTI SML
Tupperware Brands Corp. TUP SML
Texas Industries Inc. TXI SML
Texas Instruments Inc. TXN LRG
Tyco International Ltd. (New) TYC LRG
Continental Resources Inc. CLR MID
Covidien Ltd. COV LRG
Tyco Electronics Ltd. TEL LRG
WABCO Holdings Inc. WBC MID
Concho Resources Inc. CXO MID
Masimo Corp. MASI SML
VMware Inc. VMW MID
Teradata Corp. TDC MID
Zep Inc. ZEP SML
Patriot Coal Corp. PCX SML
SandRidge Energy Inc. SD MID
Abraxis BioScience Inc. ABII SML
Hillenbrand Inc. HI SML
Quanex Building Products Corp. NX SML
Intrepid Potash Inc. IPI MID
Lender Processing Services Inc. LPS MID
Under Armour Inc. Cl A UA SML
GrafTech International Ltd. GTI SML
Intermec Inc. IN SML
UnitedHealth Group Inc. UNH LRG
Union Pacific Corp. UNP LRG
Unit Corp. UNT MID
 185

Ultra Petroleum Corp. UPL MID

United Parcel Service Inc. Cl B UPS LRG
Urban Outfitters Inc. URBN MID
U.S. Cellular Corp. USM MID
United Therapeutics Corp. UTHR SML
United Technologies Corp. UTX LRG
Valmont Industries Inc. VMI MID
Varian Medical Systems Inc. VAR MID
Varian Inc. VARI SML
Veeco Instruments Inc. VECO SML
VF Corp. VFC MID
Valero Energy Corp. VLO LRG
VistaPrint Ltd. VPRT SML
VeriSign Inc. VRSN MID
Vertex Pharmaceuticals Inc. VRTX MID
Varian Semiconductor Equipment Associates Inc VSEA SML
Wabtec WAB SML
Walgreen Co. WAG LRG
Waters Corp. WAT MID
Websense Inc. WBSN SML
Warner Chilcott Ltd. Cl A WCRX MID
Western Digital Corp. WDC MID
WD-40 Co. WDFC SML
Werner Enterprises Inc. WERN SML
MEMC Electronic Materials Inc. WFR LRG
Weatherford International Ltd. WFT LRG
Winnebago Industries Inc. WGO SML
Woodward Governor Co. WGOV SML
Wind River Systems Inc. WIND SML
Whiting Petroleum Corp. WLL MID
Wausau Paper Corp. WPP SML
Wal-Mart Stores Inc. WMT LRG
VCA Antech Inc. WOOF SML
Watson Pharmaceuticals Inc. WPI MID
Warnaco Group Inc. WRC SML
Williams-Sonoma Inc. WSM MID
Watsco Inc. WSO SML
West Pharmaceutical Services Inc. WST SML
Worthington Industries Inc. WOR SML
W&T Offshore Inc. WTI MID
Western Union Co. WU LRG
Watson Wyatt Worldwide Inc. Cl A WW SML
Wolverine World Wide Inc. WWW SML
United States Steel Corp. X LRG
Dun & Bradstreet Corp. DNB MID
Cimarex Energy Co. XEC MID
Xilinx Inc. XLNX MID
Exxon Mobil Corp. XOM LRG
Dentsply International Inc. XRAY MID
XTO Energy Inc. XTO LRG
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Yahoo! Inc. YHOO LRG

Foot Locker Inc. FL MID
Zebra Technologies Corp. Cl A ZBRA MID
Zale Corp. ZLC SML
Zimmer Holdings Inc. ZMH LRG
Zoran Corp. ZRAN SML
 187

APPENDIX I. Glossary of Portfolio Theory and Arabic and Islamic Financial Terms

Portfolio Theory Terms

Arbitrage Pricing Theory (APT) – a multiple factor-based theory of asset valuation that holds
that the expected return on an asset can be described and determined by its relationship with
other common risk factors

Beta – a measure of the systematic risk of an asset

Call Option – a contract that grants the bearer the option to purchase a stock or bond within a
certain period time at a specified price (the exercise price)

Capital Asset Pricing Model (CAPM) – a single factor-based theory of asset valuation that
estimates an asset’s required or expected return based on its systemic risk relative to that of the
market portfolio

Capital Market Line (CML) – a line that extends from the intercept point and represents the
risk free rate tangent to the original Markowitz efficient frontier; investments on the capital
market line dominate those portfolios on the efficient frontier

Certificate of Deposit – certificates issued by banks and savings and loans associations that pay
higher interest rates than regular deposit accounts

Efficient Frontier – the set of portfolios that offer the maximum rate of return for each and
every level of risk, or the minimum risk for every rate of return

Holding Period Return (HPR) – an investment’s total return, including all sources of income,
for a specified time period

Holding Period Yield (HPY) – the holding period return expressed as a percentage (HPR – 1)

Market Portfolio – the portfolio that includes all risky assets available for investment

Preferred Stock – an instrument that has the characteristics of a stock and a bond, in that it
represents ownership in a company like a stock and pays a fixed dividend to investors like a
bond; preferred stock usually has no voting rights and the claims of preferred stockholders are
superior to those of common shareholders and subordinate to bondholders

Private Equity – investors and investment funds that make direct stakes in private companies or
buy the outstanding shares of a public company to “take it private”; private equity investors and
firms have access to tremendous financial resources that they can commit for long periods of
time

Put Option – a contract that grants the bearer the right to sell a stock or bond within a certain
period at a specified exercise price
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Real Estate Investment Trust (REIT) – a security that is traded on an exchange like a stock
and invests in real estate directly through mortgages or in the properties themselves; can be
equity, mortgage, or hybrid REITs

Risk Free Asset – an asset whose returns have zero variance (usually considered to be Treasury
securities, especially T-bills)

Risky Asset – an asset whose returns are considered to be uncertain

Risk Free Rate – the theoretical rate of return on a risk free asset (the interest rate on the 3
month Treasury bill is generally considered to be the risk free rate)

Security Market Line (SML) – line that represents the combination of risk and return on
investments

Separation Theorem – the theory which holds that the investment decision (whether to invest in
the market portfolio on the CML) is separate from the financing decision (whether to borrow or
lend at the risk free rate)

Systematic Risk – the risk that cannot be diversified away; measures the variability of returns to
due to macroeconomic factors that affect all risky assets

Unsystematic Risk – idiosyncratic risk; represents the risk that is unique to an asset due to its
own inherent characteristics; unlike systematic risk, it can be diversified away in a portfolio

Venture Capital – a form of high risk investment that provides financing for small businesses
and startup companies, and can also include managerial and technical expertise; most venture
capital comes from a group of wealthy investors, investment banks, and/or a dedicated venture
capital firm

Zero Coupon Bond – a bond, sold at a discounted price, which pays its par value at the date of
maturity but no interest payments
 189

Arabic and Islamic Financial Terms

Bida – innovation

Caliph – successor or representative; the head of the Islamic state; the title was held by the first
four successors of Muhammad, and later the Umayyad, Abbasid, and Ottoman dynasties, as well
as other competing ruling factions in Egypt, Spain, and North Africa

Companion - early Muslims who saw or spoke with Muhammad, the most prominent of which
were his close associates

Fatwa - a non-binding religious opinion issued by a religious scholar or scholars

Faqih/pl. Fuquha – a judge

Fiqh – Islamic jurisprudence

Gharar - excessive risk and uncertainty in business and finance

Hadith - a report from one or more of the Companions of what Muhammad said or did

Halal - any object or an action which is permissible for Muslims to use or engage in

Haram – the opposite of halal; any object or an action which is impermissible for Muslims to
use or engage in

Hila/pl. Hiyal – ruse or stratagem used to evade various prohibitions in Islamic law

Ibadat - refers to matters of religion and other obligations incumbent upon Muslims

Ijara – lease; refers to selling benefit, use, or service for a fixed price or wage

Ijma – the consensus of Islamic jurists

Ijtihad - deductive juristic reasoning

Ikhtilaf – disagreement among jurists

Illa – basis for analogy

Ilm – knowledge

Isnad – a hadith’s chain of narrators

Istislah - a mode of legal reasoning that uses maslaha as grounds for making a legal decision
Jahiliyya – the age before the coming of Islam
 190

Jamhur - a lesser degree of consensus, obtained when a majority of jurists agrees on a specific
ruling

Madhhab – a school of Islamic jurisprudence

Mujtahid - one who practices ijtihad

Makruh – an action that is frowned upon but not expressly prohibited and punished

Mandub - an action that is recommended but not mandatory

Maqasid al Sharia – the goals and objectives of Islamic law

Maslaha - public interest or welfare

Maysir – gambling

Muamalat – refers to social, political, and economic practices and issues that are most akin to
the subject matter of other legal systems

Mubah – an action that is permissible but neither rewarded nor punished

Mudaraba – a silent partnership

Mufti – an Islamic scholar who interprets the Sharia and can issue fatwas

Murabaha – a credit, or cost plus, sale

Musharaka - a full contractual partnership formed to pursue a specific line of business or

project

Naskh – the doctrine of abrogation

Qadi – an Islamic judge

Qard – a loan

Qiyas – a form of ijtihad, juristic reasoning by analogy

Quran – the holy book of Islam

Riba - unjustified enrichment through the exploitation of others or through the appropriation of
other’s property for one’s own use without a legitimate reason; commonly equated with interest
in modern times
Sadaqa – a voluntary act of charity, as opposed to zakat, which is obligatory
 191

Sakk/pl. Sukuk – an Islamic bond

Sharia - the method of conduct that Muslims must employ in their lives, revealed in the Quran
and the Sunna

Sunna – the sayings and actions of Muhammad; the example of the Prophet

Taqlid – imitation

Ulama - the community of legal/religious scholars who were well versed in Islam and the Sharia

Wajib – an obligation that is incumbent upon Muslims to perform

Waqf - a religious endowment, similar to a common law trust, which is exclusively dedicated to
religious and/or charitable purposes

Zakah - one of the well known five pillars of Islam, is alms given to the poor. It is incumbent
upon every Muslim to set aside a specific portion of their income for zakah payments

Zann – opinion
 192

APPENDIX J. TIE Example Rationale

American Eagle Outfitters – AEO

Screen Score Rationale
1 3 • Has vendor code of conduct to promote equity and fair trade
• Supports Jumpstart (national early education program), Big Brothers
Big Sisters, and Student Conservation Association (high school and
college students working to protect environment)
• Has American Eagle Foundation - focuses on improving the quality of
2 3 life anywhere AE Associates and customers live, work and play.
Foundation gives out grants to nonprofit, public charities in
Pittsburgh, New York City and Ottawa, Kansas and gift card
donations

• Prohibits child labor among vendors, as well as forced/involuntary

3 3
labor
• Two women executives
6 2 • Wholesome images of women that aren’t overly sexualized
• Many minority models in ads
• Moving some production to Cambodia and Vietnam where quality of
7 2
products may decline
• Strictly prohibits the use of real animal fur in all of its products
9 3
• Prohibits the use of animal testing on its products

Nucor Corp. – NUE

Screen Score Rationale
2 3 • Has supported Habitat for Humanity for years
• Company has a committee to keeping workers safe on the job –
3 3 obviously dedicated to worker safety through a number of company-
wide initiatives
• Recycles one ton of steel every two seconds, making it the largest
recycler of any material in America--more than the nation's entire
aluminum can industry
• Has participated in elite environmental programs, such as the
Environmental Protection Agency's National Environmental
Performance Track program
4 2
• Sponsored construction of a regional butterfly aviary, launched a
waterfowl protection project, and helped preserve wetlands
• But its plants do release greenhouse gases, including carbon dioxide.
While the company makes strides in reducing energy use, its
processes are still energy intensive.

William’s Sonoma – WSM

Screen Score Rationale
• Williams Sonoma brand has natural good food, like grass fed meats
high in omega 3’s, free range poultry, caviar is harvested from
7 3 sustainably farmed Northern California white sturgeon raised in
filtered artesian well water and fed a completely natural diet
• Its products have a reputation for high quality
 193

McDermott International – MDR

Screen Score Rationale
1 2 • Code of conduct contains antitrust language
• Code of conducts supports equal opportunity in hiring and promotion,
3 2
and contains a non-discrimination policy
• Operations and properties can emit environmentally hazardous
substances; also uses coal, natural gas, etc.
• Power Generation Systems segment is a leading supplier of fossil-
4 1
fired steam generating systems
• Designed and built the world's largest waste-to-energy facility in
Florida

Sigma-Aldrich Corp. – SIAL

Screen Score Rationale
• An equal opportunity employer; also has anti-discrimination policies
with respect to suppliers, applicants, customers, and other business
associates
1 3 • One of company’s explicit core beliefs is that employees should be
treated with respect and dignity
• Strictly prohibits harassment, sexual and otherwise, of employees
suppliers, applicants, customers, and other business associates
• Sigma-Aldrich Foundation supports numerous non-profit
2 3
organizations through monetary grants
• Dedicated to making their operations environmentally sound and
reducing their negative impacts on the environment
4 3
• Dedicated to reusing materials, recycling, and reducing waste and
spent material released in the air, water, or land
• Stringent anti-discrimination policies and commitment to equal
6 3
opportunity
• Products are used in pharmaceutical research and the life sciences,
8 3
biotechnology, industrial, and electronic applications

FactSet – FDS
Screen Score Rationale
• FactSet supports communities by making financial contributions,
2 2 matching our employees' monetary donations, sponsoring local
programs, and promoting employee activism
6 2 • FactSet is an equal opportunity and affirmative action employer

Corinthian Colleges – COCO

Screen Score Rationale
6 2 • 3 women executives in high management

Foot Locker – FL
Screen Score Rationale
• Company supports well-established non-profit organizations, schools
and youth centers
2 3 • Works with The Fred Jordan Mission on its annual back-to-school
giveaway event, providing shoes and supplies to thousands of
impoverished youths in downtown Los Angeles
 194

• Foot Locker Foundation - hosted an “On Our Feet” fundraising gala

each year, the proceeds of which are donated to organizations such as
the Twin Towers Fund and United Negro College Fund
• Two women executives
6 3 • Wholesome images of women
• Many minority models in ads

Tiffany’s – TIF
Screen Score Rationale
1 3 • Committed to stopping the flow of blood or conflict diamonds
• Refuses to knowingly purchase rubies from Myanmar due to its
human rights violations
2 3 • The Tiffany Foundation – supports design and decorative arts,
environmental and cultural preservation, responsible mining, and
coral reef conservation
• Working to stop destruction of coral reefs
4 3 • Opposed to destructive gem and metal mining in culturally significant
areas

Ralph Lauren – RL
Screen Score Rationale
• Ralph Lauren foundation serves a large variety of organizations and
2 3 causes, including cancer care, underserved communities, and the
American Heroes Fund (scholarships for children of 9/11 victims)
• Uses models of color on runway and in print work
3 3 • Women are presented tastefully in ads and aren’t excessively
sexualized
• Commitment to fair labor practices among its suppliers does not seem
to be very strong
6 1 • As of its 2008 10K, the company is a defendant in 3 legal cases where
it is accused of improper treatment of workers and improper
compensation practices