The following is some general information for the benefit of private individuals who wish to invest in accordance with the requirements of Islamic law. It is not a recommendation to any particular course of action. Specific laws and practices will vary from country to country, hence some of these comments may not apply to your situation. You should seek professional advice before making an investment decision.
Some General Points
Perfection May not be Possible
In modern times it is often difficult to attain complete shari`ah compliance in matters of commerce and investment. For example, in many Western countries, the supply of basic utilities such as electricity or gas are made under a contract in which the supplier has the right to charge interest in the event of late payment. Under traditional Islamic law, such a clause makes a contract void or invalid on account of the fact that Islam regards interest as a form of riba (usury). Should a Muslim refuse to have a supply of electricity or gas in this case? Modern scholars have accepted that a Muslim living in a Western country can sign such a contract, as the interest element is not central to the contract and life without essentials such as electricity will be difficult or in some cases impossible. Some degree of compromise seems inevitable in these circumstances. Likewise, many modern Muslim scholars have permitted the purchase of listed shares in limited liability companies on the basis that commercial life would be difficult or impossible were interaction with such companies totally prohibited. This is despite the fact that most such companies have borrowed or loaned money at interest, and that the larger ones among them have subsidiaries which deal in haram goods or undertake haram trade practices. There is even some doubt as to whether the concept of limited liability, which underpins the modern corporation, is permitted in shari`ah and investment into company shares remains something of a grey area for Muslim investors. Given such realities, one should at least try to be consistent when making decisions on shari`ah compliance. For instance, it might not be consistent to refuse to lease a car on account of the interest charge on late payments, while accepting an electricity supply which imposes exactly the same condition. Often the best that one can do in these situations is to reduce the prohibited component, and this has been the focus of much scholarly thinking (and justifications) in the field of finance in recent years. However, since one is not usually under an obligation to invest money, it is best to err on the side of caution and avoid doubtful types of investment. This is especially the case given the perspective of Islamic theology that the sustenance of an individual is fixed from before the time of his or her birth. This implies that the wealth received by an individual may not in fact be affected by his or her investment decisions, in which case the only logical course of action is to do the "right thing" so far as the rulings of Islam are concerned.
Have You Paid Off Your Debts?
In Islam it is seen as an oppression for a wealthy Muslim to delay repaying his debts when he can afford to do repay them, and it is also well known from the hadith that "the hand which gives is above the hand which takes" (narrated by Hakim ibn Hazm and recorded in Al Bukhari) in matters of charity (of which interest-free loans are one kind). It may therefore be best that Muslims consider repaying their debts before devoting their surplus wealth to investment schemes of one kind or other. This approach may be regarded as commercially unsound by non-Muslims in developed countries who are accustomed to borrowing money at interest in order to buy property. Since property tends to rise in price in most years, and provides a rental income that exceeds the interest costs in the meantime, this has been a very profitable activity for many ordinary homeowners as well as for professional speculators. When Islamic mortgages are available, Muslims may also ask why they cannot join the game of house price speculation. In the case of interest-based debt, Muslim scholars agree that it is imperative for a Muslim borrower to repay his debt as soon as possible. However, in the case of someone who has taken a genuine Islamic mortgage there is no obvious legal ruling which prevents the investment of surplus wealth while the mortgage is still outstanding.
It is usually not a good idea to put a large portion of one's wealth into one kind of investment asset. Most financial advisors will urge that investments are spread among different types of asset (for example, residential property for letting out, precious metals, company shares) and ideally these assets should themselves be diversified geographically (for example some in Europe, some in America and some in Asia). When diversification is carried out properly, a poor performance in one part of the world will affect only a small part of the investor's total portfolio. On the other hand, by spreading investments among different assets, the investor will not benefit as much from a strong rise in the value of one particular market. The decision on how much to diversify should therefore be taken with regard to each investor's preference for risk and views on the future direction of asset prices.
What are the Transaction Costs?
Always make sure you know what fees are being charged by intermediaries or investment firms. Charging practices are often unclear. For example, if a firm tells you that it charges "no initial fees" don't just leave it there. Ask whether it charges a "commission", or an "annual management fee", or any other kind of fee. Also check the "spread" (the difference between the price at which you can buy and sell the asset in question) because one day you may need to sell what you are about to buy. This applies particularly to Islamic funds which are often illiquid investments. Also bear in mind that even a small percentage fee can have a dramatic effect on the value of an investment fund over longer periods of time. For example, if you invest $1000 into a fund which yields an annual return of 8%, then after 30 years the $1000 will have grown to $10,062. However, if a fund manager had charged 1% of the value of the fund every year as a management charge, then the final value of the fund after 30 years would be $7,612. If the annual charge was 2%, the final value of the fund would be $5,743. At an annual charge of 4%, the final value of the fund would be $3,243, meaning that by the end of the 30 year period almost 70% of the value of the investment fund would have been paid away in management fees. By making and executing your own investment decisions, you can often avoid high charges, but of course you will have to do the underlying investment research yourself. Several financial institutions in developed countries offer on-line international dealing services at a reasonable cost per transaction. See for example the Lloyds TSB share dealing service in the United Kingdom.
You Probably Don't Know More than the Big Boys
Private investors who are new to financial trading often think that they have some special talent that will give them an advantage in the market. Very often this is not true, and the investor proceeds to lose a large amount of wealth to more sophisticated market players. Global financial institutions usually have large research departments and very well placed contacts in commerce and politics from whom they are able to obtain advanced information before it hits the news headlines. Whilst it is also true that large financial institutions can make very large trading mistakes from time to time, in general they tend to be profitable in most years (the long term growth of the financial sector as a percentage of the overall economy indicates this strongly). The message here is that, unless you have sensitive financial information in your possession, or a special trading programme, or some other advantage over competing investors, be very careful before becoming a frequent trader on financial exchanges.
Who is Holding your Assets?
In some cases, particularly for tax or inheritance planning reasons, it may not be best to hold assets in your own name. In these cases a family company or a trust arrangement of some kind may be a more appropriate vehicle for holding some or all of your investment assets, although this normally only applies for wealthier clients since the costs of setting up and managing these vehicles can be substantial. In many cases, including for smaller amounts of investment, it may be advisable to hold assets in your own name rather than in someone else's. The main reasons for this relate to credit risk and security. For example, if an investment manager holds a client's shares in its own name, and then goes into bankruptcy, the investor may have difficulty retrieving his investment. Some financial intermediaries hold their client's shares in their own names as 'nominees' in order to simplify the trading process, and the same concern may apply here. Also be sure to know the terms under which your investment account operates. For example, if there is a joint holder of your account, is this person able to withdraw the investment assets without your permission?
Beware Financial Salesmen
If you receive an unsolicited approach or telephone call offering you an "exciting investment opportunity" beware! Salesman are often trying to earn a commission, or perhaps trying to sell assets that their own company doesn't want to hold. And just occasionally they really do have an exciting investment opportunity to offer you. In any case, never make an investment decision on the spot. Always go away, think about it, and do some background research. Remember that the Islamic investment sector is not immune from hard-sell practices and poor performing investment assets.
What are the Tax Implications?
In many countries, tax will be payable on any increase in the value of your investments, or on any income that you receive from them. Find out how much tax you will have to pay on an investment before entering into it. In many countries, the government has created umbrella schemes to reduce or eliminate tax on a wide range of investment assets, such as Tax Free Savings Accounts (TFSAs) in Canada and Individual Savings Accounts (ISAs) in the United Kingdom. Such schemes typically allow annual contributions to be made (up to a defined limit) while keeping any income or capital gains free of tax (or in some cases, taxing them at a reduced rate). Often there are no restrictions on withdrawal (this compares favourably with pension schemes in which withdrawal cannot usually be made until retirement age). It can therefore be worth using such a scheme as a vehicle for your investments. Other types of tax concession are only available for specific kinds of asset. For example, in the United Kingdom, if you want to invest in gold then it is worth knowing that capital gains tax is not charged on gold sovereigns (as of 2012) whilst other forms of gold such as Krugerrands are liable for capital gains tax. For many kinds of investment, the tax treatment may change the net profit that you obtain on your investment significantly, so if you are investing a large amount it may be worth consulting a tax adviser first. Remember also that zakat should be paid on wealth that you have saved, however there are different schools of thought regarding whether zakat is to be paid on invested wealth such as company shares and on money that you have loaned to others. You should therefore check the position of the school of Islamic thought to which you subscribe, with regards to your investment portfolio. Of course, this should be done in all sincerity and not as part of a process of trying to reduce the amount of zakat that you will have to pay in due course.
Worldly Wealth will be Left Behind, Charity Lasts for Ever
Secular thinkers may have difficulty understanding the famous hadith that "charity does not decrease wealth" (narrated by Abu Hurayrah in Muslim). Materialistic modes of thinking are of little use in understanding this principle, but the Muslim donor trusts that Allah will supplement his or her wealth in some way that cannot be forecast. One should not make assumptions as to the form in which such a supplement will be received (it may be that the donor enjoys greater security by meeting the basic needs of others, or perhaps one's wealth will be increased in the next life). The main point to remember here is that Muslims are encouraged to give charity and this should not be forgotten in the rush to maximise the value of an investment portfolio. Worldly wealth will soon be left behind, whereas good deeds will remain in the record of each Muslim for measurement on the Day of Judgement.
Investment Assets and Investment Methods
An ordinary share (commonly known as an 'equity') gives its holder certain rights of ownership over the assets of a company in the event of its dissolution. An ordinary share is often seen as a portion of the ownership of a company, although legally speaking this is a slightly questionable way of looking at things. The holder of an ordinary share in a company generally shares its good or bad financial fortune, for example through increases or decreases in the share price, or through periodic payments of dividends that are made from the profits of the company. If the company makes a large loss, it may go into bankruptcy in which case the value of its shares may fall to zero and the investor will have lost all of his or her investment. In this sense, an ordinary share is seen as complying with one of the basic requirements of Islamic law that investors should share the profits and losses of a venture. However, it is also true that most forms of company share, certainly those traded on popular stock exchanges, are given the protection of limited liability, which protects the personal wealth of the shareholder from being approached by creditors of the company in the event of bankruptcy. In other words, the most that an investor in an ordinary share can lose is the amount that he or she spent to buy it in the first place. Muslim scholars have traditionally prohibited the use of limited liability to protect investors from financial obligations arising out of their business investments, but modern scholars have come to accept it based on the fact that it is all-pervasive in the modern world and business would be almost impossible if all interaction with limited liability companies was to be prohibited. If a Muslim is to invest in the shares of a company, these modern scholars tend to require that the business sector of the company generally complies with shari`ah (one cannot own shares of companies that operate as interest-based banks, casinos or pork producers for example) and the issuer of the share must not undertake its business in a way that is prohibited (for example, it should not have borrowed money at interest from a bank in order to finance its operations). Several investment firms now provide information on funds and shares that pass modern screening criteria on shari`ah compliance. For example, see the free trial at Eurekahedge. Bear in mind that other types of share exist that are more controversial or generally prohibited for Muslims. For example, some kinds of preference share pay a fixed amount of dividends every year to the holder, so long as the issuing company has sufficient funds available. In such cases, the return to a preference shareholder may not reflect the portion of the profitability that would be due under Islamic rulings, and both traditional and modern jurists therefore tend to prohibit such an investment.
Try not to leave yourself without a reserve of cash for emergencies, and if possible an amount of cash to meet general expenditures for a period of a few months ahead. This helps to reduce the chance of being exploited for lack of readily available money. For example, some employers may try to impose unreasonable working conditions on employees who are desperately in need of cash and therefore unable to leave their employment in order to find a better alternative. Because Muslims are often among the poorer members of society in Western countries, many are unable to build up a reserve of cash. For those who can, a decision must be made on whether to hold cash in hand or in a bank deposit. Some Islamic banks offer savings accounts which guarantee the capital amount as well as offering a potential gain on the account (see Islamic Bank of Britain for one example) although the mechanism by which this is achieved is controversial in shari`ah. Two important points to bear in mind are that savings in a bank account can often be withdrawn at short notice (in other words they are very "liquid") and in many countries the government guarantees the value of a deposit up to a specified amount in the event of the failure of the bank in question. The period of notice required for withdrawal and the precise terms of any government guarantee should be considered before making a decision to deposit in a bank. A third, and perhaps most important point to consider, is that in the long run, cash or money in a bank account loses its purchasing power compared to real assets such as property and commodities, and also compared to a basket of shares in major companies. The "long term" varies between currencies, but in most cases this comparison is correct for any period of fifteen years or more, and in some developing country currencies it is true for periods as short as five years. Holding large amounts of money in the form of cash or in a bank account for a long period of time is therefore not advisable (this point is developed further in the next section). It should also be kept in mind that by depositing cash in a bank account, Muslims may be helping to sustain a financial system that undermines Islamic values and laws (banks often finance un-Islamic business activities, and almost always use customer deposits to practice fractional reserve banking). This problem can be avoided by holding money in the form of cash (at home, or perhaps in a safety deposit box) rather than in a bank account.
Commodities include precious metals, base metals and agricultural produce. Some investors like to buy commodities in order to benefit from future price rises, for example if they expect the price of wheat or gold to increase in the future. One particular form of commodity investment that is prohibited in Islam is the hoarding of foodstuffs, particularly during times of famine, and the investor should therefore consider whether investment into agricultural commodities contravenes this ban. Over the last century, precious metals have maintained their purchasing power while every national currency has lost most of its purchasing power. There is little reason to think that this general trend will change in the near future without fundamental change in the global monetary system, hence investors who wish to store their wealth in a liquid form over a long period of time should consider keeping a portion of it in precious metals. It is however important to remember that the holder of precious metals may suffer a capital loss in the short term, since commodity prices can be very volatile. Also, commodities in safe storage do not yield an income since they are not invested into a productive process, while money invested into a business of some kind will insha'Allah produce a profit over time. The holder of commodities is trying to protect existing value, while the investor in a business is trying to increase value. There are various ways of buying commodities. One way is to buy the physical commodity, in which case the investor will take delivery of a ton of wheat or a kilogram of gold, for example. The question of how to arrange storage therefore becomes relevant here. For precious metals, a small safe storage box in a secure vault can cost around $200 per year, while for bulky items, the normal method of holding is by means of a warehouse storage facility against which warehouse receipts are issued to the owner. There are many dealers in the USA, Europe and Asia who supply precious metal commodities (see for example Kitco in North America or our own site in the United Kingdom) and rather fewer who supply base metals and agricultural commodities. An alternative way of buying commodities is through a company whose only assets are the commodity itself. Some such companies are listed on a stock exchange and are called "exchange traded funds" (ETFs). One example of such a company is ETF Securities which has issued various ETFs on the London Stock Exchange (look for the "physical" ETFs). It is important to invest only in physical ETFs, these being ETFs which hold their assets exclusively in the form of physical commodities. Some other types of ETF achieve the same returns as the physical ETFs, but do so by betting on the price of the underlying commodity rather than by buying it outright. These "contractual" ETFs are not shari`ah compliant.
Property is a permissible form of investment in shari`ah, and can be held for rental income and capital gain. Two main types of real estate asset are commercial (for example office buildings and shops) and residential (mainly homes and apartments for private use). The former type of real estate often involves more complexity from the legal standpoint and investors who buy commercial property should use an experienced lawyer to ensure that matters such as maintenance and termination rights are properly dealt with in the lease documentation. If you do not have sufficient money available to buy real estate on your own, you may wish to join together with other investors to purchase a property using some form of joint ownership where it is available (in the United Kingdom this would be the form of ownership known as "tenants-in-common"). Alternatively, one could establish a legal entity (such as a limited company, limited liability partnership, or partnership). Investors would acquire shares in the entity, and the entity would then buy the property. For investors in the United kingdom, Companies House gives details on how to establish a company or limited liability partnership. An important financial statistic in real estate investment is the prospective rental yield (this is the estimated rental income over the next year divided by the current purchase price) and real estate practitioners look at this figure closely in order to measure value. A property with a rental yield of 7% may not necessarily be better value than a property with a rental yield of 5%, if the former has a very short tenancy agreement remaining or is in a poor area where prices are expected to fall. Hence it is essential to look at the potential for capital gain, and the length and quality of any existing or potential tenancy, before deciding to invest in a particular piece of real estate.
The following points relate particularly to the United Kingdom. As governments generally wish to encourage people to save for retirement so as not be a burden on the state in their old age, they have in many countries provided tax incentives that make pension contributions tax deductible up to certain amounts. Income received on pension fund assets may also be free of tax or taxed at a reduced rate. Tax is then paid on the amounts received as a pension during retirement, and this is often at a lower rate than would have applied during the individual's working life. Three main forms of pension are common. A pension may be provided by an employer as part of an employment package, it might be provided directly by the government, or an individual might establish a private pension plan and contribute to it during his working life. There are two main issues to deal with here from the shari`ah perspective. Firstly, if you do not contribute to a fund from which your pension will eventually be paid, then the pension itself can be seen as a delayed remuneration for work that you have already performed (payment for work is of course an acceptable form of contract in Islamic law). One could go further and ask how an employer is funding the pension payments that it makes to retirees. If the employer makes payments from a fund that holds impermissible investment assets, or if the employer will be using interest income in order to make pension payments, then a more difficult question arises, namely how much attention should a Muslim pay to the origin of funds which he receives in a halal transaction? This is a question over which opinion is divided. Abu Bakr vomited food which he had eaten upon finding out that it had been purchased with money earned through prohibited means. On the other hand, it would impose considerable difficulty on a shop owner if he was required to ask each of his customers how they earned their living. Secondly, if you contribute to a fund from which some of your pension will be paid, then you are entering into a transaction of money now in return for money later and the rulings of partnership become relevant. For example, if your share of any profits made with your contributions is not specified at the outset, then this will break the rulings of partnership which require that investors share gains and losses in specified ratios. The investment of your contribution should also be made in permissible ways (hence, not by means of interest bearing loans) into business activities that are permitted in shari`ah. Depending on the local laws, it may be possible to establish a private pension scheme in which the investment policy can be designed according to Islamic requirements and these concerns will then diminish. However, local laws may also determine how the retiree is paid from a private pension scheme. For example, until recently, retirees in the United Kingdom were required to invest a minimum of 75% of their pension fund into an interest-bearing annuity. Therefore, a Muslim who intends to invest in a pension scheme should check not only the investment policy of the scheme, but also what rules apply to the fund upon retirement. A number of professional firms advise on pension and inheritance tax planning for Muslims in the United Kingdom (see for example Simply Sharia and One E).
It has become increasingly common in recent years for investors to trade shares, commodities and foreign currencies through brokers. In the past, such brokers offered a simple service in which the investor paid cash to the broker's account and the broker delivered in return a share certificate. Today trading methods are very different. Many financial dealers offer contracts-for-differences ("CFDs") in which the investor effectively makes a bet on the future direction of the price of the underlying share (or commodity or foreign currency). If the bet goes in favour of the investor he will make a profit, and if it goes against him he will lose. In shari`ah, the latter method of trading is seen as gambling, the key feature in this case being that ownership of the underlying asset is not transferred to the owner. Furthermore, in some forms of CFD, the investor can lose more money than was paid in the first instance. This is because CFD trading is a form of margin trading where only a small portion of the value of the underlying asset (the "margin") is paid by the investor at the outset. The remaining balance is usually never paid, and instead the bet is eventually reversed by making an exactly opposite second trade which 'closes out' the first trade. Two other trading methods that involve margin of some kind are futures trading and options trading. Here again, a small initial amount is paid by an investor who wishes to expose himself to the change in price of an underlying asset. Such trading methods are generally prohibited by traditional scholars of Islam as they contravene some of the basic requirements of a valid contract of exchange. For example, futures trading always breaks the prohibition on double deferment of countervalues. In other cases, the underlying asset may not be deliverable (a share index for example), or the asset itself may be something that shari`ah prohibits (an interest-based government bond for example).