When it comes to investing in the stock market, Muslim investors have historically faced a few challenges. That’s because a body of religious law that forms part of Islamic tradition, “Sharia,” forbids investments in many industries that are represented in mainstream indexes and investment funds.
However, in recent years, Sharia-compliant investment products such as eToro’s Sharia-AIGrowth Smart Portfolio have emerged as a compelling solution. With these kinds of products, which offer the ability to invest in the stock market in line with Sharia guidelines, Muslim investors — and other investors looking to invest ethically — can pursue their financial objectives without compromising their values.
Understanding Sharia law in finance
Sharia, also spelled “Shariah,” is a code of ethical conduct that Muslims follow. Designed to create a society that is just, balanced, and harmonious, its guidelines span various aspects of life, ranging from dietary laws and family issues to legal matters and financial activities.
On the financial side of things, Sharia lays out some key principles designed to ensure fair, transparent, and ethical financial practices. It strictly prohibits the earning of interest (“Riba”) as this is seen as unfair since the creditor generates wealth without making any effort. It also prohibits uncertainty, ambiguity, and/or excessive risk in financial transactions (“Gharar”) as a lack of clarity can lead to unfairness or exploitation. In addition, it encourages Muslims to prioritise socially responsible investing and avoid industries that are deemed to be harmful to society (“Haram”).
What industries are prohibited under Sharia?
Given these principles, a number of industries are prohibited from investment under Sharia law. These include:
- Interest-based financial services: Investments in financial services companies such as JP Morgan and HSBC — which derive income from lending activities and/or interest payments — are prohibited.
- Conventional financial services: Firms offering conventional financial services such as insurance (e.g., Aviva) and speculative trading (e.g., Goldman Sachs) are generally excluded due to the fact that their transactions involve a high degree of uncertainty.
- Alcohol: Any company involved in the production, distribution, or sale of alcoholic beverages is considered non-permissible for investment. An example here is Anheuser-Busch InBev, one of the world’s largest beer companies.
- Gambling and betting: Investments in casinos (e.g., Wynn Resorts), betting firms (e.g., Flutter Entertainment), and lottery ticket companies are forbidden, as gambling involves a high degree of uncertainty and can also be exploitative.
- Tobacco: Due to the health risks associated with tobacco, investments in companies engaged in its production and sale such as British American Tobacco and Altria Group are not permitted.
- Adult entertainment: Sharia law forbids investments in businesses related to adult entertainment, as this industry is considered to be morally harmful.
- Pork products: Companies that produce pork or pork-related products (e.g., Tyson Foods) are prohibited due to Islamic dietary restrictions.
- Weapons and defence: Companies that manufacture weapons or engage in military contracting may be prohibited if their activities are deemed to contribute to conflict and social harm. Lockheed Martin Corporation, a global security and aerospace company involved in manufacturing advanced military equipment, is a good example here.
With so many types of companies deemed unsuitable for investment, building a long-term portfolio has traditionally been a complex task for Muslim investors.
The rise of Sharia-compliant investing
As a result of the strict limitations imposed by Sharia law, Sharia-compliant investment products have emerged in recent decades. They offer a principled approach to investing, whereby investments are aligned with the ethical and social values prescribed by Sharia.
This area of finance is seeing very strong growth today. According to S&P Global, assets under management (AUM) in the Islamic finance sector are projected to rise to almost $5 trillion by 2025, more than double the figure in late 2023.
One reason the industry is growing so quickly is that Sharia-compliant investment products are getting a lot of attention from investors outside of the Muslim community. With their focus on socially responsible investments, these products are popular with a broad range of investors looking to invest ethically.
Building a Sharia-compliant portfolio
In order to build a Sharia-compliant investment portfolio, there are several steps a portfolio manager must take.
Stage 1: The first step is business activities screening. This involves screening out companies whose primary operations are in sectors forbidden by Sharia law such as alcohol and tobacco manufacturing, adult entertainment, and gambling.
Stage 2: The next step is financial ratios screening. Here, companies that passed the initial screen undergo further screening based on specific Sharia-compliant financial ratios. These ratios include:
- Debt to market cap: Companies with a debt-to-market cap ratio of above 33% are screened out to eliminate businesses with a large amount of leverage (Sharia discourages the use of excessive debt).
- Accounts receivable and cash to total assets: Companies with accounts receivable and cash representing more than 50% of total assets are screened out to eliminate firms with excessive liquid assets (these assets may accrue interest).
- Interest and unethical income to revenue: Companies with total interest and unethical income to revenue of up to 5% are permitted. This recognises that some incidental interest income is almost unavoidable in modern-day business operations.
Stage 3: Finally, there’s the “purification” process. Even after the first two steps, Sharia-compliant investments can inadvertently generate a small amount of non-permissible income. So, investors are advised to purify their holdings by calculating and donating any impermissible earnings to charity, ensuring their investments remain fully in line with Sharia ethics.
Sharia indexes
Note that today, there are several Sharia-compliant stock market indexes that cater to investors seeking to align their investments with Islamic principles. Many of these are based on existing stock market indexes such as the S&P 500 Index, with companies that are non-compliant with Islamic finance removed.
Some examples of Sharia-compliant indexes include:
- The S&P 500 Shariah Index: This contains all Sharia-compliant stocks within the S&P 500 Index (the leading benchmark for the US equity market). Currently, it contains around 275 stocks versus 500 for the regular S&P 500, with the Technology, Healthcare, and Consumer Discretionary sectors having the largest weightings.
- The Dow Jones Islamic Market World Index: Established in 1999, this Sharia index was among the first to offer investors a comprehensive snapshot of the global Islamic investment landscape. It currently has around 4,700 constituents with the Technology, Healthcare, and Industrials sectors having the largest weightings.
- The MSCI World Islamic Index: This is a Shariah-compliant version of the MSCI World Index, which tracks the performance of large and mid-cap stocks across 23 developed market countries. It currently contains around 370 stocks, compared to 1,465 stocks for the MSCI World, with the Technology, Energy, and Healthcare sectors having the largest weightings.
Over the long term, these indexes have provided very competitive returns due to their focus on businesses with conservative financial practices. The S&P 500 Shariah Index, for example, returned 14.25% per year for the 10-year period leading up to the end of March 2024 versus 12.96% per year for the regular S&P 500 index.
That said, there have been times when Islamic indexes have underperformed traditional stock market indexes due to their different compositions. For example, when banking stocks generated big gains in 2016, some Sharia indexes lagged behind their traditional counterparts.
eToro’s Sharia-AIGrowth Smart Portfolio
While Sharia indexes and products have been around for a while now, they haven’t exactly been very exciting. Ultimately, there has been a real lack of innovation in this area of finance.
To shake things up and offer investors a more sophisticated investment solution, eToro has partnered with FinTech company Arabesque AI to develop the Sharia-AIGrowth Smart Portfolio. This is a fully allocated Sharia-compliant portfolio that leverages the power of artificial intelligence (AI) when selecting stocks in which to invest.
With this strategy, a series of Sharia screens are run to create a universe of US stocks that meet the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) guidelines. This includes a business activities revenue screen and several financial ratio screens.
Once the universe is Shariah “clean,” we apply advanced analysis to evaluate each stock on a range of factors including fundamental metrics, technical indicators, and analyst estimates, with Arabesque’s proprietary AI Engine leveraging a range of machine learning models to identify the most attractive investment opportunities in terms of expected return.
Finally, a portfolio of around 40 stocks is assembled, with a focus on companies with strong earnings growth over the previous 12 months and high ESG scores.
It’s worth pointing out that Arabesque AI has been developing Sharia-compliant solutions since 2014. Since then, it has partnered with many leading financial institutions, building up a reputation as a leader in the provision of Islamic fund management and investment advisory services.
With this Smart Portfolio, investors can benefit from the firm’s deep expertise in the world of Sharia investing. They can also benefit from the firm’s advanced AI-driven portfolio management tools, which are designed to help deliver superior long-term results.
You can find more information on the Sharia-AIGrowth Smart Portfolio here.
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