Islamic assets are expected to reach US$3.7 trillion by 2024
The demand for ethical forms of finance and investment has increased in recent years.
People have begun to realize the need for an ethical approach to their finances and now understand the benefits of investing responsibly.
KiwiSaver Suppliers and investment firms have also placed greater emphasis on environmental, social and governance (ESG) factors when choosing investments to include in their portfolios, and many have some form of responsible investment (RI) policy, which shows the increased interest in sustainable investments.
Although ethical finance has only recently gained popularity, it has been around for centuries. Islamic finance, which falls under ethical finance, dates back more than 1400 years. While Islamic finance is as old as Islam itself, it has only been embraced by banks and financial institutions since the 20th century. The industry is expected to have $3.7 trillion in assets by 2024, according to the Islamic Finance Development Report 2020.
So what exactly is Islamic finance?
The Principles of Sharia
Islamic finance follows Islamic principles and jurisprudence (Shariah), designed to promote social and economic justice. The emphasis is on partnerships in Islamic finance, which means that for both parties to any transaction, the benefits and risks should be shared equally. This eliminates the ability of one side to take advantage of the other.
Ethical Amanah is one such investment manager who embodies these Islamic principles. Offering KiwiSaver funds and investments that follow a strict ethical mandate, Amanah aims to ensure that your investments contribute to the betterment of humanity rather than solely seeking profit at the expense of society. Avoiding speculative investments, along with their core ESG principles, makes Amanah a good example of Islamic finance operating in New Zealand.
Islamic finance does not deal with interest because it involves an imbalance of power between a lender and a borrower. Interest accrues to the lender, who charges interest at the expense of the borrower.
Islamic finance views money as a medium of exchange and does not believe that money has real value on its own.
Therefore, money cannot be earned on something that has no real value (money). Instead, it encourages making money with an asset, which holds its own value.
Risk and speculation avoided
When it comes to Islamic finance and investing, two things it avoids are excessive risk (Gharar) and speculation (Maisir), which are common in conventional finance.
Derivative contracts such as forwards, futures and options, as well as short selling are examples of excessive risk and speculation. These contracts involve uncertainty because they aim to predict the future price of an underlying asset (game), causing one party to profit at the expense of the other. Islamic finance prevents falling into excessively risky or speculative investments and requires that all conditions be clear and well defined before either party enters into a contract.
Islamic investments follow a strict set of criteria, which involve the exclusion of investments in companies involved in controversial industries such as tobacco, weapons and alcohol. Emphasis is also placed on companies that produce sustainable returns and have minimal leverage.
Islamic banking vs conventional banking
One of the fundamental differences between Islamic banking and conventional banking is the use of interest. Banks make money in multiple ways, including charging interest through credit cards, investing their customers’ money from savings accounts, and interest on mortgages.
Customers who cannot repay their credit card loans are required to pay interest to the bank. From an Islamic point of view, you are not allowed to benefit from lending money or receiving money from someone.
Conventional savings accounts are based on a creditor-debtor relationship, in which the bank borrows the customer’s money and invests it or lends it to others. The bank then returns the customer’s money with agreed interest and keeps the remaining profit for itself. There is no risk taken by the lender (customer) as they are guaranteed the interest.
In a mortgage, the bank lends money to the customer to buy a house. The client then periodically repays the money with interest over a set period. Again, there is minimal risk from the lender’s (bank’s) perspective, and if the client is unable to repay the loan, the bank will repossess the property and sell it to cover the cost of the loan.
Islamic banking is designed so that profits and losses are shared equally between the two parties in a transaction. This eliminates the bank’s ability to take advantage of the customer.
The Principle of Mudarabah
Sharia-compliant savings accounts are usually based on a partnership contract called the Mudarabah principle. The client acts as the financier and the bank acts as the fund manager. All investments made are screened and Sharia compliant. The bank and the customer agree on a profit/loss sharing ratio. As the bank will have studied the investment, there is an expected profit, but this could potentially fluctuate. Therefore, both parties take risks. The bank then receives a portion of the profit (just as a fund manager would), and the client receives the remaining profit.
For Islamic mortgages, there are several types. The most commonly used type is loan-to-lease (Ijarah). The bank buys the property from the seller and then agrees to lease it to the customer for a fixed period. Once the client has made their final lease payment, the bank then transfers ownership of the property to the client as a promissory note. The customer has not borrowed money from the bank and is not paying any interest.
Is Islamic finance only for Muslims?
Islamic finance is not restricted or benefits only Muslims. Whether you invest in managed funds or KiwiSaver, the transparent model of Islamic finance encourages being ethical and moral, which its proponents say can further improve communities and economies.
Given all of these factors, getting help from KiwiSaver advisors like National Capital can help investors ensure that their investments are in line with their personal beliefs.
Clive Fernandes is a licensed financial advisor and the principal of National Capital, a financial advisory firm that provides personalized investment advice, with a primary focus on KiwiSaver.
Disclaimer: The above article is not intended to be personalized advice. It is general in nature and may not apply to an individual’s situation. Before making any investment, insurance or other financial decision, you should consult a professional financial adviser. A copy of Clive Fernandes’ disclosure statement is available upon request and free of charge.