By Saliegh Salaam
Shariah- compliant funds have a lighter ESG footprint than conventional funds and focus on the welfare of society
The effects of the COVID-19 pandemic and the repercussions of the economic fallout continue to reverberate around the world, despite the rolling out of efficient vaccine programmes in multiple countries and the slowing of infection levels.
Advocates of sustainable or environmental, social & governance (ESG) investing have been warning for years about the risks of ignoring the interconnectivity of financial systems with society and the environment, as well as the vulnerability to biophysical shocks this relationship creates for markets.
Yet it took a ruthless virus causing the world to tilt on its axis before the majority of market participants accepted the severity of the risk.
Much has been reported on the swell of interest in ESG investing as the pandemic brought responsible investing into the mainstream. The challenges facing the global economy off the back of the COVID-19’s disruption have highlighted the need for resilient sustainably managed companies and the financial benefits of integrating ESG factors.
However, less has been made of the role of shariah investing during the upheaval of the past year. With a high degree of overlap between shariah and sustainable investing, the Islamic view underpinning shariah investing advocates sustainable development and protection of life and the environment.
Key objectives of the shariah are to promote the welfare of humanity and prevent harm by preserving religion, life, intellect, the interests of future generations and wealth. But shariah investing widens the focus beyond financial returns to include the overall wellbeing and welfare of individuals and society at large as well as environmental preservation.
Studies have highlighted that shariah-compliant funds have a lighter ESG footprint than conventional funds, with an analysis of 6,554 companies in Refinitiv’s database showing a 5.9% higher overall ESG score for shariah-compliant companies vs non-shariah compliant.
The Old Mutual Albaraka shariah funds actively integrate ESG factors into their investment process and decision-making. ESG metrics are incorporated into our definition of business quality as we firmly believe ESG to be a proxy measure for management quality. Companies with superior ESG metrics are less sensitive to market shifts and are better equipped to manage business-specific risk.
The long-run transition to a low-carbon, socially inclusive and resource-efficient economic growth path, otherwise known as green growth, is one of the most significant global economic shifts in the past two decades. At a fundamental level, companies that respond to this “disruption” will reap the benefits of stronger growth prospects, enhanced operating efficiencies, stronger social licence to operate, better staff retention, lower cost of capital and, ultimately, a stronger and more sustainable competitive advantage.
However, as the world looks to rebuild after the pandemic’s devastation, shariah investing brings additional elements that can support the economic recovery process. Through its foundational principles of risk sharing and the prohibition of speculative investments, coupled with its cautious use of debt in an environment of ever-rising debt burdens, and investment in real underlying economic activities, shariah investing can present an additional avenue for policymakers and investors to explore to remediate the damage caused by the pandemic.
In addition, by means of the global pool of income that Islamic investors are not allowed to partake in for religious reasons, shariah investing strengthens social safety nets through high-impact grass-roots investments that are aligned with UN sustainable development goals.
The exclusion of investment in highly indebted companies, or those earning excessive interest, is one of the characteristics that differentiates it from traditional ESG investing. Bailouts of countries and companies reached unprecedented highs during the past year and the levels of indebtedness facing these economies and balance sheets is a burden that will have to be carried for decades to come.
The pandemic underscored the fact that high levels of debt are likely to make a business vulnerable to adverse external developments. By reducing some of the potential downside risks during times of stress, resilience and sustainability of investment returns are improved. In this sense, leverage restrictions are an additional source of prudence and a factor that left shariah investors well positioned as the market carnage hit during 2020.
Furthermore, shariah investing precludes investing in companies with high cash balances as these could be an indication of poor corporate governance. As well as being potentially inefficient, it may be better for companies to return excess cash to shareholders. High cash also increases the risk of cash being squandered on ill-advised acquisitions or financial engineering that does not benefit the real economy.
Before the pandemic, many US corporations with “excess” cash on their balance sheets allocated their cash towards the financial engineering activity of share buybacks. When the pandemic hit, many of these companies’ balance sheets were adversely affected. This necessitated trillion-dollar taxpayer bailouts. From a shariah investing perspective, this financial engineering is not a responsible use of shareholder capital — all stakeholders, including shareholders, are better served through investments in productive assets that can stimulate the real economy and support long-term economic as well as business growth.
There have been many lessons for investors and markets since the world was turned on its head by COVID-19. But hopefully the most prominent of these has been that the fragile stability of the global economy and markets needs to be reinforced by long-term system resilience based on a common goal.
By actively integrating shariah investing principles into ESG investing and applying our investment philosophy of investing in high-quality, growing and attractively valued companies while managing risk, we have amplified the future sustainability and resilience of investment returns to our investors.
Volatility is a feature of markets. By embracing the principles outlined above, our fund is better prepared to endure these inevitable periods of volatility.