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Islamic Finance and SRI: Any Crossover?

Novethic

September 2009
 

Socially responsible investing (SRI) is an investment management approach which integrates environmental, social and governance (ESG) criteria in traditional financial analysis. Despite having less framework and detailed rules than Islamic finance, SRI shares a focus on non-economic factors in its economic and social principles.

According to the Social Investment Organisation, SRI is seeing considerably lower shareholder redemption rates than conventional funds – strong evidence that suggests investors are committed to SRI for the long-term.

The principle of Shariah, on which Islamic finance is based, applies ethical and extra-financial criteria that represent potential crossover with SRI. It bears similarity to SRI in its socially responsible purpose and the exclusion of businesses deemed unethical. Islamic finance is, however, an entire financial system in its own right.

This article points towards possible answers by first outlining the basic principles of SRI and Islamic finance. It then analyses any potential compatibility between their processes and reviews the new financial products on the market, which for the first time combine the two strategies.

Socially Responsible Investing

The first SRI resolution was filed in the late-1960s in the US by church groups and student organisations whom opposed to the war in Vietnam. Another notorious topic was apartheid in South Africa. The Interfaith Centre on Corporate Responsibility (ICCR), now comprising 275 Protestant, Catholic and Jewish institutions holding over US$120 billion, has since spearheaded shareholder activism on social issues in the US.

Religious activists in the UK also participated in the campaign against apartheid from 1970 to 1984, notably challenging Barclays Bank and oil giant Royal Dutch/Shell. Their endeavours to convince institutional investors to divest from these companies led to Barclays’ partial withdrawal from South Africa in 1985. Furthermore, the development of this campaign on both sides of the Atlantic resulted in the departure of over two-thirds of US companies active in South Africa.

Today, the SRI assets owned by religious groups are marginal compared with institutional investors such as insurance companies, welfare organisations and pension funds. Ironically, the development of SRI in the past ten years by most asset management firms has led to a degree of aversion to ethical investment approaches.

This is due to two factors – the financial management problems arising from the exclusion of certain securities or sectors, and the difficulty in identifying ethical standards shared by investors who are not united by a single religious conviction. Instead, much stronger emphasis has been placed on sustainable development focused on environmental, social and governance issues.

Crossover with SRI: Islamic Purpose and Moral Principles

Islam may be considered a system of standards based on moral and ethical values. The purpose of Islamic finance is to improve living conditions and well-being, establish social equity and prevent injustice in trade relations. This is precisely the reasoning behind the prohibition of usury and its replacement with a system whereby profits and risk are shared more equally.

This purpose resembles that of SRI as it has developed in recent years, with its focus on sustainable development in its economic and social principles – creation of wealth for society and improvement in the quality of life.

The environment is also considered in Islamic finance – one of the tenets of Islam is that man plays the role of steward over divine creation.

God’s creation, which encompasses not only nature and the environment but also humans and society, belongs to God and is entrusted to man, who is vested with the duty of maintaining and managing the earth on God’s behalf. The application of this principle is often that wasteful and useless, superfluous consumption are unacceptable.

Norm-based Exclusions and The Global Compact

Unlike what may be the case for SRI, Islamic finance does not explicitly exclude issuers guilty of the worst social and environmental practises. Nevertheless, a report by OWW Consulting, a CSR (corporate social responsibility) and SRI consulting firm in Southeast Asia, highlights the compatibility between the tenets of Islam and those of the United Nations (UN) Global Compact.

The UN Global Compact is a strategic policy initiative for businesses that are committed to aligning their operations and strategies with ten universally accepted principles in the areas of human rights, labour, environment and anti-corruption.

These principles draw on the standard references in these areas, including the Universal Declaration of Human Rights, the International Labour Organisation Declaration on Fundamental Principles and Rights at Work, the Rio Declaration on Environment and Development and the UN Convention against Corruption. It should be noted that the Global Compact does not enforce any regulation nor does it measure or review the practices of signatories.

OWW Consulting’s report describes how the tenets of Islam comply with each of these principles, despite being based on different sources and motivations and often stricter ethical standards. It does not examine the application of these principles in Islamic finance, which is significantly less effective.

In Practise

Novethic called on a number of experts that specialise in both SRI and Islamic finance in order to assess how this theoretical compatibility is reflected in management practises.

On the supply side, three asset management companies involved in both investment strategies were consulted – Pictet and SAM Sustainable Asset Management (Swiss), and F&C Investments (British). On the potential demand side, the sovereign fund Abu Dhabi Investment Authority (ADIA) was contacted. The latter fund does not feel concerned as it does not practise SRI or Shariah-compliant investments.

Lastly, the viewpoints of the Association for Sustainable & Responsible Investment in Asia (ASrIA), an association dedicated to promoting SRI and CSR in Asia, and OWW Consulting were also taken into account. These two organisations are located in Southeast Asia, the only geographical region outside the UK where Islamic finance and SRI are developing side-by-side.

Conclusion: Compatibility and Complementarities

Many in the financial community believe that Islamic finance and SRI are compatible but there is no natural link between the two, first because they do not employ the same expertise, and second because they do not target the same clientele.

Pictet is the perfect example – its SRI fund and Shariah-compliant fund were launched separately, and its management teams are based in different countries, Switzerland for the former and the UK for the latter.

OWW and ASrIA have observed similar phenomena in Southeast Asia, both markets are growing but in different countries. Islamic finance is strong in Malaysia, Indonesia and Singapore, while SRI has a firmer foothold in Japan and South Korea.

Traditional investors show less enthusiasm with regard to religious finance, expressing limited interest for what they consider to be a niche market which, more importantly, does not outperform indices (although Islamic finance may provide less risk). They clearly lean towards the more buoyant environmental fund market.

Perhaps the only exception is SAM. The Swiss asset management firm is an expert in the application of ESG criteria to sustainable investment themes and issuer practises. In collaboration with the UK Islamic bank Gatehouse, it recently launched a Shariah-compliant fund focused on water.

The initiative of SAM and Gatehouse Bank therefore seemed perfectly coherent. SAM’s “sustainability” team had extensive discussions with Gatehouse’s Shariah board, whose members were very interested in theme-based and ESG analyses of issuers. The project initiated by SAM and Gatehouse Bank remains a unique example of how SRI strategy can be combined with Islamic finance.

Notwithstanding the basic purpose of these types of finance which encourages social well-being and environmental protection, Islamic finance remains a more formal system that provides both financial and extra-financial guidelines.

These guidelines, when compared with responsible investment, are consistent with ethical finance and sharing, both in approach and objective, but do not preclude compatibility with other SRI approaches.

Still, despite the fact that Islamic finance does not subject company practises to ESG screening, it is in line with UN Global Compact principles, which are used by a number of SRI managers in defining norm-based exclusions.

As long as these approaches do not have any conflicting purposes, they could, in fact, be not only compatible but complementary, with the integration of ESG criteria offering both ethical and financial added value, notably by limiting risk.

The success of Islamic finance and SRI does not seem correlated today, but it will be up to financial experts, research centres, ratings agencies, non-governmental organisations and even regulators to consolidate the two approaches. As they both focus on encouraging more ethical, responsible and transparent practises, they could be developed jointly, as could their potential client bases, thus spring boarding SRI into new markets.

 

 

This article first appeared in Islamic Finance News (Pg 14, Vol 6, Issue 29).

 


 

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