2.6 Shariah-Compliant Schemes, Their Risks and the Role of the Shariah Advisory Council

How a Shariah-Compliant Scheme Differs

A Shariah-compliant scheme is very similar to a conventional one, except that all activities must comply with Shariah requirements. The study guide lists six areas where the two may differ:

1. objectives of the fund;
2. investment strategy;
3. operations and management;
4. documentation;
5. investment avenues and activities; and
6. accounts and reporting.

Objective – a conventional scheme seeks capital and income growth; a Shariah-compliant scheme seeks the same within the scope of Shariah principles, and its strategy must match.

Operations – the Scheme Provider must ensure daily operations meet both SC requirements and Shariah requirements. A Shariah adviser or Shariah committee strengthens compliance and supervision.

Investments – Islamic funds hold halal companies, Islamic debt securities and sukuk. They exclude companies in conventional banking, insurance and financial services, gambling, alcoholic beverages and non-halal food. A scheme may only invest in instruments approved as Shariah-compliant by the SC's Shariah Advisory Council (SAC) and/or the scheme's Shariah committee or adviser, consistent with the fund's objectives.

Cash and income – excess cash goes into Shariah-compliant instruments such as Islamic current or investment accounts. Returns avoid riba' (interest/usury) through a systematic cleansing or purification process that removes amounts from non-compliant sources; these amounts are normally donated to charity.

Risks of Shariah-Compliant Schemes

The study guide's Diagram 2.9 shows that Shariah-compliant schemes face the same kinds of risk as conventional schemes: investment, business, liquidity, regulatory, change in fees and (for UTS) borrowing-related interest rate risk.

The extra risk: Shariah non-compliance risk

Shariah non-compliance risk (also called Shariah-specific risk) arises when a security the fund holds is reclassified from Shariah-compliant to Shariah non-compliant. This usually happens when:

• a substantial part of the company's income comes from non-compliant activities;
• the company undergoes a corporate restructuring such as a merger or acquisition; or
• the company changes its business direction and becomes non-compliant.

The manager must then cleanse or purify the fund by disposing of the reclassified securities. Selling may happen at an unfavourable time, so the fund may earn a lower return or make a loss, reducing the NAV.

The Role of the SC's Shariah Advisory Council (SAC)

Those twice-yearly publications also set out:

• the benchmarks used to decide the Shariah status of companies with mixed income; and
• the disposal treatment for securities reclassified as non-compliant and for non-compliant securities held as investments.

Further SAC resolutions and documents are on the SC website. At fund level, the scheme's Shariah committee (or adviser) is responsible for making sure every aspect of the scheme is consistent with Shariah principles, including SAC resolutions.

Worked Scenario: A Holding Is Reclassified

An Islamic equity UTS holds shares in Company K, a logistics group. K acquires a hotel business that earns a large share of its income from serving alcohol. In the next SAC review (May or November), K is reclassified as Shariah non-compliant.

1. The fund's Shariah adviser confirms the reclassification and the disposal treatment published by the SAC.
2. The manager sells the K shares under that treatment. If K's share price has fallen, the fund realises a loss and its NAV drops.
3. Any amounts the SAC treatment requires to be cleansed are channelled to charity rather than kept by the fund.
4. The fund report later carries the Shariah adviser's opinion on whether the fund was managed in line with Shariah requirements.

This is why the study guide treats reclassification as a risk unique to Shariah-compliant schemes: the manager has no choice about selling, even when the timing is poor.

Who Does What in Shariah Governance

Exam Pointers

• The difference between conventional and Shariah schemes lies in Shariah compliance, not in the basic trust structure. Both have a Trustee, units and NAV pricing.
• The list of Shariah-compliant securities is updated in May and November.
• The specific extra risk is reclassification (Shariah non-compliance risk); cleansing can lower returns.
• Purification amounts are typically given to charity, not kept by the manager or returned to investors.
• Chapter 7A covers the Shariah contracts (musyarakah, wakalah, bai and wadiah yad dhamanah) that govern relationships in Shariah-compliant UTS and PRS.