Understanding mutual funds Islamic Finance

A mutual fund (or funds) comprises money pooled by investors, which is generally used to buy stocks of publicly traded companies or bonds.

Ideally, a fund's size coupled with its high management expertise, provide advantages for a common investor.

These include prudent diversification, timely exit and entry into stocks and bonds, proper selection of securities, comparatively low running costs and convenience regarding liquidation of their portfolio.

The legal structure of a mutual fund is similar to that of a corporation that receives preferential tax treatment in most countries with investment-friendly laws.

Most funds are open ended, allowing investors to enter and exit at any time.

Mutual funds issue shares to investors in exchange for cash. Unlike shares of publicly traded companies, the shares of a fund do not comprise a pre determined amount of stock.

For example, while the market value of a public joint stock company share is determined by the supply and demand correlation and has nothing to do with the net asset value (NAV) of the company, the ownership value in a mutual fund is ascertained by dividing the net assets of the fund by the number of shares the fund holds.

An Islamic fund operates on the same concept but with a difference in the criteria it follows in selecting stocks. These criteria include Sharia screening guidelines. They are:

1. Total interest-bearing debt of a company at any point in time should remain less than one-third of its average market capitalisation in the past 12 months.

2. Total interest income of a company should not be more than five per cent of its total income.

3. The sum of a company's cash and interest bearing securities must not be greater than 33 per cent of its trailing 12 month average market capitalisation.

4. The firm's account receivables should be less than 45 per cent of its assets.

Islamic funds have existed in some form or another since the mid 1980s. They were on a small scale and largely localised, serving certain social purposes, such as community welfare.

These funds became popular on a commercial scale in the early 1990s. At that time, it used to be a Herculean task for a fund manager to select the right stocks.

In addition to Sharia-permitted activities, the criteria in selecting a stock were stringent and narrowed down to relatively debt free companies that at times were difficult to find.

Some managers also bought zero-coupon bonds while considering their higher value nearing maturity as capital gain rather than interest. This approach was not in line with Sharia principles.

The launch of Islamic indices in February 1999 provided a shot in the arm for the growth of Islamic funds. The appearance of a number of companies in an Islamic index made it convenient for an Islamic fund manager to select stocks.

This is because of the approval granted to a stock by the Sharia board of an Islamic index.

While investing in a fund could be a relatively low-risk option in view of its diversified nature, there is an attendant cost to it in addition to the dividend tax.

This is the administrative cost at a pre agreed rate a fund manager is authorised to charge in the capacity of a Mudareb.

Sohail Zubairi is the vice-president for structuring, documentation and product development at Dubai Islamic Bank