Green ETFs vs Halal ETFs: 7 Key Differences Explained | Musaffa Academy

Green and Halal ETFs are drawing attention from Muslim investors who seek sustainable investing. Yet, how exactly do they differ in what they measure and how they are created? We examine the 7 differences of Green vs Halal ETFs, to help Muslim investors make a more informed decision.

What is striking is the similarity between Green / ESG ETFs and Halal ETFs. Whilst there are marked differences between the two, there are also a number of similarities. Firstly, most Green/ESG/SRI solutions screen out particular industries / sectors from their benchmark. Halal ETFs use a similar investment approach to screen out companies and investments that are against Islamic dietary laws as well as those that are engaged in sins as classified in common texts on Shariah-compliant investing. There are some product providers that focus more on the Environmental aspect of Green and ESG investing but it is interesting to note the difference between Green/ESG ETFs and Halal ETFs. Both may offer providers a range of investment solutions with different emphases.

Green and halal-labelled ETFs are not exactly the same thing. And for Muslim investors, understanding this simple but important distinction can be key. That’s why our new Guide goes beyond brand names and highlights key differences between green and halal ETFs, and what this means for returns and faith. Read it now.

What Are Green ETFs and Halal ETFs?

A Green ETF, also known as an ESG ETF, is an index fund that screens or weighs the constituents based on certain Environmental, Social and Governance (ESG) criteria set by the provider of the ETF. ESG criteria vary from provider to provider and can even vary within a provider’s offerings. Some criteria focus on a company’s actual or effective carbon emissions. Others look at labour practices, gender diversity on the board and a host of other corporate governance practices. The investor is effectively trying to invest in ‘good’ corporate citizens or exclude certain ‘bad behaviour’ from the market. Most of the ESG ratings are provided by commercial rating agencies including MSCI, Sustainalytics and others. What is particularly interesting is that a single company can receive vastly different ESG ratings from different rating providers.

An ETF which is halal or Shariah-compliant is a fund of shares which has been screened by a qualified Shariah supervisory board utilising fixed religious rules to ensure that the fund is in compliance with Islamic teaching. All impermissible business activities, financial ratios and methods for dealing with any impermissible income are removed from the portfolio. A company is either Shariah-compliant or it is not, there is no middle ground and companies which are deemed non Shariah-compliant are actively excluded from the screen. Unlike non Shariah-compliant shares there is no sliding scale of ‘how Islamic’ a company is. Real Estate and Insurance Investments are alternate vehicles for increasing investment options. Both have legitimate uses in industrial and personal portfolios. However, their investment principles are quite different.

Screening Authority: Who Decides What’s Ethical?

Consensus on ESG ratings does not currently exist due primarily to the fact that commercial agencies rating companies ESG such as MSCI, Sustainalytics, Refinitiv and others all use different proprietary rating methodologies to evaluate companies, which means that one company can receive a high ESG score on one ESG index but receive a low score on another. There is no single governing authority, no independent religious or ethical body involved in rating companies for environmental, social and governance concerns, and therefore ESG is a market-driven phenomenon. The very term green means different things to different people and within different markets.

In addition to ensuring the fund and shares are listed on an appropriate exchange, a fundamental consideration for many Islamic investors is whether the fund is compliant with Shariah principles. To address this, we engage a Shariah supervisory board of 'experts' who continuously review the investments in the Fund on behalf of the shareholders. The Board then provides a fatwa on what investments are permissible. Members of the Shariah Supervisory Board are generally qualified Islamic scholars who have expertise in fiqh (Islamic law) as well as Shariah compliant finance, and their role and remit is distinct from any commercial due diligence that we undertake on an investment. Their views and fatwa are guided by Islamic laws and are independent of the views of other market participants. From the perspective of the Muslim investor, it is important to understand that ESG (Environmental and Social Governance) screens are opinions as opposed to Shariah screens which are religious determinations.

What Gets Excluded And Why It Matters

In addition to traditional ethical screens, we also consider ESG factors that measure the degree of social harm caused by a company such as poor labour practices or the production of controversial weapons, as well as governance failures such as flawed board structures or accounting irregularities. Environmental criteria, or ‘green’ ESG, also form the basis of screens whereby companies are excluded or given a negative weight due to their environmental impact. Here we take a brief look at screens focused on social and governance failure before reviewing some ‘green’ ETFs that aim to support low carbon activities and reverse the environmental harm already done.

There are certain Shariah screens that actually screen out some companies. Some Shariah screens will prohibit companies that are involved in the production or sale of alcohol and pork products (such as McDonalds/Hilton) as well as any companies involved in riba/commission based banking and insurance and weapons / defence industries. In addition screens may exclude companies involved in gambling and adult entertainment. Environmental issues are ignored in the screening process.

What do screens do? Under ESG, screens filter out companies or industry segments that do not meet minimum Environmental, Social and Governance standards. Under Shariah, screens examine the underlying business models to ensure that they comply with Islamic Finance principles. Hence, a conventional bank gets a pass under ESG for its “excellent ESG rating and climate action” because its model of lending at interest is not a factor in typical ESG scoring. Conversely, an integrated oil and gas company with a strong governance and environmental record may clear a fairly weak ESG screen on a emerging positive trend on emissions, only to fail a more stringent Shariah screen because many Shariah scholars and asset managers believe that investing in the fossil fuel industry is Shariah non-compliant due to the resulting harm to society and environment.

Financial Ratio Screening in Halal Investing

There is no comparison in the world of ESG criteria. Compliance not only concerns the substance of a company's actual business activity, but also its structural financial ratios. Shariah financial screens are typically used to identify companies that are permissible to invest in. Although a company may have a permissible core business, it may be excluded from the screen if it has high conventional debt (e.g. total debt exceeds 33% of total assets or market capitalization) or interest bearing cash and receivables (e.g. interest bearing income exceeds 5% of total revenue or cash and receivables exceeds certain ratios).

While mainstream ESG frameworks do not apply ratio tests in screening for E and S aspects in order to avoid what they call “crowded trade”, the screening for a ‘green’ ‘crowded trade’ player with excessive levels of debt may not result in a failure even if no due diligence is conducted as to the terms and structure of the debt. Unlike the mainstream ESG approach that focuses only on the industry of the company, the Muslim investor is concerned with both the industry of the company as well as the terms and structure of the financial debt of the company.

Purification of Income: A Unique Halal Requirement

While even the most advanced screening algorithms and research teams do their absolute best to guarantee that a Shariah-compliant ETF is in line with the investor’s principles, in reality a ‘purification’ layer is also required. This is because even the most high-tech, most thoroughly managed portfolio will inevitably generate some proceeds that are not Shariah-compliant. Usually, these improprious portions of revenue are very small, i.e. a fraction of a percent of the total generated income (e.g. interest on cash deposited into a money market account pending reinvestment, a very small percentage of sales from a division or subsidiary that is not Shariah-compliant). It is also important to remember that a Shariah-compliant ETF can also generate income from Dividends and Capital Gain. In this case, the investor will be required to purify a portion of this revenue in proportion to the improprious fraction of the total revenue and contribute the amount to charity.

Most Shariah compliant fund providers calculate and declare the purification ratio to enable investors to know how much of the gains they would need to return to the Almighty. This is a religious requirement and not the provider's recommendation. Thus, the returns can be pure. We should also note that ESG funds do not have an obligation to identify and exclude any impermissible income. Since ESG screens are not religious in nature, all returns generated by the ESG fund would be considered acceptable to the ESG investor without any obligation to undertake a separate process to purify any such income.

Portfolio Overlap: How Similar Are They Really?

A common question we get is how similar the screens are between ESG and halal. Many would naturally assume there to be a small difference between the two screens, leading to only a modestly different portfolio. This is not the case.

Like other ESG or Sustainable ETFs, neither the Green ETF nor SSGI’s Core ESG ETF includes products of tobacco, conventional weapons or some forms of gambling. Where the two ETFs diverge is with the constituents that make up their indices. For example, renewable energy infrastructure companies which are highly geared may be excluded from the Green ETF because they do not meet the Shariah debt ratio screens. Financial services companies with high ESG ratings may be excluded from the SSGI ESG ETF because they fail the Shariah screens on interest. Pharmaceutical companies may be included or excluded from the SSGI ESG ETF or the Green ETF depending on whether they are involved in research activities that are contested under Shariah views. Technology sector companies such as Apple, Amazon, Google, Facebook and Microsoft, which make up a large portion of popular ESG indices, may pass their ESG screens but fail Shariah financial ratio tests due to how they structure their cash and debt.

A relatively new area of analysis is the comparison between ESG screened indices and Shariah (or Sharia)-screened indices. While there is a modest correlation between the two (on average 53%), there are significant differences between the two in terms of sector weight. While Halal ETFs are underweight financials and utilities compared to their ESG counterparts (for example, Financials represents just 13.7% of the Dow Jones Muslim Market Index, compared to 20.25% of the Core ESG U.S. ETF from Core Performance, and 28.84% of the SP 500), they are differently weighted in areas like technology and healthcare. Essentially, this analysis finds that there are two sets of screening criteria and each has distinct characteristics such that investors must chose which criteria most represent their investment goals and values.

Zakat Obligations for ETF Investors

Just as a Muslim investor would be required to pay Sadaqah Fareedh (zakat) on any of his other investments, similarly an investor in Shariah compliant ETFs would also require payment of zakat. Some Shariah providers disclose the zakatable assets ratio as part of the details provided for the fund, revealing the proportion of the net asset value of the fund that comprises liquid and tradeable assets upon which zakat would be calculated. This disclosure is part of the overall Shariah governance wrapper applied to the fund.

There is however, no framework in place for ESG ETFs/ Index Funds. As Muslim green ETF/ Index Funds investors, the calculation of the zakat liability would rest with the individual, based on the composition of the underlying assets of the fund. Since there is no published figure for the zakatable assets ratio of the fund, the liability would need to be calculated as 2.5% of the full market value of the assets on the zakat anniversary date. This may in fact be more conservative. While Shariah compliant ETFs have the advantage of simplifying and accurately calculating zakat for investors, green ETFs are a more complex and time consuming area for managers to navigate.

The Spiritual Dimension of Halal Investing

The final difference is the one that is perhaps the most important for Muslim investors. The differences we highlighted prior to this pertained to the method that was used to establish the various screen criteria. However, the actual criteria can differ between ESG and SRI approaches. The first difference we highlighted was that although both ESG and SRI are expressions of personal values, the two approaches to ethical investing have different natures. SRI is an expression of religious or moral instruction to ‘do good’; whereas, ESG investing is a completely secular pursuit that is driven by profit.

Halal investing is an act of worship. And when an investor does Shariah compliant investing, the intention (ḥubayya) is not only to avoid harm and to add values in doing investments, but also to make all of the wealth he has clean infront of Allah. Thus he can reap the benefits of his investment while his income are completely haram-free. And of course it is also very important for the halal investor to be able to calculate and purify his wealth with the correct amount of zakat and to pay it in compliance to the requirements of Shariah. That is the key to make halal investing a part of the act of worship. And it ends once the investor has fulfilled the obligation to purify and pay the zakat.

On the surface, ESG screens and Shariah screens are both solutions designed to deliver a ‘sustainable’ portfolio. However, the fortunes of ESG screens are closely dependent on the fickle nature of markets, laws and the big index providers. Shariah screens, based as they are on centuries of detailed fiqh, are a good bet to stand the test of time. The confidence one has that money invested in a portfolio designed in compliance with the teachings of Allah, will remain Shariah compliant in three years’ time, is unlikely to be the same with a portfolio screened for ESG criteria.

Green ETFs vs Halal ETFs: Side-by-Side Comparison

Can Muslim Investors Invest in Green ETFs?

Yes, with caution. Many Muslim investors will choose to hold a Green ETF within an existing Shariah compliant portfolio. The holding of Green ETFs is permissible, provided the investor is aware that such an investment does not comply with their religious beliefs. Any impermissible income would require purification, and zakat calculations would need to be done on the full market value of the investment. Holdings that do not comply with Shariah principles are not made permissible by Shariah due to ESG approval.

Some Muslim investors include ESG ETFs in their portfolio but with ESG as one of the quality criteria to pursue alongside other quality factors. Their primary investments however remain within a fully Shariah compliant framework and are not to be confused with each other.

Which ETF Is Better for Muslim Investors?

In this edition we look at two ETP product types that provide responsible investment solutions for the growing numbers of ‘responsible investors’. Although two distinct product types that address a real investor need, they serve two fundamentally different objectives. On one hand Green and Eco ETFs are ETP solutions for the socially responsible investor. On the other hand we have the new breed of halal ETFs created to offer the investor a permissible investment before Allah.

For Muslim investors, the key questions differ: can the answer to the second question be outsourced to an ESG rating agency? The answer is no. Answering questions of Shariah compliance, of purifying and paying zakat is a religious duty, which requires a religious framework. While there may be some overlap with Green investing, they are not the same.

And Allah knows best.

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