Know The Rationale behind the Halal Stock Screening Benchmark

The Rationale Behind The Halal Stock Screening Benchmark

There are different opinions about the percentage of halal stock screening benchmarks. Isn’t riba totally impermissible? Then why do Halal stock screening methodologies use 5%, 20%, 25%, 30%, and 33% benchmarks?

The Islamic capital market only operates in ways that do not violate the Shariah law. Therefore, it needs a specialized stock screening process to filter the Shariah-compliant companies. This article will briefly explain the rationale behind the Halal stock screening benchmark percentages.

Halal stock screening Benchmark on the Impermissible Income

The research conducted by Khatakhatay & Nizar in 2007 on the Bombay Stock Exchange 500 (BSE500) found that when applying the 5% threshold on the impermissible and interest income on those stocks, almost 90% of the passed the filter. But, when they reduced the percentage to a 1% threshold, only 75% of the stocks passed the screening. Although they criticize the 5% benchmark as too relaxed, their research indicates that it is hard to find a business with totally permissible and non-interest income. They also stated that if there is valid research and reasoning that truly requires the benchmark of more than 5%, Scholars should allow it. Please note that Shariah scholars and regulatory bodies must unanimously approve the cap.

Here is an example; assume that after doing some research and observation, Muslim investors in London Stock Exchange need at least 50% of listed companies for investment. Again, this is justified based on the principle of necessity. Furthermore, according to the research, they need a 10% benchmark for this filter to make 50% of the stocks available for Muslim investors. The Shariah scholars may then decide to allow the 10% benchmark due to necessity. Later, they can gradually reduce the 10% to a lower percentage or even zero percent.

In short, the Scholars determine the threshold for the impermissible income based on deep and comprehensive research and the necessity that is proportionate to the circumstances of such jurisdiction. Many Shariah authorities and committees, standard-setting bodies, and individual scholars support the view that participation in mixed businesses companies should be allowed based on the principle of removal of hardship and harm from Muslim investors, provided that the impermissible business and operations of such companies are restricted to a certain tolerable limit (SAC-SC, 2006; AAOIFI, 2015)

The Rationale behind the 30% Benchmark on Interest and Debt Ratio

Furthermore, there are differences among the Shariah screening methodology on the allowable percentages of interest-bearing and debt ratio under the financial screening assessment. For example, KLSI, S&P, DJIMI, and ISRA use a 33% threshold. Meanwhile, AAOIFI, Thompson Reuters Ideal ratings Islamic Indices use a 30% threshold; and FTSE and MSCI use a 33.33% allowable percentage.

The thresholds in the range of 30% are based on the hadith narrated by Saad bin Waqqas: “I was seriously ill at Mecca, and the Prophet came to visit me. I said, “O Allah’s Messenger! I shall leave behind me a good fortune, but my heir is my only daughter; shall I bequeath two third of my property to be spent in charity and leave one-third (for my heir)?” He answered, “No.” Then I said, “Shall I bequeath half and leave half?” Prophet said, “No.” I said, “Shall I bequeath one-third and leave two-thirds?” He said, “One-third is alright, though even one-third is too much.”

Scholar’s View…

According to Mufti Faraz Adam, scholars need a reference from the sacred text related to excessiveness. The above-mentioned hadith implies the rationale of one-third (the minority) against the majority of two-thirds. In other words, the 2:1 ratio makes 2 as the dominant and 1 as the inferior. The Maliki scholars use one-third as a benchmark in several issues; such as rulings on dirty money; exempting one-third when selling an unknown amount of food; tolerating deficiencies in a sale item when it is less than one-third; rubbing one-third of the head in Wudhu; allowing pricing up to one-third when sale items are priced lavishly; and many other issues. Therefore, one-third has manifested as a measure and benchmark in other areas of jurisprudence as the reference to excessiveness.

AAOIFI methodology uses the 30% benchmark for screening halal stocks. Mufti Faraz argued that even though 30% is not the exact one-third, 30% was considered a reasonable benchmark to prevent excessiveness. However, this is an Ijtihadi matter. The AAOIFI scholars took 3 years and 12 Shariah board meetings to agree on this standard.

The AAOIFI Screening Methodology

Musaffa screen the Halal stocks based on the AAOIFI standard. The AAOIFI Halal Stock Screening methodology consists of two screenings; business and financial screening.

Business screening:
  • The total income generated from impermissible activities should be less than 5%
Financial screening:
  • Interest-bearing securities and assets should be less than 30% of the company’s market capitalization
  • Interest-bearing debt should be less than 30% of the company’s market capitalization

Previously, AAOIFI set the standards for the company’s liquidity ratio. The total value of tangible assets and benefits should not exceed 30% of the company’s total assets. However, AAOIFI revised this condition on its latest Shariah Standard No.59 about the sale of debt. Following the latest AAOIFI standard, the liquidity ratio is no longer the requirement for stock screening.

The reason behind eliminating the liquidity ratio is that it disadvantages the companies in the service sector. Due to the nature of service sector business, where the main activity is on the services and only involved in a few illiquid assets, these companies are unlikely to pass the liquidity filter. Similarly, financial services companies, including Islamic financial institutions, primarily deal with cash and debt (liquid assets).

A company’s shares notably represent the company itself (its main business, human management, production ability, and revenue generation prospects). Before, owning a share simply represented ownership of the company’s assets. However, due to economic and legal developments, this concept has evolved to represent a bundle of rights that belong to the shareholder. Therefore, the rules of bay’ al-sarf (currency exchange) and bay’ al-dayn (sale of debt) no longer need to be imposed based on this situation, and the liquidity ratio will be regarded as unimportant.

In summary…

Muslims often wonder whether it is halal or not to invest in the stock market. As long as the stocks that Muslims invest in meet the Shariah requirements, the investment is deemed Halal.

What about the company’s involvement in interest and impermissible business?

Shariah scholars have considered this issue and came up with the Halal stock criteria. The criteria are based on Scholars’ ijtihad to remove the hardship among Muslims who might be disadvantaged if excluded from the stock market. Muslim scholars set the Shariah standards for Halal stock based on deep research, discussions, and level of necessity. As discussed in this article, the Shari’ah ruling on participation in the capital markets deserved some relaxation; however, the relaxation should be limited to its actual need.

Read more about why Muslim investors need Halal Stock Screening here.

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