Margin Trading, MTF & Leveraged ETFs: Halal or Haram? | Musaffa Academy

With the increasing availability of leverage within modern brokerage platforms, novice investors are often drawn to the tantalizing potential returns by using Margin, through the Broker’s Margin Trading Facility or via the issuance of Leveraged ETFs that amplify return by two or three times, delivering what appears to be phenomenal returns in a highly fluid marketplace. Returns that come with well-documented levels of risk that appear to be often underestimated. For Muslim investors however, there is an additional consideration beyond their appetite for risk – that of permissibility.

Are leveraged products halal? For most forms of leveraged investing the simple answer is no, but it is far more useful to know why and to have an understanding of the nuances behind each product. In this article we shall discuss margin trading, Margin Trading Facilities (MTF) and leveraged ETFs, detail the Islamic finance concerns that surround them and offer alternatives for Muslim investors.

Why Riba Makes Leveraged Investing Problematic in Islam

Before we go into the specifics of the Instruments used for leveraged investing, it will be useful to clarify our primary concern. The primary reason for its prohibition in Islam is riba (interest). As mentioned before, riba is one of the most detested practices in Islam and the Qur’an goes to the extent of clearly forbidding it. Surah al-Baqarah specifically lists the evil effects of riba in verses 275 to 280 and also warns of severe torment on those who do practice it. The prohibition of riba is amongst the clearest financial prohibitions in Islam and all the four major schools of thought (Fatawa Razia, Bareilia, Deobandi and Hanafia) are in agreement with it.

Riba is attributed any charge or excessive surcharge beyond agreed upon terms. In the case of broker lending this means charging interest on the broker lending his own capital to an investor. All mainstream leveraged investing product functionality revolve around this formula: borrow, pay interest and gear up to increase potential returns. That investors pay interest is not an extraneous factor, it is central to the product.

An additional concern in some leveraged instruments is the element of gharar or excessive uncertainty/ambiguity in a contract. Where returns are provided through underlying derivative contracts or synthetic replication as opposed to actual ownership of assets, this exacerbates the already present riba concern.

Margin Trading in Islam: Why It Is Not Permissible

Margin trading or leveraged stock buying allows a trader to borrow money from a broker to buy and sell shares that they couldn’t afford to purchase for their own money. Margin requirements stipulate that a trader must deposit, for example, 20% of the trade value in cash to receive a loan for the remaining 80%, for which interest must be paid back to the broker whilst the position is open.

Islamic finance presents a problem for broker loans. Every broker loan gives rise to interest charges on outstanding amounts. Islamic finance prohibits the payment and acceptance of interest on debts and other obligations, and calling debt and other obligations together “interest,” the finance is obviously violated. That intent is beside the point: even shares deemed Shariah compliant can be purchased through this mechanism, as a margin account incorporates riba into the otherwise legitimate transaction.

While some Muslim investors argue that for a short-term position the interest component may be insignificant to worry about, the vast majority of scholars consider that there is no materiality threshold and any interest, be it small or large, is prohibited as riba. The focus is not on the amount of interest but on the nature of the transaction itself.

However, it cannot be ignored that there is another secondary aspect to margin trading. This relates to short selling. Like futures, margin accounts enable traders to short sell securities they do not own with the intention of purchasing them later at a lower price to realise a profit. This is also prohibited by a well-known hadith quoted in both Sunan Abi Dawud and Sunan al-Tirmidhi, adding the two prohibitions in margin trading.

Is Margin Trading Facility (MTF) Halal?

A Margin Trading Facility (MTF) or commonly known as a Margin Loan is a special product offered by brokers and other financial institutions, predominantly offered in South Asian and Gulf markets. Using Margin Trading Facility, an investor can purchase or short sell securities using a portion of his/her own money and a credit facility extended by his/her broker or other financier. The investor will have to pay a financing charge on the portion of loan, which is referred to as interest rate in the terms and conditions of the facility.

In Muslim markets where there is huge advertising of MTF products, there has been a lot of debate on their permissibility. The consensus of mainstream Muslim scholars is that a conventional MTF product is not halal. This is similar to the position on margin trading earlier where the financing charge is considered riba and the packaging of MTF products does not change the mechanism and underlying of borrowing to increase gains of an existing position.

Are There Shariah-Compliant MTF Alternatives?

While some Islamic Financial Institutions have offered Margin Trading Facilities (MTF) under the name of Share Purchase Facility, these have generally been structured on a cost-plus basis under a murabaha contract where the financier purchases the shares and then sells them to the investor at a marked-up deferred price. Such a structure is likely to be permissible under a majority of the available scholarly views, provided that the structure is genuinely a murabaha transaction and not a loan at interest in disguise.

It is important to note that the instrument must actually be in the form stated in the text. A murabaha financing arrangement masquerading as a loan would still not be Shariah compliant. Muslim investors should also verify that the Islamic MTF products offered by respective exchanges have actually been approved by a credible Shariah supervisory board. They should not just rely on the name of the Shariah compliant institution offering the product. In case there is no oversight or information is lacking, it is best to err on the side of caution.

Leveraged ETFs: Why They Are Not Shariah-Compliant

Leveraged ETFs (LNK) are trading funds listed on the stock exchange. The aim of the funds is to correlate their returns with 2x or 3x daily returns of a given index, like the S&P 500. A 2x S&P 500 ETF thus tries to return 2 times the daily gains and losses of the S&P 500. It offers small traders an easy mean to realize tremendous returns without having to open a margin account and deal with all the margin requirements.

From a Shariah compliance perspective there are several issues that come to mind regarding the topic of Leveraged ETFs.

Embedded Interest Costs in Leveraged ETFs

The Leveraged ETFs, providing higher returns by adding more volatility, achieve their increased movement by using derivatives, such as swaps and futures. In addition to the cost of the transaction to enter into these positions, the provider of the derivative charges the ETF sponsor an implicit interest rate on the notional amount of the leveraged position. The ETF investor never sees this cost; it is built into the expense ratio that is described in the fund’s prospectus. This is similar in nature to the margin interest charged on margin accounts.

Yes, it is true that the investor will not see the separate interest charge on his statements. The point is, however, that the interest is still hidden in the price of the financial instrument. The methodology may still be viewed as incorrect. Just because the method is packaged differently does not mean that the method of pricing investment instruments is more permissible.

Derivatives and Gharar (Uncertainty)

Leverage is not the only component of contracts based on swaps and futures that could be seen as involving gharar. Many of the classic Islamic jurists would be uneasy with the nature of the current derivative contracts that lack essential elements of actual trade and are valued based on price movements of underlying, possibly un-owned, commodities. Such contracts can be extremely speculative and border line maysir (gambling-like) rather than the “real” trade that the majority of scholars consider Shariah compliant.

Every Shariah Supervisory Board that studied leveraged ETFs concluded that they are not permissible, due to the element of riba and gharar. Similarly, AAOIFI standards that are the base of many Islamic financial institutions do not permit any instrument that is based on interest derivatives.

Daily Rebalancing and Speculation

Unlike Index Futures or Options, Leveraged ETFs adjust their derivative positions on a daily basis to try to achieve a multiple of the index (i.e. 3x S&P 500) on a yearly basis. Because of this, these trading tools are designed for short-term trading and come nowhere near their targeted return over any period longer than a trading day. For this reason, we think it is completely inaccurate and irresponsible for anyone to recommend the use of 3x Leveraged ETFs for long-term trend following. Their use is as a tool for day trading or tactical positions where one expects to be on the correct side of the trade in only a few days.

Within the Islamic finance construct, the design of a product that has a short duration is somewhat of an anomaly given the emphasis placed on real economic participation and real ownership of assets as opposed to price speculation. This product is not designed to facilitate long term investing and as such, it does not facilitate sharing of profit and loss over a longer term as a company may develop. Instead, the product is designed to help facilitate gearing and potentially enhance returns for traders undertaking shorter term trading activities.

What Muslim Investors Can Do Instead of Leveraged Investing

Even if leveraged instruments are off-limits, still very competitive returns are possible and a large fortune can be created. Here are some practical solutions which build high-conviction growth portfolios without using interest-bearing borrowing or even positions that don’t involve ownership.

Concentrated Equity Positions

As Muslim investors look to scale up in specific sectors or opportunities, a concentrated position of Shariah compliant equities held completely free of leverage could be an option that carries a higher risk than simply complying with the market weightings, but offers full business ownership, without debt or interest.

Shariah-Compliant Growth Funds

Some Shariah providers offer Passive Growth funds to big buyers, whereas other providers would prefer to actively manage the money to express a “higher conviction view”. These actively managed growth products could potentially outperform for the sophisticated investor, albeit with increased risk. They are not geared/increased leverage.

Murabaha-Structured Financing (Where Genuinely Available)

While still an emerging trend, there is scope in theory for Islamic financial institutions' (IFIs) murabaha-based facilities to be used to increase their securities exposure (beyond levels supported by cash). However, such a facility must be structured genuinely and approved by a reliable Shariah board, and must not resemble a conventional loan masquerading under the guise of 'Shariah compliant'.

Quick Reference: Shariah Status of Leveraged Instruments

The Bottom Line

The promise of enhanced returns can be very tempting. Especially when packaged in an easy-to-use product with real-time pricing feeds. But for the Muslim investor there is a reality that must be faced. What in conventional products provides leverage — interest bearing debt, derivatives and synthetic positions — is all prohibited.

To most this is a small matter, but in Islamic finance short selling has been ruled out and considered on par with gambling. The logic is shared by all four schools of Islamic law, and levages and gearing of any sort is against the law.

Don’t let the “traditional” concept of wealth creation restrict your potential. True wealth can be created through true ownership – an Islamic method of wealth creation that is also sustainable. Leveraging on the other hand, brings massive potential to losses as it does to gains. Moreover, the agony of facing margin calls far exceeds that of watching markets drop – and there are many examples of people who fully understand the substantial downside risk to their leveraged positions, but still manage to substantially over- estimate their objectivity and skill in managing the potential exposure. Eventually, the harsh reality of a margin call puts an abrupt end to their brilliant financial plans.

In Islam it is stated that wealth which one gradually acquires whilst intending it to be Halal will remain with you whereas if one acquires wealth very quickly with the intention of making it haram will not remain with you and will not be blessed by Allah.

And Allah knows best.