Basic Concept of Islamic Mutual Funds
Islamic mutual funds are similar to conventional mutual funds, and both work similarly. What is different in Islamic mutual funds is that they only deploy funds that follow Shariah rules. Shariah principles do not allow to deal with prohibited practices such as riba (charging interest), maysir (gambling), and gharar (uncertainty), and this is also applied to mutual funds.
Shariah rules play a dominant role in Islamic mutual fund portfolios in every process, including asset allocation by screening and income distribution. In the case of income, it needs to be purified by excluding some percentage of it.
However, in conventional mutual funds, there are no such criteria. Traditional mutual funds do not need to screen stocks or search and invest in only certain stocks which are halal. In other words, when you invest in conventional mutual funds, you can invest in any stocks, bonds, or different combinations.
The following are some aspects that an Islamic mutual fund should address:
- An Islamic fund manager who has received a license from the regulator is the one who can administer the fund. In many countries, except Malaysia, the fund manager has no separate responsibilities and can work as the Islamic fund manager.
- The fund company must appoint an independent Shariah advisor or committee. Additionally, the fund must undergo a Shariah audit regularly.
- The fund manager should consider the purification of the fund. Zakat payment may also be an item of consideration.
- It is necessary to pay attention to sales and marketing practices. Some countries have specific regulations on selling Islamic fund products.
5 stages of Investing in Islamic mutual funds:
- Initially, Islamic mutual fund investors visit the mutual fund manager and meet with the fund managers.
- The investors talk about their financial investment’s goal. There are numerous examples of financial objectives. Some are saving for their retirement, children’s educations, cash for their children to start their own business after graduation, and so on.
- The fund manager needs to know the time period the investors choose. Therefore, the fund manager may subsequently recommend certain Islamic mutual fund portfolios with appropriate risks. If the investors prefer to invest in a limited time, the manager should choose less risky investments. For example, the manager has plenty of time if the goal is retirement and the investor is 30 years old.
- The next one is the process of selecting investing opportunities. Mutual funds come in a variety of shapes and sizes. For instance, Islamic equity, Sukuk funds, Islamic money market funds, and Islamic hybrid funds are the four types of Islamic funds. If the goal is to invest for the long term, the fund manager will use his ability and knowledge to choose a riskier investment, such as equities funds that offer a higher return. However, if the investor wants to invest for a limited period of time, the fund manager may choose Islamic Treasury notes. This is because the government is extremely unlikely to default on its obligations.
- The profit gained from the investment will be given to the investors on a regular basis. They may add this profit to the initial capital to continue their investment in Islamic mutual funds.
4 Types of Islamic Mutual funds:
Islamic money market funds
To ensure and distribute annual income to unitholders, the money market fund invests largely in short-term debentures, short-term money market instruments, and placement in short-term deposits. The Islamic money market fund must ensure that its investments are in Shariah-compliant products in order to comply with Shariah. Money market funds are one of the safest investment options. However, lower-risk assets generate a lower return.
Sukuk or fixed-income funds
These Islamic mutual funds invest in Sukuk, which are Islamic fixed-income instruments. Based on the Sukuk’s issuer, the Sukuk can be in different varieties.
Usually, Sukuk funds can be classified based on their maturity, such as short, intermediate, or long term, and also based on the issuer. It can also be determined by whether the Sukuk is issued domestically or internationally. For example, the government issues government Sukuk, municipalities issue municipal Sukuk, and companies issue corporate Sukuk.
An equity fund is where the fund’s assets are principally invested in stocks or shares of listed companies to secure capital growth. To be in an Islamic mutual fund portfolio, stocks must unquestionably be Shariah-compliant. These stock funds can be classified in two ways: (1) by market capitalization and (2) by investment types, such as growth stock or value stock. Equity funds are popular in Malaysia and Indonesia as they expose investors to the companies listed on the stock exchange. Additionally, this fund’s performance depends on the exchange’s performance.
A balanced Islamic fund aims to achieve a mix of capital growth and income by investing partially in stocks and partly in Sukuk while avoiding excessive risks. The goal of a balanced fund is to give investors the option of investing in a single mutual fund that meets both growth and income goals. The income comes from Sukuk investments, whereas the growth comes from stock investments. This sort of investment will suit the needs of investors who want to diversify their portfolios across all main asset classes to lessen the risk of investing in just one. During a bull market, however, the balanced fund often provides lower growth than an all-stock fund.
Islamic mutual funds have increased in popularity as a Shariah-compliant alternative to conventional mutual funds in the Islamic capital market. It has grown in tandem with its conventional counterpart, attracting the attention of international institutions and retail investors. Additionally, Islamic funds can appeal to a broader range of investors because they cater to both Islamic and conventional investors.
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