Educational content only. We analyze passive investing through the lens of Shariah Screening Standards (AAOIFI) and the principles of Mu'amalat (Financial Transactions). This is not financial or religious advice. Please consult a qualified professional for your specific situation. We do not issue fatwas.
Passive investing through index funds and ETFs (Exchange Traded Funds) has revolutionized wealth building for retail investors in the UK. By buying a single fund, you can own a tiny slice of hundreds or thousands of the world's most successful companies. However, for a Muslim investor, this creates a significant challenge: how do you ensure that none of the companies in that index are engaged in prohibited (Haram) activities?
Scholarly consensus overview
What is an Index Fund?
An index fund is designed to track a specific basket of stocks, like the S&P 500 (the 500 largest US companies) or the FTSE 100 (the 100 largest UK companies). Because it is managed by a computer rather than a human picker, the fees are incredibly low.
In Islamic finance, the core principle of profit-sharing (Musharakah) is fulfilled here—you are an owner of these businesses and you share in their successes and failures. The complication lies in the nature of those businesses.
The Screening Dilemma: S&P 500 & Others
If you buy a standard S&P 500 index fund (like VUSA or CSPX), you are buying into companies like JPMorgan (Conventional Finance), Anheuser-Busch (Alcohol), and various defense and gambling firms.
- Direct Exposure: You are technically a shareholder in these companies.
- The Threshold Argument: Contemporary scholars recognize that in a globalized economy, it is almost impossible to find large companies with *zero* interaction with interest (Riba). This led to the creation of "Screening Standards."
Index Composition Analyzer
Estimating non-compliant exposure within a diversified fund.
"Requires careful screening and purification. Most scholars suggest avoiding broad indices like S&P 500 in favor of screened versions."
Indices are often managed by algorithms. While the individual companies may be screened, the ETF management fee and Securities Lending (loaning shares to short-sellers) are additional points of scholarly debate.
Shariah Screening Criteria
Major bodies like the AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) have established thresholds to help Muslims identify compliant stocks. A company is generally considered compliant if it passes two filters:
- Business Filter: The core activity must be permissible. Prohibited areas include Conventional Financial Services, Alcohol, Pork, Gambling, Pornography, and Tobacco.
- Financial Filter: The company's interaction with interest and debt must be "minimal." Common benchmarks include keeping interest-bearing debt below 33% of the company's market capitalization.
Shariah Screening Tool
Commonly used financial ratios for stock/index screening.
*These criteria are based on popular standards (e.g., S&P Shariah, Dow Jones Islamic). Different scholarly boards may have slightly varying thresholds (e.g. 30% vs 33%).
The Concept of Purification
Even if a company passes the screens, it might still earn a small amount of interest on its bank balance (e.g., 2% of its revenue). Scholars specify that such "impure" income must be purified.
Purification involves calculating the percentage of non-compliant income and donating that exact portion of your dividends to charity (without expecting a spiritual reward for the donation, as it is seen as clearing tainted wealth).
ETF-Specific Concerns: Securities Lending
A technical issue often overlooked is "Securities Lending." Many large ETF providers (like Vanguard or BlackRock) lend the stocks held in the fund to short-sellers for a fee.
Some scholars argue this is problematic because it facilitates betting against companies and involves a form of lending for a fee. Islamic ETFs usually prohibit this practice, which is one reason they might have slightly higher fees.
Where scholars usually draw the line
- • Broad Market Indices: Most contemporary Shariah boards advise against unscreened broad market indices (like S&P 500) because they contain companies whose primary business is inherently prohibited (e.g. Banks).
- • The 5% Rule: If a company derives more than 5% of its total revenue from prohibited activities, it is almost universally considered non-compliant, regardless of its financial ratios.
- • Leveraged ETFs: Using 2x or 3x leveraged ETFs is generally prohibited as it typically involves interest-bearing swaps and derivatives, which contain excessive uncertainty (Gharar).
Options for UK Investors
UK investors have several pathways to invest ethically:
- Shariah-Compliant ETFs: Look for funds with "Islamic" or "Shariah" in the name (e.g., ISDU, ISDW). These are UCITS-compliant and available on platforms like Trading 212, Vanguard UK (certain options), or Hargreaves Lansdown.
- Robo-Advisors: Services like Wahed Invest specialize in automatically building screened portfolios for UK residents.
Risk Reduction Planner
Pathways to align your investment strategy with ethical standards.
Summary
- The Preferred Path: Investing in specifically screened Shariah-compliant ETFs is the safest way to ensure compliance.
- Screening Matters: Financial ratios and business activities must be checked. Most broad indices fail these checks due to banking and interest exposure.
- Purification: Any minority non-compliant income must be calculated and donated to charity to cleanse the wealth.
- Long-Term Ethos: Investing is encouraged in the Islamic tradition as a way to grow wealth, provided it avoids Riba, Gharar, and prohibited industries.
Transparency
How we wrote this
We analyzed the AAOIFI Shariah Standard No. 21 (Financial Paper/Shares) and the Dow Jones Islamic Market Indices methodology. We compared these with UK-available UCITS ETF prospectuses to understand the mechanics of securities lending and fund composition.
- AAOIFI Shariah Standard No. 21
- MSCIB: Islamic Index Methodology
- Mufti Faraz Adam: "Shariah Analysis of ETFs" (Amanah Advisors)