Need for standard Shariah stock screening criteria

The act of narrowing down the universe of all potential stocks to a selected group of equities that meet the requirements of a certain investment strategy is known as stock screening. The underlying investment strategy may emanate from a certain belief system, a cause or preference for certain sectors of economic activity.

For example, an environmentally concerned investor may want to know all ‘green stocks’, while a Shariah conscious investor may only invest in Shariah compliant securities. Thus, indexes of Shariah compliant securities, sustainability indexes and sectoral indexes, e.g., oil and gas indexes are constructed to embrace inclusivity and efficient mobilization of resources.

Shariah screening of different stocks is designed to weed out equities based on screening criteria, which depends upon factors like proportion of conventional debt, liquid assets, interest bearing investments and revenues from Shariah impermissible businesses.

Ideally, from Shariah perspective, companies are expected to abstain from Shariah non-compliant businesses, avoid interest-based borrowing and refrain from investing in instruments yielding interest.

However, stringent application of the principles would screen out vast majority of companies, if not all, including those having a Shariah compliant core business activity.

That is why Shariah scholars have identified ‘minimum acceptable ratios’ based on Shariah principles and market dynamics for the purpose of Shariah screening of securities.

According to Islamic Finance Bulletin released by Securities and Exchange Commission of Pakistan (SECP) in February 2024, around 48% stocks listed on Pakistan Stock Exchange are Shariah Compliant based on the Shariah screening criteria followed for construction of KMI All Share index, which is an all-inclusive index of Shariah compliant equity stocks on PSX.

The Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI), a global standard-setting body for the Islamic financial services industry, uses different tolerance level criteria for quantitative stock screening compared to the KMI index.

Therefore, certain securities that might not meet the KMI’s standards for Shariah compliance might be considered Shariah compliant by the AAOIFI and vice versa.

Changes of Shariah Compliance status should only be caused by changes in the companies’ core businesses, instead of differences in the methods used in Shariah-compliance screening.

The variation in Shariah screening criteria is primarily attributed to several factors, including diverse interpretation of Islamic law, nature and maturity of financial markets.

The Shariah stock processes of Bursa Malaysia Islamic Index and S&P Global BMI Shariah Index also differ notably. While both exclude companies involved in non-compliant sectors, Bursa Malaysia’s screening emphasizes industry classification, considering the nature of primary business activities.

In contrast, S&P Global BMI Shariah Index focuses on financial ratios, utilizing metrics like debt to market capitalization.

In an attempt to regulate the Shariah stock screening process in Pakistan and to ensure transparency, Securities & Exchange Commission of Pakistan (SECP) announced an acceptable quantitative tolerance levels and other conditions for Shariah screening in September 2023. Index providers may adopt the minimum acceptable quantitative tolerance level notified by SECP for screening of securities, or can determine different tolerance level with prior approval of the Commission.

The SECP has also successfully addressed a longstanding issue concerning the screening of unlisted companies. Previously, private companies faced challenges in claiming Shariah compliance due to non-compliance with quantitative criteria related to transfer or sale/purchase of shares.

However, now the unlisted companies are no longer obligated to undergo stock price screening. Instead, they can assert Shariah compliance status if their income, investment and financing fall within acceptable threshold.

Nevertheless, there is a need to re-examine the screening process as quantitative tolerance levels are static in nature and provide a company’s state of health at specific point in time whereas economic conditions and market fluctuations can impact the interpretation of debt ratios.

Considering the unprecedented growth in the Islamic finance sector around the globe, it is also imperative that a consistent global Shariah screening process be developed to promote clarity, consistency, and openness. Such uniformity would boost the credibility of Shariah-compliant investments, attracting a larger number of ethical investors.

A single approach also reduces the potential of disagreements on the permissibility of specific financial practices, resulting in a more coherent and stable Islamic financial ecosystem.

(The authors work at Islamic Finance Department of SECP. According to them, the opinions expressed in this article are those of the authors and do not necessarily reflect the official views of SECP)

Copyright Business Recorder, 2024