Home Publications Islamic Banking & Finance Page 28-02-2020

Islamic Banking & Finance Page 28-02-2020

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What are Islamic Mutual Funds and how they work?

Muhammad Arif : Chairman Centre of Advisory Services for Islamic Banking and Finance (CAIF), Former Head of FSCD SBP, Former Head of Research ArifHabib Investments and Member IFSB Task Force for development of Islamic Money Market, Former Member of Access to Justice Fund Supreme Court of Pakistan

There’s a common misconception that Mutual Funds are not a Halal investment avenue. Well, this is certainly not true. Contrary to popular belief, most Mutual Funds in Pakistan have divisions which are regulated under Islamic Shariah Compliant policies.

The most important part of Islamic Mutual Investments is that they are managed and supervised by renowned Islamic experts.

The investor’s capital in an Islamic Mutual Fund is invested in companies and organizations which are run under Shariah compliant policies. This rule out any concerns an investor might have related to their capital being used for unethical means.

Whenever banking is involved, one of the first concerns of any customer is interest. Being prohibited strictly by Shariah, interest is a major concern for most people. Islamic Investment Funds make returns on capital in a way that the provider is willing to share in the risks of a productive enterprise. This means that capital in a way is lent and not invested, leading to interest being the return and not the profit. This means that the investment is devoid of interest.

In order for the equity to be Shariah Compliant, it is necessary that the core business of the company should not violate any principle of Shariah. It is prohibited to acquire shares of companies which provide services on interest such as conventional banks, insurance companies, leasing companies. In addition to this companies involved in some other business not approved by the Shariah e.g. companies making or selling liquor, pork, haram  meat, or involved in gambling, etc. in addition to the above following five criteria’s are necessary:

(1)The profit Bearing Debt to Total Assets ratio. (2) The ratio of Non Compliant Investments to Total Assets. (3) The ratio of Non Compliant Income to Total Revenue. (4) The ratio of Illiquid Assets to Total Assets. (5) Market Price per share should be at least equal to or greater than net liquid assets per share.

Islamic Investment Funds are the perfect option for someone who wishes to save and invest to meet their short and long term financial goals. Whether it is saving for your child’s future or to go on a family vacation, with Islamic Investment Funds, you can easily do so by remaining within Shariah regulated boundaries.

How a customer gets benefit out of Islamic Mutual Funds, for this we have to understand Net asset Value (NAV). NAV represents a fund’s per share market value. It is the price at which investors buy (“bid price”) fund shares from a fund company and sell them (“redemption price”) to a fund company. It is derived by dividing the total value of all the cash and securities in a fund’s portfolio, less any liabilities, by the number of shares outstanding. A NAV computation is undertaken once at the end of each trading day based on the closing market prices of the portfolio’s securities.

For example, let’s say a mutual fund has Rs 45 million invested in securities and Rs 5 million in cash for total assets of Rs 50 million. The fund has liabilities of Rs10 million. As a result, the fund would have a total value of Rs 40 million.

The total value figure is important to investors because it is from here that the price per unit of a fund can be calculated. By dividing the total value of a fund by the number of outstanding units, you are left with the price per unit—the form of measurement in which NAV is usually quoted.

Building on our example, if the fund had 4 million shares outstanding, the price-per-share value would be Rs 40 million divided by 4 million, which equals a NAV of Rs 10 per share.

The NAV calculation is important because it tells us how much one share of the fund is worth.

The NAV pricing system for the trading of shares of mutual funds differs significantly from that of common stocks or equities, which are issued by companies and listed on a stock exchange.

A company issues a finite number of equity shares through an initial public offering (IPO), and possibly subsequent additional offerings, which are then traded on exchanges such as the Pakistan Stock Exchange (PSE). The prices of stocks are set by market forces or the supply and demand for the shares. The value or pricing system for stocks is based solely on market demand.

On the other hand, a mutual fund’s value is determined by how much is invested in the fund as well as the costs to run it, and its outstanding shares. However, the NAV doesn’t provide a performance metric for the fund. Because mutual funds distribute virtually all their income and realized capital gains to fund shareholders, a mutual fund’s NAV is relatively unimportant in gauging a fund’s performance. Instead, a mutual fund is best judged by its total return, which includes how well the underlying securities have performed as well as any dividends paid.

As elaborated the NAV is simply the price per share of the mutual fund. It will not change throughout the day like a stock price; it updates at the end of each trading day. So, a listed NAV price is actually the price as of yesterday’s close. But an order you put in will be based on the updated NAV at the end of the CURRENT trading day. As a result, you may not know the exact NAV when you buy or sell shares.

For example, if you want to buy Rs10, 000 worth of mutual fund ABCDX, and the NAV as of yesterday’s close was Rs 100, that would mean you purchase 100 shares. However, if the NAV increases drastically on the day you made your purchase, you would actually be purchasing more than the 100 shares you originally planned. To prevent that issue, you can also buy or sell in Rupees amounts instead of shares.

Al Ameen, Faysal, HBL, MCB, Alfalah, NAFA (National Bank), Meezan, JS are some of the Islamic funds operating in Pakistan.

These funds exist in form of cash or Islamic Money Market Funds meaning a mutual fund that invests only in short term securities, such as bankers’ acceptances, commercial paperrepurchase agreements and government bills.

Another form is Shariah Compliant Capital Protected Fund. This means Capital protection-oriented fund or a class of closed-end hybrid fund. Its primary objective is to safeguard investors’ capital in the event of market downturns while simultaneously providing them scope for capital appreciation by participating in upturns of the equity market.

Another form is Shariah Compliant Fund of Funds. It is also known as a multi-manager investment Fund that is a pooled investment funds that invests in other types of funds. In other words, its portfolio contains different underlying portfolios of other funds. These holdings replace any investing directly in bonds, stocks, and other types of securities.

Another form is Shariah Compliant Asset Allocation Funds. This is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon. The three main asset classes – equities, fixed-income, and cash and equivalents – have different levels of risk and return, so each will behave differently over time.

Another form is Shariah Compliant Commodities Fund that means to typically invest in both the stocks of companies involved in commodities, such as mining companies, and in commodities proper. One advantage of this approach to commodity investing is that commodities mutual funds may perform well even when commodity prices overall are not.

Another form is Shariah Compliant Index Tracker Fund that tracks a broad market index or a segment thereof. Tracker funds are also known as index funds. These funds seek to replicate the holdings and performance of a designated index. Tracker funds are designed to offer investors exposure to an entire index at a low cost.

Another form is Shariah Compliant Equity fund that is a mutual fund that invests principally in stocks. It can be actively or passively (index fund) managed. Equity funds are also known as stock funds. Stock mutual funds are principally categorized according to company size, the investment style of the holdings in the portfolio and geography.

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