Islamic finance and SRI share a lot of common ground

Socially responsible investment and Islamic finance share significant common ground. SEDCO Capital is working to bring them together in an innovative financial product

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Islamic finance has grown alongside a global trend for socially responsible investment. The two spheres share a lot of common ground

In the last two decades, Islamic finance and socially responsible investment (SRI) have been among the fastest growing areas within finance. The two not only showed resilience, but also marked growth during the global fiscal turbulence, especially when compared to the near-collapse of other investment categories.

Furthermore, the growth of both Islamic finance and SRI is mostly demand-driven. Both approaches are sparking avid interest across global financial markets, and institutions are devoting increasing resources to these areas in response to demand from investors. The two areas share certain features and commonalities; their continuing success will be based on the fact they will feed off and into one another.

Common ground
Starting with John Wesley (founder of the Methodist Church) in 1760, and strengthened thereafter by the Quakers, the Federal Council of Churches, the Swedish Temperance Society, the Anglican Church, and Éthique et Investissement (founded by a group of nuns), the Christian origins of SRI can help us to understand how religious beliefs became incorporated into finance. Although SRI has grown into a full-fledged strategy, it stems from a desire to render the religious beliefs of investors into financial practices – using money in a manner that conforms to values and morals.

Meanwhile, the purpose of Islamic finance is to improve living conditions and wellbeing, establish social equity, and prevent injustice in trade relations. The environment is also considered under the tenet of Islam that says man has to play the role of steward over divine creation. In its application, waste and useless or superfluous consumption are deemed unacceptable. These elements closely resemble those of SRI: a keen focus on sustainable development, creation of wealth for society, and improvement of overall quality of life.

Both spheres of investment demand the businesses chosen for investment are socially useful, not detrimental to humanity, and compliant with humanitarian ethics. Both practice ethical exclusions as part of their investment rules, and their common list of forbidden sectors include alcohol, gambling, tobacco and weapons – businesses that are often deemed harmful to humanity and society.

The Christian origins of SRI can help us to understand how religious beliefs became incorporated into finance

While traditional finance has always been driven by an effort to maximise risk-adjusted returns, investors in Islamic finance and SRI have the additional goal of ensuring financial market activity is compatible with investors’ ethics, and that they promote social welfare. Both sets of investors seek not only financial returns, but also societal returns.

Although the principles of Islamic finance date back several centuries, its role in modern financial markets only began to receive recognition in the 1980s, and it took until the start of this century for it to gain a meaningful share of global financial activity. By most estimates, the total volume of Islamic financial assets has grown by 15 to 20 percent annually over the last two decades, and now exceeds $1trn according to an IMF study. Similarly, SRI coalesced as a recognised investment strategy in the 80s, and has grown significantly over the past two decades. Some commentators estimate the total volume of assets held by explicitly SRI investors has increased by more than 30 percent since 2005, and now exceeds $3trn according to the aforementioned IMF report.

In another parallel, both SRI and Islamic finance have hitherto focused more on equity than on fixed-income investments. The fundamental principles behind Islamic finance – emphasis on equitable risk sharing and the prohibition of interest-based financing – are complementary to investing in equities. Likewise, SRI has been applied largely to equity investing, and mostly through screening. As a result, financial intermediaries have found it easier to create SRI and Islamic equity products than fixed-income ones.

SEDCO Capital has incorporated its Sharia-compliant investment approach with its responsible investment strategy and created a concept referred to as prudent ethical investing (PEI). PEI is seen as the evolution of responsible investment, as it highlights the importance of due diligence and transparency of investment structures, processes and reporting, and has clear understanding of the underlying risks, structures and cash flows. PEI also is designed in a way that ensures the quality of its portfolios through its prudent elements, to avoid high and undue risks.

Embrace the positive
Now, with established equity products, practitioners of both Islamic finance and PEI are beginning to look into the fixed-income side of capital markets, and this conjunction of interest creates several interesting opportunities. Given their similar histories and strong focus on ethics, it should be possible to create income products that meet the needs and demands of both types of investors and the resulting products could become a useful bridge to connect them.

Often called ‘negative screening’, the most common strategy of SRI is the simple avoidance of businesses that fail to meet the investors’ ethical and moral standards. In the last decade, though, SRI investors have actively explored positive ‘impact screening’ techniques – an active search for businesses that have proven their beneficial social or environmental impacts. This proactive approach also negates criticism directed towards ‘greenwashing’, as impact investors are looking to fund efforts that achieve specific and measurable change, and do not rely on marketing or public relations propaganda.

Negative screening ensures Sharia-compliant investors do not invest in activities or structures prohibited by Islam, but these investors do not necessarily have an opportunity to support activities they believe in. The concept of development in Islam has three dimensions – self, Earth and society – and all three dimensions assign heavy responsibility on individuals and society. If balanced development is defined as progress, positive or impact screening could open up many new doors for the Islamic investor by uniting investments that generate measurable positive social impacts.

On a related note, when environmental, social and governance criteria (ESG) are integrated into financial analyses, this hybrid strategy ushers various ethical criteria into the mainstream financial industry, and helps close the gaps between conventional, Islamic and SRI investments. This is at the heart of PEI as it integrates the analysis of ESG criteria with the investment process to incorporate non-financial aspects. Based on a confluence of research, performance and demand in this area, SEDCO Capital is not only Sharia-compliant but also evaluates ESG aspects as part of its investment process.

In 2014, SEDCO Capital joined the UN Principles for Responsible Investment, and became the first Sharia-compliant and first Saudi Arabian signatory to do so. To illustrate this, in public equity, the company launched four ESG/Sharia compliant funds with AUM of more than $410m. In private equity, SEDCO Capital is the Sharia advisory to BTG Pactual Brazil Timberland Fund I (a fund that emphasises the sustainable development of commercially managed timberland in Brazil). In real estate, it has invested in India’s first sustainable green building research park in Bangalore. Moving forwards, SEDCO Capital aspires to deploy Sharia/ESG investment platforms across all asset classes and investment strategies.

Bright idea
As the global economy continues to face the challenges of a high-risk environment, SEDCO Capital’s PEI concept promises a bright future and represents a compelling proposition. Relative to strategies that involve traditional SRI only, PEI not only avoids high financial risks but has the potential to deliver and enhance long-term risk-adjusted returns, which is a key factor for investors. And relative to traditional Sharia-compliant strategies, PEI applies positive ESG screening, which also tends to incrementally improve expected returns.

With SRI and Islamic finance taking centre stage in the financial industry, PEI is merging these two forces to embrace a more sustainable economic development model that is expected to attract non-Muslim SRI investors into the Islamic finance market – truly the beginning of a new, unified age.