Usman Hayat, for the CFA Institute has written a provocative paper about the relationship between socially responsible investing on the one hand and Islamic finance on the other.
His bottom line is that “emerging trends may enable financial services to develop products that satisfy criteria of both approaches.”
In an introduction to the paper, William Tohme, the CFA’s senior regional head for the Middle East and North Africa, says each approach, taken at “face value,” is quite different. Islamic finance focuses on avoiding riba and excessive gharar (contractual interest and the sale of risk, respectively). SRI, on the other hand, is driven by social, environmental, and governance issues, such as affect screening, asset revaluation, and portfolio management. Diving deep, one sees that there are continued areas of divergence along with the convergence.
In the main body of the report, Hayat lists six methods commonly used to advance SRI across asset classes: exclusionary screening; best-in-class selection; active ownership; thematic investing; impact investing; and ESG integration. Hayat defines impact as investing aimed at generating and measuring social and environmental changes through feedback loops and the communication of performance. He writes “investors with credible impact investing processes use shared industry terms, conventions, and indicators.” ESG integration refers to “the systematic and explicit inclusion of ESG risks and opportunities.” It doesn’t require peer group benchmarking or any ex ante criteria for inclusion or exclusion.
Islamic finance, like SRI, employs some exclusionary screening. Like SRI, too, the nature of the screening can evolve over time. For example the exclusion of tobacco investments, is “not directly associated with a prohibition in the primary sources of Islam,” in the way that alcohol is. Nonetheless, tobacco has come to be excluded in modern Islamic finance as evidence has made it clear that the habit is destructive of health.
More broadly, Hayat cites a recent report from Refinitiv, which says that there is a direct correlation between Shariah compliance and higher ESG scores. ESG scores for Shariah-compliant companies were 3% higher on governance matters than the broader population of investable companies studied; 7% higher on social issues; and 7.3% higher on environmental matters.
Perhaps ESG and Shariah, despite their different origins, have this positive correlation because they both end up picking out the better performing (non-financial) companies. Five years ago, a meta-study by the University of Oxford and Arabesque Partners looked at 200 studies about the degree to which, and the direction in which, SRI/ESG practices affect performance. It found that 80% of the studies of the matter find that the former positively influences the latter.
Hayat doesn’t find anything quite so positive to say about Shariah-related performance. There are non-negative things to say, though. Ten years ago, for example, an IMF study found that “when comparing conventional and Islamic banks and controlling for other bank and country characteristics, there are few significant differences in business orientation, efficiency, asset quality, or stability.”
A 2018 meta-study, which looked at 81 articles about mutual fund, equity, and sukuk performance, found mixed results. Sukuk is neither reliably more nor reliably less valuable that the non-Islamic investing approaches in the scope of those studies.
The two approaches (SRI and Islamic) certainly face similar challenges. Islamic funds are often accused, for example, of putting legal formalities above the underlying economic realities. “They are okay with interest so long as it is not called ‘interest’” is a refrain. Likewise, SRI funds are often accused of greenwashing not-so-green entities in order to justify their investments. Hayat sees these challenges as arising out of the inherent conflict of authenticity and scale. Such issues won’t go away.
In the end, though, both approaches can work, and they can work in conjunction, by way of funds designed to satisfy both sets of criteria. As Hayat writes, “A systematic and substantive consideration of ESG issues in Islamic finance is likely to enhance its value proposition and strengthen its bridge with SRI investing.”