The spirit of investing according to the RF law (Judeo-Christian-Islamic Shari'aa law) is to participate in equity investing and not in debt-type investing. Equity investing means owning equity in the company (or companies). Debt investing means lending money to the company using a riba-based instrument, such as a direct loan, an interest-based (renting money) promissory note, or a predefined interest-based bond.

Investing in equities is highly encouraged by the law (Shari'aa). RF financing is all about equity participation in business activities that need financing.

I was part of a group of scholars and experts who started the structuring of the first RF stock investment portfolio in the world in 1988 in a $250 million portfolio according to the law (Shari'aa). The portfolio performed much better than the market averages. A number of guidelines were developed as early as 1988 to regulate investing in stocks based on the law (Shari'aa) by using RF discipline. The following is a list of these RF guidelines:

■ It is preferred to invest in companies that operate in local communities to generate economic growth and prosperity that would create new job opportunities, peace, and harmony in the community.

■ Investing should be in socially responsible companies with a management dedicated to high ethical and moral standards. Investing cannot be in companies which are involved directly or indirectly in divinely prohibited (haram) businesses, such as:

■ Alcoholic beverages, intoxicants, bars, nightclubs and associated activities, casinos, hotels that operate bars and casinos, airlines that serve alcohol on their planes, or other promiscuous activities. For example, Walt Disney Company provides family entertainment and theme parks, but it also owns movie divisions and trade names that may violate the promiscuous activities rule. Coca-Cola, in addition to its huge soft drinks business, has a thriving alcohol-related wine business. RF discipline and rules may not allow investing in either of these companies.

■ Pork and pork products industries.

■ Tobacco products.

■ Any other unethical activities and businesses that are not fair to their employees and customers or are environmentally irresponsible.

■ The company capital structure should have minimum debt. This has generated a lot of research and debate. The first issue was how to calculate the debt structure of the company. Should it be based on the company's book value or the company's market value? And how to define the market value, is it the total number of shares multiplied by market price? Or is it the fair market value of the company's shares and assets?

In the beginning, most scholars and Shari'aa committee members preferred using the book value as a conservative basis for calculating the debt as a percentage of total company capitalization and preferred to keep debt as low as possible.[1] Later on, as demand for RF (Islamic) mutual funds started to grow in the market, the RF scholars' regulation was relaxed to replace book value with market value defined as the number of shares outstanding in the market multiplied by the closing price in the market, which has allowed practitioners in the highly inflated market prices to expand the list of company stocks from which they can choose.

■ Equities in the U.S. market were screened. As part of the research,[2] more than 10,000 companies were analyzed. The percentages of RF noncompliant stocks (in 2000) were as follows:

■ Prohibited business line: 22 percent

■ Excessive borrowing: 62 percent

■ Excessive interest income: 8 percent

■ Other exclusions: 3 percent

The total percentage of companies excluded was 95 percent. Out of 10,000 companies, only 500 were RF Shari'aa compliant.

■ The maximum debt allowed is 33 percent of the market capitalization, not the balance sheet capitalization (originally the ruling was to use the balance sheet capitalization).[3] However, in an RF regime using the Marking-to-Market approach, along with the Commodity Indexation principles discussed in Chapter 5, a corrector should be used that reflects the overpriced assets in case a bubble is detected. For example, if oil price reaches $150 and, based on the Commodity Indexation principles, the oil price should be $50 to $70, that means the market valuation of that stock should be reduced to about one-third to one-half of its value, leading to a decision to sell out of the position to avoid participating in the bubble.

■ Company accounts receivables should remain at 45 percent of total company assets.

■ Interest income should be less than 5 percent of total revenue.

Investment should be in actual stocks backed by an operating company and not just a paper index. Indexes are only used for measuring performance results.

These foundations for RF stock market investing according to the law (Shari'aa) were adopted by the Dow Jones Company to develop the Dow Jones Islamic Market Index (DJIMI).[4] Later, Standard & Poor's[5] introduced its own S&P Islamic index. These indexes formed the bases for many Islamic RF mutual funds available in the market today. Amana Funds,[6] one of the most successful funds, developed its own parameters and screens. Its two funds, the Amana Income Fund and the Amana Growth Fund, realized a five-star rating on the Morningstar rating system. The company was successful in getting some of the major brokering companies, like Charles Schwab and T. D. Waterhouse, to distribute its fund for retirement plan and general investors. This has increased the assets under management from approximately $65 million in the late 1990s to almost $1 billion in 2006 and over $3.5 billion in 2012.

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