An Islamic perspective on short selling

An Islamic perspective on short selling

“Sell not what you do not own.” – Prophet Muhammad (peace be upon him)

We have been fielding some questions from clients regarding GameStop and other extreme market action in recent weeks. Here’s our list of frequently asked questions on the subject. It’s designed to help our clients through these strange times. Azzad’s portfolio managers do not have exposure to GameStop or other names that have been influenced by coordinated moves from retail investors. As you might expect, the small size of those stocks and their generally lower quality do not make them likely candidates for ownership.

It isn’t GameStop’s meteoric rise (and subsequent decline) that we want to focus on, though. It’s the target of those retail investors who used social media to bid up prices and hammer Wall Street traders: hedge funds. Specifically, let’s address short selling, the strategy hedge funds used to make money from names like GameStop before retail investors decided to push back.

At Azzad, we do not allow short selling by our portfolio managers, in keeping with the principles of Islamic finance and investing.

Short selling is frowned upon by our scholars, some of whom liken the practice to gambling or speculating. Basically, short sellers do the opposite of most investors. They try to make money when a stock’s price falls. They borrow shares from their brokerage for a fee, immediately sell them, and plan to buy them back later at a lower price when the price falls.

The conventional short sell has two parts to it. First, a stockbroker borrows stocks from the owner. The stock owner usually gets certain percentage of interest on the loan, which is an impermissible interest-based (riba) transaction. Second, the stockbroker sells the borrowed stocks in the market and buys them back at a lower price at a future date, finally returning them to the stock owner. It is because of both riba and selling the stock without ownership that short selling is prohibited in Islamic finance.

The outstanding shares of companies are considered by Islamic finance scholars to be specified and unique assets that cannot be lent out the way one might lend money or commodities, which are fungible.

What’s more, the unfair manipulation of prices is wrong, and as we’ve seen, it can lead to catastrophic losses for the short seller. Allah tells us in the Qur’an:

“O, believers, do not consume one another’s wealth unjustly, but rather trade by mutual consent … ” – Holy Qur’an (4:29)

Mutual consent is a key concept in Islamic finance. Without it, fairness and accountability are lost in frenzy to make more money.

Many exchanges will tell you that short selling is a good thing because it improves market efficiency and liquidity, driving down overpriced securities. Clearly, that’s not the case with GameStop and other “meme” stocks.

Retail investors conspired to soak the rich by driving GameStop and other similar stocks higher. In so doing, they forced short sellers into a so-called “squeeze,” requiring them to buy the stock they originally borrowed in order to cover demands from their brokerage firm. Ironically, those retail investors who artificially drove up the prices of certain stocks to irrational levels often used borrowed money to accomplish this goal.

Two wrongs don’t make a right.

There’s a clear lesson here: Stick to the fundamentals of halal investing. Do not deviate or indulge in speculation, whether it’s short selling or anything else.

Azzad Asset Management

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