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Halal Investing 101: Back to Basics

Halal-Investing-101-Back-to-Basics - Azzad Asset Management

The complex world of investing can be daunting for American Muslim investors. To make it more accessible, let’s look at some investing basics through the lens of Islamic finance and go over the halal options available in the United States.

Stocks and bonds 

There are many kinds of investments available in the U.S., a number of which we’ll discuss later in this piece. The most common publicly traded investments are stocks and bonds. So, let’s start with those.

Stocks represent ownership shares of a publicly traded company, including a claim to a share of the corporation’s assets and earnings. When you buy a stock, you own a tiny part of that company. If the company’s value increases or decreases, the value of your stock investment increases or decreases with it. Any money you earn from a stock comes from the business of the company, so Muslim investors usually want to know how the company operates and how it makes its money. Stocks are part of the “equity” market, so they may also be referred to as “equities.”

Bonds are interest-bearing ownership shares of debt, usually issued by a country, city, or company. If you buy a bond, you own a tiny part of that debt and will receive repayments, including interest, based on that ownership. There are alternatives to traditional bonds that do not bear interest, including Islamic bank deposits and sukuk (asset-backed bonds, sometimes called “Islamic bonds.”) Bonds are part of the “fixed-income” market, and are generally considered to be conservative investments.

Bonds and riba

Riba is one of the most often misunderstood terms in Islamic finance, but it plays an important role in the proper practice of Islam in our financial lives. Riba is prohibited by the Qur’an, the sunnah of Prophet Muhammad, and the consensus of the scholarly community.

What do we really mean when we use the Arabic term riba? The literal translation of the word is “increase, addition, or growth,” although it is often translated as “usury.” English speakers typically understand usury as charging an exploitative rate of interest. But riba refers to any excess value in transactions that Islamic Shariah, or sacred law, has prohibited.

One of the most common types of riba recognized by almost all Muslim scholars is riba al-nasee’ah. This is the only type of riba that is mentioned in the Quran, and it’s considered the most harmful and unethical of all forms of riba. Simply put, riba al-nasee’ah is an increase in the amount of a commodity due to the mere passage of time. 

This is the category into which interest-based bonds fall. Most bonds, therefore, are generally not acceptable investments for Muslims. There are, however, new alternatives in the market that help to meet investors’ needs.

The Islamic prohibition on interest has left many Muslims to favor stock investing in the United States. Unfortunately, however, many of those do-it-yourself approaches are too simplistic and ignore the carefully outlined rules for halal investing explained by our scholars.

Introducing AAOIFI

You may be wondering how to determine which lines of business are impermissible and how the financial tests are derived. To help with this, an international entity called the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was established in 1990.  AAOIFI’s Shariah advisory board consists of Islamic scholars, specifically those with an extensive background in the fiqh (jurisprudence) of trade and transactions. They come together from different parts of the world and from different schools of thought to issue international Islamic finance standards. 

Using AAOIFI guidelines helps to ensure that your investments genuinely comply with Islamic principles. Combined with guidance from a trusted advisor, they’re a great way to help judge if your investments are halal.

Finding halal stocks

Most Shariah scholars agree that a two-step screening process best determines compliance with the principles of Islamic financial transactions:

  1. Qualitative: The company’s lines of business go under the microscope. Scholars and fund managers look for any indication that the company engages in business or other activities that are prohibited.
  2. Quantitative: The company must also pass certain financial tests. For example, it can’t have too much debt on its books.

These two steps get to the heart of the process for finding halal stocks and stock funds. Keep in mind that just because a company has a halal line of business, it doesn’t mean that it’s halal to invest in. It could also have too much debt or interest income, or also own a secondary line of business that engages in Islamically impermissible activities above a certain threshold. There is much more detail on both the quantitative and qualitative screens, not to mention the importance of paying zakah and purification, and we would counsel those interested in investing to speak with an Islamic finance professional for more information.

How to invest for college or retirement

Stocks, bonds, and mutual funds are types of investments, which can be held in different investment account types such as a retirement plan or education savings account. Many American Muslims think that 401(k) plans are investments, but they’re not — they’re tax-advantaged accounts that hold investments. The same goes for IRAs, 403(b) plans, 529 plans, and Coverdell Education Savings Accounts. You choose which investments you put in these accounts.

 Type of investmentWhat is it?Can it be halal?
StocksOwnership shares of a companyYes. Stocks should be screened for lines of business, financial ratios, and other considerations. Even halal stocks are subject to purification dues.
BondsOwnership shares of debtTraditional bonds: No — they are based on borrowing and lending in interest. Also, trading in debt is not considered to be permissible.   A halal alternative is sukuk (some people call them “Islamic bonds”).
Hedge fundsA private investment partnershipNo. Hedge funds rely on borrowed money and frequently engage in high-risk practices. They often deal in short-selling and derivatives (not halal because it’s selling something you don’t own) and margins (not halal because it involves borrowing with interest).  
OptionsContracts that give an investor the right to buy or sell an asset at a certain price before a certain date. The investor is not required to buy/sell the asset, but they pay a nonrefundable price to buy the option.Generally, no. Options are  speculative in nature. They represent a financial right, not a tangible asset.   Exception: buying stock options in a company you currently work for is considered halal. Trading those options would be problematic.  
CurrenciesAn accepted form of money. Examples: dollar, euro.No. Currencies are usually purchased through options. To be halal, their trade would need to be settled immediately, not on a deferred basis as with options. Currencies and gold are considered to be monetary assets (pricing tools).  

Common investment accounts for retirement

  • IRA (traditional, Roth, others) — generally established and managed by individuals
  • 401(k) plan — generally established and managed by a business
  • 403(b) plan — generally established and managed by a hospital, school, university, or nonprofit
  • TSP (Thrift Savings Plan) — retirement plan for federal government employees

Common investment accounts for education savings

  • 529 plan — managed by states; always includes interest bearing investments
  • Coverdell Education Savings Account
  • UGMA/UTMA (Uniform Gift/Transfer to Minors Act) custodial accounts

From halal screening to picking the right fund, there’s a lot to consider when it comes to halal investing. The important thing is to do your research and ask the professionals if you’re unsure about something. American Muslims are fortunate to be able to take advantage of investment options that cater to their needs. Of course, there’s no excuse for waiting to get started.

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