Do Fund Managers Keep Their Promises? : The Case of Shari’ah Equity Funds

This paper examines the compliance of a large sample of faith-based ethical funds – Shari'ah equity funds (SEFs). SEFs screen their investment for compliance with Islamic law, where riba (conventional interest expense), maysir (gambling), gharar (excessive uncertainty), and non-halal (non-ethical) products are prohibited. Using a set of stringent Shari'ah screens similar to those of Morgan Stanley Capital International (MSCI) Islamic, we find less than one-third of the equity holdings of SEFs are Shari'ah-compliant. While most (95%) of the fund holdings pass the business screens, only about 42% pass the total debt to total assets ratio screen. This finding suggests that, in order to overcome a significant reduction in the investment opportunity set, Shari'ah principles are compromised, with SEFs adopting lax screening rules in an attempt to achieve financial performance. An implication of our results is that SEF investors may be exposed to Shari'ah compliance risk since the fund managers do not always fulfill their fiduciary obligations as promised in the prospectus. While younger funds and funds that charge higher fees and are domiciled in more Muslim countries are more compliant, funds that have greater disclosure of the Shari'ah compliance framework are not necessarily so