A market edge for Muslims

Islamic funds make gains by avoiding financial-services firms and those deep in debt.

The strategy is almost heresy on Wall Street: Find a top-performing investment by seeking out a mutual fund with some of the industry's strictest ethical screening requirements.

Yet that approach, if adopted, would work in at least one case. The Amana Income Fund, which avoids not only alcohol, tobacco, and gambling stocks but also pork producers and lenders who charge interest, received a Lipper award earlier this year for outperforming 180 equity income funds – screened and unscreened – over the past three years.

Amana Funds dominate the relatively small niche of socially responsible investing (SRI) that aims to reflect Islamic law, or sharia. The idea is for an entire portfolio to reflect moral values from the Koran, which deems pork products unclean and regards the charging and paying of interest as immoral endeavors that foster exploitative relationships.

"If Islam forbids it, then we're not going to buy it," says Monem Salam, deputy portfolio manager at Amana Funds. That principle generally "keeps us out of trouble," he says, by requiring the funds to avoid such ticking time bombs as Enron and WorldCom, which imploded in accounting scandals a few years back. Both were too heavily leveraged to pass muster at Amana.

In theory, Islamic funds face an uphill battle since about half of the stock market universe – including most financial services companies – is off limits to them. But in practice, Islamic funds fulfill their moral ideals in considerable measure by mimicking some revered habits of billionaire investor Warren Buffett.

For instance, because excessive stock trading amounts to gambling in the eyes of Islamic authorities, Islamic funds practice a buy-and-hold strategy that helps keep trading costs down. Also, concern about the ethics of borrowing and lending leads Islamic fund managers to avoid deeply indebted companies, such as several big-name airlines, which tend to stumble in recessions and in times of slow economic growth. Both practices are quintessential Buffett, the CEO of Berkshire Hathaway, based in Omaha, Neb.

As Islamic funds gain notice, observers are weighing whether their extra-high moral standards might actually provide them with a leg up on both their unscreened competition and conventional SRI funds, which are often heavily weighted in ecofriendly financial stocks. It's a matter of some debate.

David Kathman, a mutual-fund analyst with fund tracker Morningstar, sees the unique Islamic screens as potentially adding value, especially in slow economic times, to the funds' bottom lines.

"Avoiding leverage, I think, is a good long-term strategy," Mr. Kathman says. His reason: Even though highly leveraged firms can enjoy big upward spikes in stock price, big debt on the books also "increases the risk that something bad will go really bad."

He says minimal trading also bodes well for investors because "for the most part, lots of trading tends to drag a portfolio down."

Others are more skeptical of approaches used by Islamic funds. Any good fund manager will already be shunning complex trading strategies as well as lots of debt-heavy stocks, according to Avanidhar Subrahmanyam, a finance professor at the Anderson School of Management at the University of California, Los Angeles. But to avoid financial companies altogether is, in his view, "an extreme thing to do" because it sharply narrows an otherwise diverse universe of potential investments and overlooks the societal benefits of lending.

"I can understand religious reasons for doing such things, but I wouldn't recommend, for example, for a student who has no particular reason to avoid such companies to go invest in such funds," Professor Subrahmanyam says. "That's because I believe constrained investing, in the long run, might be a less-than-desirable way to invest."

Islamic funds hold just a tiny fraction of the roughly $2 trillion held in socially responsible investments. Amana Growth and Amana Income together count $700 million under management, up from just $30 million in 2003. Another investment group, Azzad, offers an Ethical Mid Cap Fund and Ethical Income Fund that have a meager $3 million and $6 million under management respectively. But Azzad also oversees $75 million in private money management in accordance with Islamic principles. The Dow Jones Islamic Fund, which tracks a sharia index, counts about $33 million under management.

Fund managers say this small investing niche owes a portion of its recent progress to a growing segment of non-Muslim investors. Salam notes that most of Amana's asset growth over the past four years has come from new investors, including many non-Muslims who are chasing market-beating returns. Over the past six months, Azzad's non-Muslim investor base (about 10 percent of its investors) has been growing faster than its Muslim base. Azzad aims to build on that trend by positioning itself as a morally robust option for conscientious investors of any religious or secular stripe. Azzad replaced its portfolio manager in December and plans to cut its expense ratio from 2.25 percent to 1.95 percent in July.

Most investors in Islamic funds are Muslims who aim for consistency between their religious beliefs and their investments. For Nabeel Hamoui, a Chicago-area radiologist-in-training, investing through Azzad's private money-management program means adhering to a divine code that's trustworthy for preserving "mind, body, life, wealth, and offspring."

"We truly believe God has given us principles to live by that are in our own interest," Mr. Hamoui says. "Even if you took the broadest interpretation of what's allowable [under sharia] for investing in financials, it's going to be a lot narrower than what's available for other people who don't have those same beliefs. But clearly it's not narrow enough to prevent Muslims from making the same amount of money [as non-Muslims] or beating the market."

Sometimes Islamic funds reach beyond their official screening criteria in order to reflect their clients' sensibilities. For instance, Azzad sold its shares in clothing retailer Abercrombie & Fitch in 2006 after investors objected to the company's advertisements featuring girls, apparently under age 18, in skimpy clothing.

"You shouldn't have young girls dressed up like they're prostitutes," says Portfolio Manager Omar Bassal. Such values, he says, aren't unique to Muslims but instead reflect the attitudes of morally concerned people from a range of backgrounds.

Whether a broader cross-section of investors will eventually flock to Islamic funds for moral reasons remains to be seen. By avoiding all food stocks, Azzad hopes to attract investment dollars from non-Muslims who don't want to support such practices as the raising of livestock for slaughter, for instance, or the use of nonorganic farming methods.

Another potential market: investors concerned about lending practices that trap borrowers in debts they can't repay. By steering clear of firms with a large stake in the money-lending business, Islamic funds can boast that they own neither subprime lenders nor credit-card issuers who charge double-digit interest rates or bury complex terms in fine print, or both.

But the quest for moral purity can come at a price, Subrahmanyam warns, both in ethical as well as monetary terms. By avoiding the financial sector, he says, investors in Islamic funds miss out on stocks that have done well in recent years and have, in many cases, helped borrowers put cash to good use.

"I believe that avoiding stocks that indulge in usury is a desirable goal," Subrahmanyam says. "But usury is a subjective thing. One could argue that banking companies provide a valuable service. It's valuable to be able to borrow against one's home and make investments in children's educations that couldn't otherwise be done.… So a blanket ban on financial companies can be viewed as a little too extreme in most cases."