One very interesting new principal in Ethical and Islamic fund management is Investment purification, despite being debatable, it is applied today by most prominent wealth managers across the globe.
But before we get into it, let us get back one step and Introduce permissible and non-permissible investments as per Shariah law. If you are new to Islamic Finance, the first thing they will tell you is that an Islamic investor shall invest only in permissible business activities/assets that are compliant with Shariah, such as Construction, Education, Telecoms, Aviation, etc. Whereas one shall not invest in non-permissible activities such as Riba, Alcohol, Pork, Gambling, Tobacco and I will leave aside revenue from Music businesses since the topic is a little bit too controversial.
However empirically, in today’s complex business and capital cycle, it’s becoming increasingly difficult to find a company whose activities (and therefore revenue) are completely compliant. You may find a fraction of its revenue derived from a non-permissible activity. Let’s take Lufthansa as an example, Industry Sector: Aviation, Shariah Compliant. Good, but what about its revenue from Alcohol sales? McDonald’s, Sector: Food Processing, Shariah compliant, but what is it’s revenue ratio from Pork sales? Similarly if you look into most companies you will find a fraction of its revenue that is non-permissible.
One would think that you can not invest in these companies, but in recent years Shariah scholars have concluded that as long as the main business activity and thereby the majority of revenue stream are derived from a Shariah compliant business activity, then investment is permissible, yet the investor shall Purify/forgo a fraction of the capital gains that is equivalent to the revenue ratio derived from the non-permissible activity. And that is what we call Investment Purification! It is the approach by which an investor can purify their returns from any fraction non-permissible revenue they have gained from investing in a compliant stock. And to surprise you more, Purification, despite still debatable, is applied by most prominent wealth managers across the globe. They may differ in application or calculation, but they all do purify their funds from any non-permissible revenue.
Calculating Purification ratio/amounts takes into consideration many factors including number of shares, days held and net income per share for each and every stock position in the portfolio. A mathematical logarithm that instantly gives you the amount of monetary return you need to purify every quarter.
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