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What is an ETF?

What is an ETF and does it have a place as a sharia-compliant Islamic investment? This was a recent topic of discussion with an old friend so I thought I would pen a few words as I realised we had not really touched on it.

At IFG, we’re big on breaking what seem like complex financial topics into simple language so that you are empowered to make your own decisions and benefit economically. ETFs seem like a foreign world, but they are actually really quite simple.

What an ETF is

It stands for an exchange-traded fund. Let’s break that down from back to front.

The ‘fund’ part of it is simply because it is a collection of money which is managed by a fund manager. The fund manager will make decisions about how to allocate the collective pot of money which all the investors have put in, with the idea being that if the collective whole is successful, your portion of that fund will see a positive return.

The exchange-traded bit of it means that the fund is listed on a stock exchange. This seems a bit confusing at first because one normally associates individual companies being listed, not funds. But funds can and do exist on the stock market, and you can buy them much in the same way as you would buy an individual company. The difference is obviously that you aren’t buying an individual company’s shares when you buy into an ETF, you are buying a portion of the collective fund. If the fund performs successfully, the traded price of the fund will inevitably rise with it, and you will therefore be able to sell you shares of the ETF back to the market at a higher price.

What goes into an ETF?

You will find all types of ETF on the market. For instance, you will find some ETFs specifically focussed on one type of thing – for example, gold. The fund manager will buy into what he or she deems to be good exposure to gold – that might be gold miners, explorers, actual physical gold, etc. Other ETFs might be focussed on ethical investments – they will be investing in companies that fit their criteria of being ethical; some ETFs have small cap exposure, international exposure, etc.

Many ETFs simply track an index. That means that the ETF holds all the companies in the FTSE100, for example, and thus it essentially becomes a tracker of the FTSE100. This is a really good way to track global indices: some ETFs will for example buy a selection of stocks from lots of different parts of the world thus giving you good global exposure. We’ll discuss the sharia-compliance aspect towards the end.

The benefits

The most obvious benefit is that you can choose an ETF based on a macro theme. For instance, let’s say you know you want exposure to commodities, you can simply hone in on ETFs that are focussed on that. You don’t have to worry about picking individual companies and you can leave that down to the expertise of the fund manager.

More than this, because the ETF has a sizeable pot of money, it has investments open to it that won’t be open to you. For instance, a fund manager might invest in unlisted companies, or other types of investments that wouldn’t be open to you as an individual but are open to the fund manager with the money that they have at their disposal and the contacts and networks in which they operate. So buying into an ETF potentially gives you some exposure into areas you would otherwise not be able to access.

A further benefit is that you can leave your investment well alone. This is great for the more passive investors who do not want to be checking stock exchange news every day to keep up to speed with their individual stocks portfolio. You are outsourcing management of your investment to a fund manager and nothing is needed from you.

Lastly, diversification is an obvious benefit to ETFs as well. ETFs will generally hold a good number of assets within the fund so that the bad performance of any single aspect of the ETF will not have too bad an impact on the overall value of the fund.

The drawbacks

There are costs associated with holding an ETF beyond the actual trading cost to buy and sell [read this article for more about trading costs]. The actual administration costs of the ETF are baked into the price so you won’t see that charge directly. What you will have deducted from your account is whatever your broker charges you to hold a fund. This is usually a fraction of a percentage but I suggest you check with your broker what their charges are to hold a fund in your account. This will obviously marginally eat into any profit so it’s important to bear this in mind. The costs associated with holding an ETF rather than individual stocks will generally be higher – but this is a price that you might be willing to pay for the ease and simplicity involved.

Another negative is the diversification. We also have this down as an advantage, but diversification can be bad too depending on what type of investor you are. I argued in this article that diversification is probably not the way to go if you are focussed on pure growth of your portfolio. Thus an ETF, which will be well-diversified, potentially stunts growth.

Are ETFs a halal investment?

Good question. The answer is in two parts.

  1. Some ETFs are certified as being sharia-compliant. These are undoubtedly ok.
  2. Other ETFs might also be halal to invest in but you will have to do some work to get to the answer. You will need a list of all the individual assets within the fund, and then you will need to do a manual analysis of them all. If all the individual assets within the fund are sharia-compliant, then the fund is halal. If there are a small number of haram companies in there, then the ETF is still halal to invest in but you should purify your profits by giving that % away in charity.

Conclusion

Sharia-compliant ETFs offer a really useful tool for the investor who does not have the time or appetite to individually analyse stocks. Whilst I am a big proponent of people doing this, I recognise that in our busy lives, we sometimes want to invest and are happy to pay ongoing administration fees into assets which give exposure to something we think will be profitable. For the more hands-on investor, ETFs probably are not your thing but they might also serve as a useful diversification tool within an existing portfolio of stocks. I would personally consider a sharia-compliant ETF to gain exposure to something which I would not be able to myself. For instance, if an ETF invested in halal global companies – something which is very difficult to do cheaply as an individual investor – I would certainly consider this sort of thing later down the line.

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15 Comments. Leave new

  • Layla Begum
    June 7, 2019 12:31 pm

    Salaams Mohsin. Can I get a broker to get in touch with me regarding investing in ETF? I am interested. Thank you.

    Reply
    • Mohsin Patel
      June 9, 2019 12:02 pm

      Ws Layla,

      We personally use AJ Bell. It helps us a lot if you go via our link if you are signing up for an ISA with them.

      Mohsin

      Reply
  • Shazil Rehman
    June 10, 2019 1:25 pm

    Salaams Mohsin, love reading your articles, jazakum Allahu Khayran! I’ve two questions:

    1) Are there ETF’s with minimal diversification? I agree that too much diversification is not good but I also don’t have the time or aptitude to individually analyse stocks.

    2) I’m based in Australia, which broker would you recommend for me, ideally someone who is affiliated with IFG?

    Reply
    • Mohsin Patel
      June 10, 2019 9:51 pm

      Ws Shazil, thanks for reaching out and great to hear you’re finding the content useful alhamdulillah! To answer your questions using your numbering:

      1) Hmm, good question. I have come across a very small number of ETFs that have minimal diversification, and certainly no sharia-compliant ones. You’ll tend to find with ETFs that they are quite well-diversified because the nature of them is to act as low-cost, well-diversified, hands-off vehicles. Your particular circumstance represents a gap – i.e. people who want “risky” ETFs. I’m sure someone can correct me if I’ve missed something in the market but I’ve not come across something sharia-compliant that would fit your needs.

      2) I sadly don’t have close knowledge of the Australia share broker market. As a general comment, the key things to look out for are trading fees and custody fees (i.e. the ongoing fees just to keep your account open). I’m not sure if it’s available in Australia, but have you checked out Wahed? Our affiliated link for Wahed: https://campaign.wahedinvest.com/ifg.

      P.S thanks for your support, we really appreciate it.

      Reply
  • Salaam. There doesn’t seem to be many Shariah compliant ETFs though our UK brokers. The ones I found are below:

    ISUS – iShares MSCI USA Islamic
    ISWD – iShares MSCI World Islamic
    ISDE – iShares MSCI EM Islamic

    With ISDE having the most expensive TER at 0.88% and ISUS at 0.5%. Compared to Vanguard’s Total stock market index VTI which only has an expense ratio of 0.03%. So the Shariah alternatives do seem quite expensive.

    I will be interested to know if you know of any ethical ETF’s available that is Shariah compliant but having lower fees than above?

    Also I would like to say that this is a great blog and a great resource especially for educating Muslims in the UK about investing in a halal manner. Keep up the great work.

    Reply
    • Mohsin Patel
      June 10, 2019 9:50 pm

      Ws Amjad, good to hear from you, and some astute observations here.

      To answer your first point, I believe you’re right in saying that these are only ETFs I’ve seen available via the mainstream UK brokers. It’s a shame that we are lacking in different types of ETFs to give us genuine choice.

      In terms of expense: yes, relative to Vanguard, the iShares stuff does look a tad expensive. But then Vanguard is phenomenally cheap so perhaps it’s not a fair comparison. Looking at it in the round, I think the iShares ETFs are decent value to be honest.

      As an aside, it’s worth dropping Vanguard a line about offering something sharia-compliant. I reached out to them a while ago and they did seem receptive provided that there was enough demand being demonstrated. I might well do an article on this and see if we can drum up a little campaign.

      Thanks for the kind words, it’s great to hear you find our content useful. Please do share amongst your contacts!

      Reply
  • Rehan Ahmed
    June 14, 2019 2:21 am

    Salaam Br Amjad,
    Jazakallah khair for the informative post!
    One question that has been worrying me about ETFs that hold common stock is their high levels of liquidity. If the fund holds close to 100% liquid assets (I.e shares on the stock market), can it be traded on anything but par value of those stocks?

    Reply
    • Mohsin Patel
      June 14, 2019 2:16 pm

      The way to think about ETFs is that they hold shares in companies, and those companies hold assets (not all of which are liquid). So the par value element goes away by virtue of that.

      Reply
      • Thanks Mohsin! Apologies for getting your name wrong earlier I can see how that’s a different way to look at it.
        So the transaction is that when purchasing a share of an ETF, is it viewed as the sale of a portion of shares in multiple companies at the same time (entering into multiple musharaka agreements at the same time)?
        Or should it be viewed as an agency style transaction where the ETF fund manager takes on agency of the amount and invests it on behalf of them? While also allowing for deducting their fees for managing such a fund, thus the price / book value of the etf is always > value of just the shares it holds?
        So what I’m really asking is What intention should a person make when entering into buying an ETF, should it be entering multiple musharaka or is it mudaraba or something else altogether?

        Reply
  • Regarding ETFs, is it halal to invest or buy ETFs that short the market? I know it is haram to short a stock outright because you do not own the stock you are shorting (i.e., you are selling something that you do not own and then buying it at a lower price). But can you buy for example SQQQ to short the tech stocks because you actually are taking possession and therefore own the ETF (in other words the short ETF is in your possession)?

    Reply
    • No you shouldn’t buy ETFs that short stocks. They’re usually doing it by investing in derivatives that create that effect, or by actually shorting stocks. Either way is not permissible.

      Reply
  • Salaam Ibrahim: Further to my original question, can we buy ETFs that are not shorting stocks but are long stocks? For example, an ETF that is long a basket of oil stocks (i.e., the XLE or triple the leverage of XLE, the ERX)?

    Can we buy ETFs that are long a commodity? For example, if I want to buy natural gas or oil here in the states and we know that futures are haram can I buy the USO for oil and UNG for natural gas? How do we invest in these types of commodities the halal way?

    Also, is it impermissible to buy the volatility index? For example, the VXX etf that tracks volatility?

    Reply
  • Also, after taking the course about how to screen to see if a stock is halal, what should we do if we determine a current company is not sharia compliant? For example, the debt to asset ratio is 35-40% and we have held the stock for years and we have a loss in the stock. Do we sell and take the loss or do we wait until the stock rebounds to breakeven and then sell? Please advise as I bought the oil and gas stock because I thought it was halal and continued to add to my position and am sitting on a rather big loss.

    Reply
  • Assalamualaikum. how would zakat be calculated on ETF’s?

    Reply

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