What makes a stock halal? The business-activity screen
The first screen asks what the company does. A company is generally excluded when its core business is not permissible. Lists differ at the edges: S&P’s Shariah indices, for example, do not exclude defense companies, while the Dow Jones Islamic Market indices do. A permissible core business can still earn a little non-permissible income, which the next screen measures. Commonly excluded activities:
- Conventional interest-based finance: banks, lenders and conventional insurance
- Alcohol and pork products
- Gambling and casinos
- Adult entertainment
- Tobacco, in many screens
- Sharia screening
- Checking a company’s business and financial ratios against a Sharia standard to classify its shares as compliant or not. It is a method, not a fatwa.
Financial ratio screens: the AAOIFI thresholds
The second screen looks at the balance sheet and the income statement. The most widely cited reference is Sharia Standard No. 21 (Financial Paper: Shares and Bonds) of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). Its ratio tests are commonly summarized in the list below, with market capitalization as the yardstick for the first two.
A stock has to pass every test. In the hypothetical example drawn below, the company passes the debt and income tests but holds too much cash in interest-bearing deposits, so it fails the screen; cash-rich companies sometimes fail this way. Ratios change with each new financial report and, when measured against market value, with the share price, so a stock’s status can change over time.
- Interest-bearing debt below 30% of market capitalization.
- Interest-bearing deposits and securities below 30% of market capitalization.
- Non-permissible income below 5% of total revenue.
- Interest-bearing debt
- Borrowing on which the company pays interest, such as bank loans and conventional bonds it has issued.
- Non-permissible income
- Revenue from sources outside Sharia rules, such as interest on cash or a small non-permissible side business.
Why a stock can pass one Sharia screen and fail another
Screening providers and Sharia boards do not all use the same rules. S&P’s Shariah indices, for example, use a 33% limit measured against a 36-month average of market value; MSCI’s Islamic indices measure debt and cash against total assets, with a one-third limit.
The drawing below shows why that matters. A hypothetical company has $300 million of interest-bearing debt, a market value of $1,200 million and total assets of $800 million. Against market value, debt is 25%, inside a 30% limit. Against total assets, it is 37.5%, above a 33% limit. Same company, different verdicts. A ratio based on market value also moves with the share price: if the shares fall sharply, the same debt becomes a larger percentage.
So when two apps or brokers disagree about a stock, both may be applying their own method correctly. Check which standard your screener follows.
How to purify dividends
A screened company may still earn a small share of non-permissible income, often interest on its cash. Many scholars therefore require investors to give that share of their dividends to charity, as a way of disposing of it rather than as voluntary charity. A common method multiplies the dividend by the company’s non-permissible income ratio.
Hypothetical, drawn below: a $100 dividend from a company whose non-permissible income is 3% of total revenue. $100 × 3% = $3 goes to charity, and you keep $97. Methods differ, for example on which income figure to use and on whether gains from selling shares also need purifying, and some screening apps and brokers show a purification amount per stock. Ask your scholar or your broker’s Sharia board which method they follow.
Sharia-compliant ETFs and indexes
If screening stocks one by one is impractical, Sharia-screened funds do it for you. Index providers publish Islamic index families, such as the S&P Shariah indices, which include an S&P 500 Shariah index, and the MSCI Islamic indices; they apply business and ratio screens to a broad index and review them regularly. ETFs that track screened indexes, or that apply their own screens under a Sharia supervisory board, are listed in the US and elsewhere; see what is an ETF and index fund investing. A plain S&P 500 fund, by contrast, holds conventional banks and insurers, and screening services commonly classify it as non-compliant.
Before buying one, check which index or standard it follows, which Sharia board oversees it, whether purification is done inside the fund or left to you, its expense ratio and how concentrated it is. Screens remove most banks and insurers and many heavily indebted companies, so these funds can lean toward low-debt sectors such as technology and behave differently from the broad market; see portfolio diversification.
Margin, short selling and options in Sharia-compliant investing
Sharia-compliant investing generally avoids buying on margin, because the margin loan charges interest, and short selling, which sells shares you do not own. Many derivatives are avoided too, for similar reasons.
Views on options differ. Many scholars do not permit them, while some Sharia boards have approved specific option structures under strict conditions. If a broker presents options as Sharia-compliant, ask which board approved them and under what conditions, and check that each trade fits those conditions. Whatever the tool, a screen is a method, not a ruling: when in doubt, ask a qualified scholar.