Why Shariah compliance alone cannot guarantee sound investment returns

Shariah compliance changes more than what a fund may own; it also reshapes risk, diversification and returns. IMTIAZ SULIMAN explains what discerning investors should examine before entrusting their capital to a Shariah-compliant portfolio.

Shariah-compliant investing is usually introduced as an ethical framework first and an investment discipline second. That framing sells it short. The rules that define a Shariah-compliant portfolio, such as limits on leverage, exclusion of interest-based financials and a preference for companies whose earnings come from real economic activity rather than financial engineering, do not just answer a religious question. They actively reshape the risk and return characteristics of the resulting portfolio in ways that matter to performance and deserve to be understood on their own terms.

The right question is not only ‘Is this compliant?’ but ‘What does compliance actually do to a portfolio’s risk and return profile, and what should an investor be checking before allocating capital?’

How does a stock actually qualify?

Shariah compliance is assessed through two independent tests, and a company must pass both.

Business activity screening excludes companies whose core business involves conventional interest-based banking and insurance, gambling, alcohol, pork production, pornography and similar prohibited activities. The edges are not always clean; a conglomerate with a small insurance subsidiary needs to be assessed according to how much that subsidiary contributes to overall revenue.

Financial ratio screening catches companies in permissible industries that still carry too much interest-bearing debt or earn too much interest income. Common thresholds cap interest-bearing debt and interest-bearing cash or receivables at roughly a third of assets or market capitalisation, and cap non-permissible income at around five per cent of revenue.

Because balance sheets move, compliance is not static: a company can drop out of a Shariah index as debt rises and re-enter after deleveraging. Credible Shariah funds conduct ongoing, typically quarterly, re-screening overseen by a qualified Shariah supervisory board rather than a once-off check at purchase. Ask any fund directly how often re-screening happens and who signs off on it.

Purification is a mechanism, not a workaround

Even a compliant company usually generates a small amount of incidental non-permissible income (NPI), such as interest on a cash balance. Below the threshold of five per cent, the stock stays investable, but the investor’s pro rata share of that income must be purified by donating the NPI to charity. It does not ‘clean’ a company that fails the screens outright; it only strips a small, incidental element of impermissible income from an otherwise compliant holding.

What the screens do to risk and return

Excluding entire sectors, especially conventional banks and insurers, shrinks the investable universe and changes its composition. Shariah portfolios are typically underweight financials and often overweight technology, healthcare, industrials and consumer sectors relative to a conventional benchmark, so performance can and does diverge meaningfully in either direction, depending on the cycle.

Compliance shapes the universe. Manager skill determines the outcome. This is why performance analysis on a Shariah mandate has to go a layer deeper than a simple return comparison. Two funds can both be ‘Shariah compliant’ and still deliver very different outcomes because compliance dictates the eligible universe, not the portfolio built from it. Within that universe, there is still an active decision to make about concentration, factor tilts and stock selection, and that is where genuine manager skill shows up, or fails to. Look beyond the compliance label to metrics such as active share and information ratio, which reveal how much of the return comes from real insight versus simply holding whatever the screen leaves behind.

The sector reshaping is also a factor bet, whether or not a manager frames it that way. Underweight financials and overweight growth sectors can be a harder combination in a rising-rate, value-led market than in a growth-led one, purely because of what the screens exclude. A well-run mandate should be able to articulate this exposure explicitly and show how it is monitored, rather than treating benchmark deviation as an unavoidable side effect of being compliant. Diversification also takes more deliberate work in a smaller universe, which means that sector and country concentration require active management, not the assumption that screening has already handled them.

A due-diligence checklist before you invest

1. Which Shariah standard is applied, and by which scholars or supervisory board?

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2. How frequently is the portfolio re-screened, and what happens when a holding falls out of compliance mid-cycle?

3. Who performs purification, and how is it communicated to investors?

4. How diversified is the portfolio, given the narrower starting universe?

5. How do fees and long-term performance compare with an appropriate benchmark?

The bottom line

Compliance is a starting filter, not an investment thesis, and it should never excuse weaker performance or looser scrutiny than an investor would apply to any other mandate. A Shariah-compliant fund still has to earn its place in a portfolio the way any fund does, through disciplined stock selection, sound risk management, competitive fees and consistent, benchmark-relative performance. The screening rules shape the universe a manager works with and impose a genuine quality and leverage bias worth understanding, but what a manager does within that universe still determines the outcome.

The real differentiator between products is rarely the headline claim of ‘Shariah compliant’. It is the combination of rigorous, well-governed screening and a manager capable of turning a narrower universe into genuinely competitive returns. Both halves matter, and neither should be assumed on the strength of the other.

Imtiaz Suliman is head of Shariah Solutions at Vunani Sentio Fund Managers and has more than 20 years of investment experience across multiple asset classes and sectors. As part of his portfolio management responsibilities, he conducts in-depth analysis of local and global equities. His coverage of international markets alongside South African equities provides a broader perspective on investment opportunities and risks in an increasingly interconnected global economy. This global lens enhances his ability to make well-informed investment decisions and construct resilient portfolios. Before joining Sentio, he was a senior member of the Alternative Investments team at RMB Asset Management.

Why Shariah compliance alone cannot guarantee sound investment returns

Shariah compliance changes more than what a fund may own; it also reshapes risk, diversification and returns. IMTIAZ SULIMAN explains what discerning investors should examine before entrusting their capital to a Shariah-compliant portfolio.

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