Islamic Finance - Thoughts on Stock Screening in Equity Funds

More often that not, those involved in Islamic finance will admit not all is rosy in Islamic finance...at least not yet. As in all matters of faith be it Islam, Christianity or other major religions, controversies in rulings & practices exist.

Since the resurgence in Islamic finance in the 60s and 70s, Islamic finance has gotten a firm foothold notably in Muslim countries but controversies over certain major practices continue to exist. This includes areas such as Bai Inah and stock market practices, just to name a few. At this juncture, two points come into my mind.

1. As rightly pointed out by numerous scholars, it's easier to play the blaming game to say that a certain practice in Islamic finance is controversial & point out that it is haram. Simply saying something is haram does not help the cause for Islamic finance. The better way is to evaluate or provide a constructive & practical alternative to improve the practice.
2. With this in mind, I wonder if there exists a collective, synergistic body that continuously considers approaches that will make those practices less controversial. It is my understanding that throughout the past few decades since the inception of the contemporary Islamic finance that we know of today, scholars noted that the use of controversial practices are transitional in nature. These are not permanent solutions but rather due to dire situations or darurat, they are tolerated.
   

The point now is to ask ourselves whether we can expedite this transitional period. Again, easier said than done but let's start somewhere. For instance, in the stock screening process used in Islamic stock markets or funds, ratio analysis is one criterion towards evaluating firms for investment. One common ratio is debt ratio, where certain Islamic funds will only invest in firms with a debt ratio of 33% or less.

Would it be beneficial to divide these firms into subcategories or divisions? For simplicity's sake, let's use color-codes & assume debt ratio is the only ratio analyzed; red for firms with a debt ratio of 27-33%, orange for firms with a debt ratio of 21-26% and yellow for firms with a debt ratio of 20% & below. Then allocate more funds for 'yellow' firms, less so for 'orange' firms and even less for 'red' firms. In short, allocation of funds is weighted according to these categories, with preference to firms with minimal debt ratios & other such ratios.

The aim of this approach is to encourage more firms to move towards the 'yellow' category which has the least involvement in interest-based lending. One may argue if firms will actually be motivated to reduce their debt ratio for Islamic fund management. That said, with the growth of Islamic finance at around 15-20% per annum, would it be inconceivable for the funds to grow attractive enough for firms to reduce their debt level & other ratios?

Actually, I believe I have read this approach stated in an article before but I would like to know if it actually had been adopted anywhere. And what are its implication or effect? I would appreciate it if anyone who is aware of this approach to drop me a line.

Wassalam.