Shariah Investment Planning

Contents:
1. Basic Concepts in Islamic Investment
2. Discounting and the Time Value of Money: The Islamic Perspective
3. Portfolio Diversification and Portfolio Theories
4. Investment in the Share Market
5. Investment in Sukuk and Other Fixed Income Securities
6. Islamic Structured Products and Derivatives
7. Investment in Shariah-compliant unit trust funds
8. Investment in Real Estates
9. Financial Statement Analysis
10. Technical Analysis
11. Portfolio Management and Monitoring
Basic Concepts in Islamic Investment

Chapter/Topic Outline
1.1. Introduction
1.2. The Philosophies of Islamic Economics and Finance
1.3. Types of Hukum (law) in Islamic Teachings
1.4. Elements of Contracts According to Shariah
1.5. Shariah Considerations for Halal Investments
1.6. Shariah-compliant Instruments
1.7. Steps in Investing
1.8. Conclusion Chapter Objectives Upon completion of this chapter, you should have knowledge of:
(a) The Philosophies of Islamic Economics and Finance
(b) Hukum (law) in Islamic Teachings
(c) Pillars of Contracts According to Shariah
(d) Shariah Considerations for Halal Investments
(e) Shariah rules on financial transactions
(f) Process in investing either in real property, securities or investing in other investment vehicles

Definitions:
TAWHID-UL-RUBUBIYYAH (Oneness of Allah’s Lordship) – is the concept of Allah being the Master of the universe. The meaning of Tawhid-ul-Rububiyyah (Oneness of Allah’s Lordship) is the ascription of all Acts of Allah (Glorified and Exalted be He) to none but Him Alone, such as: creation, bringing into being, providing sustenance, giving life, and causing death.
TAWHID-UL-ULUHIYYAH (Oneness of Worship) – is the dedication of all acts of the servants to none but Allah Alone, such as: Du`a’ (supplication), asking help, seeking refuge, fear, hope, reliance and all other forms of `Ibadah (worship). May Allah grant us success. May peace and blessings be upon our Prophet, his family, and Companions.
IBADAT – is the act of worshipping Allah. In Islam, ibadah is usually translated as “worship”, and ibadat—the plural form of ibadah—refers to Islamic jurisprudence (fiqh) of Muslim religious rituals.
Instruments of sales contracts
MUDHARABAH –  is a partnership where one party provides the capital while the other provides labor and both share in the profits. The party providing the capital is called the rabb-ul-mal (“silent partner”, “financier”), and the party providing labor is called the mudarib (“working partner”).
MURABAHAH – refers to a sale and purchase of an asset where the. acquisition cost and the mark-up are disclosed to the purchaser.
IJARAH – is an Arabic word and it means “to give something on rent”. Under the concept of Ijarah in Islamic banking, a customer can use an asset or equipment, which is owned by an Islamic bank, for a fixed period against a fixed price. Al Ijara is very similar to a leasing contract, and the asset under the Ijarah finance could be used for cars, homes, plants, or machinery. The Ijarah contract may be defined as: “A legal binding contract, where the owner of something with value, transfers its usufruct to another party, for a pre-defined period, in exchange of an agreed consideration”.
Human and economic affairs
MUNAKAHAT (marital affairs) – is an Islamic Fiqh law relating to marriage, divorce, the husband’s responsibilities, etc
JINAYAT (criminal affairs) –
MUAMALAT (economic affairs) – Refers to commercial and civil acts or dealings under Islamic law. Islamic law divides all legal acts into either ibadat or muamalat. Ibadat are acts of ritual worship such as prayer or fasting, and muamalat are acts involving interaction and exchange among people such as sales and sureties (economic affairs). The distinction is important because the principle in all matters involving ibadat is that they are not susceptible to innovations or change (ittiba). In muamalat, however, there is considerably more room to develop and change the law to facilitate human interaction and promote justice. There is disagreement among Muslim jurists on whether certain legal acts, such as marriage or divorce, fall under the category of muamalat or ibadat. Mu’amalat provides much of the basis for Islamic economics, and the instruments of Islamic financing, and deals not only with Islamic legality but also social and economic repercussions and the rationale of its prohibitions
TABARRU – means donation for the purpose of solidarity and cooperation among the Takaful Participants and to be used to help all Takaful Participants in times of misfortune. In the context of the Company, Tabarru’ will be allocated into the Participants’ Risk Fund.
5 Types of Hukum (law) in Islamic Teachings:
FARD OR WAJIB –  An obligatory duty, the omission of which is punishable. For example, to perform 5 obligatory prayers a day, fasting in the month of Ramadhan, paying zakat when it is due and performing hajj once in a lifetime for Muslims who are financially and bodily able to do so.
MANDUB OR MUSTAHAB – An action which is rewarded, but the omission is not punishable. In fiqh ibadah, to fast on Mondays and Thursdays is mustahab.
JAIZ OR MUBAH – An action which is permitted, and the law is indifferent whether the act is performed or otherwise. The recent fatwa from the Majlis Agama Islam Selangor stated that investment in PNB Unit Trust is mubah since investing in the funds are of societal interest (maslahah ummah).
MAKRUH – An action which is disliked yet not punishable, but omission is rewarded. An example in terms of fiqh ibadah is to eat food with pungent smell before performing prayers in congregation or entering a mosque. This is in consideration of others who may be subjected to the bad smell.
HARAM – An action which is absolutely forbidden and punishable. For example, to be involved in riba-related transactions and to drink liquor.
Shariah rules on financial transactions:
Prohibition of RIBA (interest) – Income and wealth generated from RIBA is prohibited in Islam due to the fact that the gains are acquired from waiting rather than from risk-taking and work.
Application of BAY’ (trade and commerce) – Profits acquired from al-bay’ as commonly seen in day to day trading business are generated from work and effort as well as placing capital at risk. In al-bay’, sales and cash flows are not guaranteed, thus profits are subject to the vagaries of price movements.
Avoidance of (ambiguities) in contractual agreements – The existence of GHARAR in contractual agreement will cause a contract (‘AQD) to be null and void.
Prohibition of MAISIR (gambling) – The outcome of gambling is based on pure chance rather than on work and knowledge. Usually, the gambler stands practically no chance of winning, but due to the illusion of winning big, gamblers become irrational and make bets on outcomes that tend to favour the gambling operator.
Prohibition from conducting business – involving impure commodities such as pork, liquor, narcotics, pornography etc.
Cancellation of Contracts:
FASAKH – is a cancellation of a contract where the contract is invalid from the beginning due to an Islamically impermissible condition. For example, the seller may be selling goods that are not his property. This concept is similar to the concept of “NULL” in the law of contract.
IBTAL – is the suspension of a valid contract due to either party not fulfilling the contract’s requirement. A contract is considered “ibtal” with the death of one of the parties in the contract. This concept is similar to the term “VOID” in the conventional law of contract.
Common types of ’AQD TABARRUAT‘ (in structure financial assets in modern Islamic finance)
QARD HASSAN – It is an interest-free loan in which the borrower is only required to repay the principal amount borrowed. The borrower can pay extra to the lender to appreciate the willingness of the lender in sacrificing his current consumption of money. For example, Islamic banks disburse benevolent loans to marginal societies for worthy economic projects.
HADIAH / GIFT – A non-contractual gift from one party to another. It can serve as an encouragement for good performance.
HIBAH – It is a contract of distributing wealth without repayment from the receiver. Hibah contracts must follow the process of Ijab and Qabul. An example of the use of hibah instruments is the payment of hibah from Islamic banks to depositors at the end of their financial year as a form of profit distribution to depositors.
SADAQAH – A gift from one party to another. It is given to get barakah from Allah S.W.T.
WAQF – A charitable trust (plural is Awqaf). An endowment or a charitable trust set up for Islamic purposes. It involves tying up a property in perpetuity so that it cannot be sold, inherited, or donated to anyone. Waqf can be divided into “waqf am” (general waqf) or a waqf contract in which the giver does not specify the use of the money/property that had been surrendered); and “waqf khas” (the giver specifies the
use of the money/capital/property surrendered such as stipulating that it is for the use of building mosques, etc).
JU’ALAH – A reward or promised gift. The promised gift will be given after the prospective receiver performs the required actions under the offer, e.g. monetary reward to the general public to bring in criminals to the police.

Four types of ’AQD AMANAH’
MURABAHAH CONTRACT – is a cost plus profit sale contract. The cost and profit margin (mark-up) are made known and agreed by all parties involved. The profit margin added by the seller must be agreed by the purchaser when entering into the contract. The settlement for the purchase can be either on a cash basis, a deferred lump sum basis or on an instalment basis, which will be specified in the agreement. Murabahah financing is a financing facility for working capital to purchase stocks, inventories, replacement, semi-finished goods or raw materials.
TAULIYYAH CONTRACT – is a sale transaction performed at cost price. This sale transaction can be in cash and credit sales. Amanah is important to the seller to show the cost price. Example of sales under this contract is a mega sale contract where the sale price is low (at the cost price).
WADHIAH CONTRACT – is a sale transaction below the cost price. Sales under this contract are meant for clearance of old stock items or sales to attract customers. It must be stated on the cost with amanah.
AQDUL MUSAWAMAH CONTRACT – on the other hand is a contract that exists between two parties in agreement after going through the bargaining process.

Shariah Concepts and Bank Products
Bank Rakyat is an Islamic cooperative bank. Its products, services and financial facilities are based on Shariah concepts and conform to Islamic principle which prohibit interest in all activities. Products and financing facilities are based on these concepts:

1.0 INTRODUCTION
The principles of investment that are used in Islamic finance are based on Islamic teachings related to the muamalat or the ways of interaction between the players in the economy. The laws of Islam are divided into laws for various areas needed by individuals and society in life. Muslims are bound by following the guidelines prescribed in Islam for guidance in marital affairs (munakahat), criminal affairs (jinayat), economic affairs (muamalat) and how to actually perform the act of worshipping Allah (ibadat). That is what Islamic law prescribes to the believers of the religion. Islam, being the religion that provides guidance in every aspect of the followers’ lives, is referred to as the religion of the way of life. This chapter will deal with the philosophies of Islamic finance, sources and types of laws in Islam and the considerations to be observed for investments for them to be considered Shariah- compliant. In order to learn about the technicalities of how Islamic-compliant products are designed, we need to first understand the concepts or instruments in Islamic finance. These instruments of mostly sales contracts, such as mudharabah, murabahah and ijarah can be employed to create Islamic-compliant financial products including options and other Islamic structured products.
1.2 The Philosophies of Islamic Economics and Finance
Afzal-ur-Rahman (1974) in the Economic Doctrines of Islam stated that the economic philosophies of Islam or simply put, the aims of the economic dealings in accordance to Islamic teachings, are as follows:
(a) The concept of worshipping of Allah (Tauhid)
It refers to the relationship of human beings with Allah which extends to when people deal with each other, that is, people need to be good to others as a result of their good relationship with Allah. Wafa et al. (2007) reported that in terms of economic activities, the concept of tauhid can also refer to the responsible behavior of individuals towards Allah’s creation. It brings about the efficient utilization of resources, taking care of the environment and such. In short, the act of worshipping Allah needs to be translated into responsible economic dealings in the course of obtaining profit, via good dealings among people without doing injustice to the planet.
(b) The concept of Allah being the Master of the universe (Rububiyyah)
It refers to the fact that Allah is the Creator and the Owner of the universe and hence the Law-maker. As such, the law prescribed by Him should be observed by Muslim individuals. Even economic dealings have to be in within the boundaries of the permissible or Shariah- compliant.
(c) The concept of Good Manners (Akhlak Cleansing)
Economic activities need to be conducted in a way that contributes to the objective of achieving good ethics. Having said that, no economic dealings should be carried out in such a manner as to oppress and cheat others. For example, it is prohibited for Muslims to be involved in “sweat shop‟ activities where workers are forced to work in poor working conditions for unjustified wages. This practice is haram or forbidden as it does not comply with the spirit of good ethics.
The concept of believing in Judgment Day This concept stems from the concept of accountability of human actions, including in economic affairs. Islam states that all of human action will be rewarded; good deeds will be rewarded favourably and bad deeds will be rewarded unfavourably regardless of how small the actions may be1 . This suggests that in Islam, the concept of hisbah or accountability is strict so that order in society can be maintained.
(d) Human as the creation in charge of the world (Khalifah)
With the intelligence provided to humans comes the responsibility to manage the world in a responsible way. Humans as “managers of the world‟ must allocate and distribute resources in the economy judiciously by avoiding corruption and oppression.
(e) The concept of equitability among human beings
This concept serves as one of cornerstone philosophies of Islamic economy because oppression of any one group of people proves to be one of the factors that contribute to the malfunction of society. Advanced economies such as the US and the UK rightfully observe this concept by ensuring equal opportunity in their economy. When jobseekers apply for jobs in these countries, they are assured that everyone will be treated fairly and be given equal opportunity regardless of ethnicity, gender and social class.
(f) The concept of Allah being the ultimate owner of all property
Allah has stated that He is the ultimate owner of the whole universe in order to prevent humans from being insatiable towards material possessions (Al-Fatiha: 1). This is a means of achieving equitable distribution of resources. The obligatory duty of Muslims to pay zakat or alms-giving on specific assets and income stems from this concept. Humans need to appreciate the fact that it is not worth it to have material possessions if they obtain them through unlawful ways, such as through oppression or injustice to others, and being involved in riba-related activities. Ultimately, it is not humans who own the possessions but Allah. Iqbal (1997) in his study on the subject of an Islamic financial system discussed the principles of Islamic banking. In order to understand more about how an Islamic financial system is different from its conventional counterpart, his work is reproduced in Table 1.1.
Table 1.1: Principles of an Islamic Financial System.

1.3 Types of Hukum (law) in Islamic Teachings
Hukum (Islamic law) can be divided into five (5) types. The status of hukum that is applicable to a person may change depending on the current conditions surrounding the issue. For example, in fiqh ibadat (law governing the performance of ibadah or worship), the status of having ablution is mustahab or recommended, but is a fard or obligatory if the person is performing a prayer. The types of hukum are as follows:
(a) Fard or Wajib: An obligatory duty, the omission of which is punishable. For example, to perform 5 obligatory prayers a day, fasting in the month of Ramadhan, paying zakat when it is due and performing hajj once in a lifetime for Muslims who are financially and bodily able to do so.
(b) Mandub or Mustahab: An action which is rewarded, but the omission is not punishable. In fiqh ibadah, to fast on Mondays and Thursdays is mustahab.
(c) Jaiz or Mubah: An action which is permitted, and the law is indifferent whether the act is performed or otherwise. The recent fatwa from the Majlis Agama Islam Selangor stated that investment in PNB Unit Trust is mubah since investing in the funds are of societal interest (maslahah ummah).
(d) Makruh: An action which is disliked yet not punishable, but omission is rewarded. An example in terms of fiqh ibadah is to eat food with pungent smell before performing prayers in congregation or entering a mosque. This is in consideration of others who may be subjected to the bad smell.
(e) Haram: An action which is absolutely forbidden and punishable. For example, to be involved in riba-related transactions and to drink liquor.
1.4 Elements of Contracts According to Shariah
’Aqd or a “Contract” is a symbol of willingness between the parties involved. Without it, there is little or no legitimacy to expectations of responsibility assigned to any or both of the parties. “’aqd” in Arabic means “bonding” or “tie”. ’Aqd can be defined as an agreement between the first and second parties through “ijab & qabul” where it is the endeavor of bonding an agreement. The reasons for “’aqd” are to clarify and document the terms and conditions that have been willingly agreed by both parties in a contract and to know the implications of the contract. There are five arkan or pillars of contracts:
(a) Seller: The seller must honour the contract, i.e., to deliver the goods for the price paid. The seller must be willing to exchange the goods/services for the price paid, as forced selling is not valid.
(b) Buyer: The same applies for the buyer in the contract. The buyer must honour t h e c o n t r a c t by making payment for the goods/services received. The buyer must be willing to pay the price, i.e., the agreed price.
(c) Goods: The goods must exist at the point of contract except in forward contracts such as Istisna’ (in manufacturing) and salam (forward sale in agriculture). For salam contracts, the price is paid now for goods to be delivered at a specified time in the future. The goods sold must be legally owned by the seller. If there are any changes in the contract, the buyer will be given the option or khiyar to be exercised in relation to the goods/services in the contract.
(d) Price: The price agreed to by both parties. For a contract to be valid, the seller and the buyer must agree on the price of the goods; otherwise it will result in gharar or uncertainty in the contract. In conventional insurance contracts, three situations of gharar can take place (Asmak et al, 2008). One of them is related to gharar in the exchange of premium price paid for goods or services. In the case of conventional insurance, no products are to be exchanged for the price paid. Payment can be in cash, cheque, credit card, etc.
(e) Sighah: Ijab and qabul or offer and acceptance of the contract. Sighah is the symbol of willingness of both parties entering into the contract. Ijab is the first step in a contract before Qabul. Ijab and Qabul can be verbal (BilKalam), written (BilKitabah), by sign language, or through a third party as a mediator.
A sale contract between the contracting parties, a buyer and seller, is formulated when the offer and acceptance is concluded, and the contract takes effect on the subject matter. However, the contract can be discontinued if it is cancelled, based on the mutual consent of the two parties. There are two terms which indicate the cancellation of the contract: IBTAL and FASAKH. Fasakh is a cancellation of a contract where the contract is invalid from the beginning due to an Islamically impermissible condition. For example, the seller may be selling goods that are not his property. This concept is similar to the concept of “null” in the law of contract. Ibtal is the suspension of a valid contract due to either party not fulfilling the contract’s requirement. A contract is considered “ibtal” with the death of one of the parties in the contract. This concept is similar to the term “void” in the conventional law of contract.
Dr. Yusuf al-Qaradawi1 notes eleven accepted Islamic legal maxims or principles pertaining to Halal and Haram in Muamalat contracts. They are as follows:
(a) The basic principle is the permissibility of things;
(b) To make lawful and to prohibit is the right of Allah alone;
(c) Prohibiting the halal and permitting the haram is similar to committing shirk;
(d) The prohibition of things is due to their impurity and harmfulness;
(e) What is halal is sufficient, while what is haram is excessive;
(f) Whatever is conducive to the haram is itself haram;
(g) Falsely representing the haram as halal is prohibited;
(h) Good intentions do not make the haram acceptable;
(i) Doubtful things are to be avoided;
(j) The haram is prohibited to everyone alike;
(k) Necessity dictates exceptions. The above-mentioned principles represent parameters and guidelines which support a good understanding about the Shariah norms that govern financial transactions.
1.5 Shariah Considerations for Halal Investments
In Malaysia, a Shariah Advisory Council (SAC) was established in May 1996 to advise the Securities Commission on Shariah matters pertaining to Islamic Capital Market (ICM). Members of the SAC are qualified individuals who can present Shariah opinions and have vast experience in the application of Shariah, particularly in the areas of Islamic economics and finance. The duties of the council are to advise the Securities Commission on Islamic capital market operations, standardize and harmonize the application of Shariah principles and concept, review Shariah compatibility with other conventional instruments and new Islamic Instruments, and endorse the halal or permitted counters in its list of Shariah-approved securities. The members of the Council comprise Muslim scholars who are experts in Shariah principles related to finance and investment.
To facilitate Muslim investors’ participation in acquiring halal financial assets, the Council revises and publishes the halal securities list every six months. By updating the information on halal counters on such a regular basis, Muslim investors can be confident that they are adhering to Shariah requirements while investing. In order to compile a list of Shariah-compliant counters, the Council agreed that securities that fall in the categories listed below must be excluded:
(a) Operations based on RIBA (interest) involving such financial institutions as commercial and merchant banks and finance companies,
(b) Operations involving gambling activities.
(c) Activities involving the manufacturing or sale of haram (forbidden in Shariah’s point of view) products such as pork, liquor and non-halal slaughtered meat; and
(d) Operations in the presence of GHARAR(uncertainty) elements such as conventional insurance companies.
Furthermore, if companies are involved in both permitted and non-permitted activities, the following criteria are to be used:
(a) The core activities must be those conforming to Shariah guidelines. Haram elements must be very small compared to the halal activities;
(b) The public perception of the company must be good or accepted as companies dealing in lawful Islamic activities; and
(c) The core activities must be important and beneficial from an Islamic point of view.
In addition to the general outline on core activities, Shariah scholars also agreed on the benchmark of non-permitted activities that may be allowed for a security to be granted Shariah adherence status.
For the Business Activity Benchmarks, the Securities Commission (SC) has introduced two major benchmarks which are as follows:
The 5% benchmark would be applicable to the following business activities: conventional banking; conventional insurance; gambling; liquor and liquor-related activities; pork and pork[1]related activities; non-halal food and beverages; Shariah non-compliant entertainment; interest income from conventional accounts and instruments; tobacco and tobacco-related activities; and other activities deemed non-compliant according to Shariah.
The 20% benchmark would be applicable to the following activities: hotel and resort operations; share trading; stockbroking business; rental received from Shariah non-compliant activities; and other activities deemed non-compliant according to Shariah.
In addition to the above benchmarks, there are other Financial Ratio Benchmarks to be observed as follows:
Cash over Total Assets
Cash will only include cash placed in conventional accounts and instruments, whereas cash placed in Islamic accounts and instruments will be excluded from the calculation. This is known as the Cash Asset Ratio.
Debt over Total Assets
Debt will only include interest-bearing debt whereas Islamic debt/financing or sukuk will be excluded from the calculation. Both ratios, which are intended to measure riba and riba-based elements within a company’s balance sheet, must be lower than 33%.
It is to be noted that SAC approval includes ordinary shares, warrants and transferable subscription rights (TSRs). Loan stocks and bonds are not included unless they are issued in accordance with Islamic principles. Other Shariah issues dealt with by the SAC are on the revision of the halal status of securities from halal (allowable) to non-halal and vice versa.
The bottom line is that with the establishment of the SAC, Muslim investors are guided in choosing halal investments. Prior to that, Muslim investors were either reluctant to deal in stocks or had great difficulties in looking for halal investments. The SAC is particularly responsible for the increasing Muslim investors‟ participation in the equity markets. Muslim investors are hence urged to keep up-to-date with current changes in the list of approved securities, as well as Islamic scholars‟ opinions on certain investment modes. This ensures that investment ventures and financial planning processes as a whole are executed in accordance with Islamic principles.
Variations in Screening Process
Differences in the Shariah screening methodology exist. For example, the Dow Jones Islamic Index (DJII) focuses on quantitative filters that include the gearing ratio, liquidity ratio as well. Other variations are generally based on the DJII and include the AAOIFI screening ratio, MSCI, FTSE Islamic and others. The Malaysian screening process is the most unique of the filters practiced globally, due to its various levels of tolerance.
1.6 Shariah-compliant Instruments
Islamic financial instruments differ from the conventional instruments on the basis of five Shariah rules they are grounded on. As Shariah rules are derived from the Quran and Hadith, they bear commonality in all aspects of financial transactions taking place, whether one is dealing with Islamic banks, mutual funds, investments, and financial planning. Shariah rules help market players know and understand what is permissible (halal) and prohibited (haram) in the conduct of business. These rules given by Allah and to remain paramount in all business decisions undertaken by Islamic financial institution. The 5 Shariah rules on financial transactions are given below:
(1) Prohibition of RIBA – Income and wealth generated from RIBA is prohibited in Islam due to the fact that the gains are acquired from waiting rather than from risk-taking and work.
(2) Application of bay’ (trade and commerce) – Profits acquired from AL-BAY’ as commonly seen in day to day trading business are generated from work and effort as well as placing capital at risk. In AL-BAY’, sales and cash flows are not guaranteed, thus profits are subject to the vagaries of price movements.
3) Avoidance of (ambiguities) in contractual agreements – The existence of GHARAR in contractual agreement will cause a contract (‘AQD) to be null and void.
For example, when the price of an asset is not clearly presented or even its delivery date is not confirmed, the contract may be void due to GHARAR.
(4) Prohibition of MAISIR (gambling): The outcome of gambling is based on pure chance rather than on work and knowledge. Usually, the gambler stands practically no chance of winning, but due to the illusion of winning big, gamblers become irrational and make bets on outcomes that tend to favour the gambling operator. Thus, gamblers lose money in making bets in a zero-sum game. This often results in addiction to the illusion of winning the next ‘hand’, resulting in destruction of the individual’s moral compass and his ability to think rationally. Making bets in derivatives saw the collapse of Barings Bank and municipalities such as Orange County.
(5) Prohibition from conducting business involving impure commodities such as pork, liquor, narcotics, pornography etc.
Each of the above Shariah rules is unique in its own way when one looks at each particular market at a time. For example, the prohibition of RIBA is the cornerstone in deposits and financing of the Islamic banking business. However, when one deals with Islamic investments and the use of derivatives for hedging purposes, the gambling (MAISIR) and uncertainty (GHRAR) are likely to command more attention than RIBA. In takaful, RIBA, GHARAR and MAISIR are given equal importance. In Shariah stock screening, attention is given to the avoidance of impure commodities in the core activities of issuing companies, as well as the manner in which their financial structure relies on conventional finance and/or debt.
 Irrespective of the varying emphasis given to each of the Shariah principles, say on banking or takaful, one thing remains clear: Shariah rules are meant to uphold and promote justice (‘ADL) in business transactions. Allah has guaranteed that justice will prevail when man obeys His rules (i.e. Shariah rules) in making business decisions.

Figure 1.3: The Building Blocks of the Main Principles of the Shariah Compliance of Islamic Financial Instrument Contracts

From the five Shariah rules outlined the above, Islamic financial institutions have developed many instruments with approval from Shariah scholars. As shown in the diagram above, Shariah scholars rely tremendously on the requirement of ‘aqd (contract) in validating financial products forwarded by Islamic financial institutions. For example, ambiguities (gharar) must be avoided in all contractual obligations. An agent in a sale contract, a buyer, must be an adult who is rational and thus capable of discerning right from wrong. If the seller is a minor, then the contract becomes void, thus any disputes between the contracting parties cannot be settled in a court of law. Likewise, ambiguities must not exist in the subject matter of trade. Ambiguities in the subject matter include the non-existence of price during the sale or failure to prove ownership of goods by the selling party. If the subject matter is money rather than goods, then any profit derived from the transaction is deemed as riba, thus the contract becomes void.
According to Hanohan (2001), Islamic financial instruments can be categorized or divided into two families. The first is venture financing and the second, that constitutes the larger portion of Islamic banks’ assets are the payment-smoothing arrangements. The instruments in the first family is Mudharabah and Musyarakah financing that are thought to be desirable due to the ability of the instruments to capture the essence of the objective of Islamic finance of profit and loss-sharing in business dealings. The second family, however, due to its broad area of practicalities in modern finance are practiced more by Islamic banks. The second family is sometimes referred to as debt-based financing and contracts that have natural certainty. This is because, the return for the financier for this type of financing is guaranteed during the enforcement of the contract. The instruments that fall under this family are Murabahah, Ijarah, Salam and Istisna’, Bay’ Inah, Bay’ Dayn and Bay’ Muajjal.
In addition to the two families observed by Hanohan (2001), gratuitous contract is another form of contract that is valid according to the Shariah point of view. This is because the Qard Hasan or gratuitous loan is not chargeable with interest.
1.6.1 Types of Islamic Instruments
Islamic finance possesses the basic instruments that span a wide and varied menu of financial instruments. There is a theory developed in the 1980s referred to as the spanning theory which asserts that if there is one basic financial instrument it can be spanned into an infinite number of instruments. Islamic finance has at least 14 basic instruments and financial experts can span these into a much larger menu to provide greater security, liquidity, and diversity to meet the demand of investors on a global scale.
In this section, basic characteristics of Mudharabah, Murabahah, Musyarakah, Ijarah, Istisna (and Salam) and Qard Al-Hasan will be provided. These are the fundamental instruments permitted for the engineering or construction of Shariah-compliant financial assets.
In Muamalat, contracts can be either contracts that benefit the sellers and buyers economically called Mua’wadah contracts; or contracts that benefit only one party called Tabarruat contracts. Examples of Mua’wadah contracts are sale contracts (e.g. Murabahah, Inah), leasing contracts (Ijarah) and wage contracts (Ujr). The common types of ’aqd Tabarruat that can be used to structure financial assets in modern Islamic finance are:
(1) Qard Hassan – It is an interest-free loan in which the borrower is only required to repay the principal amount borrowed. The borrower can pay extra to the lender to appreciate the willingness of the lender in sacrificing his current consumption of money. For example, Islamic banks disburse benevolent loans to marginal societies for worthy economic projects.
(2) Hadiah / Gift – A non-contractual gift from one party to another. It can serve as an encouragement for good performance.
(3) Hibah – It is a contract of distributing wealth without repayment from the receiver. Hibah contracts must follow the process of Ijab and Qabul. An example of the use of hibah instruments is the payment of hibah from Islamic banks to depositors at the end of their financial year as a form of profit distribution to depositors.
(4) Sadaqah – A gift from one party to another. It is given to get barakah from Allah S.W.T.
(5) Waqf – A charitable trust (plural is Awqaf). An endowment or a charitable trust set up for Islamic purposes. It involves tying up a property in perpetuity so that it cannot be sold, inherited, or donated to anyone. Waqf can be divided into “waqf am” (general waqf) or a waqf contract in which the giver does not specify the use of the money/property that had been surrendered); and “waqf khas” (the giver specifies the use of the money/capital/property surrendered such as stipulating that it is for the use of building mosques, etc).
(6) Ju’alah – A reward or promised gift. The promised gift will be given after the prospective receiver performs the required actions under the offer, e.g. monetary reward to the general public to bring in criminals to the police.
Shariah divides contracts in muamalat into two broad categories; ‘aqdulamanah and ‘aqdul Musawamah. ‘Aqdulamanah contracts are contracts that exist from an agreement that does not involve a bargaining process. It is trust contracts that are based on trustworthiness, faithfulness and honesty. An important secondary meaning which the term is also identified with is a transaction where one party keeps another’s funds or property in trust. By extension, the term can also be used to describe different financial or commercial activities such as deposit taking, custody, or goods on consignment.
Contracts based on ’aqd Amana need the exposure of information directly between the parties who are involved in the contracts. Basically there are four types of ’aqd Amanah, which are:
a) Murabahah Contract is a cost plus profit sale contract. The cost and profit margin (mark-up) are made known and agreed by all parties involved. The profit margin added by the seller must be agreed by the purchaser when entering into the contract. The settlement for the purchase can be either on a cash basis, a deferred lump sum basis or on an instalment basis, which will be specified in the agreement. Murabahah financing is a financing facility for working capital to purchase stocks, inventories, replacement, semi-finished goods or raw materials.
(b) A Tauliyyah Contract is a sale transaction performed at cost price. This sale transaction can be in cash and credit Amanah is important to the seller to show the cost price. Example of sales under this contract is a mega sale contract where the sale price is low (at the cost price).
(c) Wadhiah Contract is a sale transaction below the cost price. Sales under this contract are meant for clearance of old stock items or sales to attract customers. It must be stated on the cost with amanah.
An ‘aqdul Musawamah’ Contract on the other hand is a contract that exists between two parties in agreement after going through the bargaining process. Some of the contracts listed as bargaining contracts are:
(a) Bai’ Bithaman Ajil (Deferred payment sale) – Apart from cash sales, the buyer and seller can transact through deferred payment terms. Bai’ Bithaman Ajil also known as BBA is a deferred payment sale. It refers to the sale of goods on a deferred payment basis at a price (which includes a profit margin) agreed to by both the buyer and seller.
(b) Musharakah (Profit and Loss Sharing) – This Islamic financing technique refers to a partnership between two parties, where both provide capital towards financing the project. Both parties share profits on a preagreed ratio, but losses are shared on the basis of equity participation. In other words, it is a joint-venture profit-sharing contract between the bank as the financier and the initiator(s) of the relevant project. All parties have the right to participate in the management of the project. A variant to Musharakah financing is Musharakah. Mutanaqisah (Diminishing Musharakah). In Musharakah Mutanaqisah both financer and the client provide some financing to acquire an asset, and become partners of the ownership and in running the project. The client will pay a monthly instalment from which a portion serves as rental and another portion as payment to obtain the financier’s share of the asset. Upon the completion of the payments, the client has purchased the entire financier’s share or claim on that asset and he can become the sole owner of the asset.
(c) Mudarabah (Profit Sharing) – This is an agreement made between two parties; the capital provider (Rabbul mal) is the financier and the entrepreneur (Mudarib) provides the business expertise to manage the business. The profit-sharing ratio is predetermined in the contract. Capital losses are borne solely by the financier while the entrepreneur loses his effort and time managing the business. In the case of the deposit products practiced by Islamic banks, a profit-sharing agreement is sealed between the Bank (Mudarib) and the depositors
(Rabbul mal). The bank will invest the depositors’ money to generate profit that in turn, will be distributed to the depositors based on the agreed profit-sharing ratio.
(d) Ijarah – Ijarah contracts or leasing contracts are popular financing techniques used by banks. The lessee will pay the ujrah or lease payment to the banks from the use of the assets on lease. Using this method of financing, real assets such as houses, motor vehicles
and machines can be leased by one person (lessor) to the other (lessee) for a specific period against a specific price. The benefit and cost of the each party are to be clearly spelled out in the contract so as to avoid any ambiguity (gharar).
(e) Bai’ Inah – It is a contract which involves the sale and buy-back transaction of assets by a seller. A seller sells an asset to a buyer on a cash basis and later buys it back on a deferred payment basis where the price is higher than the cash price. It can also be applied when a seller sells an asset to a buyer on a deferred basis and later buys it back on a
cash basis, at a price which is lower than the deferred price. In other words, it is a contract of sale where a person sells an article on credit and then buys back at a lesser price for cash.
(f) Bai’ Wafa – It is a sale agreement in which the buyer agrees to return the goods bought at the same price to the seller once the agreement is concluded. It is permissible if the clause for returning the goods is not instituted beforehand. But if the said clause is the essence of the contract, the agreement becomes void.
(g) Wadhiah – It is a placement of goods or deposits with another person, who is not the owner, for safekeeping custody. The contract between the depositor (customer) and the custodian (bank) is the basis for most of the savings deposit in Islamic banks where the banks are the custodians of depositor’s money. Wadhiah Yad Dhamanah is, on the other hand, a guaranteed trust where the bank becomes the guarantor and therefore, guarantees repayment of the whole amount or a portion of it when demanded. The depositors are not entitled to any share of the profits but the bank may provide returns to the depositors as hibah or gift.
(h) Ar-Rahn or Ar-Rahnu – It is Shariah based pawn-broking that allows individuals to acquire financing facilities by using gold items and precious stones as a collateral. The loans disbursed by the pawnbroker will be paid by the debtor at par. The pawn broker will accept fees that are based on the value of the gold/precious items pawned for its safe-keeping.
(i) Istisna’ – It is a purchase order contract of assets whereby a buyer places an order to purchase an asset to be delivered in the future. The payment is agreed on the spot and the goods will be delivered in the future. The buyer requires the seller or a contractor to construct the asset and deliver it in the future according to the specifications given in the sale and purchase contract. Both parties decide on the sale and purchase price and the settlement can be delayed or arranged based on a schedule of work completed.
(j) Sarf – It is a contract of buying and selling of currencies or in other words a contract of exchange of money for money of other currencies. This contract is tightly regulated under Shariah because it can be easily manipulated for the purpose of producing an interest-bearing loan, which is prohibited in Islam. Sale of monetary value for monetary value
currency exchange. In Islamic law, foreign exchange is only a spot exchange, which means immediate delivery of exchanged currencies at the prevailing rate.
1.7 Steps in Investing
Investing is a process of acquiring any investment vehicle with the expectation of obtaining returns or profit. The returns on investment can be divided into two categories: increase of capital value of investment and gaining a stream of income from holding the investment vehicles. Investment activities can be carried out using various avenues of investment vehicles. They include investment in securities, real properties such as land and buildings and other tangible properties such as gold and artwork.
Securities consist of shares, bonds and sukuk, unit trusts and options. A direct Investment is via purchasing shares, bonds or sukuk issued by the companies or issuers. An advantage of holding direct investments is that the returns from holding them are comparatively higher than investing in indirect forms of investment. However, the risks of holding them are higher. Indirect Investment holdings can be performed by investing in unit trusts. Unit trusts are securities issued by investment companies that invest unit holders’ funds in a diversified portfolio of securities.
Investment can be divided into equity, debt and derivative securities. Examples of equity securities are shares and unit trusts. An example of debt securities are bonds that are issued by issuers in exchange for fixed income repayments.
A derivative instrument, on the other hand, is the ownership of title or certificates derived from the value of underlying assets from where the security is derived. Examples of derivative securities are gold and palm oil derivatives. Investment can be short term and long term.
Investment in bonds and sukuk can be for short and long term. Investment in shares can also be for short term or long term depending on the preference of the investors.
According to Gitman and Joehnk (2008), the following steps can be taken when an individual wants to invest either in real property, securities or investing in other investment vehicles.
(1) Meeting investment prerequisites
Individuals can embark on investment activities when they have provided for the necessities of life such as having a place to live, adequate clothing and transportation necessary for earning a living. In the Islamic point of view, the needs of individuals can be divided into three groups. They are the Daruriyyah needs, Hajiyyah needs and Tahsiniyaah needs. Daruriyyah needs are basic needs such as housing, clothing, transportation and security. Hajiyyah needs, on the other hand, can be referred to as
“wants” more than human needs. These are needs usually possessed by the middleincome group in society. The middle-income group usually has access to health, better clothing and comfort rather than just basic access to housing, etc. Tahsiniyyah needs, on the other hand are achieved when a society experiences abundance. This is the state where they are required to pay zakat on their wealth and income.
(2) Establishing investment goals
Investment goals can either be accumulated retirement funds, enhanced current income, savings for major expenditure and minimized tax on income. When income is invested, it will be less taxable. Most investment vehicles are not taxable until they are realized (or sold). For example, retirement investments in the EPF account are not taxable until the amount is taken out from the account.
(3) Adopt an investment plan
In order to adopt an investment plan, an individual needs to consider each type of investment alternative and weigh its risks in comparison to the returns. This has to do with the available funds to be invested. By investing in investment vehicles that have different magnitude of risks and returns, an investor is practically diversifying his portfolios.
(4) Evaluate investment vehicles
Evaluation of investment alternatives, theoretically need to be done once in half a year. This is because some of the investment vehicles such as bonds pay returns once in every 6 months. By making a half-yearly evaluation of investment vehicles that are performing badly can be monitored more closely so that they do not adversely affect overall portfolio returns. The evaluation of investment vehicles’ performance can be done via technical analysis or fundamental analysis. An example of technical analysis is to analyze the behaviour of stock prices and the factors affecting them. Factors that should be studied include the demand and supply of stocks purchased, as well as the general performance of the economy such as interest and inflation rates.
(5) Select suitable investment vehicles
After the evaluation process, individuals should act by disposing or adding other types of investment vehicles. In order to make appropriate selections, research on possible alternatives should be conducted.
These processes will need to be repeated once the investment objective changes. It is also dependent on the performance of investment vehicles in the portfolio.

1.8 Conclusion
The chapter covered the Basic Concepts in Islamic Investment. Among the topics discussed are: the Philosophies of Islamic Economics and Finance, Types of Hukum (law) in Islamic Teachings, Elements of Contracts According to Shariah, Shariah Considerations for Halal Investments, Shariah-compliant Instruments and Steps in Investing. The above topics are
relevant and crucial in the fundamental understanding of Shariah financial planning.

Self Assessment
Circle the letter of the correct choice for each of the following.
1. Which statement correctly defines MUBAH?
A. An obligatory duty, the omission of which is punishable.
B. An action which is permitted, and the law are indifferent whether the act is performed or otherwise.
C. An action which is disliked yet not punishable, but the omission is rewarded.
D. An action which is absolutely forbidden and punishable.
2. _________________ is the sale of debt to another party. Only documents evidencing real debts arising from bona fide commercial transactions can be traded.
A. Ar-Rahnu
B. Bai-BithamanAjil
C. Bai’ al-Dayn
D. Murabahah
3. The following is TRUE about Sighah:
A. Qabul of contracts come before the Ijab of the contract.
B. Ijab and Qabul are the offer and acceptance of the contract.
C. Ijab and Qabulthat not performed in writing are void.
D. Ijab and Qabul are not commandments of contract in Islam.
4. _______________ refers to the sale of goods on a deferred payment basis at a price which includes a profit margin agreed by both parties.
A. Ar-Rahnu
B. Bai-Bithaman Ajil
C. Wadiah
D. Murabahah
5. A Contract can be discontinued through FASAKH when:
i. Cancelled or the contract is ended due to death of one or both
parties of the contract.
ii. Ended due to damage of the subject of the contract.
iii. Ended due to Khiyar.
iv. Ended due to not performing the contract.
A. i, ii, iii
B. i, ii, iv
C. i, iii, iv
D. All of the above
6. Which contracts are forms of the Tabarru’ contract:
i. Murabahah
ii. Hibah
iii. Musharakah Mutanaqisah
iv. Qard Hassan
A. i and ii
B. ii and iii
C. i, ii and iii
D. ii and iv
7. Which of the following listed below is NOT true about the MURABAHAH terms?
i. The seller needs to state the actual cost and capital to the buyer.
ii. The investment capital is contributed by all the partners.
iii. The liability of the partners is normally unlimited.
iv. Both parties agree on the profit as an addition to the actual cost.
A. i and ii
B. ii and iii
C. i and iv
D. All of the above
8. The following is the main sources of HUKUM in Islam EXCEPT
A. Al-Quran B. Urf C. Qiyas D. Ijma
9. A 10% benchmark of non-permissible portion that is allowed to be present in Shariah-compliant shares is______________:
A. Activities that involve expressly prohibited activities.
B. The activities include income generated from fixed deposits received from conventional banking institutions.
C. Activities that involve gambling.
D. Activities in hotel operations and share brokerage.
10. The following are the conditions of ‘URF‘ EXCEPT:
A. Past custom.
B. The phenomenon is common and recurrent.
C. The Urf must not violate clear stipulation of Al-Quran and Al-Sunnah.
D. Custom must not contravene the terms of a valid agreement.
Answer: 1-b, 2-c, 3-b, 4-d, 5-d, 6-d, 7-c, 8-b, 9-b, 10-a.

CHAPTER 2
DISCOUNTING AND THE TIME VALUE OF MONEY:
THE ISLAMIC PERSPECTIVE
Chapter Outline
2.1. Introduction
2.2. Economic Rationale for Discounting
2.2.1 Subjective Justification
2.2.2 Objective Justification
2.3. The Shariah View and Application for Discounting
2.4. The Discount Rate Allowed According to the Shariah
2.5. Conclusion

Study/Learning Objectives
Upon completion of this chapter, you should have knowledge of:
(a) The Definition of Discounting
(b) The Economic Rationale for Discounting
(c) The Shariah View and Application for Discounting
(d) The Discount Rate Allowed According to Shariah

Definitions

The me Value of Money in investment

Present Value (PV) of an amount expected to be received in the future. For example, how much is earned if some amount of money is invested in a unit trust scheme which gives an average of 9% per year for 5 years? (Future value of a present sum – single payment).
Future Value (FV) of an amount invested now will be earning in the future at a specified rate of return. If we need to have RM50,000 in five years’ time, how much should we put in today to a fixed deposit account which can give a 4% rate of return? (Present value of a future sum – single payment).
Present Value of Annuity (PVA) is the present value of a stream of equal size future payments such as financing repayments at a specified rate of profit.
Future Value of an Annuity (FVA) is the future value of a stream of payments received assuming the payments are invested at a given rate of profit, for example annuity payment received.
Present Value of a Perpetuity is the value of a regular stream of payments that lasts indefinitely.

2.1 INTRODUCTION
The concept of discounting is central to the allocation of resources in investment. The main assumption to discounting is that the money received today is worth more than money to be received tomorrow, i.e., recognition of positive time value of money. This is because, partly due to inflation, money that is worth RM1 today will have less value in the future. For that matter, money to be received in the future has to be discounted to the present day in order for investment to be evaluated. To compensate the decreasing value of money due to time factor, money invested will need to earn returns in the future.
Discounting is performed in order to bring future costs and benefit into the current time for economic decisions to be made. Discounted cash flow is what someone is willing to pay today in order to receive an expected amount of cash flow in the future. The fact that future expected cash flow is discounted to the present day brings about arguments in the point of Shariah.
Expected cash flow is something that is not definite, thus, discounting using a fixed rate of return such as interest is not permitted as ex-post investment results are not necessarily realized. To mitigate, an ex-ante rate of return on equity for similar projects can be used.
2.2 Economic Rationale for Discounting
Discounting of future benefits and costs arising can be justified due to two reasons. One is the subjective justification that is based on the time value of money and the other is the objective justification that is based on the net productivity of investment. The human tendency is to adopt positive time value of money results to the discounting of future benefits and cost.
2.2.1 Subjective Justification
Discounting is a result of positive time preference that states that an investor prefers a payment of a fixed amount today to an equal amount of money to be received in the future, ceteris paribus. This is because, in the conventional environment, the same amount of money received earlier rather than later is more valuable since the money can be deposited in an interest-bearing account and earns interest. This is to compensate for the risk of borrower default and the reduction of what the same amount of money can buy due to the force of inflation. In general, humans are risk-averse, resulting in discounting of future consumption. However, there are situations where individuals have negative time preference as argued by Zarqa'(1983).
According to Zarqa’ (1983), the risk aversion of humans is one reason why discounting of future money receivable has to be made. Discounting has to be performed when an investor values money today as more valuable than money to be received in the future, i.e., positive time value of money. The human nature of risk aversion requires that an uncertain amount of money to be received in the future to be valued less in the present day, i.e., the promised amount of money to be received has to be evaluated prudently, so as to discount it if we would like to account it today. Another reason for adopting a positive time value of money is the condition of progressive economy that we are in. In a progressive economy, income and consumption will be higher in the future as compared to the present day. Quoting from Zarqa’, “If an investor is asked to sacrifice present consumption in return for extra consumption in the future, he would require future consumption to be larger, i.e., he would discount it.”
However, there are cases where he argued that the application of discounting is not necessary.
This is because human motivation for money to be received differs. There are times when negative time value of money is applicable. This is to mean the willingness of investors to sacrifice a unit of consumption now for less than a unit later. In many conditions, investors rationally sacrifice consumption today to consume less in the future. Their choice, albeit the
diminishing value of money in the natural setting of the economy, is a rational one.
The arguments for negative time value of money are plenty. We will be discussing them in turn.
a) Consumers in a high-rate inflationary economy still save money, albeit the value of money diminishes when compared to the to the rise in the prices of goods and services in the future. This suggests that negative time value of money is present.
b) Changes in income and expectation of future rises of consumption bring about negative time value of money. For example, in the case of individuals who expect a decrease in income will tolerate one unit less to be consumed tomorrow. Individuals’ uncertainty that their level of income will rise, as opposed to the generic condition of future rising income, accelerate the effect of negative time value of money. An expectation of increasing future consumption such as spending on children’s education also motivates an individual to defer consumption although losing the value of money due to it.
c) Implications of the relative income hypothesis. Duesenberry (1964) in his permanent income hypothesis states that individuals respond to higher income in the future by smoothing it in order to maintain the level of income they used to enjoy. In the situation of rising income, positive time value of money applies, while in the situations of decreasing income, negative time value should take place.
d) Voluntary intergenerational transfers will result in negative time value of money to be in place. The current generation is willing to forgo high utility of consumption now for the future generation to enjoy the savings, albeit at a declined value. For this reason, negative time value is tolerated.
e) The precautionary motive. A large percentage of individuals’ income is put aside to cater for emergency needs should it arise in the future. Individuals are willing to forgo current consumption even though the benefit from one unit of money now is valued less than one unit in the future.
The situations laid out above challenge the perpetual need of discounting of future value of money. The reasons stated, especially the final reason on the precautionary motive, form a high volume of transactions that invalidate the positive time value of money. Thus, it is fair to conclude
that positive time preference can be invalidated based on the notion of rationality as well as the lack of empirical evidence to it (Zarqa, 1983). The final nail to the coffin is: Time value of money is not always positive, thus it is not perpetual that there is a need to discount future costs and benefits in projects and investment evaluations.
The application of the time value of money can be extended to two scenarios. One is the occurrence of compounding effects and the other is the application of discounting of future value to the current period. The usual applications of the time value of money in the investment world are as follows:
(i) Present Value (PV) of an amount expected to be received in the future. For example, how much is earned if some amount of money is invested in a unit trust scheme which gives an average of 9% per year for 5 years? (Future value of a present sum – single payment).
(ii) Future Value (FV) of an amount invested now will be earning in the future at a specified rate of return. If we need to have RM50,000 in five years’ time, how much should we put in today to a fixed deposit account which can give a 4% rate of return? (Present value of a future sum – single payment).
(iii) Present Value of Annuity (PVA) is the present value of a stream of equal size future payments such as financing repayments at a specified rate of profit.
(iv) Future Value of an Annuity (FVA) is the future value of a stream of payments received assuming the payments are invested at a given rate of profit, for example annuity payment received.
(v) Present Value of a Perpetuity is the value of a regular stream of payments that lasts indefinitely.
2.2.2 Objective Justification
The second argument for discounting is more solid as the discounting of future returns and costs between two alternative investments to the current period will make it possible for comparison between the projects to be objectively made. Discounting a project’s benefits and costs is
essential in both commercial and national profitability analysis. In project valuation the two most used discounting techniques are Net Present Value (NPV) and the Internal Rate of Return (IRR).
Thus, the discounting of future benefits and costs is an application of opportunity cost of investing resources over time. The magnitude or the discounting rate should be related to marginal product of the possible investments having a similar degree of uncertainty or risk-return profile.
The application of discounting of future benefits and costs results in the evaluation of projects to be more accurate than using the payback method, accounting rate of return method and return on investment method. This is because these methods ignore the risk that one must bear due to receiving the cash flow later rather than now. Taking into consideration the risky rate of discount factor allows for better decision-making for project evaluation.
The payback method is one of the techniques used in capital budgeting that does not consider the time value of money. In other words, the amount of money earned in the future is assumed to have the same value as each dollar that was invested many years earlier. Payback only answers
one question: How long before the cash invested is returned? Payback does not address which investment is more profitable. Payback not only ignores the time value of money, it ignores all of the cash received after the payback period.
The payback method simply computes the number of years it will take for an investment to return cash equal to the amount invested. For example, if an investment of RM100,000 is made in January 2007 and it generates cash of RM50,000 for two years followed by RM10,000 per year for four additional years, its payback is two years (RM50,000 + RM50,000). If another investment of RM100,000 generates cash of RM20,000 per year for two years and then provides cash of RM40,000 per year for six additional years, its payback is approximately 3.5 years (RM20,000 + RM20,000 + RM40,000 + 0.5 times RM40,000).
The accounting rates of return or the return on investment (ROI) are two more examples of methods used in capital budgeting that does not involve discounting future cash amounts. To overcome the shortcomings of payback, accounting rate of return, and return on investment,
capital budgeting should include techniques that consider the time value of money. Two of these methods include (1) the net present value method, and (2) the internal rate of return calculation.
Under these techniques, the future cash flows are discounted. This means that each dollar in the distant future will be less valuable than each dollar in the near future, and both of these will have less value than each dollar invested in the present.
From a Shariah perspective the time value of money is recognized in business dealings when there is an underlying asset that represents the object of the trade. In case the transaction is on spot basis which represents the normal sale, the price will be according to the market value of the asset. In case the cash is advanced such as in the Salam contract, the price is normally discounted and the value of the commodity is below the market price, however in case the asset is advanced, and the payment is deferred, such as Bai’ Bithamanl Ajil, the amount of the
commodity will increase and the price will be above the market value. This is because time has a portion in the price, provided there is a deferred payment in price and exchange of commodity.
2.3 The Shariah View and Application for Discounting
Anas Zarqa’ writes extensively on the time value of money in project evaluation. His paper entitled Economics of Discounting in Project Evaluation produced in 1983 for the International Centre for Research in Islamic Economics is considered to be a classic paper discussing the
subject. This chapter is built on his arguments on time value of money rather extensively.
In terms of the time value of money, Islam does not altogether disallow the application of the concept. It is evident in the sayings of the Prophet Pbuh, “Virtuous are they who pay back their debts well (above the original debt)”
. Mujahid also reported that “Abd Allah Ibn ‘Umar took some dirhams as a loan and paid back better dirhams” (Rosly, 2003). This signifies that Islam encourages debtors to pay back debt well to express gratitude for the sacrifice of the creditors to forgo their consumption of the money lent, or foregoing the possibility of earning better money in other investment avenues. The possible profit forgone is to be paid by Allah in the form of rewards in the hereafter, but the debtors may do their part to pay back “better money”, if they can afford it. However, Islam does not allow any form of contractual reward determined in advance as a predetermined obligation in exchange for a loan.
In terms of the Islamic banks’ application of murabahah financing, some critics are of the opinion that the murabahah sale contract is more form than substance since the return is positively related to positive time preference. The BBA credit price is higher than the cost price and the
customers are paying the price over a period, which in turn results in the price paid tied to the element of time preference. BBA thus, contains almost all features of credit finance (Rosly, 2003). Shariah scholars are silent on the issues of the positive time preference, as well as other related variables such as opportunity cost, inflation and credit risk in murabahah financing (Rosly, 2003).
Time preference indicates the extent of a family’s preference for current consumption over future consumption. The rationalization of interest as a price of credit began when people believed that present consumption is superior to future consumption. According to Bohm Bowerk, the famous Austrian economist, people prefer the present because the future is uncertain. They also think that present wants are more keenly felt than future wants.
Also, people think that the present goods possess a technical superiority over future goods. That is, the passage of time allows the use of more roundabout methods of production that are more productive.
Since current consumption brings more satisfaction than future ones, people who are asked to postpone current consumption (i.e. creditors) are expected to be compensated for the benefits of pleasure foregone today. Such compensation is the payment of interest or usury.
When people think that one dollar today is worth more than one dollar tomorrow, they become true believers of positive time preference. Capitalism is based on the belief that people generally embrace positive time preference. The implication of positive time preference is the
contractual payment and receipt of interest. Laws in financial transactions require debtors to pay interests on loans. In this manner, debtors who have forgone the pleasure of current consumption are guaranteed a contractual surplus on the loan as a compensation for postponing current consumption.
The problem lies when compensation for waiting have become contractual in nature coming out from a sense of belief that the future is uncertain. A contractual payment must be made to compensate for the utility loss from delayed consumption. This does not make sense when he in the first place is not certain of getting it himself.
For example, Mr. Ali invests his money in bonds to earn 10% interest a year. Can he get the same yield if he uses this money to run his own business? Certainly, he may get more or less than 10%. There is no free lunch. Business risk does not guarantee anything. But why is this not
true for interest-bearing debt?
Profit made from a loan (qard) in Islam is unlawful (haram) because it constitutes riba. Riba predominately originates from debt instruments like bank loans as well as private and public interest-bearing bonds. The Islamic jurists (fuqaha) at the Shariah Supervisory Boards say that
the Islamic alternatives to interest-bearing loans, for example murabahah, are not based on a debt contract but rather on the contract of sale. For this reason, profits acquired from a murabahah sale are considered lawful.
A seller may take into account the time factor in fixing a higher price for his commodity in a credit sale, but the increased price is being fixed for the commodity and not exclusively for the time element. However, once a commodity is sold, the resultant debt established on the buyer may
not be increased in view of any further extension granted for payment; nor could a debt be sold to another at a discounted price in view of the latter’s cash payment.
This could indicate that the Shariah admits the effect of time on the value of commodities and recognizes the innate human preference of what is in hand to what is deferred. It is permissible

to place a premium on time in the credit sale of commodities. However, time valuation is
possible only in business and trade of goods, and not in the exchange of monetary values or
loans and debts. Thus, time in itself may not be the subject matter of a contract. Negation of the
economic value of time in the case of a loan means that time is treated differently in loans and
sales.
Shariah accepts the value of time in a sale contract. One example is in the case of
deferred payment sale or bay’ al-muajjal. In deferred payment sale, credit price can be higher
than the cash price. This is to compensate the seller for his inability to use the assets
relinquished to the buyer, when he is not taking the full price of assets sold.
Another proof that Islam accepts the concept of time value of money in sale contracts is
the permissibility of bay’ al-salam. Bay’ al-salam is the sale of goods in the form of commodities
to be delivered in the future with the price paid immediately by the buyer. The price of the
sold item is cheaper at the point of sale as compared to when the goods are delivered to the
buyer in the future. The concept applies to bay’ al-istisna’ where the buyer of manufactured items
must pay immediately upon contract conclusion whilst the manufactured items are to be
delivered in the future.
The ulama’ however are rather silent about why the murabahah credit price is always higher than
the cash price. They say that as long as the buyer is willing to pay the agreed price via
bargaining and haggling (musawammah), and the sale is concluded with the offer and
acceptance (ijab and qabul), then the contract is considered valid. Any profit derived from a valid
contract is lawful.
Shariah scholars however do not consider the time element invoked in the pricing of murabahah.
A sale of goods X paid by deferment is valid even if the price is higher than the cash price. For
example, if the customer buys on cash basis, he pays RM100,000 for the goods. But if he buys
the goods based on an installment payment scheme, he pays say RM150,000. Thus, the
additional RM50,000 is acquired by the seller from deferment in payment, which in essence is
waiting. The deferment of payments to a future date puts an obligation on the buyer to pay more
than the cash price.
One important observation that one must take note o f concerning the legitimacy of murabahah profits is the argument that the murabahah sale is based on a n ‘underlying asset’. This is not evidenced in loans as the subject matter in a loan is money rather than an “underlying asset”.
Hence, the existence of an “underlying asset” (i.e. the subject matter in the sale contract) warrants the legitimacy of profits from a murabahah sale even if it means that profits are generated from waiting. In this manner, positive time preference has been found acceptable to Shariah scholars.
However, to take the matter one step further, the selling party, namely Islamic banks, are expected to observe the requirement of sale concerning the ‘underlying asset’ in expediting the deferred sale transaction. Firstly, the selling party must assume legal ownership of the ‘underlying asset’ prior to the murabahah sale. Therefore, as owner, the bank carries
all risk of the asset for the period immediately after first purchasing the ‘underlying asset’ from the supplier. The bank will suffer losses when say, the sale was effected below cost price due to adverse market movements. Hence the acquisition of profits from the deferment payment
system of murabahah is lawful by virtue of the ownership risk carried by the selling party.
The implication of positive time preference in capitalism is the contractual payment and receipt of interest. It is the institutionalization of positive time preference that makes it prohibited inIslamic finance. This is different from the Shariah recommendation of debtors to pay extra at the end of a financing period. This is because the addition is paid ex-post, i.e., not institutionalized in the financing contract.
As for the second justification of discounting, Islam views it as a realization of one of the objectives of Islamic economics to prevent israf (waste) and promote efficiency. For that matter, project evaluation using the discounting method is used to decide on the better performing
project. However, in conventional finance, the discounting process is performed using the interest rate which is prohibited as it is a contractually fixed return. Therefore, the rate of return on equity is the proper discount rate to be applied to reflect the uncertain risks of the projects’ cash inflow and outflow. Zarqa concluded that discounting is accepted in Islam, even desirable, as it allows for the promotion of investment efficiency.
Abdullah (2006) in his unpublished Master’s thesis compiled the needs for fair project evaluation.
Resources in Islam are the trusts of Allah given to man as khalifah (representatives) to manage efficiently. The khalifah is entrusted to utilize these resources in the correct manner, within Shariah boundaries (Haneef, 1997). Appraisal of a project ex-ante to the project execution is in line with the spirit of allocative efficiency due to reasons as follows (paraphrased from Abdullah 2006):
1. Project evaluation is about rationalizing the use of resources for useful purposes. The irrational and unjustified use of resources is condemned as evident from the Hadith narrated by Ahmad and al-Nasai where a bird which was killed for no useful purpose will claim to Allah in the hereafter and say: “Oh Allah! This man has killed me for no purpose
and not for any benefit” (Al-Masri, 1999; Al-Qardawi, 1999).
2. Prior project evaluation provides ways to prevent al-Israf or excessive use of resources either in production or consumption (Choudhury & Malik, 1992; Zarqa’, 1983).
In verses 17:27 and 7:31, The Quran condemns Israf or wasteful expenditure. Some Islamic economists too recognize the prohibition of Israf or the sanction against wasteful expenditure/consumerism as an important principle of Islamic economics.
3. Project evaluation involves prioritization of potential competing projects, in terms of deciding which project bears high priority to benefit the society or private projects that produces highest return. Al-Qardawi (2000) states that, with the right status, each matter
could be ordered and prioritized according to its importance and urgency from the point of Shariah. The prioritization of project commencement can be made based on the main five values; wajib (obligatory), mandub (recommended), mubah (permissible), makruh (reprehensive) and haram (forbidden). The final hukm is indeed a non-occurrence of prioritization as it is not allowed to be performed according to Shariah, such as the
building of a casino.

2.4 The Discount Rate Allowed According to the Shariah
The elimination of riba’ is one of the central Islamic economic objectives. For that matter, an alternative discount rate is to be used to discount future benefits and costs. Islamic economists such as Choudhry(1983); Zarqa’ (1983); and Khan (1991) are in consensus that the rate of return on capital or the equivalent profit rate should be used as the discount rate replacing the rate of interest, especially the rate of return on equity.
Shariah allows for rate of return on equity to be used as the discount rate. The Weighted Average Cost of Capital (WACC) is usually used for project evaluation. WACC is the weighted average of the capital employed by the firm that consists of debt capital and equity capital.
Conventional debt capital is prohibited in Islam as interest is payable on them. Thus, WACC that is calculated using conventional debt-based interest is not legitimate from the Shariah perspective. Instead, rate of return required from equity financing is allowed when a firm discounts future benefits and costs of its projects, and Islamically permissible financing in the form of Murabaha and Ijara with its applicable profit mark-up, may be used.
The use of profit rate or the rate of return on capital is based on the concept of opportunity cost.
The rate of return in similar projects to the one to be discounted, when available, is to be used to discount future costs and benefits. This is to reflect the similar risk element to the future cash flow to be generated from the project.
Traditional finance recognizes the use of the rate of return as opposed to the use of the cost of debt. This is because the common goal of a firm is to maximize the market value of its shareholders’ equity. Technically, Earnings per share/Price per share can be used as the cost of capital in all equity firms. The traditional and the new theory of Modigliani and Miller (MM) recognize the risky rate of return rather than the interest rate as a discounting factor.
For public projects, Social Rate of Discount (SRD) as termed by Zarqa’ (1983), is to be used when evaluating public projects. One possible determinant for SRD includes the explicit concern for future generations. Another more relevant determinant is the extent of priority of the project according to Shariah law of Fiqh Awlawiyyat, i.e., a project that is mandub to be constructed is preferable than a project that is mubah. Other ways to evaluate the foundation for building a project is based on the needs of the society as prescribed by Masalih Mursalah (Public benefit) and Istihsan (juristic preference).
A related question arising is whether it is permissible to use the compound interest table to discount future costs and benefits. The compound interest table, according to Zarqa’ has been misnamed by the practitioners in finance since the table is actually nothing less than the periodic growth and decline table based on relevant rates that rates of returns on equity can be used. The periodic growth and decline table is indeed a mathematical expression of quantity that grows and declines regularly.
Islam encourages allocative efficiency based on permissibility of the use of discounting as a mode to measure opportunity cost between competing projects. A project that provides a greater return is preferable to the ones producing lower returns unless they are public projects where other considerations have to be made on top of the evaluation based on the returns alone. Discounting is objectively allowed and encouraged in Islam for it provides an indication of achieving efficiency and avoiding Israf. Subjectively, the application of discounting is justified based on Shariah permissibility on the positive time value of money, albeit its prohibition on the fixed contractual payments in the contracts to mitigate the time value of money by the use of interest.

2.5 Conclusion
This chapter covered the topic of Discounting and the Time Value of Money: The Islamic Perspective.
Among the themes discussed included: Economic Rationale for Discounting, The Shariah View and Application for Discounting and The Discount Rate Allowed According to the Shariah. The aspects discussed are essential in understanding the area of investment to ensure Shariah compliance advise on related matters.

Self-Assessment
Circle the letter of the correct choice for each of the following.
1. Which discount rate is not allowed to be used in discounting future returns and costs in project evaluation?
A. Weighted Average Cost of Capital
B. Cost of Equity Capital
C. Profit Rate
D. Earnings per Share/Price per Share
2. The following are examples of the application of discounting in project evaluation EXCEPT:
A. Net Present Value (NPV)
B. Internal Rate of Return (IRR)
C. Payback period
D. Discounted cash flow
3. Positive time preference means __________.
A. Future values of cash flow are preferred to the current cash flow
B. An uncertain amount of money to be received in the future is to be valued less in the present day
C. Investors’ preference for future and current cash flow is equal
D. Investors are willing to sacrifice current consumption to earn greater cash flow in the future cash flow.
4. The cost of capital for public projects according to Zarqa is _____.
A. The rate of return on equity
B. Rate of return similar to competing projects
C. Social Rate of Discount
D. Weighted Average Cost of Capital for the public projects
5. The incidence of negative time value of money arises due to the following, EXCEPT:
A. Wealth accumulation due to intergenerational factor
B. Precautionary Savings
C. Opportunity Cost of investment alternatives
D. Changes in income and expectation of future rises of consumption
6. Which of the following statements on time value of money is FALSE according to Shariah principles?
A. Time belongs to Allah S.W.T. He will reward the reduction of money due to the time factor.
B. The cost of capital used to compensate the loss of the value of money is interest rate.
C. Time value of money is allowed as long as contractual reward is determined ex-ante stated in exchange for a loan.
D. Uncertainty of future events leads to the usage of rate of return on equity as the cost of capital.
7. The following is TRUE on the objective justification for discounting EXCEPT:
A. Discounting permits the evaluation of alternative projects.
B. Discounting is used to measure opportunity cost of selecting one project over another.
C. Discounting is based on net productivity of investment.
D. Discounting is performed due to the time value of money.
8. According to Shariah, prioritization of competing projects according to importance means _____________.
A. A project that is mandub is more encouraged than a project that is wajib.
B. A project that is mubah is more encouraged than a project that is mandub.
C. A project that is wajib has to be prioritized above all other projects.
D. A haram project can be built if all other wajib, mandub, mubah and makruh projects have been built.
9. Which is FALSE about allocative efficiency in Islam?
A. It is the prohibition of Israf.
B. It can be achieved by examining the opportunity costs of competing projects.
C. Public projects should be allocated only based on the best rate of return to promote allocative efficiency.
D. A project that earns higher discounted cash flow is better than a project that earns a lower figure of discounted cash flow.
10. An investor would like to know the amount he would be receiving if he invests a sum of money at a certain rate of return. Which concept of discounting is to be used?
A. Future Value
B. Present Value of Annuity
C. Present Value of a Perpetuity
D. Present Value
Answer: 1-a, 2-c, 3-b, 4-c, 5-c, 6-b, 7-d, 8-c, 9-c,10-d.

CHAPTER 3
PPOTFOLIO DIVERSIFICATION AND PORTOLIO THEORIES
Outline/Topics
3.1. Introduction
3.2. The Definition and Measurement of Risks and Returns of a Security
(a) Measuring returns using historical rates of return
(b) Measuring returns using expected returns
(c) Measuring risks of investing in a security
(d) Required rate of return versus expected rate of return
3.3. Risks Involved in Portfolio Holdings
(a) Beta coefficient
3.4. Portfolio Diversification and Asset Allocation
(a) Overview of portfolio management
(b) Portfolio, return and risk measures
(c) Variance, co-variance, correlation coefficient and portfolio diversification
(d) Modern Portfolio Theory (MPT) and portfolio diversification
3.5. Pricing of Financial Assets and Portfolio Diversification according to Markowitz and CAPM
(a) Markowitz and “The Efficient Frontier”
(b) Capital Assets Pricing Model (CAPM)
(c) Market Risk versus Specific Risk
(d) Security Market Line (SML)
3.6. Conclusion
Study/Learning Objectives
Upon completion of this chapter, you should have knowledge of:
(a) The Definition and Measurement of Risks and Returns of a Security
(b) The Types of Risks Involved in Portfolio Holdings
(c) Portfolio Diversification
(d) Pricing of Financial Assets and Portfolio Diversification According to Markowitz and CAPM.
Definitions:
al-ghorm bil ghonm –
Al-bay’ –
Al-ijarah –
Salam –
Mudharabah –
Murabahah –
Musharakah –
Wakalah bil istithmar –
Ta’awun (mutual aid and cooperation) –
Al-kharaj bil dam =
Rabbul- Mal (the capital provider) –
3.1 Introduction
Islam enjoins market agents to take risks (ghorm) in their business engagements. The Islamic legal maxim (al-ghorm bil ghonm), which means “with risk comes reward” is invoked to invite people to participate in ventures which involve taking risks and entitlement of earning reward. This is evidenced in the contracts of al-bay’, al-ijarah, salam, mudarabah and musharakah. Islamic law requires risk taking in investment. This fact has been demonstrated in many Shariah contracts such as mudarabah, musharakah and wakalah bil istithmar.
Legitimate profit generated from commercial activities that involve risk-taking is seen as an act of virtue (mahmudah) in Islam. Profits created under the pretext of risk-taking show the way to justice since these profits are not made by mere manipulation and deceit but via mutual aid and cooperation (ta’awun). In the early days of Islam, international trade by land was carried by the caravans across deserts and mountains, which by no means was easy and smooth. The goods carried by the caravans were bound to destruction even before reaching their respective markets. Sandstorms and sickness were most common. Highway robbery and accidents often complicated the journey. These incidences were beyond one’s control. They are risks that caravan trading cannot avoid. Such risk in fiqh muamalat is called ghorm. The legal maxim al-ghorm bil ghonm is directly related to this phenomenon of market or systematic risk.
Likewise, in Islamic investments, one is expected to assume risk in an expectation to earn a return from the investment. The return however must not involve the element of riba, which is commonplace in the conventional system. For example, individuals in a capitalist economy invest when they experience surplus of income after considering expenses paid from the income. They can also invest using borrowed funds earning returns to pay the smaller cost of capital of their borrowings that were used to invest. Reilly and Brown (2006)1 stated that investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investors for:
(1) the time the funds are committed
(2) the expected rate of inflation
(3) the uncertainty of the future payments.
The above reasons are not acceptable to Islam when the transaction concerned involves a loan. Investment, according to Shariah however, is justified by the returns from investment through the risks resulting from the operation of the business itself. Investment, in the Islamic perspective must be backed by real assets. For an investment to produce returns, investors must be exposed to the risks of holding the assets and the rights to use the assets. Investment returns over time are justified due to the opportunity cost of investors committing to invest in a specific investment, foregoing returns obtainable from alternative investment. Having said this, Shariah does not recognise the time value of money as money received now is more desirable than money received later in the future (the central concept of time value of money) to the effect that future returns are guaranteed upfront. Time value of money is acceptable in Islam only when it does not produce fixed compensation for the postponement of consumption.
In this chapter, the measurement of risks and returns, when individuals invest in a security and in a portfolio, will be provided. The sources and types of risks will be discussed in order for investors to understand the risks they are taking when putting their resources into investments. The risks can be firm-specified as well as industry/market-specified. As the aim of investors is to hold an efficient portfolio, an introduction to the efficient frontier as well as portfolio diversification will be provided. In addition, the modern portfolio theory and capital asset pricing model (CAPM) will be explained for investors to have a better understanding of their investments.
3.2. The Definition and Measurement of Risks and Returns of a Security
Investing in a security involves risks. Shariah it is the risks involved in an investment that justify the return from that investment. Investments can be made based on the contracts such as mudharabah, murabahah and musharakah where every one of them involves risk-taking. For example, in a mudharabah contract, the Rabbul- Mal or the capital provider is taking the risks of incurring losses on the capital provided. The entrepreneur, on the other hand, is risking his labour and time in a business venture that may be an unprofitable one. In Musharakah, the risks to be assumed by the partners are according to the predetermined profit and loss sharing ratio.
Based on the same principle, Islamic finance prohibits the charging of interest. It argues that the interest-charging practice denies risk sharing among the financier and the party taking up the loan since interest needs to be paid regardless of whether profit or loss results from the business. This argument is further supported by the legal maxim ‘al-kharaj bil daman’ which means ‘with profit comes responsibility’, i.e. taking risks. It implies that when one is doing business, he must ensure that profit is acquired through work and effort and thus, profits cannot be earned by just sitting on money as evidenced in interest-bearing fixed deposits and fixed income instruments.
Risks and returns can be measured when investors invest in a security. An extension to the discussion on risks and returns will be made when the situation of investors investing in multiple securities in order to spread the risk, is discussed. Theoretically, investors must hold an efficient portfolio consisting of securities that has various combinations of risks and return characteristics. An efficient portfolio is a portfolio that produces the lowest risk at a specified level of return and highest return at a specified level of risk. In the logical sense, investors do not want to assume higher risk for the same level of returns from a portfolio. This is the central concept of efficient portfolio.
First, an introduction to the measurement of risks and returns from investing in one security will be provided. The concept and calculation of risk and return of a portfolio will also be provided.
(a) Measuring returns using historical rates of return
Returns can be expressed using historical information as well as using the expected rate of returns of the investors. In cases where the historical information is available, the calculation of holding period return (HPR) can be performed. HPR is a total return earned from holding an investment for a specified holding period. From the historical rate of return time series of returns, the risks calculation using standard deviation and variance will be provided.
The formula is:
HPR= nding Value of Investment / Beginning Value of Investment
For example, if Alia bought Hup Seng shares in the main board, for RM1.30 in August 2005, with the current price on the 19th August 2008 of RM1.41, her HPR is as follows:
HPR = 1.41/1.30 = 1.08
Holding Period Income (HPY), on the other hand is the expression of the return on a percentage basis.
HPY is HPR-1
HPY = 1.08-1  = 0.08  =  8%
HPR provides information on the change of the value of an investment. However, investors are more likely to know their returns in percentage terms on an annual basis. To have that, we need to calculate the annual HPY.
Annual HPY= HPR ^1/n – 1
Where n= number of years the investment is held (4 years)
Using the same example, the calculation of Annual HPY is as follows:
Annual HPY =1.08^1/4 -1 = 1.02-1 = 0.02=2%

(b) Measuring Returns Using Expected Returns
Realized historical rates of returns are useful for calculating the returns from an investment. However, in the case of investors who would like to anticipate their future investment returns, the holding period return calculation cannot be performed. This is because future returns are not available to the investors. Instead, investors may use their rate of expected returns from the investment to calculate investment returns. For example, if an investor expects to receive 12% from his investment, he can analyze the estimates of expected returns. Expected returns, in this case is defined according to the point of view of the statistical analysis. To arrive at the percentage of expected returns, he needs to assign probability values to all the possible returns from the investment. The probabilities can range from 0 to 1, 0 being the chance the investment does not produce the specified returns. A probability of 0.5 indicates that there is a 50% chance that the investment will generate the specified rate of return. The probabilities to be used are in line with the expectation of the economy, i.e., investors need to assign the probability values based on the market conditions and other factors. The formula for the calculation of expected returns is:

Expected Return   = ∑ (Probability of Return) x (Possible Return)
E(R) = [(P1) (R1) + (P2) (R2) + (P3) (R3)+…. + (Pn) (Rn)]
E(R) = ∑ (Pi) (Ri)

As an example, let us consider this scenario:
An investor is assigning a set of probabilities to relevant rates of returns from his outlook on the economic climate based on advice from his financial planner and his readings. The information is provided in Table 1 as follows:

Table 1: An Investor’s Outlook

The computation of the expected rate of return E(R) is as follows:
E(R) = [(0.20) (0.20)] + [(0.10) (-0.30)] + [(0.70) (0.10)] =0.08= 8%
Therefore, Expected Return is the rate of return an investor may expect from the performance of an investment based on a range of possible returns from that investment and based on a set of probabilities assigned to each level of performance.

To measure the dispersion of obtaining possible returns around the expected return, variance and standard deviation can be calculated using the possible return and the expected return calculated as above. The larger the variance for the expected return, the greater will be the risk
of the investment. The most common single indicator of an asset’s risk is standard deviation (σ).
It measures the variation of returns around a securities’ expected return (r^).
The formula for standard deviation is:

This means that the risk for an investor obtaining his expected rate of return of 8% is 12.75%. The real return can be 8% ± 12.75%.

3.1.4 Required rate of return versus expected rate of return
The expected rate of return is different from required rate of return. Required rate of return is the minimum profit percentage an investor requires before he is willing to provide the funds for investing. As mentioned earlier, in traditional finance, required rate of return compensates investors with:

(a) the time value of money during the period of investment,

(b)  the expected rate of inflation during the period, and

(c) the risk involved.

The expected return must be greater than the required return for the investment to be feasible.

Often, the required rate of return is based on the firm’s cost of capital or weighted average cost of capital, plus or minus a risk premium to reflect the specific risk characteristics of the investment. Risk premium is the amount of risk in addition to the risk-free rate where investors are certain of the amount and timing of the expected returns (Reilly and Brown, 2007). Risk premium may arise from business risk, financial risk, liquidity risk, exchange rate risk and country risk (to be discussed in greater detail in the next section).

3.2 Risks Involved in Portfolio Holdings

Sources of risk vary from one economy to another. For example, in Malaysia, the risk of asset expropriation is low as compared to government-based economies where assets of investors can be expropriated by the government during times of difficulty in the economy. For example, the BATA shoe factories in Eastern European countries were expropriated and nationalized in 1945 by the communist government. Due to that, BATA had to look for expansion using its factories outside Eastern Europe, such as the one in Canada. Investors are likely to avoid investing in an unstable economy as the investment will attract high economic risks.

In relation to financial securities, there are economic risks that arise from the political environment of the economy such as the change of the ruling party and so on. Inflation risk is another type of economic risks. Inflation rate can be stable or volatile in different economies. Consider the inflation risk in Zimbabwe where in March 2008, the rate of inflation was at its hundreds of thousands o f percent (355,000%). With that level of inflation, the prices of goods increase rapidly from day to day. When comparing the risk of increasing inflation in such economies to that of Malaysia, investors are likely to invest in Malaysia due the stable nature of the rate of inflation that stood at 3.8% in September 2018. The economy of Malaysia has somewhat recovered since the financial crisis of 2007/2008, improving inflation rates from 8% in 2008 to around 4% by 2018. This was due to external and cost-push factors from the rise of world oil price and commodities in 2008. At its core, economic risks threaten cash flows from financial securities that are affected by the performance of the real economy. This is compared to financial risks such as liquidity, currency and interest rate risks that do not directly affect cash flow from the real economy. Financial risks come under the financial sphere, due to the depth and width of the financial market (liquidity risk) and the fluctuation of exchange of domestic currency in relation to international currencies (currency risk). These risks can be managed by ways of financial regulation and hedging of currencies, among others.

Both types of risks, economic and financial risks, regardless of their nature, lead to fluctuations in the value of a financial security. A security’s risk is measured in terms of the volatility of its price (or of its rate of return). Greater volatility means greater risk involved, and vice versa. For a closer look, the investment scenario in Malaysia attracts the following types of risks:

(1) Market risk is the change in returns in all companies resulting from the changes in a market as a whole.

(2) Inflation risk is the change in price level in the economy that will adversely affect the purchasing power of the returns received from an investment.

(3) Interest rate risk is the risk where price changes on investment as a result of change in interest rate. It inversely affects the prices of securities.

(4) Business risk is the risk of doing business in a particular industry.

(5) Financial risk relates to the use of debt. The larger the portion of debt used to finance investment, the greater the financial risk.

(6) Liquidity risk is the risk of not being able to liquidate an investment easily and without losing substantially.

(7) Currency risk is the variability of returns caused by currency fluctuations.

(8) Event risk is the risk that comes largely from an unexpected event that has significant and immediate effects on share investment.

Event risk is the risk that comes largely from an unexpected event that has significant and immediate effects on share investment.

The total risk of a financial security can be divided into market related risks (market or systematic risks) and a specific risk that is independent of the market (intrinsic, diversifiable or unsystematic risks).

Diversifiable (Unsystematic) risks are risks that are unique to a particular investment, i.e., business risks, financial risks and liquidity risks. They result from uncontrollable or random events that are firm-specific. Other events of unsystematic risks are labour strikes and law suits faced by a firm. Diversifiable risk is the risk of a specific security. The risk is dependent on the return performance of the security or the price fluctuation of the security. This type of risks can be diversified through proper management of an investor’s portfolio. As a rule of thumb, risks of investing in securities can be significantly diversified when an investor invests in 30 or more securities that consist of risk-free assets, equity and unit trust funds. Another allocation, for example, would be to put 60% of the available capital in stocks, 30% in bonds, and the other 10% in cash. The subject of Finance offers one important theory to deal with diversifiable or unsystematic risks. The theory is called portfolio diversification theory. Portfolio diversification exploits the correlation of return among securities. Securities that have negative or low positive correlation are regarded as good in bringing diversification to the portfolio. We will revisit the concept of portfolio diversification in greater length in the next section.

Non-diversifiable (Systematic) risks, on the other hand, refers to events or forces such as war, inflation, or political events that affect all investments. Non-diversifiable risks, which cannot be eliminated by holding a diversified portfolio, are considered the only relevant risk. This is because the “smart” investor is expected to remove unsystematic risk through diversification. Hence, the market will reward an investor for only the systematic risk. Examples of systematic risks are interest rate risk, market risk and currency risk. Unsystematic and systematic risks are totally independent of each other.

The market risk of a security is dependent on its Beta coefficient, which measures the correlation between the return on the security and the market return. Mathematically, this is the regression line of the security’s return versus that of the market. Beta is a measure of systematic risk that can indicate how the price of a security responds to market forces found by relating the historical return on the security with the historical return for the market. The higher the beta, the riskier is the security. The concept of Beta is also an important aspect of Modern Portfolio Theory.

3.2.1 Beta coefficient

Beta is a popular measure of risk that measures non-diversifiable or systematic risk. Beta indicates how the price of a security responds to market forces by comparing historical returns of a security to the market return. For example, if the beta indices of the KLCI and the EMAS are compared, it will provide a proxy of the market return which will be quoted as 1.

Stocks may have positive or negative betas, but nearly all are positive to indicate their return covariance with the returns of the market. Stocks with betas greater than 1.00 are more risky than the overall market. On the other hand, stocks with betas less than 1.00 are less risky than the overall market. Beta coefficient is the mathematical relationship that states the return of a security in relation to the movement of the returns of the market. To measure the co-movement, the covariance between the two is calculated. The formula for the Beta of an asset within a portfolio is:

B_a = Cov (R_a, R_p)/VarR _p

In the CAPM formulation, the portfolio is the market portfolio that contains all risky assets, and so the Rp terms in the formula are replaced by R_m, the rate of return of the market.

Beta coefficient depends on various factors, among others:

(a) the sensitivity of the company’s business sector

(b) the economic situation

(c) the com any’s operating costs structure (the higher the fixed costs, the higher the Beta)

(d) the quality and quantity of information provided to the market (the greater visibility there is over future results, the lower the Beta)

(e) earnings growth rates (the higher the growth rate, the higher the Beta).

Figure-3.2 – illustrates the differences between securities that carry different Beta.

From the figure, Security C has a beta of 0.8 that indicates a lower risk of investing in Security C as compared to the overall market. Security D, on the other hand has a Beta value higher than the market, i.e. 1.30. This indicates that if the market is expected to increase by 10%, a stock
with a beta of 1.30 is expected to increase by 13%. Higher stock betas should result in higher expected returns due to greater risk of the security as compared to the market. Beta values of specific stocks can be obtained from Value Line Reports or market watch websites such as that in the finance section of yahoo.com.
3.3 Portfolio Diversification and Asset Allocation
Diversification is the financial term for the adage “Don’t put all your eggs in one basket”. It explains that investors should include a number of different securities in a portfolio in order to increase returns and reduce risks. As discussed earlier, there are two categories of risks, i.e. systematic and unsystematic risks. The benefit of diversification is only to reduce unsystematic risks.
In order to ensure the best combination of shares that can reduce most of the unsystematic risks, an investor has to understand the concept of correlation. Correlation is a statistical measure of the relationship, if any, between a series of numbers representing data of any kind. If two series move in the same direction, they are positively correlated. If the series move in opposite directions, they are negatively correlated. However, some shares are completely unrelated.
To reduce overall unsystematic risks in a portfolio, it is best to combine shares that have negative correlation. Even if shares are not negatively correlated, the lower the positive correlation, the lower the resulting risks.
The concept of portfolio diversification relates greatly to the Modern Portfolio Theory that builds on the concept of the Efficient Frontier. The Efficient Frontier contains the portfolio that provides the highest return for a given level of risk or vice versa. Given the option between two
investments that have the same risks but offer different returns, investors would pick the one with the higher return.
To understand the concept of the efficient frontier, let us examine the following example that lists the portfolios A through J together with their returns and risks in Table 3.3.
Table 3.3: Returns and Risks of Portfolio A through J

These portfolios can be represented in the feasible or attainable set to reflect the efficient frontier as indicated in the Diagram 3.4 below.

The efficient frontier, i.e. portfolios BJFCH are the portfolios that provide the highest return at the same level of risks or the lowest risk at the same level of returns.
Although portfolios AIEGD are feasible or an attainable set of portfolios, they are not efficient as they do not provide the highest rate of return at a specified level of risk. Cons der portfolios F and I. Portfolio F provides 11% return at 6% level of risk, whereas portfolio I only provides 5% at 7% level of risk. At only 1% difference of level of risk, portfolio F provides a much higher return than portfolio I.
Before portfolio diversification can be drafted, investors have to observe whether their portfolios are in the efficient frontier in order for returns to be maximized.
3.3.1 Overview of Portfolio Management
A portfolio is a collection of investment vehicles assembled to meet one or more investment goals. There are various objectives for portfolio allocation so as to meet investor investment objectives. The amount of an investors total portfolio placed into each asset class is determined by an asset allocation model. A growth-oriented portfolio is a portfolio where the primary objectives is to achieve long-term price appreciation. An income-oriented portfolio on the other hand has a collection of income
generation Securities in it. Its primary objective is to earn dividend income and profit sharing income generated yearly or semiannually. New preservation of capital portfolio will contain Securities that are
fixed income in nature as provided by money market instruments such as overnight deposits in the Islamic money market as well as pre-agreed income ratios of profit provided by corporate Sukuk. He balanced portfolio, as the name suggests, contains a balanced ratio of equity Securities l as well as fixed income Securities. This is in order to provide stable returns during the time of a bearish stock market.

3.3.2 Portfolio Return and Risk Measure s
Before embarking on the discussion of portfolio diversification, let us examine the returns and risks of a collection of securities in a portfolio. We have already identified and calculated returns and risks of individual securities represented by the securities’ expected returns for return measures and standard deviation for risk measures.
(a) Portfolio Return
Return on a Portfolio is the weighted average f return on the individual assets in the portfolio. This simply means the average return of all securities in the portfolio. The formula for the calculation of return of a portfolio is as follows:

(b) Risks of the portfolio
Risks of the portfolio can be measured using variance and standard deviation. Standard deviation of a portfolio’s return is calculated usi
formula for portfolio variance is as follows:

For example, Ahmad’s portfolio holds Security A, which brought a return of 12.0% and Security B, which brought a return of 15.0%.At the beginning of the year, 70% was invested in Security A and the remaining 3 % was invested in Security B. Given a standard deviation of 10% for Security A,
20% for Security B and a correlation coefficient of 0.5 between the two securities, Ahmad’ portfolio variance is 11.27%, i.e. the square root of the portfolio variance of 127. (Portfolio Variance= (0.72x 102) + (0.32x 202) + (2×0.7×0.3x10x20x0.5) = 127).
3.3.3 Variance, co-variance, correlation coefficient and portfolio diversification
(a) Variance and covariance
Variance is dependent on the way in which individual securities interact with each other. This interaction is known as covariance. Covariance tells us whether or not two securities’ returns are correlated. Covariance measures by themselves do not provide an indication of the degree of
correlation between two securities. As such, covariance is standardized by dividing covariance by the product of the standard deviation of two individual securities. This standardized measure is called the correlation coefficient. The formula for correlation coefficient is as follows:

In the previous case, the correlation of returns of 0.5 was given. This means that the covariance of returns between Securities A and B is: 0.01 (0.5* 0.2*0.1). Since the correlation coefficient of A and B is 0.5, we can conclude that Securities A and B move in the same direction, at the rate of 0.5. This means that if Security A’s return was to increase by 10%, Security B’s return will increase by half, that is to 15%.
(b) Correlation Coefficients
Perfectly Positively Correlated describes two positively correlated series having a correlation coefficient of +1. Perfectly Negatively Correlated describes two negatively correlated series having a correlation coefficient of -1. Uncorrelated describes two series that lack any relationship and have a correlation coefficient of nearly zero. Correlation between two or more securities gives rise to portfolio diversification. To reduce overall risk in a portfolio, it is best to combine assets that have a negative (or low-positive) correlation. Uncorrelated assets reduce risk somewhat, but not as effectively as combining negatively correlated assets. Investing in different
investments wit high positive correlation will not provide sufficient diversification. This concept can be graphically shown in Diagram 3.5 below.

Asset F brought a more average return in the first half period before it dropped to less than
average return during the second half of the investment period. Asset G, on the other hand,
moved in the opposite direction to Asset F. The return is below average in the first period while
the return is more than average in the second half period. By having a portfolio that has both
Assets F and G, the returns can be smoothed out to a less significant reduction in times of less bullish performance.
Although the return on a portfolio of shares is equal to the average return on the shares within the portfolio, the risk of a portfolio is lower than the average risk of the shares making up that
portfolio. This happens because returns on shares do not all vary to exactly the same degree, since correlation coefficients are rarely equal to 1. As a result, some portfolios will deliver better returns than others. By including risk-free assets, i.e., assets on which the return is guaranteed, such as government bonds, it is possible to obtain portfolios that are even more efficient.
(c) International Diversification
Other than investing in different asset classes, i.e. in equity and fixed-income securities, international diversification can also take place. International diversification can offer more diverse investment alternatives than domestic-based investments only. This is because, foreign economic cycles may move independently from a local economic cycle. For example, during the time of economic crisis due to sub-prime credit burst in the American market, Asian markets were less prone to the effect because of the different structures of Asian markets on mortgage
debt selling to third parties from the American market. A study performed between 1984 and 1994 suggests that a portfolio of 70% S&P 500 and 30% EAFE would reduce risks by 5% and increase returns by 7% over a 100% S&P 500 portfolio. The EAFE Stock Index tracks the European, Australasian, and Far East stock indices.
The advantages of international diversification include broader investment choices and potentially greater returns than in the domestic country; thus, reducing overall portfolio risks. The disadvantages of international diversification are the existence of currency exchange risk and it
will be less convenient to invest in than in the domestic market.
3.3.4 Modern Portfolio Theory (MPT) and portfolio diversification
MPT models an asset’s return as a random variable, and models a portfolio as a weighted combination of assets so that the return of a portfolio is the weighted combination of the assets’ returns. Moreover, a portfolio’s return is a random variable, and consequently has an expected value and a variance. Risk, in this model, is the standard deviation of return.

MPT is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risks are an inherent part of higher reward. MPT emphasizes statistical measures to develop a portfolio plan. It focuses on
the quantitative measurement of expected returns, standard deviation of returns and the correlation between returns. As a result, MPT combines securities that have negative (or low positive) correlations between each other’s rates of return.
Key aspects of MPT are the Efficient Frontier concept as discussed earlier, as well as the concept of Portfolio Beta. The beta of a portfolio is calculated as the weighted average of the betas of the individual assets the portfolio includes. Thus, in order to earn more return, one must bear more risks.
The development of the modern portfolio theory (MPT) reflects the historical inability of those concerned with investment analysis, portfolio decision-making, and performance evaluation to quantitatively express their views concerning risk and its relationship to investment return. Past returns cannot be compared through the use of a generally accepted common denominator of “risk”, and the future uncertainty of expected returns cannot be expressed with much quantitative precision.
The modern portfolio theory treats risk in quantitative terms. It focuses attention beyond the traditional exhaustive analysis and evaluation of individual security issues to the problem of overall portfolio composition predicated on explicit risk/reward parameters and on the identification and quantification of portfolio objectives.
3.4 Pricing of Financial Assets and Portfolio
Diversification according to Markowitz and CAPM The discussion in the previous section on portfolio diversification is borrowed from various theories of portfolio as indicated by three important theories namely Markowitz, Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory. For a complete understanding of finance and investment, it is required for candidates to know these theories and how they were built.
3.4.1 Markowitz and “The Efficient Frontier”
The basic elements of the modern portfolio theory emanated from a series of propositions concerning rational investor behavior set forth by Dr Harry M. Markowitz briefly in 1952 and later in a complete monograph sponsored by the Cowles Foundation.
The central theme of Markowitz’s work is that rational investors should conduct themselves in a manner which reflects their inherent aversion to absorbing increased risks without compensation, by an adequate increase in expected returns. To Markowitz, this meant any given “expected” rate of return (where the expected return is the mean of a probability distribution) as studied in the previous section. Most investors would prefer a portfolio containing minimum expected deviation of returns around the mean. Thus, risk was defined by Markowitz as the uncertainty, or variability of returns, measured by the standard deviation of expected returns about the mean.
Moreover, the use of standard deviation of return as a measure of risk focused attention on the time horizon of investment calculations; that is, expectations for, say, a one-year period, are not necessarily the same as for a three-year period. In fact, as we can observe from both Lipper Fund and Standard and Poor’s Fund Services Fund, the performance rankings of different unit trusts in Malaysia frequently depend upon the length of the measurement.
Starting with this concept of risk and the assumed aversion to risk, Markowitz observed that investors should try to minimize deviations from the expected portfolio rate of return by diversifying their security selection, holding different types of securities and/or securities of
different companies. More importantly, he pointed out that simply holding different securities would not significantly reduce the variability of a portfolio’s expected rate of return if the income and market prices of these different issues contained a high degree of positive covariance – that is, if the timing, direction, and magnitude of their fluctuations were similar. Effective diversification is only achieved if the portfolio is composed of securities that do not fluctuate in a similar fashion, so that the variability of the portfolio’s rate of return becomes significantly less than the variability of the individual components of the portfolio. However, it should be noted that the variability of returns – either absolute or relative to the market as a whole – does not capture entirely the concept of investment risk.
This important principle can be more easily understood by considering a simple two-stock portfolio with equal amounts invested in each issue. Let us first assume that both securities are perfectly and positively correlated with respect to their price movements. When one moves up,
the other does the same in exactly the same proportion; and a similar relationship exists on the downside. For the sake of simplicity, let us also assume that each security fluctuates in perpetual up and down pattern of equal dimensions, as shown in Figure 3.7 Chart 1. In this case,
combining the two securities into a portfolio does not reduce the variance in total returns. The variance of portfolio return will be the same as the variance in the return securities.

Now, let us assume that the two securities are negatively related to each other: when the return from one security moves up, the other moves down in exactly the same proportion. This is shown in Figure 3.7 Chart 2.
By combining these two issues into a portfolio, variance in the portfolio’s return is completely eliminated. Obviously, practical problems go far beyond the consideration of two-stock portfolios.
Therefore, for each security it is necessary to determine a mean expected return, an expected standard deviation of return, and a covariance of return for each security. Given this information, Markowitz showed how quadratic programming could be used to calculate a set of optimal
portfolios (he referred to them as “efficient portfolios”) such as the curves shown in Figure 3.8 Charts 1 & 2.

In the Markowitz scheme of things, if there were an actual Portfolio A, it would be considered suboptimal, or “inefficient”, because Portfolio B could produce the same expected return but at a lower risk level, while Portfolio C could have the same degree of risk as Portfolio A but would afford a higher expected return.
In general, portfolios that lie in the middle region of the curve usually contain many securities, while those at the extremes contain few. For example, point D would usually be associated with total investment in the one security expected to produce the maximum return. Obviously,
different investors and portfolio managers will reach different decisions as to which of all possible efficient portfolios is best suited to reflect their own specific risk/return preferences. For example, conservative investors (i.e., those investors more interested in preserving their capital and earning a fairly consistent and predictable return) would choose portfolios lying at the lower left portion of the efficient frontier near Portfolio B in Figure 3.9. More aggressive investors,
those willing to absorb higher risk in exchange for the prospect of possibly earning higher but more variable and less certain returns would form portfolios nearer to point D on the curve in Figure 3.9.
It should be recognized that an efficient portfolio, once constructed, will not retain its optimum status for long due to the basic nature of fluctuating stock prices.
The Markowitz approach has been subjected to criticisms from both theoretical and practical points of view. One serious attack relates to the assumption that rational investors are necessarily risk averters.
A practical obstacle in the use of the Markowitz model is that each time a change in the existing portfolio comes under consideration, the entire population of possible securities must be reevaluated in order to preserve the desired risk/return balance. This reevaluation, in turn, requires a large number of mathematical calculations. Markowitz himself pointed this out by observing that “an analysis of 100 securities requires 100 expected returns, 100 variances, and almost 5,000 covariances.” He then suggested a simpler procedure – relating returns on each security to the returns on an overall index of market prices and thereby, implicitly relating the
returns on each security to each other.
Another more serious practical obstacle is that the portfolio alterations required to achieve constant portfolio efficiency may be so numerous that they can give rise to large, uneconomic transaction costs. This high cost could be true even if portfolio managers review their holdings as
infrequently as quarterly.
3.4.2 Capital Asset Pricing Model (CAPM)
The presentation of the portfolio theory by Markowitz in 1952 was followed by a period of active academic research and publications dealing with the security market pricing mechanism. The CAPM was thus developed by William Sharpe (1964), John Lintner (1965) and Jan Mossin (1967).
Since CAPM builds on the Markowitz model, it automatically makes the assumptions listed on the top part of Table 3.4. The bottom part of Table 3.4 lists the additional assumptions.

It is immediately apparent that many of these assumptions may not coincide with reality. William Sharpe and other theorists argued, however, that they are close enough to reality to draw implications about security pricing behavior. The main implication in their view is that individual
security, and the market as a whole are, on balance, in equilibrium – that is, they are priced “fairly” in relation to the risks associated with their ownership. Therefore, investors should focus their attention on the risk profiles of their portfolios. They should not expect to earn higher returns without increasing risks, and lowering the risk element should be expected to reduce returns.
Whereas the Markowitz model adjusts risks by moving up or down the efficient frontier of alternative portfolios of different individual security, risk is adjusted under CAPM by borrowing or lending against a single optimal risky portfolio. This portfolio, moreover, because of equilibrium assumptions, is the entire market. The concept is presented graphically in Figure-3.11.

A key tenet of CAPM is represented by point M. It is the expected return and the variability (risk) for the market as a whole – the complete universe of risky investments available for purchase – with each issue weighted in proportion to its share of the total market value of all risky
investments. Since it is virtually impossible to calculate precisely this universe of all risky investments at any given point in time, it is much more practical to use a “proxy” for the market universe. In the Malaysian market, the KLCI may be used but the choice is certainly not limited to it.

The important concept to recognize is that the market, or its surrogate stock price index, is seen in CAPM as the optimal risky portfolio. No other combination of investments can produce a better trade-off between reward and risk.
The point Rf in Figure 3.11 is the expected rate of return available from investment in a risk-free asset during the period under consideration. The line segment Rfm indicates the various returns available through the combination of commitments in risk-free assets and “risky” assets as
represented by the market index. Possible portfolio combinations range from a totally invested position in risk-free assets to one which exactly mirrors the market.
In order to achieve an expected return greater than the market, some point along that portion of the line between M and point A, the investor is assumed able to borrow at the risk-free rate and thus “leverage” the portfolio by reinvesting the borrowed funds in the market. As shown in Figure 3.11, the returns thus achieved will be greater than those achieved by moving upward on the Markowitz frontier.
Critics point out that the line segment MA is not practically available to most investors. Virtually all institutional portfolios are restricted in their ability to borrow, and most individual investors are
reluctant to do so. And in any event, they have to pay more for borrowed funds than the risk-free rate. Presumably, therefore, the rate of return most investors can achieve by increasing risk is considerably less than that indicated by the line segment MA.
3.4.3 Market Risk versus Specific Risk
Based on the CAPM approach, Sharpe further indicated that risk could be separated into two distinct elements. The first, identified as the “market risk” (also called systematic or non-diversifiable risk), is that portion of a stock price (or portfolio) movement which can be attributed
to the movement of the market as a whole. The second element of risk is that portion of price movement unique to the specific asset and is defined as nonsystematic or diversifiable risk. This is the concept of portfolio diversification discussed in the previous section.
Once the assumption that diversifiable risk tends towards zero, it becomes clear that the return on a portfolio is essentially a function of the portfolio’s non-diversifiable risk (beta) multiplied by whatever the market’s return happens to be. Beta becomes the most important determinant of the portfolio’s return, given the movement of the market (which the portfolio manager cannot control). Thus, it is argued that the beta coefficients of alternative portfolios can be used to measure their comparative “riskiness”. As a result, Sharpe’s “market line” can be relabeled as shown in Figure 3.12 and expressed as follows:

R_p = R_f + b (R_m– R_m)

Where:

R_p = portfolio’s return over the measurement period.

R_f = the risk-free rate over the measurement period.

R_m = the market return over the measurement period

b = the portfolio’s beta (risk level) over the measurement period.

3.4.4 Security Market Line (SML)
Security Market Line extends the risk analysis to the pricing of individual assets as distinct from the overall market. Instead, the measure of risk is related to return of the security in relation to
the market return, i.e., covariance. The equation of the SML may be expressed as follows:

When the equation of the SML is plotted in expected return beta coordinates, it yields a straight line as shown in Figure 3.13. From the figure, Share A (which is below the SML) is considered over-valued because its estimated return is less than the expected return for that level of risk. On the other hand, Share B (which plots above the SML), is under-valued as it is expected to provide higher return for the same risk level. In short, at equilibrium, any share with expected return less than or more than the expected return based on the SML will be considered over or under-valued respectively.

3.5 Conclusion
This chapter covered the topic of Portfolio Diversification and Portfolio Theories. Among the theme discussed were: The Definition and Measurement of Risks and Returns of a Security, Risks Involved in Portfolio Holdings, Portfolio Diversification and Asset Allocation, Pricing of Financial Assets and Portfolio Diversification according to Markowitz and CAPM. The aspects discussed are crucial to understanding of investment to ensure Shariah compliance advice is comprehensives and has taken relevant investment theory into account.

Self-Assessment
Circle the letter of the correct choice for each of the following.
1. “Beta coefficient of a security” depends on these factors EXCEPT:
A. The sensitivity of the company’s business sector
B. The current economic situation
C. The quality and quantity of information provided to the market
D. The securities’ expected returns
2. What is the main risk of venturing into international markets for portfolio diversification?
A. Systematic risks of the domestic market
B. Unsystematic risks of a specific portfolio
C. Currency risk
D. Risks of falsely interpreting the economic report of the foreign country
3. According to the CAPM, if the market portfolio used has been misidentified, the manager’s performance is likely to be:
A. The question is based on a false premise. Any well diversified portfolio is a good
proxy for the market portfolio.
B. Either over or under-estimated.
C. Overestimated.
D. Underestimated.
4. Which of the following assumptions are shared between the CAPM and Markowitz’s Theory of asset pricing?
A. No taxes and no market imperfections.
B. Unrestricted borrowing and lending at the risk-free rate.
C. Investors have homogenous expectations regarding mean, variance and covariance
of the return of the securities.
D. Investors are risk-averse expected utility maximisers.
5. Which of the following statements regarding “optimal portfolio” is TRUE?
A. The efficient portfolio that has the highest utility for a given investor.
B. Lies at the point of tangency between the efficient frontier and the investor’s indifference curve.
C. The portfolio that gives investor the maximum level of return at a specified level of risks.
D. Portfolios that are fully diversified.
6. The best combination of securities to be added in a portfolio to achieve diversification is _____________________.
A. Both securities have zero correlation
B. Both securities have perfectly negative correlation
C. Both securities have low positive correlation
D. Both securities have low negative correlation
7. The following are examples of systematic risks EXCEPT:
A. Risks that the economy is experiencing inflation
B. Interest rate risk
C. Default risk due to financing exposure
D. Currency risk
8. Which of the following statements about the portfolio theory is FALSE:
A. Total risk equals systematic risk and unsystematic risk.
B. If a security plots above the SML, it is undervalued.
C. The risk measure associated with the CML is standard deviation (total risk).
D. If a security plots above the theoretical CML, it is undervalued.
9. Which of the following statements about portfolio diversification is FALSE?
A. As more securities are added to a portfolio, total risk falls but at a decreasing rate.
B. In a well-diversified portfolio of over 25 stocks, market rise will account for over 85% of the portfolio’s total risk.
C. The lower the correlation coefficient between the portfolio and a stock, the lower the diversification effect from adding that stock to the portfolio.
D. International diversification can further reduce the total risk of a portfolio.
10. In the context of the security market line (SML), which of the following statements best characterizes the relationship between risk and the required rate of return for an investment?
A. The slope of the SML indicates the risk per unit of return for a given individual investor.
B. A parallel shift in the SML occurs in response to a change in the attitudes of investors towards risk.
C. A movement along the SML shows a change in the risk characteristics of a specific investment, such as a change in its business risk or financial risk.
D. A change in the slope of the SML reflects a change in market conditions, such as ease or tightness of monetary policy or a change in the expected rate of inflation.
Answer: 1-d, 2-c, 3-d, 4-d, 5-c, 6-b, 7-c, 8-d, 9-c,10-c.

CHAPTER 4
INVESTMENT IN THE SHARE MARKET
Chapter Outline
4.1 Introduction
4.2 The Pros and Cons of Share Investing
4.3 The Structure of Bursa Malaysia
4.4 Types of Shares Traded in the Bursa Malaysia
4.4.1. Ordinary Shares
4.4.2. Preference Shares
4.4.3. Bonus and Rights Issues and Their Effects on Share Price
4.5 The Development and Issues of Shariah-compliant Share Investing
4.5.1. The Islamic View on Share Ownership 4.6 Brief Knowledge on Market Indices Including the Kuala Lumpur Shariah Index (KLSI) 4.7 Fundamental Analysis for Share Valuation
4.8 Share Valuation Models
4.8.1. Dividend Discount Model
4.8.2. Price/Earnings (P/E) Approach
4.9 Islamic Exchange Traded Funds (ETF) 4.10 Share Investment Strategies
4.10.1. Passive Investment Strategy
4.10.2. Active Investment Strategy
4.11 Conclusion
Study/Learning Objectives:
Upon the completion of this chapter/topic, you should have knowledge on:
(a) The Pros and Cons of Share Investing
(b) The Structure of Bursa Malaysia
(c) Types of Shares Traded in the Bursa Malaysia
(d) The Development and Issues of Shariah-compliant Share Investing
(e) Brief Knowledge on Market Indices Including the Kuala Lumpur Shariah Index (KLSI)
(f) Fundamental Analysis for Share Valuation
(g) Share Valuation Models
(h) Share Investment Strategies
4.1 Introduction
As at the end of 2019, the overall size of the capital market stood at MYR 3.5 trillion with the equity market valued at MYR 1.5 trillion. The number of companies listed on the exchange increased to more than 900 at the end of 2019. Households with medium to high risk preferences preferred to invest in stocks rather than in unit trusts. Furthermore, a considerable amount of risk involved in the investment of bluechip stocks encouraged households to hold stock. Investment in shares demands the investors to have good understanding of risks. A positive relationship usually exists between the level of education and the amount of equity holdings. King and Leape (1987) suggested that educated people have better information about various investment opportunities. Since shares and other equity related investments are information-driven investment ventures, better-educated households usually acquire more shares and equity related investments.
4.2 The Pros and Cons of Share Investing There are a number of reasons why households want to hold shares:
(i). The shareholders have the opportunity to make big money through capital gain (price appreciation) of the shares bought. This is usually in the case of Initial Public Offering (IPOs) where the shares are usually offered at low prices and the prices will rise resulting in capital gain.
(ii). Share ownership provides a steady income flow through dividend payment. For example, Shell adopts a high dividend payout policy.
(iii). Shares are easy to liquidate as secondary market for them is available. Shareholders only need to deal with a broker to sell them in the open market (Bursa Malaysia).
(iv). The cost of investing in shares is moderate – The cost that an investor needs to bear is the buying price of share he/she intends to buy and some percentage of commission to be paid to the broker/remisier. Shares are traded in lots of 100 units (previously, it was in 1000 units, the benchmark was reduced in order to encourage transaction). The minimum commission is fixed at RM12. E-trading further reduced the commission to MYR0.42 per share. For E-trading, however, the minimum commission is RM 40 per trading counter. E- traders are also needed to trade a minimum of RM10, 000 worth of shares at a time as compared to the old regulation of only RM 3,000.
(v). Market information is widely disseminated – for example, research on stock market can be read in most newspapers. The Star has its Star-Biz business section that educates the public on share investment and unit trust investment, among others. Other types of information freely available are the market indices, for example, the Composite Index, the Emas Index and the Shariah Index.
(vi). Share ownership is a hedge against inflation (Edelman, 1998). In the case of the U.S, due to inflation, in the year 1998 an individual would have needed $90,150 to buy what he could have bought with $10,000 in 1926.This is what we call the loss of value of money due to inflation. Investing in the stock market is one way to mitigate inflation, for $10,000 invested in 1926 would have been worth $18,284,637 in 1998, or 200 times as much as the rate of inflation would have produced.
There are many disadvantages of share ownership. Investment in shares expose shareholders to risks such as business risk, financial risk, market risk and event risk. The former two risks are firm specific, while the latter risk is due to the operation of the market where shares are traded. Income from share investment is also comparatively smaller compared to the returns generated from the investment in real property, for example. In that sense, low unit cost of shares makes it attractive to the investors albeit with modest returns on investment in comparison to investment in real property which requires a high initial amount of investment.
4.3 The Structure of Bursa Malaysia
As a result of the Securities Industry Act which came into force in 1976, the Kuala Lumpur Stock Exchange (KLSE), a company limited by guarantee was formed in 1976 to take over the operation of Kuala Lumpur Stock Exchange Berhad (KLSEB) in December the same year.
Arising from the demutualization exercise, the Kuala Lumpur Stock Exchange (KLSE) has on 5 January 2004 been converted from a company limited by guarantee to a public company limited by shares. With this conversion, the KLSE has vested and transferred its stock exchange business to a wholly-owned subsidiary, Bursa Malaysia Securities Berhad, whilst the demutualization of the KLSE has been approved as an exchange holding company, Bursa Malaysia Berhad.
The capital market where shares, bonds and other fixed income securities and derivatives are traded is governed by the following Acts of Parliament:
(a) Capital Markets and Services Act 2007
(b) Securities Industry (Central Depositories Act) 1991
(c) Securities Commission Act 1993
(d) Companies Act 1965
(e) Offshore Companies Act 1990
(f) Labuan Offshore Securities Industry Act 1995
Bursa Malaysia, handles the complete range of exchange-related services including trading, clearing, settlement and depository services. It is an exchange holding company approved under Section 15 of the Capital Markets and Services Act 2007.The activities of Bursa Malaysia and the flow of its operation can be referred to Diagram 4.1.

4.4 Types of Shares Traded in the Bursa Malaysia
Shareholders are the owners of the firm who are entitled to dividend income and a prorated share of the firm. The shareholders are entitled to the residual income after the consideration of other obligations of the firm has been taken care of. The income to be received by the shareholders, usually at the end of the financial year, is the profit after tax figure. The total profit earned will not be distributed to the shareholders, but to be retained in the business for future development of the business or to be retained for the purpose of income smoothing in the future in case the company is not doing well. The retained profit, in that case will be used to pay dividend in the forthcoming years.
In the Bursa Malaysia, equity, debt and derivative securities are issued and traded. For share capital, ordinary shares from different industries such as consumer, industrial, trading/services, construction, finance, hotel, property, plantation and mining are traded. Fixed income securities are also traded, such as preference shares, non-convertible loan stocks and convertible loan stocks. However, all of these are not Shariah compliant. Other than that, warrants/Transferable Subscription Rights (TSRs), property trusts and close-end funds are also traded. For the purpose of this chapter, we will discuss further on ordinary shares and preference shares as well as on bonus issue and its effect on the share price.
4.3.1 Ordinary Shares
Ordinary shares are equity-based security that represents the portion of the owner‘s capital in the business. The shareholders collectively own the business according to the amount of shares invested. This type of provision of capital to the business, in the form of mudharabah is encouraged in Islamic finance as the owners and the managers are sharing the risk of the business and the amount of profit to be made. Shareholders will, at the end of the year receive dividend that is to be declared by the board of directors who is in command of the management of the business. The rate of dividend however, is not fixed depending on the performance of the business. The rate usually fluctuates from year to year although some companies use the policy of dividend-smoothing by allocating about the same amount of dividend payable to the shareholders. This is done in order to stabilize the share of the company.
In terms of rights, ordinary shareholders own the voting right; one for every share held, thus having the element of control on the direction and management of the company. Voting rights can be exercised to make decisions such as the management and dismissal of directors in the annual general meeting (AGM). Majority shareholders hold 50% and 1 share of the company. By having the majority shareholding, the person/s can control the company. In terms of risks, ordinary shares characterize higher risks than the ownership of other types of shares such as preference shares.
In practical terms, some symbols were introduced to indicate the types of ordinary shares that fall in the category. This is useful for shareholders and prospective shareholders in the quest for information. For example, in the StarBiz section of the Star, one of the local newspapers in Malaysia, these symbols were used:
Shariah-approved shares
# – Shares with 50 sen par value
PE – Price earnings ratio, using historical EPS
DY – This stands for dividend yield, using historical dividend paid
4.3.2 Preference Shares
Preference shares carry the right to dividend before payment is to be made to ordinary shareholders. The rate of dividend is usually fixed, or promised upon from the terms of issuance of the shares. In times of liquidation, preference shareholders‘ capital will be repaid before repayment is to be made to ordinary shareholders, but after the payment made to secured creditors and other creditors.
Some preference shares may have a cumulative entitlement in that dividends not paid can be carried forward and must be paid prior to any ordinary dividend payment or distribution on liquidation. Some preference shares are ― participating with ordinary shares in all dividends above a set rate, in addition to their own preferential dividend rate. Other preference shares are redeemable at a certain date.
Preference shares carry no voting rights, but the right can be made upon failure of the company to pay dividends on preference shares for a period of time. In Malaysia, these types of preference shares are sold and traded in Bursa Malaysia5 .
(I). Participating preference shares are entitled to participate in the profits beyond the fixed dividends, by way of an additional fluctuating dividend if the company is successful.
(II). Cumulative preference shares are preference shares which, apart from having a preferential right to receive a fixed dividend ahead of ordinary shares, also carry the right of any arrears of the preference dividends which may have built up.
(III). Non-cumulative preference shares are preference shares which are not entitled to any arrears in dividends.
(IV). Redeemable preference shares may be redeemed by the company at a stated redemption price on advance notice of a period of time. It is usual to set a redemption price above the par value to compensate the owner for the involuntary loss of his investment.
(V). Convertible preference shares are preference shares which carry the right to be made convertible, at the option of the holder, into another class of shares, normally into ordinary shares. Examples of preference shares quoted in the Bursa Malaysia that can be found in a separate column in The Star are:
(a) PMCap-PA
(b) SittTatt-PA
(c) Tasek-PA
(d)  YTL Land-PA
 To provide understanding on the technical procedures of buying and selling shares, the following information is provided.
1. Investors have to open a Trading Account and a Central Depository System (CDS) Account at a stock broking firm through a license dealer or remisier.
2. Transactions will begin with an order to buy/sell a specified number of shares of a company at a specified price. Order has to be made through a remisier. There are two types of orders:
(a). Limit order is where the transaction will be executed at the order price or better.
(b). Market order is where the transaction will be executed at any price within the upper and lower limit.
3. The order will be keyed into the Win SCORE terminal at the stock broking company by the remisier. The Win SCORE system is directly linked to the Bursa Malaysia. 4. Orders will be matched by the system. The prices are determined by the market force of demand and supply through a process of bid and offers. 5. Once the order is matched, a trade confirmation (contract note) will be printed at the stock broking company which provides details like order number, price and quantity together with the cost. 6. For the clearing and settlement, a seller must ensure sufficient shares in their CDS Account and the buyer must make payment within 3 days. If the buyer fails to pay by 12.30pm on the third day, the stock broking company will then sell out the shares to pay the seller. 7. Trading sessions at the Bursa Malaysia is available 5 days a week from Monday to Friday.
In terms of trading costs, the brokerage fees is payable by both the buyers and the sellers. From 2nd January 2008, the minimum brokerage fees are as follows:

Table 4.2: Minimum Brokerage Fees at the Bursa Malaysia (As at December 2019)

4.3.3 Bonus and Rights Issues and Their Effects on Share

Price Bonus issue, as the name implies, are bonus shares issued to the existing shareholders holding ordinary shares in the company. It is commonly known as scrip issue or a capitalization issue. Bonus issue is a mere adjustment to the accounts with no money to be paid by the shareholders. To finance the bonus issuance, balance in the retained profit account will be used (debited) for the bonus issue. One of the reasons for the issuance of bonus issue is that the value of the company assets may substantially exceed the value of its issued capital. When the reserves or the retained profit has been capitalized, new shares are issued without payment, and only existing shareholders will get these issued in proportion to their existing shareholdings (e.g. one for two: i.e. one bonus share for every two shares held). With bonus issue, the share price will generally fall accordingly as there is no increase in cash or asset.

To illustrate the effect of a bonus issue, let us assume a corporation has 100 million shares of RM1 each. The net assets per share is RM2.20 and the shares are traded at RM6 per share with Price/Earnings ratio of 10 times or earnings per share of RM0.60 (this implies total profit after tax of RM60 million). If the corporation declares a bonus issue of 1 for 2, the number of shares shall increase from 100 million shares to 150 million shares. As a result of the increased number of shares, the earnings per share will be RM0.40, based on the same P/E ratio of 10 times, the share is expected to have an adjusted price of RM4 per share. Theoretically, the shareholders do not seem to have any benefit at all. Notwithstanding the aforesaid, there are advocates who argue that the price may not drop as much as 33.33 % from RM6 to RM4. Several reasons are offered:

(a) Prices after adjustment are lower and make them more affordable to the general public. When this happens, more people or investors are able to buy, hence transforming it into higher demand. This seems to make sense for counters traded at very high prices.

(b) Some shareholders receiving additional shares feel good and have psychological thoughts that the company is doing well.

(c) Bonus issue increases the paid-up capital of a corporation. To the bankers and suppliers, it is considered financially more stable. The validity of this is further backed by the fact that cash is conserved under the bonus issue as compared to cash dividend that involves outflow of cash. Rights issue is an issue of new shares through existing shareholders according to their holding proportions (e.g. one for three: i.e. a shareholder is entitled to buy one ordinary share for every three shares held). This happens when a company needs to raise additional funds for whatever valid purposes such as expansion or other projects. It is also commonly used to refinance bank loans. This exercise leads to an increase in paid-up capital and shareholders‘ funds or equity. Rights issues are usually issued below the prevailing market price. Otherwise, there is no logic and reason for the existing shareholders to purchase the rights issues since they can buy them at lower prices from the market. The actual rights issue prices are very much dependent on the prevailing market conditions. During a bullish market, rights issues are usually well-received and could be done at better prices at a premium above the par value of the shares. However, during a bearish market, it is always tougher to get rights issues completed at a premium price above the par value. Some issuers have to add sweeteners such as free transferable warrants to attract the subscribers.

At Bursa Malaysia, we may also find a rights issue at a discounted price of RM0.28 when the par value is RM1. What the company has done is to capitalize the difference of RM0.72 from the share premium account. (Reference: a two-call rights issue of 167,443,363 new Tanco shares with free warrants to the shareholders of the company at an issue price of RM1.00 per Rights share with a first call of RM0.28 payable in cash and RM0.72 payable out of the share premium account in Jan/Feb, 2002).

When the rights to subscribe additional shares are provisionally allotted to existing shareholders, shareholders could either exercise their provisional rights (buy up the shares allocated) or sell off their provisional rights (selling the rights to buy the share at below market price) to other investors. The trading of the provisional rights to subscribe for rights issues is usually for a short period so that the purchasers can have ample time to take up the rights issues.

After the Rights Issues, share prices will generally fall. There are several reasons for such movements. Firstly, the increase in the number of shares will dilute the earnings per share and dividend per share. Secondly, the net asset per share is also likely to be reduced. There is no scientific way to determine the ex-right price of a share as general market sentiment also plays a very vital role. For illustration of changes, let us assume the following hypothetical example:

If the market as a whole, prices the share based on its net asset per share, its price before the rights issue should be RM2.25. After the rights issue, since the net asset per share is reduced to RM1.90, the price of the share shall be reduced to RM1.90. However, as we all know, prices of shares are not determined solely by its net asset value. Hence, the ex-right price is very hard to ascertain in practice.

4.4 The Development and Issues of Shariah-compliant Share

Investing Bursa Malaysia on 22 January 2007 added FTSE Bursa Malaysia Emas Shariah Index and on 21 May 2007 further added FTSE Bursa Malaysia Hijrah Index to its series of FTSE Bursa Malaysia indices. These new indices are subjected to the same international indexing features such as free float and liquidity. Therefore, the investors are now able to have a clearer picture of the quality of Shariah investments and track them more effectively on Bursa Malaysia. FTSE Bursa Malaysia Hijrah index comprises companies from FTSE Bursa Malaysia Emas Shariah Index that meet international screening requirements of Shariah investors.

In an effort to broaden the development of overall Islamic financial services in Malaysia, Bursa Malaysia released the Best Practices in Islamic Stock broking Services guidelines in September 2007. The Best Practices is a set of voluntary guidelines that outline key areas and recommended best practices in carrying out stock broking services in accordance with Shariah principles. The guidelines can be used to assist intermediaries in setting up stock broking businesses through either a full-fledge basis or ‘window’ basis. In terms of performance of the three indices, a sample monthly balance comparison is offered below:

4.4.1 The Islamic View on Share Ownership

The hukm or verdict on share dealing has been extensively discussed by Islamic scholars. The International Fiqh Collaboration and the European Fatwa Council are among the parties expressing their opinions on the subject of investing in shares. The purchase of shares in companies is deduced from the hukm of Musharakah or partnership or mutual consent. It is allowed by virtue of the Quranic revelation in An-Nisa‘( 4,29).

In An-Nisa’ (4,29), Allah says: ―O ye who believe! Eat not up your property among yourselves in vanities: But let there be amongst you traffic and trade by mutual good-will: Nor kill (or destroy) yourselves: for verily Allah hath been to you Most Merciful!

Prophert Muhammad (Pbuh) also permitted musharakah when he mentioned: “I will be the third person to be among two people in a musharakah as long as they do not betray each other.” (From Abu Daud)

In general, the purchase of shares in Shariah-compliant companies is mubah or allowed. It is a consensus that it is haram for a person to purchase shares in companies dealing with haram activities or producing haram products. These include activities in riba’, gambling, gharar and the production of liquor and pork.

The majority of ulama’(Islamic Scholars) are of the opinion that investing in shares is mubah because the ijab and qabul (offer and acceptance) is complete from the sale and purchase of shares. This includes the use of technology in share purchase. Ijab and qabul is one of the requirements of contract in Islamic law, besides the legality of the buyer and seller, price and product terms. The Board of Directors becomes the agent to the shareholders in making decisions on their behalf. Ulama such as Shaikh Mahmud Sjaltut, Shaikh Ali Kahfif, Shaikh Muhammad Abu Zahrah, and Dr Muhammada Yusuf Musa are of the opinion that the act of purchasing shares is mubah or allowed according to the Islamic muamalat law.

Opinion differs, however regarding holding shares in companies where the majority of shareholders are non-Muslims. The essence of the non-permissibility is because of the tendency of these companies to deal in haram activities. Some scholars have the opinion that it is haram to hold shares under such conditions. Others consider it as makruh. This is based on the narration of Ibnu Abbas in his discussion with Ibnu Hamzah. Ibnu Abbas was quoted as saying: ― Don’t you perform collaboration with Yahudi, Nasrani and Majusi. Ibnu Hamzah responded by asking why it is the case. Ibnu Abbas replied that it is because non-Muslims are involved in riba’ and riba’ is not allowed. Imam Shafi’, taking this saying as a foundation does not permit the holding of shares in a non-Muslim majority company. However, Imam Ahmad, Awzai’ and Hasan al-Basri considered it as mubah or allowed. Imam Ibn Quddamah is of the opinion that the narration of Ibnu Abbas was only an opinion of the Prophet’s (Pbuh) companion and that the opinion was not shared by the other companions. To eliminate the doubt of purchasing shares in a non-Muslim majority shareholding company, a Niyyah or intention when buying is to consider that the dealing is based on the portion of halal income of the majority of non-Muslim shareholding. This reflects the true situation of most companies since not all activities of non-Muslim majority shareholding companies are haram. Muslims can hold shares based on the halal portion of income in these companies. This is based on the opinion of the Caliphate of Umar al-Khattab that it is mubah to do so since the Prophet (Pbuh) bought his food and his armour from Jews.

Therefore, it is permissible to hold shares in Shariah-compliant companies regardless of who owns the companies. Since Shariah Advisory Council of Securities Commission has the mechanism to filter the companies‘ involvements in halal or haram activities, Muslim investors are ensured that their investment is in accordance with Shariah.

Brokers are the intermediaries between the buyer and the seller of shares. Their roles are to advise buyers on the value of the shares and to analyze market conditions so that buyers may decide whether to buy or sell their shares. From the Islamic point of view, brokers perform their tasks based on the concept of al-Wakalah bil Ujr (Fee-based agents). It is mubah or allowed to play the role of a broker as long as one is involved in Shariah-compliant shares. Islam states that fees from selling something that is not allowed according to Shariah is also not allowed.

There is also an argument on the mechanism of buying and selling of shares. Short-selling, broadly, is not allowed in Islam since the sellers of shares (usually the brokers) do not own the shares. Short-selling is the mechanism used by brokers to earn profit by borrowing the shares under their portfolio and selling them in the market. The difference between the higher selling prices as compared to the lower buying prices will be pocketed by the brokers. In Muamalat law, goods to be sold must be in the possession of the seller or a contract to be valid. In the case of short-selling, the brokers do not own the shares. This fact should invalidate the practice of short-selling from the Islamic point of view. However, the practice of short-selling is governed closely by the Securities Commission Malaysia. Among the measures taken to ensure that the brokers are not jeopardizing their clients is that they have to have a certain amount of money in their account as collateral for the amount of shares they are short-selling for. That is why the Ulama’ in the Shariah Advisory Council in the Securities Commission Malaysia are of the opinion that regulated short-selling is permitted.

They use the concept of exceptional Ijarah (Hiring concept) based on the concept of Istihsan. Istihsan is one of the 4 additional methodologies of hukm deduction in addition to Al-Quran, As-Sunnah, Qiyas and Ijma’. Istihsan literally means to deem something preferable. In its juristic sense, Istihsan is a method of exercising personal opinion (ra’y) in order to avoid any rigidity and unfairness that might result from literal application of law. Istihsan as a concept is close to “equity” in Western law. However equity in Western law is based on natural law, whereas Istihsan is essentially based on divine law.

4.5 Brief Knowledge of Market Indices Including the Kuala Lumpur Shariah Index (KLSI)

There are broad types of indices ap pl i ed at Bursa Malaysia, reflecting the extensive range of stocks offered in the market. They act as indicators to measure the performance of stocks held by individuals. One objective of fund managers is to manage funds under their authority to outperform the relevant index. Good managers are rated by their ability to outperform the index that their collections of stocks are in. The indices are as follows:

1. Composite Index (top hundred companies listed in Bursa Malaysia): The Kuala Lumpur Composite Index is generally accepted as the local stock market barometer. It was introduced in 1986 after it was found that there was a need for a stock market index which would serve as an accurate indicator of the performance of the Malaysian stock market and the economy. In 1995, the number of component companies was increased to 100 and will be limited to this number although the actual component companies may change from time to time.

2. EMAS (Exchange Main Board All Share) Index:
The Kuala Lumpur Stock Exchange Main Board All Share Index is a capitalisation-weighted index of all companies quoted and listed on the KLSE Main Board. The index was developed with a base value of 100 as of October 16, 1991.
3. Industrial Index:
Index calculated based on performance of companies dealing in industrial businesses.
4. Consumer Products Index:
Based on performance of companies producing consumer products.
5. Industrial Products Index:
Based on performance of companies producing industrial products.
6. Construction Index:
Based on the performance of companies operating in the construction sector.
7. Trading/Services Index:
Based on the performance of companies offering trading services such as shipping and postage.
8. Finance Index:
Based on the performance of companies in the finance sector such as banking and insurance services.
9. Properties Index:
 Index calculated based on the performance of companies operating in property dealing.
10. Mining Index: Based on the performance of companies dealing in mining businesses such as in gold and copper.
11. Plantations Index:
Based on the performance of companies operating in plantations such as in palm oil and rubber.
12. Shariah Index:
The Shariah Index was launched in April 1999. The Shariah Index is a weighted-average index with its components comprising the securities of Main Board companies which have been designated as Shariah-approved Securities by the Shariah Advisory Council (SAC) of the Securities Commission (SC).
13. Technology Index:
The Kuala Lumpur Stock Exchange (KLSE) launched a technology sector and a corresponding technology index on Monday, 15th May 2000. This is to help spread an understanding that technology stocks are not only confined to IT and internet related stocks, but include stocks of companies from a broad range of economic activities which are innovative in the development and use of technology. For example, those from the computer hardware and software, electronics and telecommunication areas which are technologically innovative and currently engaged in or committed to research and development activities.
14. Second Board Index:
Index calculated for newly listed stocks which have the potential for future growth. 15. MESDAQ Market Index (Malaysian Exchange of Securities Dealing & Automated Quotation): It was launched on 6th October 1997 as a separate market mostly for technology-based companies listing.
On 22nd January 2007 Bursa Malaysia Berhad (Bursa Malaysia), in collaboration with FTSE Group (FTSE) the global index provider, launched the FTSE Bursa Malaysia EMAS Shariah Index (FBM Emas Shariah).
The new index ran parallel with KLSI for nine months and KLSI was deactivated on 1 November 2007. Thereafter, FTSE-Bursa Malaysia EMAS Shariah Index became the singular broad Shariah benchmark index for Malaysian Shariah-compliant investments. Add in/updates the total component number of index.
FBM Emas Shariah index design is in line with FTSE internationally accepted index methodology by taking the constituents of the FTSE Bursa Malaysia EMAS Index, which has been free-float weighted and liquidity-screened, and overlays the Securities Commission‘s Shariah Advisory Council‘s (SAC) screening methodology to derive a highly investible and transparent Shariah[1]compliant index. For a share counter to be regarded as halal, The Shariah Advisory Council (SAC) agreed that securities that fall in categories listed below must to be excluded: A. Operations based on riba (interest) involving such financial institutions as commercial and merchant banks and finance companies; B. Operations involve gambling activities; C. Activities involving the manufacturing or sale of haram (forbidden in Shariah‘s point of view) products such as pork, liquor and non-slaughtered meat; and D. Operations in the presence of gharar (uncertainty/ambiguity) elements such as conventional insurance companies. Additional criteria for companies involved in both permitted and non-permitted activities as well as the benchmark of non-permitted activities that are difficult to remove from the operation of the business are in practice. A 5% and 20% are applicable for three different situations. Lengthy explanations have been provided in Chapter 1 of this module.
4.6 Fundamental Analysis for Shares Valuation
Shares analysis is also called security analysis. It is a process of gathering and organizing information to be used to determine the intrinsic or the underlying value of the shares. The underlying value of a share is determined by the future cash flow it will bring calculated from the estimation of future dividend income payable. The dividend income payable is discounted to take into account the inflation in the economy. The amount of risk from investing in that particular share is also taken into account when calculating the intrinsic value of the share. Fundamental analysis is performed using the top-down approach following the steps below:
Step 1: Perform Economic Analysis – by analyzing the condition of the economy in general. Share performance is influenced heavily by the state of the economy. A key economic measure that can be used is the Gross Domestic Product (GDP). When GDP goes up, the economy will further grow which demands for more capital in the market, thus better performance of share value. Other measures to be used to analyse the performance of the economy is the government‘s fiscal policy such as tax and spending policies. Monetary policies also contribute to the expansion and contraction of growth in the economy. Other contributing factors are inflation, consumer spending, foreign trade and the currency exchange. For example, an increase in inflation rate in the economy will suppress the economy due to the increase in prices of goods and services which in turn will adversely affect the price of shares in the market.
Step 2: Perform Industry Analysis – analyzing the outlook of the specific industry and level of competition in the industry. Analysts may look for potential of growth and new opportunities in a particular industry, such as strong market positions, pricing leadership and economies of scale. For example, in 2007, analysts were positive on the performance of plantation and property shares. For that matter, TA securities research head, Kaladher Govindan was reported in Starbiz (Wednesday 25th July 2007) as positive that the TNB stocks were a buy at that time. Growth cycle stages also affect industry performance. It reflects the vitality of the industry or a company over time. Growth cycle stages can be divided into initial stage, rapid expansion stage, mature growth, stability and decline. Shareholders may like to buy shares of an industry that is in the rapid expansion stage, where the future values of shares are likely to increase. On the other hand, shareholders may avoid an industry that is declining for the reason that the share price will reduce due to the downward demand of the industry‘s products. Information on the industry‘s outlook can be referred to in trade publications, stock brokerage publications such as the Edge and so on.
Step 3: Fundamental Analysis – analyzing the financial position of the specific company and charting the historical behaviour of the specific company‘s shares. The value of shares is influenced by the financial performance of the company issuing the share. Analysts will use the financial statements to perform ratio analysis that will reveal the financial performance of the company. This is a time-consuming and demanding phase of share selection and analysis. Financial statements consist of Balance Sheet, Income Statement and Statement of Cash Flows. The first statement lists the company‘s non-current and current assets, as well as the current and long-term liabilities of the company. By having information on the financial standing of the company at a point of time, shareholders may learn about the liquidity or ability of the company to meet short-term and long-term financial obligations. The Balance Sheet, when used with the Income statement, will reveal the information on the Return on Asset as well as other profitability measurement. Information from the Income Statement will provide shareholders with information such as the profitability and efficiency of the business. The Cash Flow Statement, on the other hand, provides information on the cash generated and usage for the year of operation. It is vital to know about the cash position of the company invested in as profit generated usually does not match the amount of cash that is important to pay short-term obligations, as well as to service operation, pay for taxation and dividends to the shareholders.
4.7 Share Valuation Models
The Valuation Process is the process to determine the intrinsic value (IV) of a share on the basis of its forecasted risk and return performance. When various types of share valuation models are used, the end product represents the intrinsic value (justified price, or the underlying worth of a share) we have been seeking. When computed, if the intrinsic value is greater or equal to the market price of share, then the share can be recommended for purchase. There are several stock valuation models being used in the market. The most common method being used is the Dividend Valuation Model. Another alternative that will be discussed is the Price Earnings (PE) Approach.
4.7.1 Dividend Discount Model
This model may be sub-divided into three sub-models based on three different assumptions. The three assumptions are:
(a). Zero growth model
In this version we assume that the stream of dividends is fixed, i.e., assume for no growth of dividends during the investment horizon. To value the share under these assumptions, we are merely computing the capitalized value of its annual dividends. To find the capitalized value, we just divide the annual dividends by the required rate of return. The required rate of return is the return required to compensate an investor for the risk involved plus his risk-free rate of return. In practice, required rate of return of individual investors differ from one another. Applying different rates will give different valuations of shares. This helps to explain why share prices can be transacted at different prices on the same trading day. The formula is as follows:

For instance, if a share gives an annual dividend of 1.50 sen, and assuming you want a 15% return on your investment, you would then value the share as below:

Value of Share = 1.50 sen / 15% = 1.30 sen / 0.15 = RM10.00

(b). Constant Growth Model (Gordon Model)
This is the most standard and most widely recognized version where we assume that the dividend will grow over time at a specified rate or constantly. The assumption of this model realistically resembles the real situation in the market where the dividend payment fluctuates from year to year. Established companies with strong track records pay higher dividends from year to year in order to portray good performance of their operations. The formula for the valuation is as follows:

Where

D1 = annual dividend expected for next year

K = the discount rate or capitalization rate

g = the annual growth rate of dividends (a constant rate) up to infinity

The model is applicable to companies that have established dividend policies, particularly with regard to the payout ratio, and fairly predictable growth rates in earnings and dividends. These are companies with good growth records of narrow range and minimal fluctuation. We can then obtain information like the current dividend, and determine the growth rate of the dividend by going into past growth rate of the share. When we have the growth rate (g), and current dividend, we can work out the next year‘s dividend (D0 = D0 x (1+g)). For example, a share gives a current dividend (D0) of 80 sen per share, the expected growth rate is 9%, and the required rate of return of the investor is 15%. What should be the fair price of this share? Substituting the above information into the equation:

V = Do X (1 + 0.09)/(k – g) = (80 sen X (1.09))/(0.15-0.09) = RM14.50

If an investor wants to earn 15% return on investment, according to this valuation model, he should not pay anything above RM14.50 per share. Note that with this valuation model, the price of share will increase over time so long as the k and g do not change. This is because the cash flow from the investment will increase with time as dividends grow. To see how this happens, we extend the above example into five years, and this is how it will be:

We can see that as far as k and g do not change, the dividend for each year can be computed as in the above table and so can the share price using the same formula above. On the other hand, if future expectations of k and g do change, the future price of the share will also change accordingly. Should this happen, the investor could use the new information to decide whether to continue to hold the stock.

Although the constant growth version is the most widely used model, it still has some shortcomings. It does not allow for changes in expected growth rates of dividend. The rate of dividend growth in the real world is not fixed to a rate, thus it is a simplification to say that the

dividend will be growing by, for example 10% each year. In order to overcome the problem, the variable growth version was introduced. This model is derived in two stages, a value based on future dividend, and the other is the future price of the share. The formula derived is as
follows:

Note: The last part of the formula is the constant growth model formula, which is used to find the
price of the share at the end of the initial variable growth period.
This valuation model is more suitable for companies that are at the initial growth stage, where the growth of the dividend changes in the first 3 to 5 years, and then settle down to a constant growth stage afterwards when the company is at a maturity stage.
For instance, let us consider the following case:

Given an estimated annual rate of growth in dividends, g for year 3 and thereafter is 9% and the rate of return, k is 15% during the initial variable growth period (first three years).

The present value of dividends for the three years will need to be added with the present value of the price of the share at the end of the period. The calculation for that is as follows:
1.4 x (1.09) = 25.43 x 0.658 = 16.73
[0.15 – 0.09] x (1.15)³
The value of the share is the addition of PVIF of dividend for the n period and PVIF of the price of the share at the end of the period.
That is:
2.536 + 16.73 = RM19.26
Therefore, with the required rate of return of 15% and the projected dividends as above, the variable growth model will suggest not to pay anything more than RM19.26 per share.

4.7.2 Price/Earnings (P/E) Approach

The dividend discount model discussed earlier is mathematical and involves number crunching. Price/earnings ratio is an alternative valuation that is widely practiced in the industry. This is a relatively simple method because it is based on the standard P/E formula (P/E = market price of share/EPS), that is, the market price per share divided by the share‘s EPS (Earnings Per Share). By solving this equation, we can obtain the market price of the share.

Given an estimated EPS figure, investors decide on a P/E ratio (the amount of RM an investor is willing to pay for each RM of earnings the share enjoys) they feel is appropriate for the share. The application of an acceptable P/E ratio into the above equation will provide an indication of the acceptable price of the share. The computed price is then used to compare with the market price. If the computed price is higher than the market price, the decision is to buy. If the computed price is lower than the market price, the decision is to sell or to avoid acquiring the shares.

Another way of looking at P/E ratio is that it actually means the payback period of an investment. If a P/E ratio is 10, it suggests that it will take 10 years for the investor to recover the cost of acquisition of the investment. The shortcoming of this approach is that it ignores the time value of money. In addition, the earnings of the company may not be paid out to the shareholders fully as dividend, although one can argue that retained earnings could help to generate higher future earnings and result in higher share prices.

Most quoted shares in the Exchange of Bursa Malaysia have their P/E ratios published together with their prices in the daily newspapers. The P/E ratios here are basically based on the company‘s earnings per share for the last 12 months in relation to the latest price of the share. In practice, an investor buys shares for expected future earnings and not for their past. Thus the forecasted EPS, not historical, should be used in valuation.

We may have concern over the use of P/E ratio. Indeed, a lot of time is spent to arrive at an appropriate P/E ratio. This P/E ratio can be derived directly from the constant growth dividend discount model. By dividing both sides of the constant growth model by expected earnings per share for next year, E1, we get an equation that defines a stock‘s P/E:

In this equation, it is important to note that the P/E ratio is defined as the current price of the stock, P0, relative related to next year‘s expected EPS, or E1. This is a common way of looking at P/E ratio, and in fact is the standard for the P/E stock valuation approach. In this approach we have included the dividends payout ratio (D1/E1) in the numerator of the equation. As both the dividends and earnings are of next year‘s estimates, we are using the expected payout ratio rather than the current dividend payout which is outdated. From the above equation we notice that the share‘s P/E ratio is determined by three main variables (factors):

(i). the investor‘s required rate of return – k;

(ii). the expected rate of growth in dividends (earnings)  g; and

(iii). the expected payout ratio.

The three variables are all important for P/E ratio calculations; however it (P/E ratio) tends to be more sensitive to the expected rate of return (k) and the expected rate of growth in dividends (g). Take for example that the required rate of return is 15%, the expected dividend growth is 9%, and the expected dividend is RM1.10, which is 60% of its earnings. Putting the information into the above equation:

P/E = 0.60 / (0.15 – 0.09) = 10

From the above equation, the P/E is 10. Since the expected EPS is RM1.10, the share price is RM11.00 (10 x RM1.10). Now let us see what happens when the expected growth rate (g) drops to 7%:

P/E = 0.60 = 7.5 (0.15 – 0.07) = 7.5

Therefore, the share price now becomes RM8.25 (7.5 x RM1.10).

On the other hand, if the expected return is to increase by 2% to 17%:

P/E = 0.60 / (0.17 – 0.09) = 7.5

In both the cases, the P/E fell to 7.5 times earnings, and the share price dropped to RM8.25.

We may conclude that, when the growth rate is expected to fall or if the required return goes up (higher perceived risk); the net effect is a lower P/E and therefore a lower share price.

4.8 Islamic Exchange Traded Funds (ETF)
Exchange Traded Funds (ETFs) is an investment in undivided interest in a pool of securities or other assets such as commodities and exchange rates. It is similar to the investment in unit trusts or mutual funds, except that ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker or dealer. Another difference of ETFs and unit trust investment is ETFs do not sell or redeem their individual shares at NAV, instead investors purchase and redeem ETF shares directly from ETF in large blocks of 25,000 to 200,000 shares, called creation units. If there is a strong investor demand for ETF, its respective share price will increase above its NAV per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market.
In the U.S and Malaysia alike, ETF are structured as open-end management companies; the same structure used by mutual funds). With the increased demand for Shariah compliant products, Islamic ETF began to flourish in the market. This is partly due to the increase in price of oil which results in “oil-money” needed to be parked in diversified Shariah compliant products other than shares and sukuk. In i-ETF tracks a benchmark index comprising securities that are Shariah compliant. It is necessary for the management company to appoint a Shariah adviser to monitor the adherence of the management company to the Shariah guidelines.
In Islamic Finance Asia Magazine, issue August-September 2008, Michito Higuchi, president and CEO of Daiwa Asset Management reported that Daiwa FTSE Shariah Japan 100 listed on the Singapore Exchange in May 2008. The asset management company is planning to have its i[1]ETF listed on more Asian countries such as Hong Kong and also London.
In Malaysia, i-VCAP, a subsidiary of a fund management firm and Malaysian government-linked Valuecap, launched the MyETF Dow Jones Islamic Market Malaysia Titans 25 (MyETF-DJIM25) on the Bursa Malaysia. This launching made it the first Shariah compliant ETF on Bursa Malaysia. This ETF uses the Dow Jones Islamic Market Malaysia Titans 25 Index as the underlying benchmark, and covers 25 leading Shariah compliant stocks on Bursa Malaysia. The screening variables remain the same for Islamic ETF as other securities.
It was launched in the 21st January 2008 at the price of RM1 per unit. The performance of the fund for the period of its inception until 30th May 2008 was that its NAV fell 8.3%, while the benchmark Titans Index lost 9.2% to indicate that the fund‘s performance managed to beat the benchmark. In comparison to KLCI, it fell 9.4% and FTSE-Bursa Malaysia Emas Shariah lost 11.9%.
4.9 Share Investment Strategies
As a financial planner, we will need to be able to advise clients on the available strategies when it comes to investing in shares. Two available strategies will be discussed. Earlier in the chapter, readers as future financial planners are provided with the conceptual and practical knowledge on the technical aspects of investing as well as on the valuation of shares which is important in selecting shares to purchase and to give suggestions on which shares to sell based on the valuation. However, clients need to understand the dynamics of their required rate of returns and future expectations for the investment in shares to be rewarding.
4.9.1 Passive Investment Strategy
This strategy is normally used by conservative investors. Their objective is only to place money and watch it grow over time. The strategy is only to buy-and-hold for a long period of time. Investors here will give more attention towards dividends for their return compared to capital gain.
In order to reduce volatility, investors should buy–and-hold a diversified portfolio of shares that are least correlated. Investors must decide the time horizon to hold the portfolio. In choosing a suitable time horizon, investors should consider their objectives, age, financial commitments, level and stability of income and net worth.
4.9.2 Active Investment Strategy
This strategy is normally used by aggressive investors. They seek capital gain in the short time period as their primary source of return. Dividend for them is only an extra return. Investors here will buy shares with prices that are expected to appreciate in the shortest time period. When the prices of the shares appreciate as per expectation, these investors will sell and earn capital gain. However, they have to be aware of market anomalies such as calendar effects and the PE effect because market anomalies are irregularities or deviations from the normal behavior in an efficient market.
4.10 Conclusion
This chapter covered the topic of Investment in the Share Market. Among the themes discussed were: The Pros and Cons of Share Investing, The Structure of Bursa Malaysia, Types of Shares Traded in the Bursa Malaysia, The Development and Issues of Shariah-compliant Share Investing, Brief Knowledge on Market Indices Including the Kuala Lumpur Shariah Index (KLSI), Fundamental Analysis for Share Valuation, Share Valuation Models, Islamic Exchange Traded Funds (ETF) and Share Investment Strategies. The aspects discussed are very important in the area of investment to ensure the Shariah compliance advice on related matters. All Shariah financial planners must advise their clients to invest in Shariah compliant investments.

Self Assessment
Choice Circle the letter of the correct choice for each of the following.
1. What are the common types of securities that are listed in Bursa Malaysia?
i. ordinary share
ii. loan stock
iii. bonds
iv. government securities
A. I & ii
B. i, ii & iii
C. All of the above
D. None of the above
2. Which of the following is NOT a fixed income security?
A. Ordinary shares B. Loan stocks C. Notes D. Sukuk
3. All of the statements below explain the characteristics of an ordinary share, EXCEPT:
A. It entitles holders with the right of ownership.
B. It gives the right to share the profit of the company invested in.
C. It gives the right to vote in the general meeting.
D. It provides fixed income to holders.
4. Buying securities in the Bursa Malaysia involves costs. Such costs may include
i. brokerage commission
ii. clearing fee
iii. stamp duty
iv. registration fee
A. I &ii
B. i, ii, & iii
C. All of the above
D. None of the above
5. The standard trading lot in Bursa Malaysia is _________.
A. 50 units B. 100 units C. 150 units D. 200 units
6. Which of the following does NOT relate to a bonus issue?
A. It is also known as scrip issue.
B. It is a capitalization of either retained profit or an appropriate reserves account.
C. Recipient must pay money for the shares given.
D. It is only given to existing shareholders.
7. The following are true about stock market indices EXCEPT:
A. It is an indicator of a stock market.
B. It is a guide to fund managers.
C. This number of figures can be computed either based on all the stocks listed on a stock exchange or on only a sample of it.
D. It is the total of number of shares traded in a day.
8. The following are the reasons why investors may like to invest in shares EXCEPT:
A. Shares can be liquidated easily in the secondary market.
B. There is opportunity to make money through the appreciation of the prices of shares bought.
C. Shares provide yearly fixed dividend to shareholders.
D. Share ownership can be a hedge against inflation.
9. From which Muamalat principle is the hukm of share ownership deduced?
A. Al-Mudharabah B. Al-Murabahah C. Al-Wakalah D. Al-Musharakah
10. Which Dividend Valuation Model is most likely to be suitable to value the shares of a large mature company?
A. Dividends and Earnings Approach
B. Constant Growth DVM
C. Zero Growth DVM
D. Variable-Growth DVM
Answer: 1-b, 2-a, 3-d, 4-c, 5-b, 6-c, 7-d, 8-c, 9-d,10-b.

CHAPTER 5
IINVESTMENT IN SUKUK AND OTHER FIXED INCOME SECURITIES
Chapter/Topic Outline
5.1 Introduction
5.2 The Types of Sukuk Issued in Malaysia
5.2.1. Ijarah Sukuk
5.2.2. Hybrid Sukuk
5.2.3. Zero Coupon Non-tradable Sukuk
5.2.4. Variable Rate Redeemable Sukuk
5.2.5. Other Types of Sukuk: Salam, Ijarah and Murabahah Certificates
5.2.6. Current Developments in the Issuance of Sukuk in Malaysia
5.3 Basic Characteristics of Bonds
5.3.1. Principal Amount
5.3.2. Sukuk profit-rate or Coupon Payment
5.3.3. Maturity Date
5.3.4. Indenture
5.3.5. Secured or Unsecured Bonds
5.3.6. Call Provision
5.3.7. Conversion of Bonds
5.3.8. Sinking Funds
5.3.9. Claim
5.4 Risks of Sukuk
5.4.1. Risks of Investing in Bonds
5.4.2. Risks When Investing in Sukuk
5.4.3. Returns When Investing in Sukuk and Bonds
5.5 Ratings Agencies for Bonds and Sukuk
5.5.1. The Two Rating Agencies in Malaysia
5.5.2. The Rating Process Adopted by RAM
5.5.3. Ratings Adopted by MARC
5.6 Valuation of Bonds and Sukuk
5.6.1. Interest rate
5.6.2. Rate of inflation
5.6.3. Exchange rate
5.6.4. Liquidity
5.6.5. The fiscal policy
5.6.6. Sukuk Valuation: The Extra Features
5.6.7. Sukuk Index 5.7 Factors Affecting Bonds and Sukuk Prices
5.7.1. Annual compounding method
5.7.2. Semiannual compounding method
5.8 Bond Yield/ Yield-to-maturity
5.8.1. Current Yield
5.8.2. Yield-to-Maturity (YTM)
5.8.3. Yield Curves
5.9 Trading Strategies for Fixed Income Securities
5.9.1. The Simple Strategy
5.9.2. The Passive Strategy
5.9.3. Active Strategy
5.10 Conclusion
Definitions:
Murabahah –
Istisna –
Ijarah bond –
Sukuk – can be classified into two groups, namely asset-based Sukuk (ABSS) and asset-backed Sukuk (ABKS).
Mudarabah or muqaradah – is a profit sharing contract; it is a form of partnership between the capital provider and mudarib who represents the managing trustee, or the entrepreneur who runs the business. In Mudarabah, one party provides capital t to an investment partner/trustee. If the joint venture (mudarabah partnership) makes a profit, it will be shared between the two partners according to a certain ratio agreed upon upfront.
Sukuk Mudarabah –
Sukuk musharakah –
Sukuk salam –
Hybrid Sukuk – Another basis for Sukuk issuance is hybrid Sukuk where the assets can be from a pool of assets from Istisna’, Murabahah and Ijarah contracts. For the Sukuk to be tradable on the secondary market, 51% of the assets in the pool need to be from Ijarah contracts. This is because the settlement of Istisna’ and Murabahah sale will be in the form of future income streams from installment payments from the buyer of the respective assets.
Sukuk istisna –
Ijarah Sukuk = are certificates representing assets that have been leased. These assets may be newly constructed or may even be purchased by the SPC from the company (known as the asset originator or issuer) that requires funds, typically in the form of a sale and lease-back.
Hybrid Sukuk –
Principal amount – is the par value of the Sukuk. The amount must be settled by the issuer at the end of the life of the Sukuk.
Malaysian rating Agency –
The Passive Strategy (of managing investment in bonds) –
The Yield Curve –
The KLIBOR futures market –
Chapter/Topic Objectives
Upon completion of this chapter, you should have knowledge of:
(a) The Types of Sukuk Issued in Malaysia
(b) Basic Characteristics of Bonds
(c) Risks of Sukuk
(d) Ratings Agencies for Bonds and Sukuk
(e) Valuation of Bonds and Sukuk
(f) Factors Affecting Bonds and Sukuk Prices
(g) Bond Yield/Yield-to-maturity
(h) Trading Strategies for Fixed Income Securities
5.1 Introduction
When a corporation requires funds for investment or whatever reasons, it has the option of either raising equity capital or debt capital. The former can be done by reducing dividend payment. The firm may also issue additional shares, limited to the amount of authorized capital. It could also borrow from financial institutions. Raising funds through Sukuk and bonds issuance is yet another option. Raising funds through different sources has advantages and disadvantages.
Fund-raising through reduction in dividend payout has the advantage of minimizing the costs of raising funds. In fact, it is the cheapest or as cost efficient as other instruments. Compared to rights issues, funding through retained earnings could ensure that the earnings per share of the corporation would not be diluted. Another advantage of such a technique of fund raising is that there is no waiting period as the funds are already in the corporation. The funds are kept by the corporation instead of being paid out as dividend. However, this measure has the disadvantage of frustrating some shareholders who rely on dividends as a source of income to meet their living expenses. The frustrated shareholders or those that need the cash flow may resort to selling the shares and thereby reducing the share price to the disadvantage of all the shareholders as a whole. Nonetheless, it could be argued that the prices need not fall as long as the funds are used for good investment and hence, benefit the shareholders in the long run.
Raising funds through bank borrowings usually involves some loan documentation and hence, legal fees and stamp duties on the loan documentation are incurred. In addition, the bank or a loan syndicate may also impose restrictive conditions on the use of the funds and the management of the company. Of course, there is also financing expenses payable on the financing as compared with rights issue and the use of retained earnings. Usage of funds is also not immediate as drawdown notice may be necessary after the completion of financing documentation. In case of business failure, banks, like other creditors have the right to wind up the corporation. An advantage of bank financing is that the financing charge is tax deductible. In addition, the earning per share is not diluted as compared with a rights issue that increases the number of shares.
Raising funds through rights issues will increase the number of shares and therefore, may reduce the earnings per share. During good times, it is usually quite easily done even though the rights issue price could be higher than its par value. However, during bad times or bearish markets, it would be difficult to raise the required amount even when they are priced at par value. The right to subscribe for rights issues could be sold by the owners to the public. Costs of issuance will include commission to the merchant bankers and all the related administrative expenses. However, rights issues would enable a corporation with a small capital base to enlarge the number of shares. Usually, the share prices of corporations with small capital bases are high. Increasing the number of shares through rights issues will help to make prices more affordable to the general public and hence, increase the liquidity of the shares. In addition, the management of the company need not face any restrictive conditions that bankers may impose. The gearing of the company can be improved because of increased shareholders’ funds.
Issuance of Sukuk avoids possible restrictions by bankers. In the Islamic capital market, the comparable financial asset to bonds is Sukuk. It will not increase the number of shares and hence possibly reduce earnings per share. Like raising funds through bank financing, periodical payments to the Sukuk holders (either in the form of rental or profit sharing) are tax deductible.
The basic principle behind Sukuk is that the holder has an undivided ownership interest in a particular asset and is therefore, entitled to the return generated by that asset. The classic Sukuk structure involves an acquisition of a property asset by a Special Purpose Company (SPC) or Special Purpose Vehicle (SPV) established in a tax neutral jurisdiction. The company funds itself by the issue of Sukuk, declaring a trust in favour of the Sukuk holders. In Ijara Sukuk for example, the Sukuk holders receive a return based on the rental income of the asset, taking the credit risk of the underlying lessee.
Sukuk, are securities of equal denomination that represent individual ownership in a portfolio of Shariah compliant assets. They are considered trust certificates that provide stable income like bonds do. The value of Sukuk issued to the Sukuk holders need to match the amount of assets held by the issuers. The pool of assets of which the values are used to price the Sukuk certificates should not solely comprised debts from Islamic financial contracts such as Murabahah and Istisna. Sukuk have no specific rate of return, but are dependent on the returns generated from the employment of assets to which the Sukuk’s values are referred to. Sukuk certificates can be issued based on several Islamic financial instruments. Before issuing Sukuk, proper classification of the asset classes need to be done because this will determine the type of Sukuk certificate to be issued.
As a result of the Securities Commission’s effort to enhance the width of Malaysia’s financial market, the fixed-income securities witnessed several landmark issuances in 2005, including the inaugural World Bank issuance of Ringgit-denominated Islamic bonds, Cagamas issuance of the first Islamic residential mortgage-backed securities and issuance of the first floating rate Ijarah bond.
These initiatives and overall efforts at developing and promoting the Islamic capital market have resulted in its emergence as a significant area of growth in 2005.The SC in 2005 approved 77 Islamic bonds valued at MYR 43.32 billion and representing 71.4% of total new bonds approved and Islamic bonds accounted for MYR 9.7 billion or 27.2% of the total funds raised.
5.2 Types of Sukuk Issued in Malaysia
Sukuk can be classified into two groups, namely asset-based Sukuk (ABSS) and asset-backed Sukuk (ABKS). The latter refers to the Sukuk evidencing a true sale between the originator and the issuing party. Usually an ABKS transaction involves a sale of physical assets such as land and buildings compared with debt obligations such as mortgage receivables commonly seen in conventional asset-backed securities (ABS). One example of ABKS is the Global Sukuk Ijarah issued by the Malaysian government in 2002. A true sale does not appear in asset-based Sukuk, earlier known as Islamic private debt securities (IPDS). The underlying asset varies from debt-receivables to physical assets. One example of ABSS is al-bai-bithaman ajil Islamic debt securities (BAIDS).
5.2.1. Sukuk mudarabah
Mudarabah or muqaradah is a profit sharing contract; it is a form of partnership between the capital provider and mudarib who represents the managing trustee, or the entrepreneur who runs the business. In Mudarabah, one party provides capital t to an investment partner/trustee. If the joint venture (mudarabah partnership) makes a profit, it will be shared between the two partners according to a certain ratio agreed upon upfront. If the mudarabah suffers losses, it will be entirely borne by the capital provider known as rab al[1]mal and the other partner mudarib receives nothing for his work. If there is a breach on the terms and conditions, negligence or misconduct, then the mudarib will be liable. (Lahsasna, 2007).
5.2.2. Sukuk musharakah
According to AAOIFI, musharakah is a form of partnership between two or more parties. Each party contributes to the capital of the partnership to establish a new project or share in an existing one, whereby each of the parties becomes an owner of the capital on a permanent or declining basis and shall have his due share of profits. (AAOIFI, 2010) & (Taqi Usmani, 2005).
5.2.3. Sukuk SALAM
According to AAOIFI Sukuk Salam are certificates of equal value issued for the purpose of mobilizing salam capital so that the goods to be delivered on the basis of salam come to be owned by the certificate holders. (AAOIFI, Shariah Standards, 2010).
5.2.4. Sukuk istisna
According to AAOIFI, istisna is a sale contract between mustasni (ultimate buyer) and sani (seller). The sani r e c e i v e s a n o r d e r f r om t h e mustasni a n d undertakes to d e l i v e r a manufactured item or otherwise acquired masnu’ (subject matter of the contract), according to specifications of the order at an agreed price. The method of settlement can either be in advance, by installments or deferred to a specific future time. It is a condition of the istisna contract that the sani should provide either the raw material or the labour. Istisna is a contract designed for manufacturing and construction business purposes, where any business transactions involving food processing, manufacturing of cars, ships, air- craft, and engines will be within the purview of istisna.
5.1.5 Ijarah Sukuk
Ijarah Sukuk are certificates representing assets that have been leased. These assets may be newly constructed or may even be purchased by the SPC from the company (known as the asset originator or issuer) that requires funds, typically in the form of a sale and lease-back. Therefore, this type of Sukuk may use the usufruct of the asset from the balance- sheet of the issuer. An issuer can issue Ijarah Sukuk if it has stand-alone assets identified in the balance sheet that it wants to be leased. Leased equipment identified in the balance sheet such as ships or aircrafts, are examples of assets that can be the basis for issuance of Ijarah Sukuk. The income stream for Sukuk-holders will be from the lease income generated from the leasing of the equipment. The rate of returns for Ijarah Sukuk can fluctuate around the KLIBOR benchmark due to reflection of the income-generating capacity that KLIBOR provides, i.e. the rate of rental can somewhat fluctuate according to the rate of interest. Another reason for the benchmark is for the returns on Sukuk holdings to be competitive with conventional bonds.
5.1.6 Hybrid Sukuk
Another basis for Sukuk issuance is hybrid Sukuk where the assets can be from a pool of assets from Istisna’, Murabahah and Ijarah contracts. For the Sukuk to be tradable on the secondary market, 51% of the assets in the pool need to be from Ijarah contracts. This is because the settlement of Istisna’ and Murabahah sale will be in the form of future income streams from installment payments from the buyer of the respective assets. Floating the certificates derived from the respective assets will thus result in the sale of debt which is prohibited. This gharar or the uncertainty element that the issuer is not able to guarantee that payments will be made by the buyer of the assets in the future. With the issuance of hybrid Sukuk, the future installments will become part of the assets which the underlying value can be transformed into Sukuk certificates that can be sold to third parties. The rate of return of this type of Sukuk can only be a pre-determined rate since Ijarah and Murabahah receivables are part of hybrid Sukuk. For both types of transactions, profit is determined on the spot, as the rate of profit for both contracts were determined on the spot, i.e. when the sale takes place. The rate of returns, thus, would not depend on benchmarking with other markets such as KLIBOR like for Ijarah Sukuk, but subject to the issuing firms’ balance sheet actualities.
5.1.7 Zero Coupon Non-tradable Sukuk
Istisna Sukuk may be considered as non-tradable Sukuk during the period of manufacture, construction or development. This is because the asset is yet to exist. Istisna is a contract that allows buyers to pay in advance or in phase payment, for the ownership of goods to be delivered at a later date. Allowing for a third party to own the Istisna asset by way of Sukuk issuance is permitted on the basis that the would-be manufactured item is warranted by the seller. This type of Sukuk is called fixed rate zero coupon Sukuk. The holders of Sukuk will gain capital appreciation of the value of Sukuk as the price of manufactured goods will usually be valued more when it is delivered to the buyer as compared to the price paid for it at the point of sale.
5.1.8 Variable Rate Redeemable Sukuk
This type of certificate is issued using Musharakah as the underlying contract. It is usually termed as ‘Musharakah Term Finance Certificate’. This certificate has the quality of redemption. It also has a relatively stable rate of income. The advantage of variable rate redeemable Sukuk is that it has the floating rate of returns that would not depend on benchmarking with market reference such as the KLIBOR. Instead, it has its own unique rate of returns that corresponds to the Musharakah contract rate from which the certificate is based.
5.1.9 Other Types of Sukuk: Salam, Ijarah and Murabahah Certificates
The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) released an expanded list of the basis for the issuance of Sukuk under its issuance of exposure draft on Shariah Standards Concerning Sukuk in November 2002. Table 5.1 demonstrates the basis for Salam, Ijarah and Murabahah Sukuk issuance as per the guideline.
Table 5.1: Basis for Salam, Ijarah and Murabahah Sukuk issuance based on the Guidelines of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).

5.1.6 Developments in the Issuance of Sukuk in Malaysia
Malaysia, has the most active Sukuk issuance in the world. This fact is due to the role played by Malaysia Global Sukuk. The sole purpose of Malaysia Global Sukuk is to become the Special Purpose Vehicle (SPV) for the purpose of participating in Sukuk issuance transactions. The government of Malaysia had been issuing Sukuk as early as 2002, when on 3rd July, the government issued Ijarah certificates worth USD 600 million. Each of the trust certificate represented an undivided beneficial ownership of the trust assets of a land parcel. The proceeds from the issuance were used to develop the land parcels. The land parcels’ developments are as follows:
(a). The Selayang Hospital, a government-owned hospital operated by the Ministry of Health, situated in the state of Selangor.
(b). The Tengku Ampuan Rahimah hospital, a government-owned hospital operated by the Ministry of Health situated in Klang, Selangor.
(c). Government living headquarters in Jalan Duta, Kuala Lumpur.
(d). Jalan Duta Government Office Complex that houses the Ministry of International Trade and Inland Revenue Board offices.
Guthrie, a private company operating in plantation and real property also issued two series of Sukuk. Series A had the denominations of USD 500,000 with the due date of December 2004 was issued on the Ijarah basis too. Series B was issued on the same denomination value with the due date of December 2006.
For that issuance of Sukuk, an SPV was created to buy the land parcels from the government. The land was then leased back to the government who paid rental payments to the SPV. The rental payment matches the semi-annual distribution income of the Sukuk holders. The agreement for the issuance was that the government would distribute semi-annual lease payments in reference to LIBOR: 0.95%. The payment exactly matched the distributions to the Sukuk holders. After the expiration date in 2007, the government bought back the properties (land plus the buildings) at face value, effectively protecting the Sukuk issue from any variations in the value of the underlying assets.
The rental returns were guaranteed by the government of Malaysia. The trust certificates are thus equivalent to floating Malaysian sovereign debt instruments. The certificates were issued ‘Baa2’ by Moody’s Investor Services and ‘BBB’ by Standard and Poor’s Rating Services. Applications were made to list the certificates on the Luxembourg Stock Exchange and the Labuan Financial Exchange.
5.2 Basic Characteristics of a Sukuk
5.2.1 Principal Amount
Principal amount is the par value of the Sukuk. The amount must be settled by the issuer at the end of the life of the Sukuk. For example, RM 1000 8% Sukuk holders will be paid RM1000 at the maturity of the bond, whilst receiving dividend returns from the underlying assets of 8% per year, for holding theSukuk. 5.2.2 Sukuk profit-rate or Coupon Payment Sukuk profit rate is often fixed return for the Sukuk holder when there is no trading on the instrument. It will be paid either every six months or once in a year. For RM 1000 8% Sukuk, the profit to be paid is 80 per year. The payment of the coupon can be made annually or semi[1]annually. Sukuk profit rate is set based on cost of funds in London interbank money market i.e. LIBOR. For example, if LIBOR is 3% and risk premium is 2%, then the Sukuk profit rate is 5% (i.e. 3% + 2%).
5.2.3 Maturity Date
The maturity of the bond is the length of the time from the date the bond is issued to the date the bond is redeemed. There are two types of bonds in terms of their maturity date. Single maturity bond is referred to as term bonds. Serial bond, on the other hand has different maturity dates. At each maturity date, a certain portion of the principal value would be repaid.
5.2.4 Indenture
Indenture is a legal contract agreement between the issuer and the Sukuk trustee who represents the holders. The indenture comprises many provisions to protect the Sukukholders. Features of the indenture include2:
(a) Description of the face value, interest rate, maturity date and interest payment schedule.
(b) Description of properties that are pledged as security (if any).
(c) Provisions of redemption, call and sinking fund procedures.
(d) Covenants on management of issuing firm, specifying the limitations on dividend payments and further borrowings and minimum current liquidity. e) Controls on the use of properties that are pledged.
5.2.5 Conversion of Sukuk or Convertible Sukuk
Some issuance companies give options to Sukuk holders to convert their Sukuk into shares under specifies terms. This is similar to the bond conversion into shares.
5.2.6. Sinking Funds
Some Sukuk have sinking fund provisions for the maturity of the Sukuk. Under this method, profits are appropriated annually to a sinking fund (a reserve account) and a correspondent amount is invested in the sinking fund investment. The purpose of this account is to provide funds for the future maturity of the Sukuk
5.3 Risks of Sukuk
Investing in Sukuk can be considered safe but Sukuk holders still have to face some risks. In terms of investing in Sukuk, interest rate risk is not applicable but there is rate of return risk which will be discussed in the next section. Risks associated when investing in conventional bonds are discussed here:
5.3.1 Risks of Investing in Bonds
(a). Interest rate risk Interest rate risk refers to the fluctuations in interest rate. The value of the bond is inversely related to the interest rate. An increase in interest rate will lower the values of the bonds. Conversely, a decrease in interest rate will increase the value of the bond.
(b). Business or Financial Risk Business or financial risk is the risk that the issuer will default on interest and/or principal payment. This risk depends on the quality and financial integrity of the issuer; the stronger the issuer, the lower risk. To judge the risk, investors usually use two approaches: studying the financial statements of the issuer and examining credit ratings.
(c). Liquidity risk Bonds will be difficult to liquidate because most bond trading is done over-the-counter (OTC) and very little trading is done in the secondary market. It is also difficult to liquidate especially during an economic downturn. Therefore, the risk is high.
(d). Inflation Risk Inflation risk refers to the declining power of money due to inflation. The real value of money will decrease when there is inflation. Normally, during mild inflation, the risk of bonds is lower.
(e). Call risk This is the risk that a bond will be called before maturity date; as a result bondholders will end up getting cash out of the deal. Bondholders also have to find alternative investments, usually in a lower yielding issue. Normally bonds are called when the market interest rate decline because during this time bond prices are high.
(f). Maturity risk Maturity risk refers to the risk involved in holding bonds for a long maturity period. Bonds with longer maturity periods have bigger risks than bonds with shorter maturity periods.
5.3.2 Risks When Investing in Sukuk
The rate of return risk is high due to the fact that Sukuk issuers have to maintain the payout received by the companies to the Sukuk holders. For example, the rate of return for fixed rate Ijarah Sukuk is different for the fixed profit receivable whereas for floating rate Ijarah Sukuk, Sukuk holders earn floating rate indexed to the market benchmark. The rate of return risk is higher for the former as compared to the latter due to the fact that the Sukuk issuer has to make sure the fixed rate rent is achieved for the first type of Sukuk. Other than rate of return risk involved when investing in Sukuk, there are other types of risks such as market risk, foreign exchange risk and business risks that have to be assumed as presented in Table 5.5 below:

5.3.3 Returns When Investing in Sukuk and Bonds
Sukuk and bond investors are entitled to two distinct types of cash flows. The first one is the current income is the periodic payment of coupon/interest income over the life of the bond. The second income is capital gains which concerns the recovery of principal (or par value) at the end of the bond’s life. It should be noted that Sukuk are not heavily traded in the secondary market as they are bought by institutional investors that usually hold on to the Sukuk until the maturity date. This indicates that more Sukuk issuance is needed for investors so that they can trade the Sukuk in the secondary market and earn capital gains on them. Typically, conventional bonds use two measures that can be adapted for use with Sukuk as well: Current yield and Yield-to maturity.
(i). Current yield (CY)
Current yield is used to measure a bond’s interest income and it indicates the amount of current income a bond provides relative to its market price. Current yield is important to investors that seek a high level of current income. The formula is: CY = Annual interest/ Current market Price
(ii). Yield-to-maturity (YTM)
YTM is the fully compounded rate of return earned by an investor over the life of a bond, including interest income and price appreciation. YTM is used to assess the attractiveness of alternative investment vehicles. Usually the higher the promised yield of an issue, the more attractive it is. The formula is:

5.4 Rating Agencies for Bonds and Sukuk
5.4.1 The Two Rating Agencies in Malaysia
In Malaysia, there are two rating agencies, namely Rating Agency Malaysia Berhad and Malaysia Rating Corporation Berhad. Corporate debt/bonds rating specifically assess the likelihood of timely repayment of principal and payment of interest over the term of the bond.
Rating Agency Malaysia Berhad (RAM) was set up in November 1990 with a paid-up capital of RM10 million. This marked a breakthrough in the development and growth of the Malaysian capital market. In 1992, rating of creditworthiness of Malaysian corporate enabled bonds was made compulsory. This has enabled the rapid growth of the credit rating industry as investors’ demand for credit ratings at that time was low. In ensuring greater transparency and cultivating market confidence, it accelerated the development of the domestic corporate bonds as an attractive alternative source of funding compared to banking and equity funding. All the while in the Malaysian capital market, corporate bonds or private debt securities lagged behind the other two pillars, namely the equity and banking sectors.
RAM was incorporated as a public limited company with 51 shareholders including two foreign institutions, with none holding more than 4.9% stake. This structure ensured the independence and credibility of the operation. The services provided by RAM include rating of corporate bonds, financial institution and “claim paying ability ratings” for evaluating insurance institutions’ financial strength.
RAM consists of five departments: rating, business development and information services, economics and market research, corporate communications and training, electronic data processing, and accounts and administration. On the other hand, Malaysia Rating Corporation Berhad (MARC) was incorporated in October 1995 with a paid-up capital of RM10 million. The shareholders consist of major life insurance companies, major general insurance companies, stockbrokers, and discount houses. In order to ensure independence and impartiality in its business operation, no one shareholder is allowed to hold more than 4.9% of its equity. MARC is committed to the development of the capital market by providing quality rating and comprehensive research services. MARC’s services include the rating of:
(i) Private debt securities;
(ii) Islamic capital market instruments;
(iii) Asset-backed securities;
(iv) Corporations;
(v) Issuers;
(vi) Financial institutions; and
(vii) Insurance companies’ claim-paying ability.
Ratings help to complement the disclosure system of corporations and enhance the transparency of the capital market. This enables investors to make informed decisions backed by reliable and dependable qualitative and quantitative information.
MARC undertakes intensive research into issues and issuing institutions to provide investors with standardized indications on the ability and reliability of principal and interest repayment. All ratings are reviewed periodically to provide the latest updated rating information possible to investors. Ratings provide investors with dependable and comparable credit risk information, exposing them to a wider variety of market segments.
On the other hand, ratings provide issuers access to a wider pool of investors, both locally and globally. This is very important in a developing economy like Malaysia, as it increases the financing options and provides reduced financing cost, especially for high-rated issuers. Ratings and rating reviews help alleviate investors’ concerns and maintain investors’ confidence by providing current and comprehensive information.
5.4.2 The Rating Process Adopted by RAM
The rating process starts with the corporate issuer approaching the rating agency for a rating formally. Normally this takes place after the issuer has authorized a bank to manage and advice on the issue of bonds. At this stage, the issuer has to provide a list of information to the rating agency. Such information includes the company history, supporting historical and projected financial statements, and business and industry information relating to the issuer’s core operations.
A team of analysts will visit the issuer and have discussions with the key management officials. The meeting is to provide an understanding of the management philosophy and its plans for the future. After having a series of discussions, the team will come up with a report and present it for an initial evaluation by the management comprising all managers and analysts at the agency. This will then be presented to the external rating committee who will decide on the finalrating.
Rating methodology adopted by RAM is a consistent analytical framework which covers the industry, business risks, financial risks, and management evaluation of issue. The industry analysis covers the industry’s exposure to economic cycles, threat of substitutes, threat of competition, barriers of entry and the industry’s growth prospects. Other factors include regulatory trends, international trends, and monetary policies are also included in the analysis.
5.4.3 Ratings Adopted by MARC
(a) Long-term investment grade ratings This investment-grade rating is designated to high-grade investment bonds, denoting extremely strong capacity to pay principal and interest, in the case of conventional bonds.

(b) Long-term non-investment grade ratings Non-investment grade rating represents those securities generally lacking desirable characteristics of investment bonds. To indicate the inferiority of the ratings, symbols that consist of B, C and D is associated with these long-term non-investment grade bonds.

(c) Short-term investment grade ratings MARC’s short-term ratings are assigned to specific debt instruments with original maturity of one year or less.

(d) Short-term non-investment grade ratings

5.5 Factors Affecting Bonds Prices
Factors that will affect bond prices include interest rate, inflation rate, exchange rate, and liquidity in the market.
5.5.1 Interest rate
Market interest rates do affect bond prices inversely; that is, when market interest rates go up, the bond price tends to fall, and vice versa. Market interest rates refer to the interest rates offered by the users/borrowers of funds (the bonds or securities issuers) to the providers of funds (investors) in an economy. Examples of users of funds are government, banks, and corporations with cash deficits. These users of funds/borrowers (the bonds and securities issuers) compete to attract individual investors or corporations with surplus cash by offering/paying interest as return. The instruments they used may differ. For instance, the government issue bonds whereas banks could offer savings instruments such as fixed deposits. The rates offered need not be identical but have to be competitive and risk-adjusted according to the types of securities and its risk.
In the case of interest on bonds, the rate offered is known as the coupon rate and this is fixed at the time of issuance, for the entire duration till maturity. In other words, if a bond is issued at coupon rate of 8% for 10 years, the return to the bondholders who purchase the bond at par value will be 8% every year if he holds it until maturity. On the other hand, interest rates offered by commercial banks can vary over a period of time. This is evident in 1998 when market interest rates were around 11% p.a. Imagine if you were the holder of a bond with a coupon rate of 8%p.a. and were among the first to hear that interest rate would increase to around 10% in the near future. What would you do? The logical move would be to sell the bonds in the secondary market (if one existed) to realize the money to place in fixed deposits that offered a higher yield.
The continuous selling actions by bondholders will force the bond prices lower. When this happens, the bond prices will fall until such prices where it is no longer attractive for holders to sell them anymore. The reduction in bond prices in turn increases their yields to maturity.
On the other hand, if market interest rates fall lower than the coupon rates, depositors of banks who are knowledgeable will liquidate their fixed deposits and use the proceeds to purchase bonds since the yield of bond is higher. The extra demand for bonds will push up their prices and in turn reduce their yields to maturity. The conclusion is that the market interest rates and bond prices move in opposite directions.
For Sukuk, their prices do not depend on the fluctuating rate of interest due to the fact that the rate of profit applicable to them is fixed. This poses greater risks to the Sukuk holders to sustain during the period of falling rate of interest. However, as stated, it is a trend for Sukuk holders to sell their certificates of Sukuk in the secondary market to enjoy the capital gain from holding them.
5.5.2 Rate of inflation
There is an argument that if the rate of inflation increases, the nominal or the market interest rate will increase accordingly to attract people with surplus cash to part with their money for future values (that is to put the money into savings). On the other hand, imagine a situation where the rate of inflation is higher than the market interest rate. Do you think you would still want to place your money with the bank or save in bonds (i.e. holding monetary assets)? When the market interest rates are lower than the inflation rate, you would rather withdraw your money to accumulate non-monetary assets like buying properties and goods. Under such situations there is no incentive to save, so demand for bonds will fall, and so will the price of bonds. This fall in demand for bonds and bond prices is due to the high inflation rate.
5.5.3 Exchange rate
Exchange rate affected the bond price movement in Malaysia before the foreign currency exchange control was introduced. This is due to the market forces of demand and supply. The greater the demand for Malaysian bonds, the higher the price of bonds will be. Similarly, when there are many keen sellers, the prices of bonds will fall. For instance, before the currency and capital control was introduced in Malaysia, if a foreign investor foresaw that the Ringgit Malaysia was appreciating against the U.S. Dollar, he would buy into Malaysian bonds. This move tends to push up Malaysian bond prices.
For the same reason, any investment vehicle in Malaysia is worth buying, so long as the returns are expected to be higher than what the existing fund could earn elsewhere. On the other hand, if the ringgit is seen to be falling, foreign investors holding any bonds or investment in Malaysia are likely to liquidate their investments before the exchange rate moves against them.
5.5.4 Liquidity
Liquidity is another important determinant of bond prices. Liquidity here refers to the money market liquidity or supply of funds in the money market. A liquid money market (funds can be raised easily) implies lower market interest rate. Accordingly, the coupon rates will be fixed at a lower rate when a bond is first issued. As a result, bond prices are also high. Subsequently, when market liquidity is tight (less supply of fund), interest rates will rise causing bond prices to fall in the secondary market.
On the other hand, in an illiquid capital market, where fund is more difficult to raise, the coupon rate will tend to be high at the time of issuance. Subsequent fall in interest rate will push up the prices of bonds in the secondary market.
5.5.5 The fiscal policy
A reduction in income tax rate will increase the disposable income of the individuals. Higher disposable income could lead to higher level of savings and consequently, a more liquid money market. Greater liquidity in the money market leads to lower interest rates and vice versa.
5.5.6 Sukuk Valuation: The Extra Features
The principles of risk and returns apply to all instruments. Hence, the use of discount rates is still applicable. The discount rate is DF= 1/ 1+I, i being the profit rate. This is so because it is a tool that allows Sukuk-holders to calculate the opportunity cost over time. However, as opposed to conventional finance, the nature of the discount rate that is used to discount future cash flows needs to be different. Diagram 5.1 illustrates the differences between the discounting rates used in conventional finance in comparison to Islamic finance.
Thus, an Islamic or Shariah-compliant Discount rate is a percentage of real return that is gained on an alternative investment with the same level of risk.

Diagram 5.6: Differences between Discount Rates of Conventional and Islamic Finance.

5.5.7 Sukuk Index
A number of Sukuk indices list Sukuk from countries, regions or global issuances. Both the Sukuk and conventional bond markets are active and growing in the Middle East. The establishment of these indices has been designed to overcome an apparent lack of credible measures of the performance of these asset classes. It is hoped that these new measures will provide investors with analytical tools to gauge and track the performance of the Sukuk and the Middle Eastern bond markets.
The three main categories consist of 28 smaller indices. This is in order to allow investors to track various sub-sectors within the larger indices, thus providing more transparency to the market. The reason for splitting the indices into Shariah-compliant bonds and conventional ones was down to the differences between the two investment classes. The different characteristics of conventional bonds and Sukuk warrant a distinct set of indices.
The Sukuk index is aimed at being a credible source of information for investors with regards to Sukuk as an important asset class. The index analytics provide the investors with real measures on the Sukuk and hence, assist in investment and trading decisions. The indices include over 100 issues from the Middle East, with data going back to 31st December 2004. In order for a Sukuk to be included in the index it has to be considered Shariah-compliant by at least one Middle East-based Shariah scholar, and have a minimum issue size of $100 million. The Sukuk index publishes figures for total return, duration, yield, spread, life, clean price, liquidity adjusted market capitalisation, and total market capitalization. These figures are published on a daily basis to track the performance of the various Sukuk that make up the index (See Table 5.8). Within the larger Sukuk index, the smaller indices that make it up are sovereign, corporate, financial services, HSBC Amanah, DIFX listed, GCC, GCC corporates, GCC financial services, and the UAE. As with the larger indices, these can be tracked against the same measures on a day-to- day basis.
The total market capitalization mentioned in the indices multiplies the share price by the number of shares available to give a measurement of economic size. The Sukuk index is based on the gross prices of all the constituent bonds. Overall, the figures for Sukuk listed on this index showed positive signs for the industry. Since the start of the indices there has been a general pattern of growth. This is good news for the Sukuk industry and shows that it is being viewed as a serious asset class.
5.6 The Valuation of Sukuk
Bond prices are driven by market yield (expected return by the market). In the market place, the appropriate yield is determined first, before that yield is used to calculate the price of the bond.
An investor in bonds receives two types of cash flows. They are periodic coupon income and the par value of the bond upon maturity. In valuing a bond, we are dealing with annuity of coupon payments plus the single cash flow of principal repayment or the par value. Having known these cash flows, together with the required rate of return (yield) on the investment, and the length of time from time of valuation to maturity date, we can then work out the bond price by substituting these figures into a present value bond valuation model.
We will demonstrate the bond valuation in two ways, the annual and semi-annual compounding methods.
5.6.1 Annual compounding method used in bond calculation for coupon payment
In the annual compounding method, we assume that the payment of coupon interest is made once a year at year-end, and on maturity, the par value together with the coupon income for that period will be paid together. The present value bond valuation model is:

To illustrate, we will use an example of a bond with a coupon rate of 9.5% which has 20 years to maturity and the required rate of return is 10%. From this we know that the annual coupon income is RM95, maturity is 20 years, and the bond should be priced to give a yield of 10%. Now putting all these into the model above:
Bond price = ( I x PVIFA ) + ( PV x PVIF )
= ( RM95 x 8.514 ) + ( RM1000 x 0.149)
= RM808.43 + RM149
= RM957.4
In the above example, if you require a return of at least 10% p.a., the price to be paid for such an investment should not be more than RM957.43.
We can use a financial calculator to compute bond prices. This can be done by first of all matching the variables of bonds with the relevant keys in financial calculator. Our demonstration is, however, given in two models of calculators, namely, the Casio FC100 and HP10B/10BII. These models are chosen not because they are the best, but on the basis that they all more affordable to beginners or students. The matching of variables with relevant keys in financial calculators is as follows:
PV = bond price
FV = par value or maturity value
PMT = coupon interest received every interval 6 months or annually
i% (Casio) or I/YR (HP) = the yield or the required rate of return
n (Casio) or N (HP) = number of payments
We may now proceed with solving the same problem earlier.

The solution given by the financial calculator is – 957.43. There are at least two issues to be addressed here. Firstly, there is a negative sign in front of the answer 957.43. This is interpreted as cash outflow relating to the purchase of the bond. Secondly, the approach using a financial calculator is much faster once students get to know how to make use of it. In terms of accuracy, a financial calculator is definitely more accurate than the other method of using annuity tables.
5.6.2 Semiannual compounding method
In practice, most of the bonds pay coupon interests semiannually. As such, we should also know how to compute bond prices under such circumstances. What is required is to divide the coupon rate in half and make two minor modifications to the present-value factors. The two modifications are, with semiannual compounding, we would be dealing with semiannual return, and with semiannual period of maturity. With the same given example as in annual compounding method, the rate of return or the yield is now 10%/2 = 5% and the period will be 20 x 2 = 40.
Adapting the above model and substituting the information into the model:

By substitution of information given,

Bond price = = (RM95/2 x 17.159) + (RM1000 x 0.142) RM815.10 + 142 = RM957.10

The price of bond in this case is RM957.10, which is slightly less than the price computed by the use of annual compounding method of RM957.43. This clearly shows that the difference is not significant whether using the annual or semiannual method of compounding. The computation using financial calculators are as follows:

The two examples are illustrations of how the prices are determined by market forces based on 10% return. However, there are individual investors whose required rates of return are different from the market requirement. How would you advise your clients on the decisions of buying and selling? The guidelines are as follows:
(a) If the individual’s required rate of return is higher than 10%, he should not buy because the yield of this bond cannot meet his expectation or requirement. Based on a higher required rate of return, the prices of bonds should fall further before buying is done. The individual should carry on with his search for investment instruments that offer higher returns.
(b) However, if there are no other investment vehicles of similar risk that offer 10% return, and the next best offer or proposal offers only 9.5%, the investor may have to revise his required rate of return to adopt a buying decision to earn the return of 10%.
(c) In reality, prices of bonds are published. Therefore we need not have to compute market prices of bonds. What should be done is to compute prices based on an investor’s required rate of return. Different rates of return will provide different indications of price level. The prices computed based on an individual’s requirements are used to compare with market prices. Buying decisions are recommended as long as the computed prices are higher than the market prices. On the other hand, a selling decision is recommended if the computed prices are lower than the market prices.
5.7 Bond Yield / Yield-to-maturity
The common yields of bonds are current yield and yield to maturity. 5.7.1 Current Yield Current yield is simply the ratio between the annual interests received divided by the current bond prices. The annual interest received is spelt out as coupon rate and is fixed at the time of issuance. What can change during the term of a bond is the price. The ratio is as follows: Current yield = annual interest / market price of the bond. If the coupon rate is 6%, and the market price is RM1100, the current yield is calculated as follows: Current yield = RM60 / RM1100 = 0.0545 or 5.45% NB. In Malaysia, our MGS are issued with par value of RM100, whereas corporations usually issue their bonds with par value of RM1000.
5.7.2 Yield-to-maturity (YTM)
YTM is the same as internal rate of return. It is the rate of discount that equates the present value of the future cash flows (comprising interest and par value or maturity value) with the current price of the bond. It can be computed based on the same formula as stated in the earlier section on bond valuation. The only difference is that, the earlier examples were used to illustrate the calculation of bond prices, whereas in looking for YTM, the bond prices are based on actual market prices.
We will look at three hypothetical Treasury bonds to be referred to as Bonds A, B, and C as below:
Bond A – matures in a year, at which time the investor will receive RM1000.
Bond B – matures in two years, at which time the investor will receive RM1000.
Bond C – a coupon bond that pays the investor RM50 one year from now, and matures in two years from now, paying the investor RM1000 as par value and RM50 as interest.
The prices of these bonds are currently priced at:
Bond A (zero coupon): RM934.58
Bond B (zero coupon): RM857.34
Bond C (coupon bond): RM946.93
It is simple to determine the yield-to-maturity on the one-year security, Bond A. Since an investment of RM934.58 will pay RM1000 one year later, the yield-to-maturity on this bond is rate y that the issuer would have to pay on a deposit of RM934.58 in order for the account to have a balance of RM1000 after one year. Thus the yield-to-maturity on Bond A is the rate yin the following equation:
Market price = (interest + maturity value) / (1 + y)
RM934.58 = RM1000 / (1+ y) since interest = 0 in this case Solving the above equation:
y = [RM1000 – RM934.58] / RM934.58 = RM65.42 / RM934.58 = 0.07 or 7%
Therefore the yield-to-maturity for Bond A = 7%.
In the case of Bond B, the YTM is found by solving the following equation.
Market price = (interest + maturity value) / (1 + y )².
RM857.34 = RM1000 / ( 1+ y )² since interest = 0 in this case
Solving the above equation:
(1 + y)² = RM1000 / RM857.34
1 + y = 1.08
y = 1.08 –1 = 0.08 or 8% Therefore the yield-to-maturity for Bond B = 8%
For Bond C, YTM is solved by the following formula: Market price = interest + maturity value.
Since interest and maturity values are received at a future date, they have to be discounted as follows:
RM946.93 = RM50 / (1 + y) + [RM50 + RM1000] / (1+y)².
To solve this, we can either use a financial calculator or technique to solve IRR using interpolation. At this point, you should realize that YTM is also the IRR of an investment in bond. Using a financial calculator:

Upon completion of the above inputs, the display will show 7.97498. This can be taken to mean that the YTM is 8%.Having computed the yield of a bond; an investor can compare this with the fixed deposit rate of a bank. We will have to assume that the risk factor is the same; otherwise an appropriate adjustment on risk has to be taken into account before a comparison can be made. Let us take a look at Bond C, which is a Treasury bond and is risk free. We have also worked out that the yield is 8%. If at the same time the bank’s fixed deposit rate is 10% p.a. for a two-year placement, investors should sell the bond and place the money with the bank. On the other hand, if the bank’s fixed deposit rate is at 5% p.a. for the two-year placement, investors are likely to withdraw their money and use the proceeds to buy Bond C.
5.7.3 Yield Curves
A yield curve is a graph that presents the relationship between a bond’s term to maturity and its yield (rate of return) at a given point in time. Yield curves come in many shapes and forms, the most common is the upward-sloping curve, which shows that investor return (yield) increases with longer maturities.

5.8 Trading Strategies for Fixed Income Securities

Trading strategies for Sukuk and bonds can be categorized into three types:

5.8.1 The Simple Strategy

This strategy is quite simple because it believes that the market is driven by interest rates. In fact, the behavior of interest rates is the single most important force in the bond market. When the market interest rates increase, the bond with a higher coupon and shorter maturity period will be valued at a higher price. Therefore, investors should buy a bond with higher coupon and shorter maturity period. When the market interest rates fall; the bond with a lower coupon and longer maturity period will have a higher price. When profit rates fall, the same impact is seen on the Sukuk valuation. Therefore, investors should buy these instruments with lower dividend yield and a longer maturity period.
5.8.2 The Passive Strategy
Those who adopt this strategy believe that financial markets are efficient and interest rates are not predictable. One of the strategies that can be adopted is the Indexing Strategy. The Indexing Strategy is a strategy that involves investing in a bond index fund such as Salomon Brothers Broad Investment Grade (BIG) Index in the United States. A bond index fund is a diversified portfolio of bonds that is designed to track the overall bond market.
5.8.3 Active Strategy
Adopters of this strategy believe that they can earn superior returns by exploiting the inefficiencies in the bond market. One of the approaches for this strategy is based on the assumption that interest rates can be forecast and therefore, bond prices are predictable. There are a few methods to forecast interest rates such as:
(i). Horizon analysis
For this analysis, investors forecast the total return of many bonds and select those that have the highest expected return. In projecting the total returns, he will have to forecast the reinvestment rate at which coupons can be reinvested.
(ii). Riding the yield curve
When the yield curve slopes upwards and is expected to remain stable over time, you are advised to buy long-term bonds and sell short-term bonds. The idea is that as time passes, the maturity of the long-term bonds will shorten and their yield will fall. The fall in yield will produce a capital gain.
(iii). Rate expectation swap
If interest rates are expected to fall, this strategy recommends exchanging short-term bonds for long-term bonds to profit most from the expected price increase. On the other hand, if interest rates are expected to rise, then you would replace long-term bonds with short-term bonds.
5.9 Conclusion
This chapter covered the topic of Investment in Sukuk and Other Fixed Income Securities. Among the theme discussed are: The Types of Sukuk Issued in Malaysia, Basic Characteristics of Bonds, Risks of Sukuk, Ratings Agencies for Bonds and Sukuk, Valuation of Bonds and Sukuk, Factors Affecting Bonds and Sukuk Prices, Bond Yield/ Yield-to-maturity, Trading Strategies for Fixed Income Securities. The aspects discussed are very important in the area of investment to ensure the Shariah compliance advise on related matters.
Self-Assessment
Choice Circle the letter of the correct choice for each of the following.
1. Which of the following statements is NOT TRUE about Murabahah Sukuk?
A. The issuer sells Murabahah commodity.
B. Subscribers are the buyers of the commodity securitized under Murabahah Sukuk.
C. Mobilised funds are the purchase cost of the commodity securitized.
D. Murabahah Sukuk can be traded in the secondary market.
2. The following instruments generally can be traded in the secondary market EXCEPT:
A. Hybrid Sukuk B. Musharakah Sukuk C. Mudharabah Sukuk D. Salam Sukuk
3. Bonds that are common in our Malaysian capital market include
i. Malaysian government securities ii. Agency bonds
iii. Corporate bonds
A. All of the above
B. i & ii
C. i & iii
D. ii & iii
4. Which of the following statements is TRUE with regards to the relationship between inflation rate and the price of bonds?
A. Rate of inflation does not affect the pricing of bonds.
B. The higher the rate of inflation, the higher the price of bonds.
C. The higher the rate of inflation, the lower the price of bonds.
D. The rate of inflation can affect only the zero-coupon bonds.
5. The following are types of secured bonds EXCEPT:
A. Mortgage bonds backed by the real estate of the issuer.
B. Collateral trust bonds backed by securities owned by the issuer and held in trust by a third party. C. Equipment trust certificate backed by pieces of equipment.
D. Debts obligation backed by the promise of the issuer.
6. The bond market may be divided into two. One is known as the primary market where the bonds are first issued by an issuer. The other market is where existing bonds are traded. What is the name of this market?
A. Primary Market One
B. Primary Market Two
C. Secondary market
D. None of the above
7. Which is not a service provided by the Malaysian Rating Agencies?
A. Rating of private debt securities
B. Rating of Islamic Capital market instruments
C. Rating of interest
D. Rating of issuers
8. The Passive Strategy of managing investment in bonds is based on:
A. Exchange short-term bonds with long-term bonds when interest rate is expected to fall.
B. Forecast the total returns of many bonds and select the ones with highest expected return.
C. Buy long-term bonds and sell short-term bonds when the yield curve slopes upwards and is expected to remain stable.
D. Adopt indexing strategy to diversify for the understanding that the interest rate is efficient and cannot be predicted.
9. The Yield Curve is said to be the relationship between:
A. term of maturity and its rate of return
B. the price of bond and maturity
C. the price of bond and the interest rate
D. None of the above
10. In the KLIBOR futures market, one basis point refers to _________.
A. One decimal point B. 0.1% C. 0.01 % D. 1%
Answer: 1-d, 2-d, 3-a, 4-c, 5-d, 6-c, 7-c, 8-d, 9-a,10-c

Chapter 6
ISLAMIC STRUCTURED PRODUCTS AND DERIVAYIVES
Chapter/Topic Outline
6.1 Introduction
6.2 General understanding of Derivatives
6.2.1. Forward Contracts
6.2.2. Future Contracts
6.3 Forwards and Futures vs Bay’ Al-Salam and Bay Al-Istisna’
6.3.1. Forwards vs Bay’ Al-Salam and Bay Al-Istisna’
6.3.2. Futures vs Bay’ Al-Salam and Bay Al-Istisna’
6.4 Options vs Urbun
6.5 Derivative Contracts: Forwards, Futures, Options
6.5.1. Reasons for Buying Futures Contracts
6.5.2. Reasons for Selling Futures Contracts
6.5.3. The Futures Exchange
6.5.4. The Risk Involved in Futures and Options Trading
6.6 The Options
6.6.1. Call and Put Options
6.6.2. Fundamental Value of Calls and Puts
6.7 The Trading Strategies of Futures and Options
6.7.1. KLCI Options
6.7.2. Individual Stock Options
6.7.3. Convertibles and Warrants
6.8 Conclusion

Definitions:
“Derivatives” –
“Forwards” –
“Futures” –
“Options” – In finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option. Options are typically acquired by purchase, as a form of compensation, or as part of a complex financial transaction. It is also referred to the financial activities which involves Speculation and Hedging.
“Wa’ad” – This policy document specifies the Shariah and operational requirements in relation to the application of wa`d arrangement in Islamic financial transactions. Shariah requirements highlight the salient features and essential conditions of a wa`d arrangement. The operational requirements set out the core principles of good governance and oversight, proper product structuring, effective risk management, sound financial disclosure and fair business and market conduct.
“Call and Put Options” – is classified as two types of the Financial options.
“Financial futures“ – It is a promise to deliver a certain quantity of a specified item at a specified date with an agreed price.
“Strike Price” –
“In-The-Money” –

Study/Learning Objectives:
Upon completion of this chapter, you should have knowledge of:
(a) General Understanding of Derivatives
(b) Forwards and Futures vs Bay’ Al Salam and Bay Al Istisna’
(c) Derivative Contracts: Forwards, Futures, Options
(d) Options vs Wa’ad
(e) The Options: Call and Put Options
(f) The Trading Strategies of Futures and Options

6.1 INTRODUCTION
Derivative Exchange of FTSE Bursa Malaysia listed the instruments to manage the exposure to market volatility. A derivative product’s value depends upon and is derived from an underlying instrument, such as commodity prices, interest rates, indices, and share prices.
Securities available on the derivative exchange consist of equity derivatives, commodity derivatives and financial derivatives. Equity derivatives available are FTSE Bursa Malaysia KLCI Futures (FKLI), FTSE Bursa Malaysia KLCI Options (OKLI), and Single Stock Futures (SSFs). For Commodity derivatives, three types of derivatives are listed, namely; Crude Palm Oil Futures (FCPO), USD Crude Palm Oil Futures (FUPO) and Crude Palm Kernel Oil Futures (FPKO). Financial derivatives listed comprise of 3 Month Kuala Lumpur Interbank Offered Rate Futures (FKB3), 3-Year Malaysian Government Securities Futures (FMG3), 5-Year Malaysian Government Securities Futures (FMG5) and 10-Year Malaysian Government Securities Futures (FMGA).
6.2 General understanding of Derivatives
Derivatives are financial instruments whose value is based on the market value of an underlying asset such as stocks, bonds or a commodity. Examples of derivatives are forward, futures and options, swaps and warrants. The nature of Islamic derivatives is such that they do not include excessive risks which can lead to gambling. These Islamic-based instruments will work for true hedgers who seek the cover of price increases in the future. Conventional derivatives can be used to back all kinds of commodities or financial assets, whereas Islamic derivatives mainly consist of derivatives that back commodities such as oil and other precious commodities other than gold, silver. In addition, financial assets also used to be a basis for derivatives, which is used in structured products.
6.2.1 Forward Contracts
A Forward Contract is a cash market transaction where the seller agrees to deliver a specific cash commodity to a buyer at some point in time. Unlike a futures contract (which occurs through a clearing firm), cash forward contracts are privately negotiated and are not standardized. The lack of standardization results in both parties bearing each other’s credit risk, which is not the case with a futures contract. Since the contracts are not traded, there is no marking to market requirements. Given the lack of standardization in these contracts, there is very little scope for a secondary market in forwards.
6.2.2 Futures Contracts
A Futures Contract is a contract to purchase a specific underlying instrument at a specific time in the future, for a specific price. All futures are exchange-traded contracts and they are standardized in terms of delivery date, amount and contract terms. A futures contract on FTSE Bursa Malaysia Derivative Exchange, is to take the FTSE Bursa Malaysia Kuala Lumpur Composite Index (FBM KLCI) as the underlying value. Traders use futures contracts to speculate on the direction of an underlying instrument (including indices). Banks and other financial institutions use them to hedge their portfolios against adverse fluctuations in the price of an underlying exposure. Such hedging is possible because you can short futures contracts, that is, sell the futures contract. 6.2. Forwards and Futures vs Bay’ Al Salam and Bay Al Istisna’ Comparable Islamic instruments that have the quality of forwards and arguably futures are Bay’ Al-Salam and Bay Al-Istisna’.
6.2.1 Forwards vs Bay’ Al Salam and Bay Al Istisna’
Forward contracts are contracts to buy/sell commodities in the future at a price fixed today with the payment to be paid in the future. On the other hand, Salam is a sale of a commodity for an advance full payment of the purchase price for a future delivery. Both have the quality of price increase hedging for the buyers and sellers. Salam is important for both the buyer and seller because they can lock in the price from transaction date although the delivery will take place in the future.
For example, a cocoa farmer expects to harvest in six months’ time and a confectioner who produces chocolate needs to use big amounts of cocoa in six months’ time. They may decide to sell and buy later when they harvest and produce chocolate, respectively.
This will however expose both parties to market risk as the price of cocoa may go up or down. In order to hedge this risk, they may agree to enter into a salam agreement today by fixing the purchase price. This agreement will hedge the market risk of cocoa for both the farmer and confectioner.
The difference between a forward contract and a salam contract in this case is that for forwards, the price is to be paid during delivery while for salam, the price is to be paid immediately. This solves the need of financing for the producer.
Salam may provide risk management of Islamic funds in commodity/shares which may be profitable to Islamic investors/funds should the expectation or the view they hold be right. Suppose an Islamic fund has taken the view that a particular commodity or a basket of selected shares will appreciate in the future. They will purchase the commodity/shares from the broker by making all payments in advance. If the market appreciates as expected, they will receive the pay-off. Otherwise, they will suffer the loss or the fund manager could provide some risk management through wa’ad (a put option).
6.2.2 Futures vs Bay’ Al Salam and Bay Al Istisna’
There are no direct comparable Islamic finance instruments to futures. However, we may argue that futures are allowed in Islamic finance due to the origin of products being similar to forwards that are comparable to Bay’ Al Salam and Bay’ Al Istisna’.
Advantages of derivatives are as follows:
i. Cheaper than holding the underlying commodity and the financial assets it represents.
ii. Better risk allocation.
iii. Reduced information asymmetry. Conventional derivatives are controversial as many scholars such as Usmani, T (1996), Khan, M.A (1988), Mahmoud El-Gamal and Rosly S.A (2005) disapproved of them.
Sherin reported that only 2.7% of total derivatives are used by end-users (hedgers), while the remaining 97.3% are used by dealers. These percentages show that speculators are the ones who dominate the market.
Hedgers are primarily interested in the commodities. They consist of producers, like farmers, mining companies, foresters, and oil drillers. They can also be users, like bankers, paper mills, jewelers, and oil producers. The main difference between these two types of hedgers is: the producers sell the futures contracts, and the users buy them. The primary concern of the hedger is to protect against price increases that will undercut their profits.
Speculators on the hand, trade futures strictly to make money. If someone trades in the futures market, but never uses the commodity itself, then that person is a speculator. Most speculators will buy and sell futures contracts, depending on which way the market happens to be going at the time with any particular commodity. Sometimes, they will sell their futures contracts for more money than they paid for them, and use the profit that they make to off-set the higher price they will have to pay in the cash market. Either way, there aren’t any surprises in added commodity costs because the cash price and the futures price cancel each other out.
Futures are standardized forward contracts in terms of their prices, sizes and maturity. Thus, it can be said that the limitations of forwards are less flexible in nature.
Table 6.1 that follows is a comparison between Forwards and Futures.

Due to better risk management features that Futures bring, the SC‟s SAC is of the opinion that trading in the futures markets is allowed in the following:
a. Crude Palm Oil Futures
b. Crude Palm Kernel Oil Futures
c. Single Stock Futures (when the derived are Shariah-compliant)
d. Index Futures (when the derived are Shariah-compliant)
Imam al-Juwaini agreed that the trading of futures is needed in the operation of business management, thus considering them to be darurah/hajaah to society. Ustaz Ahmad Allam (Islamic Fiqh Academy – Jeddah 1992) stated that Stock Index Futures are allowed when the underlying stocks for Stock Index Futures are halal.
6.3 Options vs ‘Urbun
Bay al Urbun is a sale where the buyer deposits money with the seller as part payment of the price in advance and agrees that if he does not continue with the contract, the seller can forfeit the deposit. If the buyer carries on with the contract, the deposit will be deducted from the total price.
‘Urbun is a down payment paid to the seller to give the buyer the right to settle the remaining payment within a prescribed period. The ‘urbun payment will be forfeited if the remaining payment is not made within the prescribed time. The requisites of a valid ‘urbun are:
 The seller must already own and possess the asset.
 The sale contract is already concluded in the sense that the seller cannot sell the “same asset” to a third party.
 The ownership will only be transferred to the buyer upon full payment of the purchase price.

Example 1:
An owner of shares has sold his shares to ABC at USD10,000. ABC has paid USD1,000 as down payment. ABC is given one week to settle the remaining payment, i.e., USD9,000; otherwise his payment of USD1,000 will be forfeited in favour of the seller.
Without ‘urbun, an investor in stocks/commodity, must pay the full payment or must agree to pay a certain fixed price to the seller/vendor to have an ownership right. Should the market price decrease, the investor’s loss could be excessive. For example, an investor/Islamic fund has
purchased a basket of Shariah-compliant shares at USD1,000,000 in anticipation of market prices increasing. However, the market price of shares decreases to USD900,000. The investor/Islamic fund would have suffered USD100,000 in losses in this scenario.
By using ‘urbun, the Islamic investor/Islamic fund can limit the exposure of the loss. Suppose the Islamic investor/Islamic fund has paid USD20,000 as down payment to purchase these shares at USD1,000,000 within one month, and the market goes down. The loss is then limited to USD20,000. However, if the market goes up, the investor/Islamic fund can „exercise‟ the right to purchase by paying the remaining USD980,000 and may subsequently sell the shares to the market at say USD1,200,000; thus making a profit.
However, ‘urbun can only be practiced as a call option but not a put option. Reverse option is suggested by Al-Amine M.M.A (2000) where a condition is placed in the contract that if the seller fails to fulfill his contractual obligations, he shall pay the buyer premiums.

6.4 Derivative contracts: Forwards, futures, options
6.4.1 Reasons for Buying Futures Contract Hedgers: They buy futures contracts to lock in prices and obtain protection against rising prices.
An example of hedgers includes users of raw materials who want a controlled and steady supply at unchanged costs at acceptable levels. Hedgers are usually users of the commodity and are in a position to accept delivery.
Speculators: They buy futures contracts with the hope that prices will rise further so that they can profit from rising prices. They usually do not want to take delivery and will have to settle their position before delivery date.
6.4.2 Reasons for Selling Futures Contracts
Hedgers: They sell futures contracts to lock in prices and obtain protection against declining prices. An example of hedgers includes producers of commodities with a continual need to sell their products at minimum acceptable prices.
Speculators: They sell futures contracts with the hope that prices will fall so that they can profit from declining prices. They usually do not have any supply of the asset or commodity and will have to settle their positions before the expiry or delivery date.
One must be able to see that hedgers are not interested in taking risks. Their risks are assumed by speculators. For example, hedgers buying futures do not want to see prices increase further, so they have to look for speculators to take the risk. In the process, hedgers assume no risk of price increases but forgo the benefits of further price declines. Speculators selling the futures assume the risk of price increases but will gain from a fall in prices.
Arbitrageurs: People who buy and sell the same assets or commodity futures simultaneously in different markets to take advantage of differences in prices. Obviously, they will sell the assets in a market where prices are higher and buy at another market where prices are lower.
6.4.3 Futures Exchange
A futures exchange is a centralized and organized market place for trading futures. It is made up of members, committees and staff. All futures exchanges have a clearing house to clear and guarantee their transactions. In Malaysia, it is the Bursa Malaysia Derivatives Clearing House
Bhd.
Bursa Malaysia Derivatives Exchange provides the opportunity to trade in the following futures:
(a) Crude Palm Oil Futures
(b) KLCI Futures
(c) KLCI Index Options
(d) 3-Month Kuala Lumpur Interbank Offered Rate Interest Rate Futures
(e) 3-Year Malaysian Government Securities Futures
(f) 5-Year Malaysian Government Securities Futures
(g) 10-Year Malaysian Government Securities Futures
(h) Crude Palm Kernel Oil Futures
Out of the 8 types of derivatives contracts, the SAC allowed for the trade of Crude Palm Oil Futures, KLCI Futures and Crude Palm Kernel Oil Futures only. We will examine how to deal in these futures alternately.
(a) KLCI Futures
The KLCI is a market-weighted index, where higher capitalized stock will have a greater impact on the level of the CI than the lower capitalized stocks. To date the CI has established itself as the benchmark of market performance for the Malaysian equities market and is widely followed in
the financial community. The contract code specified by the Exchange for the KLCI futures contract is “FKLI‟.
Price of Stock Index Futures
The value of stock index futures contracts is calculated by multiplying the product of the future price with a contract multiplier which is specified as Ringgit Malaysia (RM). For the FKLI
contracts, the contract multiplier is RM50. If the market price of June FKLI contract is 702, the contract value would be RM35,100 (702 x RM50).
Contract Month and Expiry Date
All futures contracts have a pre-determined date as to when the contract matures and when to deliver the underlying asset. In the case of FKLI, there will be four contract months available for trading at any point in time. They are defined as the spot month, the next month and the next two
calendar quarterly months. The calendar quarterly months are March, June, September and December.
Settlement
Almost all stock index futures contracts provide for cash settlement instead of physical delivery of the basket of stocks. Delivery of the physical basket of stocks is often a cumbersome method and impractical. Furthermore, cash settlement will suffice as future contracts are often used for hedging purposes.
At the end of trading on the maturity date of a futures contract, all outstanding positions that have not been closed out by an opposite trade will be settled using a final settlement value. For FKLI contracts, the expiration day for the respective contract month falls on the final trading day. The final trading day is defined as the last business day of the month. The final settlement value is calculated by taking the average value of the KLCI for the last half hour of trading on the Bursa Malaysia, ignoring the highest and the lowest values. The cash difference will have to be settled on the final settlement day, which is the business day following the final trading day.
Hedging Applications of Stock Index Futures
Portfolio Managers could use stock index futures to transfer the price risk of portfolio to speculators. The transfer of risk is affected through the process of hedging. In the process, the futures contracts are used to substitute transactions made in the cash market. The hedge position locks in the current value of the cash position. We shall use the example of a short hedge as illustration.
Short hedge. A short hedge protects a stock portfolio from decline in the market price. Portfolio managers could fix the future cash price by selling an index futures contract. For instance, we assume an equity fund manager with investments in Bursa Malaysia has to pay RM4million to
the beneficiaries 6 months from now and this involves liquidating a portion of portfolio. If the prices of shares drop in 6 months time, a larger portion of the portfolio would have to be liquidated. The fund manager could execute a short hedge to lock in prices as follows:
The KLCI is currently at 600. The quote for the 6 month KLCI futures contract is 630. Therefore, the value of the index is 630 x RM50 = RM31,500.
Number of stock index futures contracts required to hedge = RM4,000,000 / 31,500 = 126.98 contracts.
The fund manager will execute a short hedge of 127 stock index fund contracts to lock in the value of the stocks in the portfolio today to meet the cash requirement 6 months later.
– Assuming KLCI futures declines 6 months later by 10%. This will mean that the KLSE CI futures contract is at 567. We can compute as follows:

The short hedge has protected the portfolio from price decline and made a profit of RM50.
– Assuming KLCI futures contracts move up by 10% to 693, we can compute the profit and loss as follows:

In both the examples, the hedges minimized the portfolio risk and thus, provide financial certainty.
(b) CPO Futures
World production of oils and fats amounted to about 100 million metric tons in 1998. Palm oil contributed about 17 % of the total and Malaysia is the leading producer of palm oil. In 1998, about 11million tons of palm oil was traded in the international market and Malaysia contributed
about 7 million tons. This implies that Malaysia had a market share of two-thirds in the world‟s palm oil export market.
The Crude Palm Oil Futures contract was launched in October 1980 and remains the most successful commodity futures ever launched in Malaysia. The main users of the market are plantations, millers, refiners, dealers and brokers.

6.4.4 Risk Involved in Futures and Options Trading
The risk involved in futures and options trading could perhaps be illustrated by the example of Nick Leeson, a 27 year old futures trader stationed in Singapore. Nick started his career in 1989 as a clerk working for Barings Bank. After a few years, it was reported that because of his hard work and good performance, he was given the chance to be transferred to Singapore. His job function was to buy and sell futures contracts in Tokyo and Osaka. Nick was to buy and sell Japanese stock index futures in a relatively safe arbitrage strategy – simultaneous buying and selling the same contract in Tokyo and Osaka to the advantage of price differences.
In January, 1995, Nick had a strong feeling that the prices of Japanese stocks were going to climb, and started the wholesale buying of Japanese stock index futures. His purchase was followed by an earthquake that struck Kobe and the Japanese stocks fell 13%. To cover his loss,
Nick doubled his bet and about one month later, the loss amounted to about US1.2 billion. Barings Bank collapsed as a consequence and Nick was sentenced to serve a 6 ½ year sentence for fraud in Singapore.
This serves to illustrate that these tools, created to assist in risk management of investments, could do just the opposite if they are not used properly.
6.5 The Options
An options contract can be defined as an agreement that gives the buyer the rights, but not the legal obligation, to buy or sell a specified quantity of the underlying product at a specified price within a period of time. However, the seller of options has a contingent liability or obligation to fulfill the contract if the buyer chooses to exercise that right.
The buyer of the options pays a premium to obtain the privilege to complete the deal only if the prices move in his favour. On the other hand, the seller receives the premium and has to oblige when the buyer exercises his option.
An option contract is a legally binding contract between the buyer and the seller. It only ends when the option is exercised or upon expiry of the option.
6.5.1 Calls and Put Options
Options can be classified into calls and puts.
A call option gives the option buyer the right, but not the obligation, to buy a specified quantity of an underlying product at a specified price within a specified period of time.
A put option gives the option buyer the right, but not the obligation, to sell a specified quantity of an underlying product at a specified price within a specified period of time.
They are a unique type of security because they are not issued by the organizations that issue the underlying assets or stocks. Instead, they are created by investors. For example, if a party wants to sell to another the right to buy a certain amount of shares, the party has to issue an
option and he is known as the option-maker or writer.
The process by which the option holder uses the right under the option is known as exercise and the time by which the exercise has to be made is expiry. An option that can be exercised any time during its life is known as American style whereas an option that can be exercised only upon expiry is known as European style.
How Calls and Puts Work
Let us now take a look at how call and put options work. As an investor, you would want to make a profit from these deals. For example, if you have a hunch that the share price of A Company trading at RM5 will go up, you could possibly buy a call option at RM500 instead of buying one lot
of shares at RM5,000. By buying this option, you have obtained the right to buy one lot of A‟s shares at RM5,000 from the option writer and sell it at a higher price before the option expires. If the price goes up to RM7 per share, you would exercise your call option to buy one lot of shares at RM5,000 and sell for RM7,000. This enables you to make a gain of RM1,500
(RM7,000 – RM5,000 – RM500).
However, an alternative is to spend RM5,000 to buy one lot of shares at RM5 per share and sell it later when the price goes up to RM7 per share. In this alternative, you are required to have an initial capital of RM5,000, compared to the capital outlay of RM500 in call options. In terms of return on investment, the options instrument gives a much higher rate of return on capital as follows:
Initial capital = RM500
Gain = RM1,500 (RM7,000 – RM5,000 – RM500)
Return on capital = (RM1,500/ RM500) x 100% = 300%
In the case of outright purchase of shares at RM5000, return on capital can be calculated as follows:
Initial capital = RM5,000
Gain = RM2,000 (RM7,000-RM5,000)
Return on capital = (RM2,000/RM5,000) x 100 = 40%
However, the expectation of price increase may not materialize. If the price of shares falls below RM5, you will not exercise your right, but allow the option to lapse. Your loss is only the premium of RM500 that you have paid.
A put option allows you to sell a certain number of shares of an underlying asset at a specified price. If you expect the share trading at RM5.00 to fall, you should buy a put option. The alternative is to sell the shares, if you have them, at RM5.00 outright.
Assuming the share price actually drops to RM4.00, you could buy the shares at RM4 from the market and sell at RM5, as an exercise of your right, thus making a profit of RM500 [RM5000 – RM4000 – RM500].
On the other hand, if the price of the shares moves up instead, you will not exercise your put option, but allow it to lapse.
In the above example, we have used share options for illustration. Options work in the same way for all other underlying basic instruments such as market indices, foreign exchange rates, and futures contracts.
Covered and Naked options
If a call option writer owns the underlying asset on which he writes a call, the writer is said to have written a covered call. Conversely, if a writer writes a call on assets that he does not own, he is said to have written a naked call.
Strike Price
This is the contract price between the writer and the buyer of the option. The strike price of a call option is the price at which the option holder can buy the shares from the option writer. In the case of a put option, it is the price at which the share can be sold to the writer. Strike price is
usually specified at or near the prevailing market price of the share at the time the option is written.
6.5.2 Rental Value of Calls and Puts
The value of call and put options depends on the ultimate exercised price stated on the option, and the prevailing market price of the underlying share/asset. The value of a call option is determined according to the following simple formula:

Therefore, the fundamental value of a call option is the difference between the market price and the strike price. A call option will have a value whenever the market price of the underlying shares exceeds the strike price specified on the call option. For example, you have entered into a call option with a strike price of RM5 per share, and the current market price is RM6, your call option value is RM1,00; i.e.[(RM6 – RM5) x 100, assuming contract multiplier of RM100].
However, a put option is valued with a different formula as follows:

In this case, a put option has a value as long as the strike price is higher than the market price of the underlying shares.
In-the-money/Out-of-the money
In-the-money denotes that there is a real or intrinsic value on the call or put options. For a call option, as long as the strike price is less than the market price of the underlying securities/shares, the call has some real value and it is termed as in-the-money. In the case of a put, as long as the strike price is greater than the market price of the underlying securities/shares, there is a real value on the put, and it is termed as in-the-money.
Out-of-the-money is the opposite of in-the-money. It refers to a situation where there is no real value in the options. In the case of a call option, it will be where the strike price exceeds the market price. In the case of a put option, it is a situation where the market price exceeds the
strike price.
Prices of Options
There are two elements to the prices of options. The fundamental or the intrinsic value of an option is driven by the current market price of the underlying shares/securities [which we have covered earlier]. The other element of an option’s price is referred to as the time premium, and
this represents the excess value embedded in the option’s price.(Two methods of valuing options are the Binomial Option Pricing Model and the Black-Scholes Option Pricing Model). This is the amount by which the option’s price exceeds the option’s fundamental value. The details are
as follows:

The following table shows the breakdown of option prices into the two elements of fundamental value and time premium.

Where:

Fv = fundamental value, i.e. difference between share price and strike price.
e.g., at strike price of RM6.5, Fv = RM7.1 – RM6.5 = RM0.6
tp = time premium, the excess of option price over the Fv (op-Fv=tp)
e.g., at strike price of RM6.5, option price = RM0.7, and the Fv = RM0.6,
tp = RM0.7-RM0.6=RM0.1.
op = options price.
From the second table, the option prices quoted have now been broken into the two elements of fundamental value and time premium. For example, the option price for March at strike price of RM6.5, is RM0.7 and this is made up of fundamental value of RM0.6 and time premium of RM0.1.
6.6 Trading Strategies for Options
The two most common strategies are speculation and hedging. There are also other more complex strategies in the more complex markets.
Speculation – Buying options is just another way to invest in the shares/underlying securities.
Speculators may find this to be a more cost-effective way to speculate as the capital involved is comparatively lower compared to buying into the shares/underlying securities. Through buying

options, it is possible to generate a much higher rate of return on capital compared to buying into
the shares/underlying securities. The earlier example shows a return of 300% through the
purchase of options as compared to only 40% when direct purchase of shares is made. The point
to learn here is, if you feel that the market price of a particular share is going to move up, one
way of capturing the price appreciation is to buy a call on the share. In contrast, if you feel that the price of the share is about to fall, a put option will also generate profit for you. Therefore, investors buy options rather than shares whenever options are likely to yield a higher return. The principle behind this is to get the biggest return from your investment, and very often this can be done with put and call options because of the added leverage they offer. Furthermore, options also give protection on the downside risk. The most you can lose is the cost of the options which is always less than the cost of the underlying share/securities.
Hedging – Hedging is simply an action carried out to reduce risk. For example, if you intend to buy a share, and want to protect your capital and minimize a loss, you can actually buy a put option at the same time. In this case, if the share price falls, you will be protected by the put
option. If the share price goes up, you can enjoy your capital gain. Your loss will be limited to the price paid for the put option. Suppose you bought a share at RM5.00 per share and pay RM200 for a put with a strike price of RM5.00. Now no matter what happens to the share price over the
life of the put option, your maximum loss is RM200, there is no limit as to your capital gain.
A put option can also be used to safeguard or protect your current position or existing gain. If you have bought some shares some time ago, and now they have appreciated from RM1,000 to RM10,000, a put option which gives you the right to sell at RM10,000 would provide the type of downside protection you need. In other words, you can keep the share to earn dividend with the assurance of being able to sell the share at RM10,000 any time before the expiry of the option.
This is indeed the instrument required for risk management by fund managers. There is no need to sell a large quantity of shares in order to safeguard the interests of the investors. In fact, if the fund managers were to liquidate a large number of shares, the move will invariably force down the share prices.
We shall look at one of the products in the following section.
6.6.1 KLCI Options
This is a stock-index option launched in early December 2000. The underlying securities are the KLCI (Kuala Lumpur Composite Index) and its contract code specified by the Exchange is “OKLI”. A call option contract is denoted by C OKLI whereas a put option contract is indicated by
P OKLI. The KLCI options are European style options. This means that they can only be exercised on their expiry dates. The value of the index option moves according to the direction of composite index. As there are no shares or other financial assets backing these options, settlement is defined in terms of cash.
The cash value of an index-option is equal to 100 times the published market index that underlies the option. For example, if the KLSE CI is at 700, then the cash value of OKLI will be RM100 x 700 = RM70,000. The premium of options is also equal to the published rate times 100.
For example, if the premium is 20, it will cost the buyer RM20 x 100 = RM2000 to acquire the options. If the underlying index moves (whether up or down) in the market, so will the cash value of the option. A put allows the holder to profit from a drop in the market and a call enables a
holder to profit from a market that is going up.
The minimum option price movement of the KLCI option contract, known as the minimum tick, is 0.1 index point. Each tick value is worth RM10.00. The exercise or the strike price for KLCI options is fixed increments of 20 index points, for example 720, 740, 760 for the spot and next month months and 40 index points for the next nearest two quarters. At the start of daily trading, there shall be at least an In-the-Money Exercise Price, an Out-of-the-Money Exercise Price, and an approximate At-the-Money Exercise Price for each contract month of both the Call Options
and Put Options.
6.6.2 Individual Stock Options
The Exchange is looking forward to launching this individual stock options contract in the near future. These individual stock option contracts will be based on stocks listed on the KLSE. The approach will be the American style options with a physical delivery at settlement. American-style
options are options that can be exercised at the strike price any time before or on the date of expiration. European-style options, on the other hand, are options that can only be exercised at the time of expiration.
6.6.3 Convertibles and Warrants
The discussion on options will not be complete without an explanation on convertibles and warrants. In M a l a y s i a , the trading of these two securities in Bursa Malaysia is rather popular amongst the investing public. Another major difference of these two instruments from the
options we discussed earlier is that they are issued by the corporations that own the underlying assets.
Convertibles. A convertible security may be a preferred stock or loan issue that can be converted into ordinary shares at a predetermined ratio and/or at a predetermined price. Based on the definition, one can see that it contains the element of an option. It provides the owner with
a regular source of income (as dividend for preferred stock or interest for loan), and at the same time offers possibility of capital gain. It is because of these two features that they are known as hybrid securities, that is, a hybrid of share and loan stock.
Let us look at AMMB-LB as a local example. This convertible was unique in the sense that 11 units of AMMB-LB plus RM0.15 were required to exchange for one unit of ordinary share in AMMB. In other words, the convertible involved a conversion ratio and a conversion premium.
This convertible loan stock paid interest of 7.5%p.a. on a half-yearly basis. The expiry date was 8th May 2002.
A convertible loan stock may be irredeemable. This means that the loan sum may not be claimed back as capital by the holder like the case of a bond. Holders are forced to convert their holdings of convertibles to ordinary shares. Therefore, issuing convertibles will not increase the gearing of
a company in the long run. In fact, it will increase the capital base and hence, will reduce the leverage of the company upon expiry of the conversion period.
The valuation of convertible stock is more complex than the valuation of bonds. This is because it has an extra unknown variable. In the case of a bond, the valuation may be represented by the formula as follows:

Bond Value

= Int / (1+ r) + Int / (1+r)² + Int / (1+r)³ +….Int / (1+r)²ⁿ + M/(1+r)ⁿ

Where

Int = represents the coupon rate of interest,

r = stands for the required rate of return;

M = stands for the maturity value or the original loan sum,

n = stands for the number of years to maturity.

In bond valuation, coupon rate, n, and value of M are stated in the prospectus. Once we can establish a required rate of return which is represented by r, we would be in a position to compute the bond value. In the case of a convertible, the valuation could follow the same formula. However, the value of M is not known because it depends on the future value or future price of the ordinary share. The future price of a share is tough to ascertain. Hence, you can see that while convertibles offer the prospect of a capital gain apart from the regular interest, its risk is also relatively higher than the ordinary loan stock.
The risk associated with buying convertibles can be divided into two areas. One is the failure of the corporation to pay interests. Another is the loss in value of the share upon expiry date. Each unit of convertible is usually issued at RM1.00 at its inception. In other words, if 10 units of the loan stocks are required to be converted into one unit of ordinary share, the maximum loss represents the acquisition price of the loan stocks less interest received. Conversion premium, if any, is usually not incurred if the price of the ordinary share is worthless.
SAC of SC opined that loan stocks and bonds are Shariah non-compliant securities unless they are issued based on Shariah principles. In addition, irredeemable convertible loan stock (ICULS) is not Shariah-compliant.
Warrants. A warrant is an option to allow the owner the right to purchase a fixed number of ordinary shares at a predetermined price during a specified period of time. How does this differ from the options we discussed earlier? The major difference lies in its transferability. In other words, they can be traded. It is because of this feature of transferability that they are also known as Transferable Subscription Rights (TSR). One can also look at ESOS (Employees‟ Stock Option Scheme) and compare this with warrants or TSR. In the case of ESOS, employees who are entitled to the scheme are given options usually at a consideration of RM1, to buy a certain amount of shares at a specified price within a certain time period. However, the rights to subscribe are not transferable or sold to others.
Warrants are usually issued as sweeteners to attract subscription of loan stocks, preferred shares or rights issues. When they are issued in conjunction with any of these instruments to raise funds, they are issued free of charge but on condition that the shareholders must subscribe
for the underlying instrument. The concept of “detachability of warrants” also arises as a result of issuance of warrants in conjunction with debt, preferred share or ordinary share. Most warrants are said to be detachable in that they can be sold separately from the security to which they were
originally attached. Therefore, an investor who acquired a loan stock with a warrant attached could sell the warrant separately from the loan stock.
Theoretically, the value of a warrant is to be represented by the difference between the market price and the exercised price. If the market value is lower than the exercised price, the value of warrant should be zero. However, the time left till the warrant expiration date provides a chance of improvement in prices and this helps to explain why prices of warrants are positive although market price is lower than the exercised price.
Table 6.3 that follows contains examples of warrants quoted in the Bursa Malaysia.

The few examples above show that all the warrants have positive values despite the fact that the exercised prices are well above the current market prices. In some cases, the price differences are rather significant, and it appears to be rather irrational for investors to hold on to their warrants. It may seem more logical to sell the warrants and use the proceeds to buy the underlying ordinary shares (if these shares are in fact worth holding by virtue of investors keeping their warrants).Another factor that supports the recommendation is the fact that ordinary shares are entitled to dividends but the warrants are not entitled to such benefits.
The loss associated with the trading of warrants is usually confined to the acquisition price of the warrants. The amount paid will not be recoverable if the warrants are not exercised upon maturity. Therefore, investors buying warrants must not adopt a strategy of “buy and hold”.
Financial planners in reviewing the assets of their clients should make it a point to ensure that such investments be classified “ICU” as they in fact require intensive care. Negligence or overlooking could result in total loss.
6.7 Conclusion
This chapter covered the topic of Islamic Structured Products and Derivatives. Among the themes discussed are: General understanding of Derivatives, Forwards and Futures vs Bay’ Al-Salam and Bay Al-Istisna’, Options vs Urbun, Derivative Contracts: Forwards, Futures, Options, The Options, The Trading Strategies of Futures and Options. The aspects discussed are very important in the area of investment to ensure the Shariah compliance advise on related matters.

Self-Assessment
Circle the letter of the correct choice for each of the following.
1. Financial options can be classified into two types. Identify the two types.
A. Call and put options
B. Buy and Sell options
C. Debtor and Creditor options
D. None of the above
2. Which statement is not true about options?
A. Options are created by investors.
B. The person who writes the call is known as option maker.
C. The option writer who sells the option is entitled to receive the price paid for the options.
D. None of the above.
3. Buying share options is not the same as buying shares. What are share options?
A. It is a right to own shares.
B. It is a right to interest.
C. It is a right to invest.
D. None of the above.
4. What do you understand by the term strike price?
A. It is the price paid for the option.
B. It is the price of which the option holder can buy the shares from the option writer.
C. It is the market price of share.
D. None of the above.
5. The term in-the-money is where
A. strike price of call is greater than market price of share.
B. strike price of call is lower than market price of share.
C. premium paid on option is less than market price of share.
D. None of the above.
6. The term out-of-the-money implies that _________
A. strike price of call is greater than market price of share.
B. strike price is lower than market price of a share.
C. premium paid on option is less than market price of share.
D. None of the above.
7. The two main determinants of option prices are ____________
A. market price of underlying securities and time to maturity.
B. the quantum of underlying securities and time to maturity.
C. the market price and the quantum of underlying securities.
D. None of the above.
8. What are the two most common strategies for the use of options?
A. Speculation and long-term investment
B. Accumulation of fund and long-term investment
C. Hedging and long-term investment
D. Speculation and Hedging
9. What do you understand by the term financial futures?
A. It is a promise to deliver a certain quantity of a specified item at a specified date with an agreed price.
B. It is buying and selling shares in the Bursa Malaysia.
C. It is a bond.
D. None of the above.
10. In financial futures trading, there is no actual physical delivery, but cash settlement. What is your opinion of the above statement?
A. Totally wrong
B. True
C. Only true for long-term investment
D. None of the above
Answer: 1-a, 2-d, 3-a, 4-b, 5-b, 6-a, 7-a, 8-d 9-a,10-a

CHAPTER 7
IINVESTMENT IN SHARIAH SHARIAH COMPLIANT – UNIT TRUST
Chapter/Topic Outline
7.1 Introduction
7.2 The Operation of Shariah-compliant Unit Trust Investments
7.2.1. Trust Deed
7.2.2. The Manager
7.2.3. The Trustee
7.2.4. Unit-holders
7.2.5. Open-Ended Versus Closed-Ended Funds
7.3 Advantages and Drawbacks of Investing in Unit Trusts
7.4 The Industry Tracks of Shariah-compliant Unit Trust Funds
7.5 Cost and Charges of Investing in Unit Trust Funds
7.5.1. Initial Service Charge
7.5.2. Ongoing Management Fee
7.5.3. Advisory Fees 7.6 Types of Shariah-compliant Unit Trust Funds
7.6.1. Equity Islamic/ Shariah Funds
7.6.2. Islamic Fixed-Income Funds/ Bond Funds
7.6.3. Islamic Balanced Funds/ Mixed Growth Funds
7.6.4. Islamic Money Market Funds
7.6.5. Property Trust Funds
7.6.6. Selecting a Unit Trust Funds
7.6.7. Capital Guaranteed and Exchange Indexed Shariah-compliant Unit Trust Funds
7.7 Performance Evaluation of Shariah-compliant Unit Trust Funds
7.7.1. Risk Classification
7.7.2. Performance Comparison
7.7.3. Raw Return
7.7.4. Annualised Return
7.7.5. Using Investment Performance Table
7.7.6. Benchmarking
7.7.7. Other Factors
7.7.8. Pricing of Unit Trust
7.7.9. Using the Dollar-Cost Averaging Method
7.8 Conclusion

Definitions:
Shariah Committee and Shariah Advisor –
(c)To prepare a report to be included in the fund’s interim and annual report certifying whether the fund has been managed and administered in accordance with Shariah principles.
Study/Learning Objectives
Upon completion of this chapter, you should have knowledge of:
(a) The Operation of Shariah-compliant Unit Trust Funds
(b) Advantages and Drawbacks of Investing in Unit Trusts
(c) Shariah-compliant unit trust fund Milestones
(d) Cost and Charges of Investing in Unit Trust Funds
(e) Types of Shariah-compliant Unit Trust Funds
(f) Performance Evaluation of Shariah-compliant Unit Trust Funds
Note:
The responsibilities of the Shariah Committee and Shariah Advisor to an Shariah-compliant:
(a) To make sure that the Trust Deed is prepared under Shariah principles.
(b) To consult with the Securities Commission if any ambiguity arises regarding the investment, instrument, system, procedure and/or process of the fund.
(c) To prepare a report to be included in the fund’s interim and annual report certifying whether the fund has been managed and administered in accordance with Shariah principles.

7.1 INTRODUCTION
Presented with an environment where individuals’ savings are growing into a more prominent pool of investible assets, the investment management industry is increasingly becoming a key intermediary in the mediation of retail savings for financing economic activities. To facilitate the
growth of investment management the SC, in 2005, worked to further broaden the range of products and investment opportunities available for Malaysian savers and investors, for example, in real estate investment trusts (REITs) and exchange traded funds (ETFs). Guidelines of Islamic
REITs were released in 2005, making Malaysia the first jurisdiction in the world to issue such guidelines.
When investors choose to invest in unit trusts, they can rely on the management of professional fund managers in terms of portfolio allocation, timing, diversification strategy and so on. The fund is then invested towards a specific goal as declared by the investment objective of the scheme.
It is a type of financial service provided by an organization that receives money from its investors known as the unit-holders and then invests those funds on their behalf in a diversified portfolio of
securities. Unit trusts are collective investment schemes t h a t usually aim to provide above average returns in the form of dividend income and capital growth at reasonable risk for medium to long-term investors. Therefore, unit trusts can be used as a longer-term investment
vehicle most suited for investors who can tolerate volatile short-term fluctuations in prices in pursuit of the long-term potential of capital growth involving riskier equity investment.
In Malaysia, unit trusts are regulated by the Capital Markets and Services Act 2007, through the Securities Commission (Unit Trust Scheme) Regulations 1996, and the Guidelines on Unit Trust Funds issued in 1997. Apart from government regulations, there is a self-regulatory body known
as the Federation of Malaysia Federation of Investment Managers Unit Trust Managers (FIMM) that was formed in 1993. Agents selling unit trusts must be a member of FIMM before they can sell unit trusts to the public.
7.2 The Operation of Shariah-compliant Unit Trust Funds
A unit trust fund is a collective investment scheme (CIS), which pools the savings of investors with similar investment objectives in a special “trust” fund managed by professional fund managers. The fund will then be invested in a diversified portfolio of equities, fixed income securities and other assets in accordance with the fund’s investment objectives and as permitted under SC’s Guidelines on Unit Trust Funds. Shariah-compliant unit trust funds operate in a similar manner to the conventional trust fund operation with exception to the investment activities engaged by the managers managing the funds. Shariah prohibits investments to be made in conventional banking, insurance and financial services business as these industries operate in riba activities. Shariah also prohibits investment in companies with core businesses in gambling, liquor and non-halal food production.
The organization of a unit trust fund is a tripartite relationship between the manager, the trustee and the unit holders governed by a legally binding trust deed registered with the Securities Commission.
The obligations and rights of each of the three parties are specified in the Deed, a legal document drawn up by the manager and registered with the SC. The Deed is designed to govern the operations of the trust fund and protect the unit holders’ interests. The manager is responsible for the management and operations of the trust fund whilst the Trustee holds all
the assets of the fund.
The agreement between the investors and the unit trust management company can be based on two models; Wakalah and/or Mudharabah. In the Wakalah model, the manager will be the agent where the manager accepts the responsibility for the investors’ funds and receives management fees in return for his expertise. In the Mudharabah model, the management company and the investors enter a profit-sharing contract. The management company and the investor will share a certain pre-determined ratio of profit when the funds pay dividends or upon the disposal of the funds by the investors. Only a small number of management companies
operate this profit-sharing model. There may also be a joint Wakalah Mudarabah model where agency fees are deducted when entering the fund and a profit share received if certain thresholds returns are achieved.
The fund management companies provide services to the unit-holders as follows:
a. Recommend on the purchase, sale and portfolio administration of investors’ funds.
b. Promote the sale of units to unit holders.
c. Provide repurchase facilities to buy back units from unit holders.
d. Provide confidence to the unit-holders by the appointment of Shariah advisors/ consultants to ensure all activities in the Shariah-compliant unit trust funds follow Shariah principles.
For Shariah-compliant unit trust funds, the Shariah adviser has the following roles and responsibilities:
(a) To advise on all aspects of unit trust and fund management business in accordance with Shariah principles;
(b) To provide Shariah expertise and guidance in all matters, particularly on the fund’s deed and prospectus, fund structure, investments and other operational matters;
(c) To ensure that the fund is managed and operated in accordance with Shariah principles, relevant SC regulations and/or standards, including resolutions issued by the SC’s Shariah Advisory Council;
(d) To review the fund’s compliance report and investment transaction report to ensure that the fund’s investments are in line with Shariah principles; and
(e) To prepare a report to be included in the fund’s annual and interim reports stating its opinion whether the fund has been operated and managed in accordance with the Shariah principles for the financial period concerned.
Where there is ambiguity or uncertainty as to an investment, instrument, system, procedure and/or process, the Shariah adviser should consult the SC.
A Shariah adviser should:
(a) be INDEPENDENT of the management company;
(b) be registered with the SECURITIES COMMISSION (SC);
(c) (where individuals are appointed) comprise at least three individuals; and/or
(d) (where a corporation is appointed) engage at least one Shariah expert who meets the fit and proper criteria in clauses 6.18 and 6.19.
Clauses 6.08(a) and (b) do not apply to a corporation which is an Islamic bank or a licensed institution approved by Bank Negara Malaysia to carry on an Islamic banking business.
Individuals appointed under clause 6.08(c) and (d) should not hold office as a member of the investment committee of funds managed and administered by the same management company.
7.1.1 Trust Deed
The trust deed is a legally binding agreement between the manager, trustee, and unit- holders.
The agreement usually spells out clearly how the unit trust scheme is to be administered.
The contents usually include:
(a) Valuing and the pricing of units;
(b) Keeping of proper accounts and records;
(c) Collection and distribution of income;
(d) Rights of unit-holders;
(e) Duties and responsibilities of the manager;
(f) Duties and responsibilities of the trustee; and
(g) Protection of unit-holders’ interest
The trust deed also includes sections which specify the need for the managers, trustees and auditors to comply with the principles of Shariah in the management, investment and reporting of the fund.
7.1.2 The Manager
A manager is obliged under the Trust Deed, the Securities Commission (Unit Trust Scheme) Regulations 1996, and Guideline on Unit Trust Fund to administer the scheme/fund in the most efficient and proper manner. The manager has to ensure a high standard of integrity and fair dealing in managing the scheme to the exclusive interest of unit-holders and investors. The manager must exercise due care, skill and diligence as well as effectively manage the resources and comply with the procedures necessary to the best performance of the scheme.
7.1.3 The Trustee
A trustee is appointed by the board of directors of the manager (Management Company) with approval from the Securities Commission. The trustee acts as a custodian for all the assets of the scheme. The trustee, therefore, must act to ensure that the manager adheres strictly to the
provisions of the trust deed, especially with regard to the following:
(a) Creation and cancellation of units;
(b) The exercise of investment of funds;
(c) Collection and distribution of income;
(d) Proper record-keeping of administration;
(e) Proper record-keeping of investments;
(f) Proper record-keeping of unit-holders’ transactions; and
(g) Upholding unit-holders’ interest.
7.1.4 Unit-holders
Unit-holders are investors who hold units (equivalent to shares of a company) in a unit trust scheme. Each unit will rank equally with all other units of the trust. The value of each unit is determined with reference to a formula, normally set out in the trust deed, which is
usually determined by dividing the value of the total assets of the trust by the number of units currently in issue. Unit-holders purchase units by completing an application form, which must be issued together with a prospectus.
7.1.5 Open-Ended Versus Closed-Ended Funds
Most of the unit trust funds in Malaysia are open-ended. In an open-ended fund, the investors buy their units from the manager and sell the units back to the manager if they want to liquidate their investment. These unit trust schemes are the unlisted trust funds. When investors buy units
from an open-ended fund, the fund will be issuing new units to replace the bought units.
Occasionally, the fund may temporarily be closed to new inventors in an attempt to keep fund growth in check. The fund managers’ guarantee the repurchase of all open-ended mutual funds sold to investors should they decide to sell them. Examples of such funds are the Public Mutual and SBB Mutual. The buying and selling of units in open-ended trust funds are
carried out at prices based on the current market value of net asset value (NAV). NAV is calculated by taking the total market value of all the securities in the portfolio, and all other assets held by the fund, less any liabilities and dividing this amount by the number of units
outstanding.
Close-ended unit trust funds, on the other hand, operate with a fixed number of units and do not issue additional new units. These units are like those shares traded in the stock market; they are traded freely in the secondary market. For these close-ended funds, once listed, units are
bought and sold through stocks brokers. The transaction is not the same as that of open-ended funds where the managers carry out the transactions. The price of units will depend on the market forces of demand and supply. Once the fund is listed, the manager’s sole duty is to manage the fund in accordance with the trust deed, which normally has a time limit, after
which time the assets of the fund must be sold and proceeds distributed to the unit-holders as at the date of closure. In most unit trust deeds, allowance is often given for continuance of the fund, subject to unit-holders approval.
Close-ended funds are common in property trusts. In these trusts, all of their investments are in real property. The property market is highly illiquid as compared to other securities like shares and bonds. Listing in the secondary market gives liquidity to these property unit trusts. The units can be traded in the stock market freely. The unit-holders cannot sell back the units to the fund as that of open-ended fund as the fund will not be able to buy back the units due to its investment
in illiquid assets (real Property). Some examples of such property trust funds are the ArabMalaysian First Property Fund and the First Malaysia Property Trust listed with the Exchange of Bursa Malaysia.
Another close-ended fund is Amanah Small Cap Fund (AmanSFB). In this company, most of the assets are investments in securities; the business of the company is to make profit through buying and selling of shares.
7.2 Advantages and Drawbacks of Investing in Unit Trusts
Unit trust funds invest in a diversified portfolio of securities and issue shares in the portfolio to individual investors. Owning unit trusts represent ownership in a managed portfolio of securities.
The unit trust fund concept, therefore, revolves around diversification. Diversification, which reduces the overall risk borne by the investor, is available through ownership of unit trusts. This, coupled with the fact that unit trust funds have professional management which frees the individual investor from managing his own portfolio, makes mutual funds attractive to individuals.
The major advantage of unit trust funds is that they provide diversification and full-time professional management. Investors with modest amounts of capital can invest in mutual funds and receive the advantages of these services. Also, mutual funds may offer several attractive services (like monthly withdrawal plans). They also handle all the paperwork and record-keeping, deal in fractional shares, and automatically reinvest dividends upon the approval from the
investors. Small investors usually have neither time nor the expertise to research and analyze investments on their own. For these investors, unit trusts can be considered an ideal way to start investing.
Foreign investors who want to invest directly in securities in the foreign market will be confronted with the risks not associated with their domestic market. They may face risks such as a lack of understanding of the foreign countries’ laws and regulations. It follows that they may misinterpret the accounting information that was prepared under different sets of accounting rules in the foreign market thus, presenting unexpected risks to the investors. Cost of gathering information is high for these kinds of investors. Therefore, it is probably better for them to invest in
professionally managed funds so that they can rely on the expertise of the fund managers of those foreign unit trust funds.
To maintain a portfolio of investments, an individual needs to keep abreast of market information and market sentiment. In today’s sophisticated financial markets, this means keeping track of a wide range of information from numerous sources. For most individual investors, it is very difficult if not impossible. It is also costly and time consuming.
Through unit trust schemes, an individual investor can also have access to portfolios that might not be possible for an individual due to limited capital for investing. For example, the usual minimum capital needed to invest in bonds is RM 200,000 which is quite high for small investors.
To mitigate this, investors may invest in Islamic bond funds that invest in sukuk to achieve the objective of investing in bonds. Investing in unit trusts helps to transfer most of the stress of investing to those best equipped to handle the job, the fund managers.
However, there are several disadvantages when investing in unit trust funds. Investing in unit trusts involves fees such as load funds, annual fees and trustee fees. For example, the cost of investing in CIMB Islamic Money Market Fund is 0.5% of the NAV of annual fees and 0.08% of
the NAV of Trustee Fee. In terms of performance over the long run, unit trusts, on average, have not done all that well; indeed, only a handful have been able to outperform the market with some degree of regularity. Their performance, in general, has corresponded to the performance of the
market as a whole. Of course, index-based unit trust funds should provide the return of that market covered less unit trust fund-related costs.
7.3 Shariah-compliant unit trust fund Milestones
The industry development of unit trusts can be divided into several phases as follows:
The Formative Years: 1959-1979: The first two decades in the history of the unit trust industry were characterized by slow growth in the sales of units and a lack of public interest in the new investment product. Only five new unit trust management companies were established, with 18 funds introduced over that period. Several parties including the Registrar of Companies, the Public Trustee of Malaysia, Bank Negara Malaysia and the Ministry of Domestic Trade and Consumer Affairs regulated the industry. The 1970s also witnessed the emergence of state government sponsored unit trusts, likely in response to the Federal Government’s call to mobilize domestic household savings.
The Period from 1980 to 1990: This period marks the entry of government participation in the Unit Trust Industry and the formation of a Committee to regulate the unit trust industry, called the Informal Committee for Unit Trust Funds, comprising representatives from the Registrar of
Companies (ROC), the Public Trustee of Malaysia, Bank Negara Malaysia (BNM) and the Capital Issues Committee (CIC).
The 1980s marked a significant development in the history of the industry when Permodalan Nasional Berhad (PNB) launched the Skim Amanah Saham Nasional (ASN) in 1981.Despite only 11 funds being launched during this period, the total units subscribed by the public swelled to an unprecedented level because of the overwhelming response to ASN. The 1980s also witnessed the emergence of unit trust management companies, which were subsidiaries of financial institutions. Their participation facilitated the marketing and distribution of unit trusts through
banks’ branch networks that widened investor reach.
The Period from 1991 to 1996: This period witnessed the fastest growth of the unit trust industry in terms of the number of new management companies established, and funds under management. The centralization of industry regulation, with the establishment of the Securities Commission on 1 March 1993, coupled with the implementation of the Securities Commission
(Unit Trust Scheme) Regulations in 1996 and extensive marketing strategies adopted by the ASN and ASB (Amanah Saham Bumiputera), played key roles in making unit trusts a betterknown form of investment in Malaysian households. Consequently, the total net asset value of funds under management grew more than five-fold from RM11.7 billion as at end 1990 to
RM60.0 billion as at end 1996. The period also saw greater product innovation and deregulation of the industry.
The Period from 1997 to current: Although the pace of growth of unit trust funds has been moderate since the financial crisis of 1997-1998, it has nevertheless maintained its upward trend, in terms of the number of units in circulation and number of unit-holders. As at 29 February 2004,
there were a total of 99.6 billion units in circulation and 10.3 million unit holders. The period also saw Shariah funds continue to gain popularity in terms of the increasing number of funds offered by a host of unit trust providers. New regulations that allowed third party distribution and the licensing of tied-agents involved in the distribution of unit trusts, as well as stock broking companies being permitted to manage unit trusts, provided further impetus to the growth and
development of the industry. More banks joined the foray of unit trust management companies as Institutional Unit Trust Agents (IUTAs).With the opening up of various distribution channels and (liberal) developments on the regulatory front, it is anticipated that the industry will register
marked growth to confirm its importance in the Malaysian Capital Market.
7.4 Cost and Charges of Investing in Unit Trust Funds
It is misleading to only look at investment performance tables when selecting a unit trust investment. These tables usually show gross return before expenses. It is vital that investors have full knowledge of costs and charges involved with an investment in a unit trust product. As all other financial services, unit trusts are delivered to the investor at a cost. These costs may be classified into the following categories:
(a) Initial service charge
(b) Ongoing management fee
(c) Advisory fees
7.4.1 Initial Service Charge
This is the “up-front” charge levied by the manager on the investor to cover the costs of distributing or selling the unit trust. Usually investors will have knowledge of this cost. The average initial service charge on an open-ended unit trust in Malaysia is usually five sen per unit.
In other words, if you invest RM100.00 into a unit trust, RM5.00 is paid to the manager, leaving only RM95.00 to be credited into your account. As a result of this high cost, unit trust is not meant for short-term investment, but for medium to longer-term so that its initial cost is spread over a longer time frame.
In some countries, the initial service charge can be as high as up to 9% of the initial capital amount. On the other hand, in countries like the United States and Australia, many products do not have an initial service charge. With the internet and electronic transaction mechanisms, more
sophisticated investors now have greater choices in selecting their investment targets and tools.
7.4.2 Ongoing Management Fee This is the annual fee paid to the manager for managing the unit trust fund. The fees average around 1.5% per annum in Malaysia to cover the management expenses incurred in managing
the fund. Such costs will include salaries, office rent, stationery and all other related administration costs. The management fee charged might vary between different categories of unit trusts. Theoretically, the cost of running a fixed income unit trust scheme should not be as high as that running a global equity unit trust. The management fees are deducted directly from the investor’s unit trust account thus directly affecting the investment return.
7.4.3 Advisory Fees
This is the fee charged for services rendered for financial planning. This is very common in markets such as the United Kingdom and Australia. In these countries, quite a lot of the sales and distribution of unit trusts is done through the ‘independent financial advisor’ channel. These
are professional individuals or franchisees that specialize in advising investors on where to invest their funds in order to achieve their desired investment outcomes.
The fees charged are based on time or the size of the portfolio of the fund. In some countries, the advisor has become more important and more visible than the fund manager behind the investment fund. In Malaysia, this trend is already setting its pace in our financial market.

7.5 Types of Shariah-compliant Unit Trust Funds
The main objectives of Shariah-compliant unit trust funds are to invest in a portfolio of
Shariah- compliant assets. In other words, this fund will not invest in assets that are involved with
business activities such as conventional banking, insurance and financial services, gambling, and alcoholic goods.
The returns of Shariah-compliant unit trust funds will also not contain elements of riba or interest through the process of cleansing or purification by the removal of such amounts representing the interest element. Such proceeds are usually donated to charities.
Based on the annual reports of the Federation Investment Managers Malaysia (FIMM), Shariah-based unit trust funds can be divided into several types matching the types of funds offered under the conventional principle. FIMM categorises Shariah-compliant unit trust funds into three types of funds:
(1) Equity Islamic/Shariah,
(2) Bond: Islamic/Shariah and
(3) Mixed Asset: Islamic/Shariah Balanced Fund.
The Securities Commission, on the other hand, categorized Shariah-compliant unit trust funds into equity funds, bond funds, fixed income funds, balanced funds, feeder funds, and money market funds.
There are many ways in which unit trusts and other related products can be classified. Due to different investors’ requirements and different regulatory regimes, each country has its own classification method and terminologies. Unit trust funds are usually categorized according to
their investment policies and objectives as stated above. All of these funds can be classified into two types: open-ended funds and close-ended funds.
7.5.1 Equity Islamic/Shariah Funds
This is the most common type of unit trust funds. Under this trust, a major portion of the funds’ assets are held in the form of equities of listed companies. It is to be noted that about 5% or more of the funds need to be in liquid assets to meet selling needs of the unit-holders. This is a more popular type of trust fund in Malaysia as it provides investors with exposure to the Malaysian equity market. When prices in the equity market go up the unit’s price will also go up accordingly and vice versa.
There is a wide range of equity unit trusts available in the market, ranging from funds with higher risk return characteristics to funds with lower risk lower returns. Examples of higher risk higher return characteristics funds are Growth Fund, Aggressive Growth Fund, and Industry Fund. On the other hand, the lower risk equity funds are the Saving Fund and Regular Savings Fund.
Equity trust funds are longer-term investments, with the anticipation that these funds would produce higher returns, but they are also more volatile.
Another type of unit trust is the ‘index fund’. These funds are invested in a range of securities whose performance will closely match that of the Bursa Malaysia indexes (e.g. KLCI). It is possible to achieve this by buying the main component stocks of the underlying index. In this way, this type of fund will normally generate return which closely resembles the performance of the stock market index both in terms of risk and return.
Equity unit trust may take the form of income fund. Such a fund emphasizes on generating periodic income as a priority or a combination of both income and growth. These funds will invest primarily in stocks that earn significant dividend income, as compared to stocks that pay little or
no dividend, but which have a high potential for capital growth.
For Equity Islamic/Shariah, the objective of the fund is to achieve steady capital growth over the medium to long-term period by investing in a portfolio of investments that complies with Shariah Principles.
The investor profile for funds categorised under this objective is for investors with moderate risk-reward temperament that aims for long-term investing. By that virtue, investors investing in this type of funds must tolerate extended periods of market highs and lows in the pursuit of capital growth with the fund. An example of the strategies of funds under this objective applied by the fund managers are as follows:
(a) Maintaining a reasonable level of exposure to equities over time. The equity investment of the fund comprises a diversified portfolio of index-linked companies, blue chip stocks and companies with growth prospects that are listed on the KLSE. In particular, companies with reasonably good earnings growth prospect over the medium to long term are sought after as much as possible to maximize the growth potential of the fund.
(b) Investments in Islamic debt securities such as sovereign debts, corporate debts and money market instruments to help generate returns. Where yields are attractive and interest rate trends are favourable, the investments in debt securities are increased. In general, however, the investments in Islamic debt securities are secondary to the focus
on equities. In other words, the allocations to Islamic debt assets are raised usually at the expense of equity allocations when weaknesses in the equity markets are anticipated. Conversely, when the equity markets are expected to perform well, the funds are reallocated from Islamic debt assets to equities.
(c) Consider attractive investments in unlisted equities, particularly in companies that are expected to seek listing on the KLSE within two years.
(d) Investing in futures and options contracts to hedge against market volatility to mitigate risk.
(e) Investing in markets abroad to increase diversification.
As such, the emphasis on growth stocks in the equity portfolio, in particular, may result in funds under the Islamic/Shariah Equity experiencing significant volatilities in times of adverse movements.

Table 7.3 lists the unit trust equity funds that are Shariah-compliant.

7.5.2 Islamic Fixed-Income Funds
These unit trust funds focus on generating regular income. They are also commonly known as bond funds. The investment activities of the funds will concentrate mainly on government and corporate bonds, government securities, negotiable certificates of deposits, bills, money market, and cash deposits. Sukuk popularity has made it possible for the establishment of Islamic Fixed-Income Funds. The emphasis is less on capital growth. However, it is possible for these funds to generate both capital gains and losses during periods of volatile interest rates.
In general, the volatility and risk element of fixed-income funds is lower compared to that of equity funds. The capital is more secure, especially if the debt securities are held to maturity.
Since the exposure to risk is lower, usually the returns are lower for fixed income unit trust.
However, this is not always true and there have been instances in the history of the Malaysian financial market where fixed income unit trusts produced higher returns as compared to equity trust.
Very often, fixed-income unit trusts are held by investors as part of their overall investment portfolio. This is a useful diversification to insulate an investor’s unit trust portfolio from the risk of
negative returns in any one period. Normally, fixed interest investments have a high negative correlation with equities, which means that when equity markets are down, the returns from fixed interest investments go up. During bullish markets, it is not unusual to find prices of bond funds
continue to rise.
7.5.3 Islamic Balanced Funds/Mixed Growth Funds
Balanced funds’ portfolios tend to consist of both stocks and fixed income securities for the purpose of generating a balanced return of both current income and long-term capital gains.
Another name for this type of fund is managed fund. This category falls between the fixed income fund, and the equity funds. Usually, a balanced fund keeps at least 25% to 50% of its portfolio in the form of bonds. Their bonds principally provide regular income, and stocks are selected
mainly for their long-term growthpotential.
The fund managers may shift the emphasis in their security holdings. For instance, when fund managers feel that the equity market is likely to decline, they would place more funds in bonds than equities. On the other hand, if a bullish market is anticipated, the fund manager would
increase the holdings of equities. Clearly, the more the fund leans towards fixed-income securities, the more income-oriented it will be. However, most of the time, the balanced funds tend to confine their investing activities to high-grade securities, including growth oriented
blue-chip stocks, high quality income shares and high-yielding investment grade bonds.
Therefore, they are usually considered to be a relatively safe form of investment, in which you can earn a competitive rate of returns without having to go through a lot of price volatility.
7.5.4 Islamic Money Market Funds
The development of Malaysian Islamic capital market makes it possible for Islamic-compliant unit trust funds to launch Islamic money market funds which include Islamic money market instruments. The funds provide opportunities to investors who prefer short-term fixed income

investments. Investors can invest in this type of funds so as to ‘park’ their money before moving to other funds earning better returns. Other than that, investors usually invest in this type of fund as a storehouse of the value for their money.
7.5.5 Property Trust Funds
Property Trust Funds provide small investors with opportunities to participate in the property market. This fund invests in real property, such as retail and commercial office properties to which most of small individual investors may not have access. Through these property
investments, returns can be in the form of rental income and capital appreciation over a period of time. However, properties may be affected by the economy just as that experienced by the stock market. The property market does experience the up and down cycles. Due to the nature of
property itself, it is a highly illiquid asset as compared to other types of investments. Most property unit trusts are listed in the stock market.
7.5.6 Selecting a Unit Trust Fund The selection process starts with the assessment of an investor’s risk profile, investment horizon, and investment needs which will set the tone of the investment program. Selecting the right investment means finding the most suitable unit trust fund to meet an investor’s investment needs. Every investor has a different risk profile which has to be determined before selection on
the types of funds. Typically, risk tolerance is inversely related to the age of a person. In other words, generally, younger people can afford higher risks than older people.
The investment needs and objectives would include accumulation of wealth for purchase of a car or a house. They could also be accumulation for a retirement fund and for children’s education needs. There are also investors who invest for a regular source of income. Thus, the selection
process of the unit trust depends very much on the intended use. For example, if the fund is used for accumulation of wealth for education purposes, it may not be appropriate to invest in an aggressive growth fund. On the other hand, if the investor intends to speculate for higher return, then the fixed-income fund may not be appropriate.
After having assessed what he is looking for, an investor is then ready to look at what the funds have to offer.
To understand what each unit trust has to offer, an investor can make a detailed study of the prospectus of each unit trust fund. The factors an investor should pay attention to apart from rate of return are the investment objectives of the fund, load charges and annual expense rates,
summary portfolio analyses, services offered, historical statistics, and review of portfolio performance. It is only through a detailed study and analyses of each unit trust available that an investor can then select the unit trust that best meets his investment objectives.
7.5.7 Capital Guaranteed and Exchange Indexed Shariah-compliant Unit Trust
Funds
The SAC had resolved that the concept and structure of conventional capital protected funds can be applied to a certain extent to Shariah-compliant unit trust funds operation. Instead of the use of capital protected funds, Shariah allows for capital to be guaranteed by a third party. A guarantor fee is payable by the investors for the service to guarantee that the capital is payable at a specified date in the future or to guarantee returns/income to investors during the life of the fund.
The Islamic Exchange Indexed Funds are attractive to investors who would like to diversify their investments by investing in the Kuala Lumpur Shariah Index (KLSI). KLSI comprises all Shariah-approved counters listed on the Main Board of Bursa Malaysia established in 1999.
This followed the innovation of RHB Securities in introducing its RHB Islamic Index as a benchmark for market portfolio in 1996. The first Islamic Shariah Index fund was introduced in 2002, by the name of MBF Shariah Index Fund managed by MBF Unit Trust Management Berhad.
The operation of Islamic real estate investment trusts have also become popular. The Islamic REIT Guidelines were introduced by the SC making Malaysia the first jurisdiction to issue such guidelines. The issuance of the guidelines facilitates the creation of a new asset class for investors who want exposure to real property investments.
7.6 Performance Evaluation of Shariah-compliant Unit Trust Funds
7.6.1 Risk Classification
Every investment has its own associated risks. Similarly, unit trust investments have their own risks. It is therefore important that every investor is aware of these risks before making an investment. In general, the higher the expected return, the higher will be the risks involved. For
example a fixed-income trust fund usually has lower risks compared to an equity growth fund.
Similarly, a growth fund usually has lower risks compared to an aggressive growth fund.
However, at times you may see that fixed-income funds perform better and give a higher return than those higher risk funds like growth funds and aggressive growth funds. This is true especially when the stock market is ‘bearish’ or not performing well.
Trust funds are usually meant for medium to long term investment and it is hoped that the return will commensurate with the risks involved. We must also know that if the investment is a geared investment (investment with borrowed capital) this will also increase the risk. The higher the
leverage, the greater is the risk involved. Generally borrowing money to invest in unit trusts is not a good idea.
7.6.2 Performance Comparison
When comparing the performance of an investment, we must ensure that the same methodology and terminology are applied to the expression of investment performance. In real life, it is difficult due to the many ways in which investment performance is measured and recorded. Take for
example the expression of return and the risk exposure. There are different ways returns can be expressed which may even lead to confusion. The rate of return on investments may be expressed in terms of a single period, annualized, semi-annualized, quarterly, and monthly and so on. Therefore, it is important to understand which form of expression is used when someone quotes an investment return. In order to effectively compare the performance of investments, it is important to standardize the performance measurement expression. The most common forms of expression used in unit trust comparisons are:
(a) Annualized Return
(b) Use of Investment Performance Table
(c) Use of Benchmarks
(d) Other Factors
7.6.3 Raw Return
This is the comparison between the original investment prices (cost) with the investment’s selling price. As its name suggests, it is raw as the time of holding the investment is totally ignored. In other words, the time value of money has been ignored. For example, an investment bought 20
years ago for RM1.00 per unit, and sold today at RM5.00 per unit, the return is expressed at 400%. Similarly, if another investor bought 10 years ago an investment at RM1.00 per unit, and sold today at RM5.00 per unit too, the return on investment is also expressed at 400%. With this
measurement, it makes performance comparison difficult because there is no time dimension added to the measure. Naturally 400% over a period of 10 years is much better than 400% over a 20 year-period. This primitive method of measurement is not recommended.
7.6.4 Annualized Return
This method of measurement takes the time of holding investment into consideration. It expresses the return in percent per year. This is a more familiar term to a layman, as it is commonly used by banks for fixed deposit rates. If we were to express the return in this form of
measure, then we are comparing like with like. Under this category, one also has to differentiate between the annualized rate based on simple interest and compounded interest basis.
Using the previous example, the annualized return based on simple interest approach is 20% per annum. It is obtained by dividing the total gain by the number of years to achieve it (i.e. 400% divided by 20 years = 20% p.a.). However, based on compounded rate of interest, the annualized rate of return is 8.38%. The way to obtain this is by using the following formula:
PV = FV / [1 + r ]ⁿ.
$1 = $5 / [1 + r ]²⁰ and we have to solve for ‘r’ which is not an easy task for most people as it involves the interpolation technique. An alternative is to use a financial calculator dealt with in another module.
To conclude, when comparing returns, one has to be very careful to ensure that the same variables are used.
7.6.5 Using Investment Performance Table
An Investment Performance Table summarizes the performance of the whole industry, as well as the performance of various benchmarks and also individual unit trust managers. The table has been used as a guide for selection of unit trust investment for many investors. Investment performance tables usually disclose the following information:
(a) Performance over various time periods, e.g. one month, one year, three years and five years.
(b) Ranking and quartiles
(c) Funds under management
(d) Use of other benchmarks
Investors, therefore, should look for unit trusts that have consistent performance over a range of time periods. For example, if a fund manager has produced consistently above average performances for the past three, six and twelve months, also for the past three, five and seven years, then their track record may indicate that they are likely to produce the same quality results in the future.
7.6.6 Benchmarking
Benchmarks can be used as a measure in assessing investment performance. It is a useful way to compare the performance of a particular investment to a consistent standard. In the case of an equity based unit trust scheme, it is more appropriate to use the share market index as a
benchmark. In Malaysia, one may use Bursa Malaysia Composite Index (KLCI) as a benchmark for measurement of performance. For measurement of small cap fund, one may consider the Bursa Malaysia Second Board composite index as the benchmark. However sometimes it is very difficult to select an appropriate benchmark for comparison.
7.6.7 Other Factors
Apart from the rate of return, we should also look into other factors when analyzing the performance of a unit trust. These non-financial factors are sometimes more significant than the financial factors stated above. Investors have to continuously compare the performance of the unit trust management company in term of consistency, risks involved and the appropriation of profit made to the unit trust holders. Another important factor that an investor has to look out for is alternative investment or the opportunity cost of investing in the current funds.
In terms of consistency, investors must analyze that the performance is consistent over the period of one month, two months, three months, six months, one year, three years and five years. By referring to a longer period of performance, one is able to form a more conclusive opinion on the ability of the fund manager.
Risk, as difficult to assess as it is, must be recognized and managed accordingly. Risk of investing in a fund is difficult to assess especially when the unit trust scheme has only been operating for a short period. Apart from that, other risks which need to be assessed and considered include the credibility of the fund manager, fund management style and service risks.
There are always investment opportunity costs when funds are invested into unit trust schemes.
If an investor withdrew money from his savings that earned good returns, he would have sacrificed the profit that could be earned as well as the low risk that savings provided. If the payment for the purchase is sourced from the EPF, he would have also risked his retirement fund should the unit fund not perform well.
Some of the funds pay dividends regularly whereas some accumulate the gains in the NAV of the units. In order to compare the performance of two or more funds, one will have to ascertain the dividends paid, if any, and take them into consideration: otherwise, the comparison will not be meaningful as it will favor the funds that do not pay dividend.
7.6.8 Pricing of Unit Trusts
The price of a unit trust depends on the total value of the asset held by the unit trust scheme less the total liabilities, referred to as the net asset value (NAV). For all quotations made, the net asset value of the unit trust scheme is calculated by taking the net asset value on the day prior to that on which a quotation is made. This is then divided by the total unit issued outstanding.
There is also an initial management and distribution fee to be charged. This initial fee is then added to the net asset value per unit to give a unit’s selling price.
The actual initial management fee charged must be disclosed in the prospectus of the respective unit trust schemes.
The net asset value of a unit trust scheme consists of the following:
(a) The value of the equity investment portfolio based on the last transaction price of the stocks and share.
(b) The cost of brokerage, stamp duty and other charges according to the portfolio of investment.
(c) The money market investments.
(d) All un-invested cash and cash balances.
(e) All accrued gross dividends and interest income after deduction of:

(i) Annual management fees
(ii) Trustee fee
(iii) Administration expenses including auditors’ fees, tax advisor’s fee and registration charges.
The selling price is based on forward pricing as the price is obtained on the last available valuation which is the previous trading day.
Example 1:
Say a unit trust scheme has the following details:
Date of quotation = 1/1/01
Net asset value of the trust Scheme on 31/12/00 = 150,000,000
Unit issue outstanding on 31/12/00 = 100,000,000
Therefore the net asset value = RM150,000,000 / 100,000,000 = RM1.500
Example 2:
Initial fee is 10%
Therefore, the selling price,
= RM1.500 + (10% x 1.500) = RM1.500 + 0.15 = RM1.65
The repurchase price is calculated in the same way as the selling price, except that the NAV taken is based on the end of the trading day on which the request to redeem is received.
Example 3:
Say a unit trust scheme has the following details:
Date of redemption = 1/1/01
Net asset value of on 1/1/01 = RM170,000,000
No. of units issued outstanding on 1/1/01 = 100,000,000
Net asset value per unit,
= NAV / Units issued outstanding
= RM170, 000,000 / 100,000,000 = RM1.700
Less: maximum fees charged of five sen = RM0.05
Therefore, the minimum repurchase price = RM1.70 – 0.05 = RM1.65
In practice, a unit trust management company will set its selling price below that of the maximum selling price computed above, and its repurchase price above that of the minimum repurchase price.
7.6.9 Using the Dollar-Cost Averaging Method
To invest in unit trust funds, one can choose to invest in one lump sum or to invest on a regular basis. The concept of dollar cost averaging applies to a situation when an investor invests on a regular basis. The principle refers to the systematic and consistent investment of a fixed amount
of money irrespective of the price levels.
One of the major weaknesses of small investors is that they try to pursue the purchase of shares when the market is bullish and fail to buy when market is bearish. The consequence of these two patterns of buying behaviour is high costs of acquisition. In the long run, it is more difficult to make profits when the costs are high. With the principle of dollar cost averaging, investors can turn fluctuating prices to their advantage, especially during the falling prices when they can purchase new stocks and reduce the average costs of their entire investment portfolio.
An illustration of the concept is as follows:

We shall assume that an investor invest $1000 per month for a period of 12 months.

The average cost of purchase per unit = RM12, 000 / 13,393.39 units = RM0.8959 per unit.
If the purchase was made in a lump sum of RM12, 000 in January, the number of units that could be bought would be 12,000 units at RM1.00 per unit. In the example here, one can see that the practice of dollar cost of averaging has reduced the average cost per unit and has enabled the
investor to acquire more units than if he were to buy in a lump sum at the beginning of the year.
The dollar cost averaging does not always benefit the investors. Based on the same example, if the market generally continues to be bullish after January, the number of units that could be bought would have been less when compared to a lump sum purchase as follows:

The total number of units acquired under the dollar cost averaging technique has thus reduced the number of units bought as compared to a lump sum purchase. The average cost is = RM12, 000 / 11,635.16 = RM1.03136.
On account of the cyclical turbulence of stock markets, unit trust investors may be tempted to either sell or buy. However, investors are advised to remain calm and practice dollar cost averaging with their long-term goals in view.
When regional and global markets succumbed to panic selling in August 2007, the severity and sharpness of the correction was large enough to make unit trust investors ask themselves whether they should redeem their units to stem further losses or buy more units at those current
low prices. In fact, if they had practiced dollar cost averaging, they need not have concerned themselves with those timing issues. Dollar cost averaging enables investors to automatically buy more units when prices fall and fewer units when prices rise.
It is especially during times of market volatility that individual investors should remain focused on their long-term investment goals and keep their emotions from influencing their investment decisions. A disciplined and methodical approach to investing is the key to long-term investment success.
Unit trust investors are advised to buy and hold their investments for the medium to long term. The buy-and-hold principle is based on the notion that a good investment will generate reasonably attractive returns over the medium to long term. This also means that investors are able to distinguish between daily movements in the market and the underlying long-term value of their investments. Professional fund managers buy and hold for the medium to long-term as they are prepared to wait patiently over several years for their investments to reach their intrinsic or fair values. For the unit trust investor, the ‘buy-and-hold’ strategy can also be applied by holding on to a well-selected unit trust fund over a period of at least three years.
There are some investors who believe they can achieve superior returns by timing the purchase and redemption of equity funds to profit from the stock market’s short-term movements.
These investors are tempted to engage in timing the market especially in an environment where equity markets are volatile. Such investors who wish to make quick gains in the stock market by switching from one fund to another will often be disappointed. Market timing strategies that are often recommended by “investment experts” have seldom been successful.
This is because stock markets are inherently volatile and are impossible to predict with numerous factors, both domestic and foreign, affecting daily and weekly fluctuations in stock prices.
Investors who wish to take a more active approach with their investments by timing the market will expose themselves to many risks. In order to profit from the market’s short-term trends, the investor has to correctly predict the market’s trend and its turning points
7.7 Conclusion
This chapter covered the topic of Investment in Shariah-compliant Unit Trust Funds. Among the themes discussed were: The Operation of Shariah-compliant Unit Trust Funds Investments Advantages and Drawbacks of Investing in Unit Trusts, Milesotones of Shariah-compliant Unit Trust Funds, Cost and Charges of Investing in Unit Trust Funds, Types of Shariah-compliant Unit Trust Funds, and Performance Evaluation of Shariah-compliant Unit Trust Funds. The aspects discussed are very important in the area of investment to ensure the Shariah compliance advice on related matters.

Self-Assessment
Circle the letter of the correct choice for each of the following.

1. The following are all true about a unit trust fund, EXCEPT:
i. It is a professionally managed fund
ii. It is a collective investment scheme
iii. It does not depend on funds from unit-holders
iv. It usually holds diversified portfolio of securities
A. i and ii only
B. ii and iii only
C. iii and iv only
D. iii only

2. Which of the following are advantages offered by unit trust funds?
i. Professional portfolio management
ii. Dividend reinvestment
iii. Consistent returns in excess of the overall market rate of return
iv. Modest capital outlay for investors
A. i and ii only
B. i and iv only
C. i, iii and iv only
D. i, ii and iv only

3. The trust deed is a legally binding agreement between the manager, trustee and unit-holders. The deed usually covers
i. how to value and price a unit
ii. the rights of unit-holders
iii. the collection and distribution of income
A. None of the above
B. i only
C. i and ii only
D. i, ii and iii

4. Which of the following does/do not apply to a unit trust manager?
i. Induce unit-holders to buy the units of the trust fund at all cost.
ii. Manage the fund with a high standard of integrity and fair dealing.
iii. Exercise due care, skill and diligence in managing the fund.
iv. The manager is bound by the Securities Commission (Unit Trust Scheme) Regulation 1996.
A. i and ii only
B. ii and iii only
C. iii and iv only
D. i only

5. An open-end investment company ___________.
A. is involved in all trades of its shares.
B. sells shares at a discounted NAV price.
C. trades like a stock on the exchanges.
D. has a set number of shares.

6. In Malaysia, we have open-ended and close-ended Islamic trust funds. Listed below are some of them EXCEPT:
A. Equity unit trust
B. Fixed income unit trust
C. Property unit trust
D. Financial unit trust

7. All of the following are considered to be costs of investment in buying of unit trusts, EXCEPT:
A. Initial service charge
B. Ongoing management fee
C. Advisory fee
D. Dividend received

8. Which type of mutual fund consists of both stocks and bonds with a combined objective of current income and long-term capital gains?
A. Equity-income
B. Balanced
C. Value
D. Bond

9. In the selection of unit trusts, the investor must consider various factors. These factors are __________.
i. The investment needs
ii. The risk benchmark of an investor
iii. Does it provide regular income?
A. None of the above
B. i only
C. i and ii only
D. All of the above

10. The following are the responsibilities of the Shariah Committee and Shariah Advisor to an Shariah-compliant unit trust funds scheme EXCEPT:
A. To make sure that the Trust Deed is prepared under Shariah principles.
B. To consult with the Securities Commission if any ambiguity arises regarding the investment, instrument, system, procedure and/or process of the fund.
C. To make sure that the fund’s investment is the most profitable to the unit holders.
D. To prepare a report to be included in the fund’s interim and annual report certifying whether the fund has been managed and administered in accordance with Shariah principles.

Answer: 1-d, 2-d, 3-d, 4-d, 5-a, 6-d, 7-d, 8-b, 9-d,10-c

CHAPTER 8

INVESTMENT IN REAL ESTATE

Chapter/Topic Outline
8.1 Introduction
8.2 The Basic Characteristics of Real Estate as an Investment Vehicle
8.3 General Classification of Real Properties
8.4 Important Factors to be Considered When Investing in Real Property
8.4.1. Physical Property
8.4.2. Property Rights
8.4.3. Time Horizon
8.4.4. Geographical Location
8.5 Determinants of Real Estate Prices
8.5.1. Supply-related and Demand-related factors
8.5.2. The Property Features
8.6 Islamic Home Financing
8.6.1. Affordable Analysis
8.6.2. Source of Funding
8.6.3. Fees and Charges
8.6.4. Available Islamic Home Financing Schemes
8.7 Home Leasing as an Investment (Ijarah)
8.8 Valuation of Real Property
8.8.1. The Cost Approach
8.8.2. The Comparative Sales Approach
8.8.3. The Income Approach
8.8.4. Expert Opinion
8.8.5. Real Estate Cycle
8.9 iREITS
8.10 Conclusion

Definitions:

REAL ESTATE – is property consisting of land and the buildings on it, along with its natural resources such as crops, minerals or water; immovable property of this nature; an interest vested in this (also) an item of real property, (more generally) buildings or housing in general.^[2] In terms of law, real is in relation to land property and is different from personal property while estate means the “interest” a person has in that land property. Real estate is different from personal property, which is not permanently attached to the land, such as vehicles, boats, jewelry, furniture, tools and the rolling stock of a farm.

REAL ESTATE INVESTMENT TRUST (REIT) – is a company that is set up like a mutual fund to offer real estate investment opportunities to a wide range of investors. In a REIT, the company owns and operates some income-producing real estate. A pool of investors contributes funds to the REIT to finance purchases and operations in return for a portion of the income.

NET PRESENT VALUE (NPV) or NET PRESENT WORTH (NPW) (of a times series of cash flows, both incoming and outgoing) – is defined as the sum of the present values (PVs) of the individual cash flows of the same entity. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting and widely used throughout economics, finance and accounting. It measures the excess or shortfall of cash flows, in present value terms, above the cost of funds. NPV can be described as the “difference amount” between the sums of discounted: cash inflows and cash outflows. It compares the present value of money today to the present value of money in the future, taking inflation and returns into account.
INTERNAL RARE OF RETURN (IRR) or ECONOMIC RATE OF RETURN (ERR) – is a rate of return used in capital budgeting to measure and compare the profitability of investment. It is also called the discounted cash
flow rate of return, In the context of savings and loans the IRR is also called the effective interest rate. The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation).

Islamic Home Financing Scheme/Contract

Ijarah (leasing), Musharakah (partnership) and Tawarruq (monetization)

Ijarah (leasing) –

An Ijarah wa `Iqtina’ (Lease to Purchase or Hire Purchase) contract – is just the same as that of the Ijarah except that the business owner is committed to buying the equipment at the end of the lease period. Fees previously paid constitute part of the purchase price. This type of lease to purchase agreement is commonly used for home financing. Ijarah or leasing is a straightforward method of house financing.

Musharakah (partnership) –

BBA and Tawarruq (monetization) –

Study/Learning Objectives
Upon completion of this chapter, you should have knowledge of:
(a) The Basic Characteristics of Real Estate as an Investment Vehicle
(b) General Classification of Real Properties
(c) Important Factors to be Considered When Investing in Real Property
(d) Determinants of real Estate Prices
(e) Islamic Home Financing
(f) Valuation of Real Property

8.1 Introduction
The term ‘real estate’ refers to properties such as agricultural property, industrial property, commercial property and residential property. Properties acquired are either for one’s own use or
for investment purposes. If a property is acquired solely for one’s own use, there will not be any rental income but it will enable the owner to save on rental expense. If it is acquired for investment, usually there will be rental income. All properties, whether acquired for one’s own
use or for investment, have chances of enjoying capital appreciation. Buying decisions on real estate greatly affect the return earned from investing in it. The mode of financing a house also affects the cost of financing that in effect will increase or reduce the returns from the
investment. This chapter deals with the characteristics of real estate as an investment vehicle and classification of real property. It also provides readers with the information on the Shariah-compliant financing available in the market.
8.2 Basic Characteristics of Real Estate as an Investment Vehicle
Investors may invest in real estate directly or indirectly, choosing among three alternatives as below:
Option 1: Investing in the form of equity or direct ownership. Investment in equity of a real estate refers to buying ordinary shares of real estate companies. Direct ownership could be taken to mean buying a property and getting the ownership registered in the investor’s name.
Option 2: Investing in indirect investment in real estate based fixed-income instrument.
For example, investors holding Ijarah Sukuk that securitize the value of real property and receiving rent paid by the issuer of Sukuk.
Option 3: Investing in real estate investment trust. This type of investment has been covered in-depth in Chapter 7 (Investing in Shariah-compliant unit trust funds).
To decide whether to invest in one of the three options stated, several factors should be considered. The main areas are as follows:
Saleability. Finding buyers can be a problem especially during bad times. In the midst of the global trend of falling prices of real property in 2008, buyers were more conscious of investing in real property. This resulted in the downtrend of demand for real estate units. Although Malaysia has not seen the spiraling down of real estate prices, homeowners in the US and the UK experienced equity losses of homes.
This further dampens real estate prices, according to the law of demand and supply in the market.
Properties auctioned by banks usually do not find takers during bad times. In fact, just to apply for the approval of auction could take one to three years, depending on whether the application for auction is contested by the owners. The time frame required for the approval of auction is the same, regardless of whether applications are made during good or bad times.
The above difficulties are usually encountered in the direct form of investments under option one. Other options encounter much less difficulty when it comes to selling or liquidating the investments.
Liquidity – It refers to the ability of the investment to be converted to cash in a short time period, say in a month’s time. In this respect, a direct investment in property under the first option is not so liquid. Even after a property is sold, it will take some time for the sale proceeds to come in. The time frame is about three months for the proceeds of completed property sales to be settled. This is evident by the fact
that the completion period in most standard sale and purchase agreements is 3 months, with the option of extension by one month if necessary. In some cases, where settlements of real property gains tax are involved, the final settlement could take more than a year. Indeed, most real estate acquired is classified as non-current assets in the balance sheet. On the other hand, investments under Options 2 and 3 are relatively much more liquid.
Taxation – In general, investors enjoy exemption of capital gains tax in Malaysia inclusive of the exemption of Real Property Gain Tax that has been in effect from 1st April 2007.
Profitability. The chance of reaping substantial gains under Option 1 is much better than investments under the other two options. There are many success stories in the property market. On the other hand, the risks of substantial losses in Option 1 are equally high. Under Option 1, the amount of losses could sometime exceed the costs of purchase of the property. This happens because of the financing when a property loan is not settled, profit on financing, incidental expenses relating to the application for auction, costs of auction and auctioneer’s fee would become additional expenses.
These costs and expenses could become substantially high to make a person
experience major losses, much to the surprise of some real property investors.
The chances of success or failure depend very much on the selection of appropriate investments and other factors such as gearing, timing of purchase and the overalll market situations. Profitability under Options 2 and 3 are relatively lower. However, the risks associated with such forms of investments are also lower. Returns for Option 3 are attractive in the long-term, based on the opportunity to grow long-term capital appreciation as well as the ability to perform constant dollar averaging.
Own Occupation – Owner-occupied housing is considered an asset in the
balance sheet for the owner. A person may increase credit-worthiness when owning a house. The need for own usage should not automatically be the overriding or sole factor in deciding on the acquisition of the property. One should identify and evaluate alternatives, such as renting the property. For that matter, the selection of location is vital for higher opportunity for value appreciation of the house bought.
For corporations, acquisition of real estate will increase the asset size of the company and has the effect of making “return on asset” and “return on equity” tougher to achieve or maintain. Let us illustrate this point with an example. We shall assume that Company X has the following summarized results last year:
Net profit: RM5 million
Total asset: RM250 million
Net worth: RM50 million
Annual Rental expense: RM250k
The Return on Asset = Net profit / total asset
= RM5 million / RM250 million = 2 %
The Return on equity = Net profit / Net worth
= RM5 million / RM50million = 10%
The property that the company considered acquiring was to cost RM15million and would have enabled Company X to save rental expense of RM250k but would increase interest expense by RM500k. The acquisition of the property would have had the following financial effects on the company:
Net profit: RM5million – RM500k + RM250k = RM4.75million
Total asset: RMRM250 million + RM15 million = RM265million
Net worth: RM50 million – RM0.25million = RM49.75million
The return on asset = RM4.75million / RM265million = 1.8%
The return on equity = RM4.75 million / RM49.75million = 9.55%
Based on the above illustration, the acquisition of the property was not good for the company in the short run. However, a longer-term analysis by taking into consideration several factors such as trend of property value, rental expense, and space requirement is required, before a final decision is made. Shareholders should be aware of management who are in for short-term gain or performance at the sacrifice of the long- term interests of the shareholders.
For individuals, family needs should be incorporated into the various factors for consideration in selection of property. These family needs could refer to security, public transport for family members, the quality of schools nearby (children are usually admitted into schools nearby), distance of the proposed home from office for the working adults
and even the majority of the ethnic group residing in the vicinity.
 For investment. It is difficult to draw a line between investment and speculation. In real life, it is difficult to get someone to admit that he is speculating rather than investing. One of the reasons is because bankers do not like to finance activities that support speculation. Property for investment or speculation is acquired for rental income and
capital gain. If it is swampy land without any immediate commercial value and hence low rental income, the investment is generally considered to be very speculative. Other properties that do not generate periodic rental income include land without access roads, or properties occupied by squatters. Even properties expected to generate rental income
may fail to generate income during bad times when tenants could not be found.
Therefore, buying properties for investment is considered riskier when compared with acquiring them for one’s own use. Because of the relatively higher risk associated with buying properties for investment purposes, investors may therefore have to consider indirect investment to make use of professional services in this area. Hence, the Options 2 and 3 seem to be more appropriate choices in this respect.
Acquisition of properties for investment purposes should be evaluated together with other investment opportunities. Usually, the risks and returns of all the investment alternatives are evaluated before final decisions are made. Investment appraisal tools such as Net Present Value (NPV) and Internal Rate of Return (IRR)2 techniques could be used.
The rate of returns from investing in real properties in relation to other investment vehicles can be illustrated in Figure 8.1:

Figure 8.1: Returns from Savings and Investment for Various Types of Investment Vehicles

In terms of liquidity, the comparison between properties investment to other investment vehicles can be visualized in Figure 8.2 as follows:

Figure 8.2: Liquidity for Savings and Various Types of Investment Vehicles

8.3 General Classification of Real Properties

Under the Land Laws in Malaysia, properties are to be used according to the purpose as stated in the title deeds. Changes would require conversion of land use. Properties are classified as follows:
(a) Residential
(b) Commercial
(c) Industrial
(d) Agricultural
(e) Hotel
(f) Resorts and golf courses
(g) Residential properties. These include landed residence (single-storey, double-storey, semi-detached and detached houses), and non-landed properties (could be known under different names such as flats, apartments, condominiums and townhouses).
(h) Commercial properties. These include shop houses, office buildings, and commercial complexes.
(i) Industrial Properties. These include light industry factories, warehouses, and factories for industrial purposes. Availability of workers is an important factor. Power supply, service roads, and other infra-structural facilities are also to be closely studied.

(j) Agricultural Properties. These include land cultivated with agricultural products such as rice, oil palm, rubber, vegetables, fruit trees, and other cash crops. Although agricultural land should be meant for agricultural use, there is a provision to allow construction of one
unit of building on the land. Access road to the property is one of the most important factors. In general, agricultural properties are relatively undeveloped on location. The issue of accessibility is therefore, more important when compared to buying properties in developed areas.
(k) Hotels. Some will classify this under commercial property. It refers to all types of hotels ranging from budget class to 5-star hotels.
(l) Resorts and golf courses. This serves a different market in providing holiday destinations recreation.
There are also other ways of classifying real estate for specific reasons. The following are examples of how commercial banks classify and evaluate real estate as collateral.
(m) Vacant land. The land could be designated for a certain use, but it is left unoccupied or unutilized for the time being. Care has to be taken to check if there are squatters. It is also advisable to fence up the area if it is possible. It is also useful to check if there is a need to fill up the land level before it can be used. Cost of earth filling can be high.
Perhaps, the most important issue to consider in the acquisition of vacant land is the accessibility to the piece of land under consideration. Vacant land is usually undeveloped land and hence, it is common to find road accessibility a problem.
(n) Completed properties and properties under construction. Completed properties refer to those fully-built in accordance with approved building plans and issued with certificates of fitness for occupation. Properties under construction refer to those still under construction and therefore, expose buyers to an additional risk of non-completion. In this
respect, the buyer or investor has to check on the track record and financial standing of the developer before commitment to purchase. During bad times, many projects are abandoned. However, the purchasers who have obtained end-financing have the legal obligation to service interests on the end-finance facilities even though the developers might have absconded.
(o) Income generating or non-income generating property. In general, properties that are unoccupied are not regarded as good collateral. Unoccupied properties would not bear any rental income. It could also mean that the location of the property is not ideal or ripe for commercial, residential or industrial use.
(q) The tenure of ownership. Properties with perpetual ownership are the most preferred forms of collateral as compared to properties that are classified leasehold. Leasehold properties with remaining lease periods that are too short are not ideal as collateral. This is because the properties are hard to sell in case there is a need to auction. Even if the government could consider renewing the lease upon expiry, there are usually costs and conditions involved.
8.4 Important Factors to be Considered When Investing in Real Property There are several features or factors one should examine in evaluating a property’s investment potential. Among the numerous factors, one should consider at least the following:
(a) physical property
(b) property rights
(c) time horizon, and
(d) location
8.3.1 Physical Property
When buying a real property, it is important to ensure that you are actually getting what you want. Problems may arise if you fail to obtain a site survey, an accurate square-footage measurement of the building or an inspection for building defects. If upon inspection of the real property you discover that it is not as per your expectation, you can always refuse to contract until the vendor has complied or renegotiation may be required. The purchaser can also seek the advice or services of a professional valuer to do the job. Upon completion of the valuation exercise, a valuation report will be made available to the interested party. The same report may also be given to the financier if the sale is concluded.
8.3.2 Property Rights
It is equally important to conduct a search of the title deed relating to the property you intend to acquire. This title deed is the evidence of ownership of the property. You may conduct a search of the title deed yourself, or seek the services of your solicitors or professional valuers. Important information that can be established from the searchincludes:
(a) Name of owner. This is important as some purchasers could not even establish the actual owner in their purchase of the property. Some could be making payment of deposit to only one owner when there could be many owners.
(b) Tenure of the land. Its status, whether freehold or leasehold, can be confirmed. If it is leasehold, it may not meet your objective of buying freehold property for the purpose of estate planning. Even if you do not mind that the property is leasehold, you should establish the remaining lease of the property. Financiers are generally not prepared to finance the purchase of a property if the lease period remaining is too short.
(c) Land area. Property is sometimes priced based on price per square foot basis. It is, therefore, necessary to ascertain the actual size of the land to determine the purchase price. Land may also be purchased for certain construction requiring a minimum land area. If the land size is insufficient, the negotiation of purchase should stop immediately.
(d) Land use. This is to establish whether the land is designated for agriculture, commercial or industrial use. Conversion of land use is necessary if it is to be used for purposes not specified in the title. Conversion of land use can be time consuming and expensive.
(e) Shape of the land. This could affect the actual land use. The ideal land shape should be rectangular or square. A triangular shape should be avoided. Some Chinese even believe that the front width of the land should be smaller than the back portion to bring good fortune.
(f) Caveat or encumbrances, if any. Common encumbrances are mortgages in favour of banks and private caveats lodged by individuals who have interest in the land. Registration of mortgage shows that the owner has a loan outstanding with the bank. A private caveat is usually lodged if a purchaser has paid 10% deposit for the purchase of the property. The caveat has the effect of freezing all transaction of the property so that the owner cannot sell the same property to another party.
(g) Notice of acquisition by government or government bodies. Investors should research on the near future development of the real estate. Sometimes certain tracts of land are earmarked for development in the near future, by government agencies such as JKR, Telekom, or Tenaga Nasional. A search would save the purchaser from possible financial losses and inconvenience.
An investor could also conduct a search on the land use at the local council. The town planner will also be able to show zoning of the property and the proposed development in the area under their jurisdiction. Any land acquisition by government authorities could also be detected. In fact, proposed road development and any other infra-structural facilities in the area are also outlined by the respective bodies before implementation. A title search at the local council will enlighten the investor on several categories of title status. Titles may be classified as follows:
(a) Freehold status – This type of title gives the holder the perpetual right.
(b) Leasehold status – This type of title gives the holder the right up to the expiry date as stated in the title deed.
(c) Strata-title status – These are individual titles issued to individual unit owners sitting on a common piece of land with a master title. These strata titles may be freehold or leasehold depending on the status of the master title.
(d) Bumiputra Restricted Title – These are titles for units reserved for Bumiputra to comply with the 30% Bumiputra ownership in all housing developments.
(e) Bumiputra Reserve Title – These are titles issued on land in areas which have been gazetted for only Bumiputra ownership. Under no circumstances can these titles be transferred to a non-Bumiputra.
(f) Master Title – A master title is a title with sub-ownership. Under most circumstances in housing development, the master title is then superseded by subdivided title (individual sub-title) except where the properties are sold with strata titles. On the other hand, not all master titles can be divided into sub-individual titles, unless approval is given by the relevant authority.
8.3.3 Time Horizon
Real property market, like any other market, has its ups and downs. While some markets such as the commodity and share markets experience active price fluctuations over a short period of time, the time taken for changes in prices of property is much longer. Therefore, for people looking for short-term gains, investing in real property is not really the right vehicle. Before entering into any commitment in the property market, an investor should decide what time period is relevant. A short-term investor might jump in due to a fall on mortgage interest rate, high
financing available and buoyant market expectations. On the other hand, a long-term investor might look more closely at population growth potential and longer-term potential development.
8.3.4 Geographical Location
Location is generally regarded as the most important factor in the selection of property. Different locations may suit different needs of businesses and individuals. For example, the choice of location also depends on the type of business purchasers are in and the availability of resources.
Many multinational companies from developed nations came to set up operations in Malaysia several years back because of the availability of cheap labour in Malaysia. These operations subsequently relocated to other countries when the cost of labour moved up in Malaysia.
Generally, commercial properties located in busy commercial areas are properties that command the highest value. Evidently, prices of properties in big cities such as Tokyo, New York, London and Paris command a high premium. This is because properties in the city have greater demand
as compared to those in the rural areas. Similarly, properties at convenient locations have greater demand as compared to those that are isolated. Convenient places mean areas which have easy access and public facilities like proximity to commuter stations, LRT (Light Rail
Transit) stations and so on.
8.4 Determinants of Real Estate Value
There are two major determinants of real estate value. They are the economic forces of demand and supply. Within the economy, there are many factors affecting demand and supply. Being an open economy, Malaysia also encounters external forces that influence the two forces of demand
and supply. Very simply, values of property prices will increase if demand exceeds supply. On the other hand, if supply exceeds demand, prices will drop.
8.4.1 Supply-related and Demand-related factors
We shall therefore focus on factors that affect demand and supply as follows:
(a) Profit rate. Profit rate in the contracts of house purchase affect the cost of borrowings. Cheaper costs of financing encourage buying by purchasers, and therefore, increase the demand. Lower costs of financing also tend to increase supply. Housing project development costs consist of numerous expenses. One of the major items is the financing expense on the financing payable by the developer. High financing cost discourages building of houses and therefore, decreases the supply side.
Profit rates on Term Deposit Mudharabah influence the demand and supply of properties in the market. This is because, when the sharing rate is high, it is more likely that it becomes an alternative investment, competing for funds of investors. The reverse is also true.
(b) Political stability. A stable government is necessary for any investor to feel comfortable in investing their money in their country. Investors feeling insecure about the stability of a country would not allow their funds to be tied up in long-term investments in real estate.
Those who have invested may consider liquidating their assets and moving their funds elsewhere. Thus, an unstable political position could reduce demand for properties.
(c) Real property gain tax. Negotiation of a sale is sometimes unsuccessful because of the RPGT. Taxes cut down the required or expected profit of the sellers and influence their decision to perhaps defer the selling until a better offer comes along. RPGT was abolished in April 2007, encouraging investors to buy and resell real properties without having to pay tax on the cash received.
(d) Bureaucratic processes. To build a new housing scheme, a developer has to seek the approval of local authorities. There are many departments involved. These would include the JKR, Tenaga, Telekom, Land Office, Planning Department, Building Department, Fire Brigade, Engineering, Water Supply, Environment, Landscaping, Drainage and Sewerage. After receiving the green light from all these departments, only then can the developer apply to the Housing Ministry for a developer’s license together with a sale and advertising permit. Getting the approvals is time consuming. Supply, in this sense, is inelastic in the short run. The tedious process increases the cost and pricing of properties.
(e) Government policy. The government’s policy of encouraging house ownership will help to increase demand. The government has also directed commercial banks by giving them individual targets on the minimum number of low and medium cost housing accommodation they must finance.
(f) Foreign investment policy. Restriction or its removal will affect foreign demand of property. Continual changes in policy are also not encouraged.
(g) Economic performance. During good times of high economic growth, demand for property is usually strong. The reverse is also true during a glut.
(h) Mortgage financing is another key determinant of demand on real estate. The higher the margin of financing, the higher is the demand for real estate as more people can have access to it.
The factors stated above are general factors affecting demand and supply which in turn affect prices. In practice, individual preferences and needs for specific property features also play a role in the selection of property and price determination.

8.4.2 The Property Features
Examples of features that could affect prices are as follows:
(a) Location –The location of a property is a major factor that determines investment in real properties. Properties in good locations are always in better demand. Even during a recession, they are easier to sell and when the market recovers, they are the first to register price changes. In a broad sense, good locations in Malaysia could refer to the Klang Valley, Johor Bahru, and Penang Island. These are the places that command better property prices. In fact, some banks specifically mention that they
are keen in financing property development projects in these areas only. Within these relatively good growth areas, good locations can further be identified or classified. This is considered a major factor when buying a house for investment since these areas are bursting with economic activities; thus a high population rate that ensures good rental.
This factor is less important if the house is purchased for one’s own occupation.
(b) Restriction in land use – This spells out the suitability of the property in meeting the needs of the purchasers.
(c) The environment – This could refer to air quality, water pollution, noise pollution and even the friendliness of the neighborhood.
(d) Security – Certain areas may have higher crime rates and thus, may be notorious for “gangsterism”, thefts and robberies.
(e) Public transport – Availability of public transport is sometimes considered in the pricing decision.
(f) The site and size – At times, the siteand size of the property also affect property prices. For example, a property located on high elevation with a good view tends to have greater demand compared to another at a low lying area and has “no view” at all.
(g) Tenure of the property – Freehold or leasehold? Freehold land refers to ownership on a perpetual basis whereas leasehold property has a specified number of years of ownership. Upon expiry of the lease, ownership could be renewed at the discretion of the state government. Therefore, freehold land will command better prices in general.
(h) The ‘fengshui factors’ – There is some logic to the Chinese belief of Feng Shui. Properties facing south will receive sunlight in the living room in the morning to indicate “freshness”. Houses above road level is preferred due to the fact that it will be better protected from dust and has better privacy for the owners’ comfort.

8.5 Islamic Home Financing
8.5.1 Affordability analysis
Before a prospective buyer commits to purchase a property, he should first work out a budget to help him determine how much he can afford and the ceiling price on any property he may wish to buy. The affordability analysis should depend on income and other financial obligations. The rule of thumb outlined by a financial institution is that most house buyers buy houses that a debt-service ratio is used to determine the applicants affordability status.
8.5.2 Source of Funding
The source of funding can be all or any combination of the following:
(a) Savings – Prospective buyers should have sufficient personal savings to pay for the down payment and other related costs associated with buying a house. A good estimate would be about 10 to 20 percent of the purchase price as down payment and another 3 to 5 percent for related costs such as legal fees and stamp duties.
(b) Employee Provident Fund (EPF) account – The EPF is a national security organization operating through a provident fund scheme in Malaysia. EPF provides two schemes of withdrawal for its depositors prior to attaining the age of 50. For the purpose of buying or building a house, a depositor can withdraw the difference between the purchase price and the loan obtained plus 10 percent of the purchase price or 30 percent of the total amount deposited in the EPF, whichever is lower.

If the total amount deposited in Account 2 is RM15,000 all of the amount in the account can be withdrawn. However, if the total amount deposited is RM30, 000 only RM20, 000 can be withdrawn to pay for the down-payment.
(c) Financing facility from a financial institution – Buyers should survey the financial institutions that offer the most preferable and suitable
financing package that suits their needs. Deciding on the best financial institutions is important since buyers will be dealing with them on a regular basis

8.5.3 Fees and Charges
There are several costs and expenses arising from the purchase of the properties. They may consist of some or all of the following:
(a) Commission payable to real estate agents.
(b) Stamp duty on transfer of property.
(c) Legal fees payable to solicitors.
(d) Interest expense if there is financing.
(e) Stamp duty on “charge document” to enable end-financier to complete documentation.
(f) Maintenance fees, regardless of whether the property is rented out.
(g) Takaful contribution for the financing (Mortgage Reduction Term Takaful).
Some examples of charges are as follows:

8.5.4 Available Islamic Home Financing Schemes
Islamic banks use various Islamic financial instruments to offer Shariah-compliant home financing. Some banks prefer to use the widely accepted Shariah-compliant instruments, namely Ijarah (leasing), Musharakah (partnership), BBA and Tawarruq (monetization).
a) Ijarah – In Ijarah home financing, the bank buys the house and charge rent to the customers; and at the end of the leasing period the customers may have the option to buy the house.
b) Diminishing Musharakah – The bank may contribute 90% and the remaining 10% is contributed by the customer to the purchase price. Over a period of up to 25 or 30 years customers, as the co-owner of the house, will make monthly purchase instalments through which the bank will sell its share (90%) of the home to the customer. With each installment paid, the
bank’s share in the property diminishes while the customer’s share correspondingly increases.
While the purchase instalments are being made, the bank will charge the customer rent for the use of the bank’s share of the property, the rent being calculated according to the respective shares owned.
The relationship between the customer and the bank is also quite different compared to a conventional mortgage. Two of the major differences are:
(i) As owner of the property, the bank faces risks associated with property ownership. This is a situation that does not exist under an interest mortgage, where the bank never actually owns the property.
(ii) In a conventional mortgage, the customer is the borrower. However, in a Musharakah structure, the customer is the bank’s tenant and partner in the property. This different relationship between the bank and its customer presents the bank with different risks and requires different remedies to problems that might occur. This concept can be further elucidated in Figure 8.3 below:

Figure 8.3: The Concept of Musharakah Mutanaqisah

Flow 1: Both the financer and company provide some financing to acquire an asset, and become partners of the ownership, in running the project.
Flow 2: The company pays monthly installments to the financer as rental and to obtain the financer’s share, from the project’s profit, based on a pre-agreed ratio (X%).
Flow 3: The company obtains the profit based on a pre-agreed ratio (Y %). After the final payment, the customer will hold 100% share and the financer will have no more share on that asset. Profit-sharing is according to the agreed ratio or capital contribution.
In the

event of loss of value of the house, it is to be shared according to the capital ratio of the bank and the customer at the time of the loss.
BBA or Bai Bithaman Ajil
There is also a mark-up home financing provided by Islamic banks. This product is the most commonly offered product by Islamic banks in Malaysia despite some scholar’s concern on the permissibility of the instrument. Murabahah financing has been argued as allowing the backdoor charging of interest. However, the Shariah scholars in Malaysia are of the opinion
that since a Murabahah transaction involves a sale transaction, the ownership of the house is actually transferred to the customer which is allowed in Islam. A Murabahah instrument is used in line with the permissibility of a customer in paying the price in instalments. The product is referred to as Bay’ Bithaman Ajil (BBA).
From the website of Bank Negara Malaysia, the following information obtained on BBA are as follows (adapted):
(a). Definition: BBA is a contract of deferred payment sale, i.e., the sale of goods on deferred payment basis at an agreed selling price, which includes a profit margin agreed by both parties. Profits in this context are justified since it is derived from the buying and selling transaction as opposed to interests accruing from the principal lent out.
(b). Main characteristics of a BBA House Financing: All the components to determine the selling price has to be fixed because the selling price has to be fixed at the time the contract is made. Hence, the profit rate for BBA financing is fixed throughout the period of financing.
(c). The mechanics of BBA House Financing:
(i) The customer identifies the asset to be purchased.
(ii) The bank determines the requirements of the customer, in relation to the financing period and nature of repayment.
(iii) The bank purchases the asset concerned.
(iv) The bank subsequently sells the relevant asset/property to the customer at an agreed price, which consists of:
-Actual cost of the asset to the bank, i.e. the financing amount.
– Bank’s profit margin
(v) The customer is to settle the payment by instalment throughout the financing period.
(d) The difference between BBA house financing and conventional housing loans
An ordinary conventional housing loan is given on the basis of debtor/creditor relationship whereby, the amount of loan is charged interest, normally quoted at a certain percentage above Base Lending Rate over a loan period, repayable in periodic instalments. The Base Lending Rate fluctuates up or down and it affects the total loan cost. Simultaneously, arrears in conventional loans are normally capitalised.
However, under the Islamic Banking Scheme, as in the BBA concept, a seller-buyer relationship will be established, and the selling price is fixed upfront. The sale price is then repaid in periodic instalments and the agreed instalment amount will remain fixed throughout the financing period. As such, the customer’s interest rate risk is eliminated.
Furthermore, arrears will not be capitalised.
In BBA, early settlement of the price of the house can be made. A customer is not required to give advance notice to the Bank for early settlement, i.e. financing being settled before the completion of the financing tenure. As such, there is no early settlement penalty fees/charges imposed on the customer. In the case of early settlement, the bank usually will grant rebate oribra’ for the unearned profit. The rebate is in the form of a reduction in the balance outstanding. The early settlement amount is the net figure after deducting the rebate.
(e) Advantages of BBA financing
i. The total cost of the property purchased is determined at the time of contract or ‘aqd.
ii. There is no additional or “hidden” cost that will change the price of the property purchased.
iii. The transaction is transparent.
iv. There is no element of uncertainties or gharar.
v. Customers will know exactly when the financing will end.
vi. There will be no compounding of arrears and outstanding penalty charges.
vii. Presently, there is no additional/penalty charge on outstanding miscellaneous charges.
viii. Repayment is not subjected to fluctuation of BLR.
X. Allows for better financial planning.
8.6 Home leasing as an investment (Ijarah)
An Ijarah contract is where the financier buys and leases equipment or other assets to the business owner for a fee or rental. The duration of the lease as well as the fee must be set in advance and mutually agreed. To be acceptable as an Islamic financial product, the leasing
contract must meet the following conditions:
(a) The service that the asset is supposed to provide and for which it is being rented should be definitely and clearly known to both parties;
(b) The asset remains in the ownership of the lessor who is responsible for its maintenance so that it continues to give the service for which it was rented;
(c) The leasing contract is terminated as soon as the asset ceases to give the service for which it was rented. If the asset becomes damaged during the period of the contract, the contract will remain valid; and
(d) The price of an asset that may be sold to the lessee at the expiry of the contract cannot be pre-determined. It can be determined only at the time of the expiry of the contract.
An Ijarah wa `Iqtina’ (Lease to Purchase or Hire Purchase) contract is just the same as that of the Ijarah except that the business owner is committed to buying the equipment at the end of the lease period. Fees previously paid constitute part of the purchase price. This type of lease to purchase agreement is commonly used for home financing. Ijarah or leasing is a straightforward method of house financing.
Leasing a house to a lessee is also a way to obtain income from investment in real estate. Bought real estate can be leased to obtain the rental from the asset.

8.7 Valuation of Real Property
Before we commence on the discussion of various valuation approaches, we shall outline the users and reasons for valuation exercises to be conducted. The various uses and the users are as follows:
Valuation for loan purposes. Real estate is a common form of collateral acceptable to financial institutions in Malaysia. In lending to consumers, it is a common practice for financial institutions to compute the amount of loan based on a certain percentage of the collateral value. To facilitate the lending and for purposes of getting a fair value, a
valuation exercise is conducted on the proposed collateral. The valuation is usually conducted by professional valuers, and for this purpose, banks usually have a list of approved valuers.
Valuation to obtain fair market value. A valuation report is also useful for a potential seller who is not sure of the market prices. To avoid selling his property well below market price, a person could seek the services of a professional valuer to advice on a fair market value.
Valuation for interested purchaser. Purchasers who are keen in buying properties could also seek the services of valuers to advice on the fair market price so that they need not overpay for the acquisition of the properties. Very often, the same valuation report could subsequently be used by the financier in loan processing. In this regard, it seems advisable to get a valuer to value the property before buying it, instead of waiting for a bank to appoint a valuer after the purchase commitment has been made. The costs or valuation fee is still the same whether it is conducted before or after the sale agreement is executed.
Valuation for acquisition compensation. The government or its agencies have the right to acquire land belonging to the private sector. In consideration of such acquisitions, compensation has to be made. A valuation report is a useful guide whenever there is a dispute. The final price need not be the value given by the valuer. However, there is
at least a basis of negotiation on the compensation sum. Such a valuation report could also be produced in court for a decision if the negotiations failed.
Valuation for estate planning. In estate planning for wealth distribution, a valuation based on the opinion of a professional valuer is also useful to ensure that the intended sum is actually distributed to the next-of-kin.
Valuation for corporate purposes. Corporations also value or revalue their properties. Surplus arising from valuation could be incorporated into the net worth, giving a better indication of net assets per share. Bonus issues of ordinary shares are practiced by some corporations based on the surplus in valuation in real properties owned by the company.
Valuation for fire insurance. A valuation report also provides recommendation on the sum assured for fire insurance.
Valuation or estimating the current market value of a real property is done through a process known as a real estate appraisal. By the use of certain techniques, an appraiser (licensed property valuer) determines what he or she feels is the current market value of the subject property. However due to information and technical shortcomings, the estimate arrived at is not error free. The values stated are valid or applicable as at certain dates and thereafter, changes could take place. Usually, an update in valuation is appropriate if the report is used for reference after some time from the date of valuation. For instance, some bank officers in conducting a credit review exercise on their borrowers do call up the valuers to get a verbal update of the properties’ values. These verbal updates are further backed by official valuation every three to five years.
There are three approaches used by appraisers to estimate the market value of properties. The three approaches are:
(a) the cost approach
(b) the comparative sales approach, and
(c) the income approach
8.7.1 The Cost Approach
This approach is based on the total cost of development of the property. The development costs would include land cost, construction costs, bank interests, professional fees, stamp duties, costs of evicting squatters, and conversion premium. This approach works very well in the price
estimates of newly completed properties. Very often, the developer’s reward for entrepreneurship in the development is also recognized as part of the value of the property. The argument is, without the reward, who will be keen in developing the properties? This approach is in fact based
on the concept of ‘Cost Plus Approach’ in new productpricing.
8.7.2 The Comparative Sales Approach
This approach uses the most recently transacted prices of comparable properties as a guide. We must bear in mind that every property is unique. Due to its uniqueness, adjustment to the recent transacted prices must be made accordingly.
If the property being valued is superior to those transacted, the estimated value must be adjusted upward according to how superior it is. Similarly, if the subject property is inferior as compared to the one transacted, then the value of the subject property should be adjusted downward. Hence, one can see that the process of valuation under this approach can be rather subjective. Personal preferences of valuers can affect valuation. In addition, there are also situations of desperate
buyers or desperate sellers paying or buying at exceptional prices. To avoid RPGT, certain transactions are known to have been under-declared in prices.
8.7.3 The Income Approach
In this approach, a property’s value is viewed as the present value (value of money in today’s terms) of all its future income. The most common income approach is called direct capitalization.
This approach uses the formula below:

Where,

V = market value
NOI = annual net operating income
R = market capitalization rate
Annual net operating income (NOI) is the gross potential rental revenue minus vacancy and collection losses, operating expenses including insurance and taxes.
The estimated market capitalization rate is obtained by referring to recent market sales figures to determine the rate of return currently required by investors (using the above formula). The capitalization rate is the rate used to convert an income stream to present value.
For example, you have data for similar properties as follows:

From the market information above, an appraiser will work through and analyse the similarities of the comparables and the subject property before he decides on an appropriate market capitalization rate (R).
Say the appraiser has selected R = 0.055, the market value of the subject property = RM16,000 / 0.055 = RM290,909.
8.7.4 Expert Opinion
Valuation of real property is a complex and technical procedure. Reliable information about the features of the comparable properties, the selling prices and terms and conditions of transactions are required in order to give a more realistic estimate on the subject property. Having obtained
such information, it also involves some subjective judgments by the expert in this field. One must therefore be aware that valuations cannot be scientifically accurate.
8.7.5 Real Estate Cycle
For anyone to invest in real property or to buy it for own occupation, he must have the financial means or economic resources to invest. The financial means and economic resources of an individual, or other entities, depend greatly on the country’s economic performance. During
good

times, many people are overconfident about their financial means and tend to commit heavily in
the real estate sector. They also resort to heavy financing even though interest rates are high.
However, when a recession sets in, these people who are overcommitted are the ones who suffer as their investments are either voluntarily or forced sold at low prices. This group of people includes real estate developers and individual purchasers. To avoid substantial capital loss or to
make substantial capital gains, one of the ways is to understand the real estate cycle. The real estate cycle follows quite closely that of a country’s economic cycle.
A typical developed property usually goes through three phases:
Growth – In this phase, news of investors or speculators making money or fortunes from properties is common. New players begin to become developers, hence increasing the supply.
Properties change hands fast and at increasing prices. Rental of properties rise, boosting confidence of owners to acquire more when they experience that the rental income exceeds the instalment repayment to financial institutions. Many investors who do not own any property express regret over missing the boat but have no hesitation to join in.
Investors who make profit become greedy and start buying more properties, with the help of financial institutions providing the bulk of funds in acquisitions.
Stagnation – The sale of properties slows down as the supply becomes excessive since more developers have come into the market. Excessive supply also leads to properties not being sold or let out for rental income. Even when properties are rented out, the rental incomes somehow drop and are far from meeting the instalment amounts. When investors cannot repay the financing, the selling of properties at a loss begins.
Decline – Reluctantly, many players are forced by their financiers to liquidate or face foreclosure
actions by financial institutions. Some of the developers would abscond. All of a sudden, everyone realizes the oversupply situation. Properties are sold at ridiculously low prices but takers are few. Non-performing loans in the real estate sector surge. It is a phase that is accompanied by an economic recession. This is the time to buy cheap properties at
low prices, although some would advocate moving in only when there are symptoms of economic recovery.
Malaysia suffered a recession from the mid-1980’s to 1989. During this recession, the real estate market was in a poor shape.Many property development projects were abandoned due to a variety of reasons. Consequently, many property loans were classified as non-performing
loans. Although the economy started to recover from 1989, the property market did not feel the impact until late 1990 and early 1991. Since then, the property market escalated and developed into huge oversupply by the time the currency crisis took place.
With the Asian Currency Crisis set in mid-1997, the Malaysian economy was severely crippled and so was the property market which was already in an oversaturated situation. Many issues had to be resolved in order for the property cycle to revert to an upward direction.
Theoretically, it has to wait for the economic cycle to revert to an upward direction first.

8.8 iREITs
A REIT is a collective investment vehicle (typically a trust fund) which pulls money from investors and uses the pooled capital to buy, manage and sell real estate assets. The real estate assets can be residential or commercial buildings, industrial lots or other real estate related assets. The objective of a REIT is to obtain reasonable investment returns provided by the stability of the real estate market as well as a liquidity of the transaction of a unit trust. Returns are generated from the
rental income plus any capital appreciation that comes from holding the real estate assets over the period. Unit holders will receive the returns in the form of dividend or distribution of capital gains for the holding period. For Islamic REITs, management companies must rent out the property to tenants whose activities are in accordance with the Sharia. The money must also be deposited into Islamic Banks. An example of an Islamic REIT is Al Aqar REIT.
The Diagram below shows how a REIT may be structured.

8.9 Conclusion
This chapter covered the topic of Investment in Real Estates. Among the theme discussed were: The Basic Characteristics of Real Estate as an Investment Vehicle, General Classification of Real Properties, Important Factors to be Considered When Investing in Real Property, Determinants of Real Estate Prices, Islamic Home Financing, Home Leasing as an Investment (Ijarah), Valuation of Real Property and iREITS. The aspects discussed are relevant to providing effective and comprehensive Shariah compliant financial planning advice.

Self-Assessment Test
Circle the letter of the correct choice for each of the following.

1. In Diminishing Musharakah House Financing, customers __________.
A. rent the house and pay rent to the bank.
B. own the house and pay the price in instalments.
C. pay rent on the bank’s portion of the house until 100% of the ownership is bought from the bank.
D. pay leasing fee to the bank.

2. Investment in property can take various forms. It can be a direct or indirect investment. Which of the following is NOT a direct investment in property?
A. Buying a unit of shop lot in a new township.
B. Buying a 700 sq. ft. office lot in an office complex.
C. Holding in joint name a piece of land along the Tanjung Bidara Beach in Melaka.
D. Holding RM1million worth of a 10-year Sukuk in a Malaysian development company operating in Guandong Province of China.

3. Real property may be classified into three general main groupings: residential, commercial and raw land. Which of the following classifications is inconsistent?
A. Residential property: a condominium, a flat and a bungalow.
B. Commercial property: a holiday apartment in a holiday resort with room service, an office lot and a shop floor in a shopping center.
C. Raw land: 20 acres of oil palm plantation in Raub, a bungalow in Bukit Damansara, and a factory lot at Glenmerie, Shah Alam.
D. Raw land: 10 acres of empty land along Port Dickson Beach, 50 acres of oil palm plantation along the Second Link to Singapore in Johor.

4. Before investing in a property directly, there are main features to be considered regarding the respective potential property. The features include
i. physical property
ii. property rights
iii. time horizon
iv. geographical location
A. i and ii only
B. iand iii only
C. i, ii and iii only
D. All of the above

5. Real property market does have its ups and downs as the stock market does However, property market is considered to have greater risk in general compared to the stock market due to ________________.
A. Holding real property is less liquid than share stocks and requires greater outlay of capital.
B. Property is cash dealing and share is noncash dealing.
C. Property cannot be sold for cash.
D. None of the above

6. The features of property themselves are determinants of a property’s price. Apart from these physical features like size, type of title, and uses, there are also other key features. They include
i. location of property
ii. accessibility
iii. conveniences
iv. social-economic surrounding
A. i, ii, iii and iv
B. i, ii and iii
C. iand ii
D. iand iv

7. Demand is one of the determinants of a property’s price. A higher demand may be caused by
i. high population growth
ii. trend of migration from rural to urban areas
iii. slowing down of economy
iv. an economic boom
A. i, ii and iii only
B. i, ii and iv only
C. iand ii only
D. i only

8. The following are the advantages of BBA house financing EXCEPT:
A. Total cost of the property is fixed as determined at the ‘aqd.
B. Low profit margin charged at around 40%-50% from the purchase price of the house charged by the bank to the buyer.
C. The transaction is transparent.
D. There is no element of uncertainty or gharar.

9. There are three commonly used approaches in property appraisal. Identify the three approaches.
i. The cash approach
ii. The cost approach
iii. The comparative sales approach
iv. The income approach
A. i, ii and iii
B. i, ii and iv
C. i, iii and iv
D. ii, iii and iv

10. Which one of the statements is NOT TRUE about property valuation?
i. The Comparative Sales Approach uses the most current transacted price of a similar property as a guide.
ii. The value of the subject property may be adjusted upward or downward accordingly from the transacted price of a similar property
iii. The property’s value is viewed as the present value of all its future income.
A. None of the above
B. iand ii only
C. ii and iii only
D. iii only

Answer: 1-c, 2-d, 3-c, 4-d, 5-a, 6-a, 7-b, 8-b,9-d,10-a

CHAPTER 9
FINANCIAL STATEMENT ANALYSIS
Chapter/Topic Outline
9.1 Introduction
9.2 Accounting Concepts and Principles
9.2.1. The Use of Financial Statements
9.2.2. Basic Accounting Concepts and Principles
9.3 Understanding Financial Statements
9.3.1. Balance Sheet
9.3.2. Income Statement/ Profit and Loss Statement
9.3.3. Cash Flow Statement
9.3.4. Sample of Financial Statements
9.4 Financial Statement Analysis
9.4.1. The Principal Tools of Analysis
9.5 Purification of Non-halal Capital Gains and Income
9.5.1. Purification of Investment Income Received
9.5.2. Purification of Capital Gains of Shariah-Compliant Securities
9.5.3. Purification of Capital Gains of Shariah-Compliant Securities
Subsequently Regarded as Non-Shariah Compliant
9.5.4. Sector Guidelines versus Financial Guidelines
9.6 Conclusion
Definitions:

Study/Learning Objectives
Upon completion of this chapter, you should have knowledge of:
(a) Accounting Concepts and Principles
(b) Understanding Financial Statements
(c) Financial Statement Analysis
(d) Purification of Non-halal Income Elements

9.1 Introduction
There are various parties that have interest in the state of an economy and the existence of a company. The main interested party is the shareholders. As the collective owners of the company, they are concerned with the current financial gain of the company for the current year and the prospect of stability and growth in the next years. Other interested parties of the financial state of a company are employees who are looking for stability and the company’s attitude
towards them. Lenders to the company are also parties that depend heavily on its performance.
Banks, trade suppliers and other lenders are in need of financial information regarding the company that is partly obtainable in company annual reports.
Prospective shareholders are also one of the main users of information supplied in company annual reports. This is because other information about the company is restricted as they are strangers to the company until they join in as shareholders. It is important that they can make full
use of all information provided in the annual reports before they invest in the company. One efficient way to do that is to conduct a ratio analysis to assess the performance of the company.
Main areas of performance usually taken into consideration are profitability, liquidity, efficiency,
leverage, return on investment and market position on the company in terms of share price, among others. In addition to analyzing the performance of these ratios, prospective shareholders also need to take into account other important aspects that are not immediately reflected in the
annual reports such as the quality of management and the risk elements of activities performed in the company to be selected. For example, investors need to understand the activities or operations involved before investing.
9.2 Accounting Concepts and Principles
Accounting information is used within the organisation as well as to provide information to external parties. The accounting profession is governed by standards such as the “Generally Accepted Accounting Principles” (GAAP), Malaysia Accounting Standard Board (MASB) and
Accounting International Standards (IAS). The use of guidelines is in order to provide consistency in the reporting of financial statements to users. There are three main uses of accounting information, namely for reporting, decision-making and for control purposes.
9.2.1 Use of Financial Statements
In terms of reporting, prepared financial statements are used by the shareholders and other stakeholders, such as major creditors, sukuk holders, tax authorities and prospective investors.
Creditors use the information in the financial statements to assess the ability of firms to meet their short and long-term obligations while tax authorities use financial statements to determine the amount of tax to be levied on the firm’ sincome.
Accounting information is also used for internal purposes, that is, to make investment decision by the use of budget and standard costing. In general, this is called management accounting. Sales managers, for example, will be using sales and profit information in the financial statements to evaluate the effectiveness of selling and promotion strategies implemented.

Control measures also need to have input from the accounting information. Managers will have to monitor and control the performance of employees, departments and the products produced in the company. Managers can prepare budgets based on the current or past year’s financial information. Standard costing employed by the company can be used to monitor the increase or decrease of cost for producing one unit of product as well as the cost of labour for producing the products. Any increase or decrease in production cost signifies the performance of employees,
department and product under the control of managers.
The company has to make sure those financial statements, namely income statement, balance sheet, cash flow statement and the statement of changes in equity are prepared based on the following basic concepts and principles.
9.2.2 Forensic Accounting Concepts and Principles
Cost concept – Assets are normally recorded at cost price, and that this is the basis for valuation of the assets. Market values are only used to value certain assets such as marketable securities and land, but not other types of assets that will be recorded at cost and depreciated accordingly.
The going concern concept – This concept assumes that the business will continue to operate for the foreseeable future. Therefore, it is objective to use cost concept when valuing assets in the financial statement. Suppose, however if an accountant knows that the business is to close down
in the next two months, then this concept shall not be applied at this point in preparation of a financial statement. Instead the assets should be valued at the expected sale price.
The situations where going concern assumption should not be made are:
(a) The business is going to close down in the near future;
(n) Shortage of cash makes it almost certain that the business will have to cease trading;
(c) A large part of the business will almost certainly have to be closed down because of a shortage of cash.
Realization concept – Indicates the stage of business transaction where profit can be realized, i.e. income is recognized in the financial statements. It is not considered realized when cash is being received, nor when the order is being received as cash concept is not practiced by business organizations. Several criteria have to be observed for realization to take place:
(a) Goods or services have been provided to the buyer;
(b) The buyer accepts liability to pay for the goods or services;
(c) The monetary value of the goods or services has been determined;
(d) The buyer will be in a position to be able to pay for the goods or services.
By ensuring that the above have taken place, there will be minimal need for adjustment due to goods returned, rejected or price reduction due to various reasons. Thus, the sales or revenue taken into account is only that which have been realized.
Accrual concept – The accrual concept states that net profit is the difference between revenue and expenses.
The revenue earned in a specified time period less the expenses incurred (either paid or unpaid) during the same specified time period, is the net profit. In real life, most of the time, the amount paid differs from the amount actually incurred.
For example, revenue generated for ABC Company in an accounting year starting 1st January 2017 is RM 10 million. The paid expenses are RM4 million and the unpaid expenses amount to RM3 million. The total expenses is RM 7 million not RM 4 million (amount paid). The accountant
of ABC Company has to recognize that the total cost of the project is RM 7 million. In order to arrive at the net profit, all expenses that fall within the dates from 1st January 2017 to 31st
December 2017 must be taken into account even though the RM3 million is still outstanding.
Materiality – Recording of expenses should be done when the amount is not trivial, i.e. material.
To arrive at the decision whether the cost is material or otherwise, a cost benefit analysis should be performed. Normally the type and size of firm will have a great effect on the decision as to which items are material. If the benefit from recording the expenses affects the decision-making by the managers, then it is material. The common practice for companies is to group the immaterial items into groups, such as stationery and office supplies.
Prudence – It is the assumption to be made that accountants do not overstate profit and asset and do not understate expenses and liabilities. For example, it is usually the practice of accountants to write off long overdue account receivables in order not to overstate asset.
Prudence is practiced by accountants so that investors do not make wrong financial decisions based on the overstated profit and assets of the business. The accountant should always do everything possible to ensure that he is on the “safe side”, and this is known as prudence. He will
take figures that will understate rather than overstate the profit. Thus, he should choose figures that give a lower net worth rather than one that gives a higher net worth. He will also ensure that all known losses have been taken into account, and profit should not be anticipated. The term
“conservatism” was widely used until it was generally replaced by “prudence”.
Consistency – This is the practice of accountants in recording financial transactions in a consistent manner. For that matter, they have to follow through the methods of depreciating assets and the benchmark amount of expenses to be categorised as expenses or assets.
Consistency in quality is important for comparison of accounting information between years; that is, trend analysis can be made.
However, this does not imply that once a method has been chosen, no other methods can be used in the future at all. A firm can change the method used, but such a change is only made after much consideration. When such a change takes place, then the effect of the change should be presented in addition to the income statement either in the profit and loss account itself or in the notes to the account, should the profits arrived at in the year of change is affected by a material amount.
Substance over form – This is the accounting principle that considers the economic substance as more relevant to be recognized rather than the legal form of the transaction. When such a situation arises, the substance (basically the economic impact on the business) should be taken into account rather than the legal form, which is of mere technical documentation. This means that accounting in this instance will not reflect the exact legal position concerning that transaction.
A common example of this instance is the recording of a hire-purchase transaction by the business in the purchase of a motor van. Legally, the business is not the legal owner of the motor vehicle until all instalments are paid. In the economic viewpoint, the business uses the van to
derive economic benefit from its use. Therefore, the business will show the van being bought on hire-purchase in its accounts and balance sheet as though it were legally owned by the business, but also showing separately the amount still owed for it.
In this way, the substance of the transaction has taken precedence over the legal form of the transaction.
9.2 Understanding Financial Statements
There are four types of financial statements used in financial analysis of companies. They are the Statement of Financial Position commonly referred to as the balance sheet, the Statement of profit and loss or income statement, cash flow statement and the statement of changes of
equity. Financial ratios are usually calculated using the information from the balance sheet and the profit and loss statement. The cash flow statement is a statement showing the cash inflow and outflow of the business including cash received paid for operating, investing and financing activities. Its purpose is to explain the cash in and out of the business since cash usually does not correspond to the profit/loss of the business.
Apart from the statements showing the financial data, the notes to the accounts are an integral part of the accounts. It is from the notes that one gets a better picture of the financial results. For example, the company may show a huge profit in a particular year. Without looking at the notes, we may assume that there is a huge increase in sales. However, in the notes to the accounts, it is stated that the company had disposed of a piece of land with high capital gain.
Another scenario may be the company is in litigation, there is no provision made as the director thinks that the liabilities will not arise, but disclosure has been made. Therefore, it is vital that as a user of financial statements, one should not ignore the notes to the accounts as these provide a better understanding of the financial statements.
In the case of listed companies, they have to make public release of quarterly reports in abbreviated format, and the annual audited accounts. Audited accounts are financial statements fully verified by independent certified public accountants (CPAs) or auditors.
Investors may use the information from the financial statements and the public release to get more recent financial information about the company. Financial information reported in the financial statements is historical information whereas the information from the public release of
quarterly reports is more recent. Using both sets of information will lead to better decision-making by the investors.
9.2.1 Statement of Financial Position or Balance sheet
The Balance Sheet is a statement showing the whole list of assets, liabilities and shareholder’s equity of a company at the end of the financial year. Asset items provide economic benefits to the company. Liabilities, on the other hand are the financial obligations of the company that must be paid at some point of time. Shareholders‟ equity is the capital that shareholders invest in the company. This includes value of all common stocks issued, additional paid-in capital and retained earnings. Shareholders‟ equity is the portion of claim of assets by the shareholders.
Total assets of a company are financed by the liabilities and shareholder’s‟ equity. This is called the accounting equation.

TOTAL ASSETS = TOTAL LIABILITIES + EQUITY

In general, assets can be categorised into fixed assets and current assets. The difference between these two types of assets is that the former requires more than a year to liquidate while the latter can be liquidated within one year. Examples of fixed assets are land, buildings
and machinery. Current assets comprise cash, accounts receivables and inventory. Accounts receivable consists of payments due from its customers who purchase goods or acquire services on credit. The inventory of a firm usually consists of raw materials, work in progress and the finished products ready for sale.
Liabilities can also be categorised into current and long-term liabilities. Current liabilities are those that are expected to be paid within one year, such as account payable and accrued expenses. Long-term liabilities are obligations that are long term in nature. Long-term financing falls into this category.
9.2.2 Statement of Profit and Loss or Income Statement
An Income Statement is a financial summary of operating results for a period of time. It is a summary of revenues generated over a period of time, the cost and expenses incurred (including tax) during the same period, and the profits. Unlike a balance sheet, a profit and loss account
covers the activities that have occurred during the accounting period. The items reported in the income statement are as follows:
a. Net sales – Sales made during the accounting year after adjusting for discounts and returns.
b. Cost of goods sold – The cost of producing or acquiring the goods or services sold during the accounting year.
c. Gross profit – equals to net sales minus cost of goods sold.
d. Operating expenses – comprise of expenses related to marketing and distributing the products and administrating the business.
e. Earnings before interest and tax (EBIT) – gross profit minus a firm’s operating expenses (sometimes referred to as operating income).
f. Net income – earnings before tax minus tax (sometimes referred to as earnings after taxes).
9.2.3 Statement of Cash Flow
The statement of cash flow as the name suggests provides a summary of cash movements (the inflows and outflows of cash and cash equivalents) and the events that cause the changes in the cash position of a company in the period. It shows how liquid a company is. Apart from the liquidity aspect, the statement also tells how efficient the company is in generating cash from its operations, where and for what types of activities it has been used. If there is an injection of funds, it is shown as a separate class of cash inflow.

However, the fact is, a company’s reported earnings may have little resemblance to the company’s cash flow. Profit/income is just the difference between revenues and the accounting costs that have been charged against the revenue; cash flow is the amount of cash actually
taken in and paid out as a result of doing business.
9.2.4 Example of Financial Statements
a) Company Balance Sheets

In real cases, additional notes will be presented to explain more about the information provided in the face of the Balance Sheet. No notes have been included in this material.

b) Company Profit and Loss Account/Income Statement

Table 9.2
Jernih Murni Corporation Berhad
Statement of Profit and Loss for the Year Ended 31st December 2013

The note column is meant for the presentation format only. However, no notes have been included in this material.

c) Company Cash Flow Statement

Table 9.3
Jerneh Murni Corporation Berhad
Statement of Cash Flow for the Year Ended 31st December 2013

In the financial services operation, the look of the balance sheet and income statem ent is different from those of manufacturing companies. This is because of the different nature of the operations of a bank.

e) Sample Income Statement of a Bank

9.3 Financial Statement Analysis
Information in the financial statements do not give much insight into the performance of a company since it is merely a collection of raw financial information. Ratio analysis can be performed to assess the performance of a company more meaningfully. This process involving analyzing data, interpreting outcome and comparison of results over a time frame and amongst companies within the industries is what we term as financial statement analysis. This will give a better understanding on the nature and operating characteristics of the company.
It is believed that the performance of a company has a great influence on the market price of its shares. If a company has good performance and the prospects look good, the market price of its shares is likely to move upwards. However, the market price does not only depend on the performance and prospects, but also its exposure to risks.
Ratio analysis is one of the tools widely used by financial managers to assess the financial condition of the firm. It evaluates the relationship between financial statement variables. Firms can use the ratio analysis to compare current performance with past performance to evaluate the impact of any financial decision implemented (internal analysis). Firms can also compare the current performance within the industry to evaluate the standing of a particular firm to the ratios of industry average.
9.3.1 Principal Tools of Analysis
There are several tools that can be used to perform financial statement analyses to gain insights into the performance of the companies under study. Usually one tool is not sufficient to learn about the financial condition of a company. For that matter, two or more tools as provided below can be used for a comprehensive financial statement analysis to be made. The tools are:
(a) Trend analysis
(b) Cash flow analysis
(c) Ratio analysis
The application of these tools as well as other aspects of analysis will be illustrated using the
information from the financial statements of Jerneh Murni Berhad offered in Tables 9.1 – 9.5.
(a) Trend Analysis
Horizontal analysis is performed by comparing the financial statements of the same company for two or more years. One of the presentations that can be performed is to express the change of current information in relation to previous information using percentages. In practice, only major
items are shown under the trend analysis.

Comparative Income Statement of Jerneh Murni Berhad

Trend analysis provides useful information when changes are examined over a period longer than two years. One would first have to determine a base year (a year that is representative of the company’s activity) and the base year is assigned an index of 100. An index for an item in the
succeeding year is found by dividing the item’s amount by the base year and multiplying by 100.
(b) Cash Flow analysis
The cash flow statement is intended to help predict the company’s ability to sustain cash from current operations. In doing so, the statement provides more objective information about:
(i) A company’s ability to generate cash flow from operations
(ii) Trends in cash flow components and cash consequences of investing and financing decisions
(iii) Management decisions regarding such critical areas as financial policy (leverage), dividend policy, and investment for growth
An important but elusive concept often used in cash flow analysis is free cash flow (FCF). It is intended to measure the cash available to the company for discretionary uses after making all required cash outlays. The concept is widely used by analysts and in the finance literature as the
basis for many valuation models. The basic elements required to calculate FCF are available from the cash flow statement. In practice, however, the definition of FCF varies widely, depending on how one defines required and discretionary uses.
The basic definition used by many analysts is cash from operations (CFO) after considering the amount of capital expenditures required to maintain the company’s present productive capacity.
Discretionary uses include growth oriented capital expenditures and acquisitions, debt reduction, and stockholder payments (dividends and share repurchase). The larger the company’s FCF, the healthier it is because it has more cash available for growth, debt payment and dividends.
c) Ratio Analysis
Ratios are among the best known and most widely used tools of financial analysis. At the same time, their function is often misunderstood, and consequently their significance may easily be overrated.
A ratio expresses the mathematical relationship between one quantity and another. The ratio of 200 to 100 is expressed as 2:1, or as 2. While the computation of a ratio involves a simple arithmetical operation, its interpretation is a far more complex matter. However, for a ratio to be
significant, it must express a relationship that has significance.
Ratios are tools of analysis that in most cases provide one with clues and symptoms of underlying conditions. Ratios, properly interpreted, can also point the way to areas requiring further investigation and inquiry. The analysis of ratio can disclose relationships as well as bases of comparison that reveal conditions and trends that cannot be detected by an inspection of the individual components of the ratio.
In addition to the internal operating conditions that affect the ratios of a company, one must be aware of the factors, such as general business conditions, industry position, management policies, as well as accounting principles that can affect them.
Before ratios or similar measures such as trend indices or percentage relationships are computed, one must make sure that the figures entering into the computation are valid and consistent. Thus, when a company’s internal controls are such that the accounting system cannot be relied upon to produce reliable figures, the ratios based on such figures are, of course, also unreliable.
Ratios should always be interpreted with great care since factors affecting the numerator may correlate with those affecting the denominator. Thus, for example, it is possible to improve the
ratio of operating expenses to sales by reducing costs that act to stimulate sales. If the cost reduction consequently results in a loss of sales or market share, such a seeming improvement in profitability may, in fact, have an overall detrimental effect on the future prospects of the company and must be interpreted accordingly.
It should also be recognized that many ratios have important variables in common with other ratios, thus tending to make them vary and be influenced by the same factors. Consequently, there is no need to use all the available ratios in order to diagnose a given condition.
Ratios, like most other relationships in the financial analysis, are not significant by themselves and can be interpreted only by comparison with (1) past ratios of the same company, or (2) some predetermined standard, or (3) ratios of other companies in the industry. The range of a ratio over time is also significant as is the trend of a given ratio over time.
In SC’s “Module 12: Investment Management and Corporate Finance” examination study guide, financial ratios are divided into five (5) main categories:

(i) Liquidity ratios;

(ii) Operating performance ratios;

(iii) Financial risk ratios/Gearing Ratios;

(iv) Growth ratios; and

(v) Share market ratios.

(1) Liquidity ratios
The short-term liquidity of a company is measured by the degree to which it can meet its shortterm obligations. Liquidity implies the ready ability to convert assets into cash or to obtain cash.
The short term is conventionally viewed as a time span up to a year, although it is sometimes also identified with the normal operating cycle of a business, that is, the time span encompassing the buying-producing-selling and collecting cycle of the company.
Liquidity is a matter of degree. A lack of liquidity may mean that the company is unable to avail itself of favourable discounts and is unable to take advantage of profitable business opportunities as they may arise. At this stage, a lack of liquidity implies a lack of freedom of choice as well as constraints on the management’s freedom ofaction.
A more serious lack of liquidity means that the company is unable to pay its current debts and obligations. This can lead to forced sale of long-term investments and assets and, in its most severe form, to insolvency and bankruptcy.
Current ratio – is sometimes referred to as the working capital ratio and is computed as follows:

In 2007, Jerneh Murni Bhd (JMB) had a current ratio of = 652,667 / 416,121 = 1.57
From the above, we can safely deduce that for every RM 1 debt JMB owed, it had RM1.57 backing of short-term assets to pay for it.
Quick Asset Ratio – this is the extension of the current ratio by taking out the inventory (stock) from the current assets before the current assets are divided by the current liabilities. Stock is considered to be least liquid among all the current assets, and takes a much longer time to
convert into cash, and the value might be subjected to high discount. This ratio tells how well a corporation can meet its current obligation immediately (within days). The formula now becomes:

In 1999, JMB’s average collection period was 167 days; to put it another way, it took close to half a year to collect the amount owing by the trade debtors. To determine if this is good, it should be compared with the company’s credit policy and industrynorm.
In assessing the quality of these ratios, the sales policy aspect of the collection period evaluation must also be kept in mind. A company may be willing to accept slow-paying customers who provide business, that is, on an overall basis bring profit to the company.
In addition to the consideration of profitability, a company may extend more liberal credit in cases such as (1) the introduction of a new product, (2) a desire to make sales in order to utilize available excess capacity, or (3) special competitive conditions in the industry. Thus, the
relationship between the level of receivables and that of sales and profits must always be borne in mind when evaluating collection period.
Inventory Turnover – this measures the average rate of speed with which the inventories move through and out of the company. Inventory turnover can be calculated relative to sales or cost of goods sold. The preferred turnover ratio is cost of goods sold as it does not include the profit
margin implied in sales. Inventory turnover can also be computed by dividing cost of goods sold by average inventory.

Note: When sales are used instead of cost of sales, the result tends to be less accurate due to the variation in profit margin.
A rate of inventory turnover that is slower than that experienced historically, or that is below the norm of the industry, would lead to preliminary conclusion that it includes obsolete items, or items that are technologically obsolescent, thus, are not saleable. However, further investigation may reveal that the slowdown in inventory turnover is due to a buildup in accordance with a future contractual commitment, in anticipation of a price rise, shortage or any other reasons that must
be probed further.
(2) Operating Performance Ratios
Total Asset Turnover – total asset turnover indicates how efficient assets are being used to generate sales. It is calculated as follows:

From the calculation we can see that for every RM1 of asset invested, it generates RM1.25 of sales. This value should be compared to other companies in the industry. A high total asset turnover could imply too few assets in the company for generation of potential sales. On the other hand, a low total asset turnover could imply that capital is tied up in excess assets.
Net Profit Margin – this is the “bottom line” of operation. We look at the net profit after tax as a percentage of the total sales (and other revenues). It is computed as follows:

In 2007, JMB has a net profit margin of,

= 88,914 / 1,164,229
= 0.0764
= 7.6 %

Return on Assets – it provides a measure of how much profit the company earned in relation to the assets it had worked with. Normally, ROA measures return on profit before interest and tax (PBIT) as a percentage of total assets (or average total assets). However, some analysts prefer
to use an after-tax profit in the numerator, as follows:

In 2007, JMB has an ROA of,

= 88,914 / (652,667 + 265,194 + 16,900)
= 0.095
= 9.5%

Return on Equity – ROE measures returns to the capital provided by the owners after accounting for payments to all other capital providers. It can be computed as follows:

In 2007, JMB has an ROE of,

= 88,914/459,391

= 0.19

= 19%

Again, this figure should be compared to both historical trends and other companies in the industry.

DuPont System
Many years ago, the DuPont Corporation recognized that its operation could be managed best if its executives were provided with data that decomposed the return on equity (ROE) into a number of critical variables. The DuPont analytical technique has since become widely adopted by both corporate managers and investment analysts, which is now known as the DuPont
System.

Based on this, the ROEs of JMB in 2007 and 2006 were:
ROE in 2007 = 88,914/1,164,229 x 1,164,219/934,761 x 934,761/459,391
= 7.6% x 1.24 x 2.03
= 19%
ROE in 2006 = 6,208/1,317,754 x 1,317,754/790,938 x 790,938/401,241
= 0.47% x 1.67 x 1.97
= 1.5%
The above example shows that the ROE of JMB improved significantly in 2007 in comparison with the previous year. The improvement is mainly due to an improved net profit margin.
(3) Financial Risk Ratios/Gearing Ratios
Financial risk ratios basically measure the uncertainty posed to equity-holders due to the company’s use of fixed obligation debt securities. The greater the proportion of debt used in a company’s financial structure, the riskier it is likely to be and less secure its financial position. A company that relies heavily on debt finance has high leverage or gearing and vice versa.
There are generally two types of ratios that will help measure financial risks. They are those that examine the proportion of debt compared to equity and those that look at the cash flow available to pay fixed financial charges.
Debt-equity ratio – this measures the amount of debt being used by the company in comparison
to the equity or the relative amount of funds provided by lenders and owners. A higher proportion of debt compared to equity normally makes the earnings more volatile and increases the financial risk of the company. A debt-equity ratio can be computed as follows:

In 2007, JMB has debt equity ratio of

= (loan + deferred liabilities) / Total equity,
= 24,446/459,391 + 34,893
= 0.13
This figure means there was only 13 sen of debt in the structure for every Ringgit of equity.
Times Interest Earned Ratio or Interest Cover Ratio – this ratio indicates the number of times the profits before interest and taxes (PBIT) can cover the interest expense. Care must be taken not to rely too heavily on this ratio, as a company with healthy times interest earned ratio may still not
be able to pay its debts. This occurs because interest payments require sufficient cash and not simply adequate profits. The coverage ratio can be calculated as follows:

In 2007, assuming JMB had paid financing expenses of RM15 mil.
Therefore, JMB has times financing rate earned ratio of:
= (Earning before tax/Financing expenses) + Financing expenses paid
= (89,823/15,000) + 15,000
= 7 times
In examining the leverage or gearing of a company, investors should also read the notes to the financial statements carefully to see the extent of contingent liabilities that the company is involved in. As the name suggests, contingent liabilities are liabilities that the company may or
may not have to pay. An example is signing a corporate guarantee to support the bank borrowing of a subsidiary. If the subsidiary fails to pay the bank, the corporate guarantor will have to face the consequences of honoring its legal obligation to pay. The presence of substantial contingent liabilities should be further explored to see the likelihood of the contingent liabilities becoming real. In the same example, if the subsidiary has been suffering from losses, the chances of the
subsidiary being able to pay its debts will be remote and the implication is that the liabilities would turn real.

(4) Growth Analysis
This analysis examines how fast a company would grow. In general, the growth of a company depends on the amount of resources retained and reinvested in the entity (retained earnings) and the rate of return earned on the resources retained (ROE).
The more the company reinvests, the greater the potential for growth. For a given level of reinvestment, the higher the rate of return, the higher will be the growth. The growth equation is as follows:

The company can increase ROE through its profit margin, total asset turnover and financial leverage as illustrated by the DuPont system.
(5) Share Market Ratios
These are ratios used to assess the performance of a company for stock/share valuation purposes. These ratios tell the investor exactly what portion of total profits, dividends, and equity is allocated to each share. The common ratios under this grouping are:
i. Earnings per share
ii. Price/earnings ratio
iii. Dividend per share
iv. Dividend yield
v. Payout ratio
vi. Book value per share
Earnings Per Share (EPS) – this is a convenient measure which is always presented at the lower part of a profit and loss account. It indicates the annual earning capability of a company.
Basically, this shows the company’s profit available to each unit of share held by the shareholders. EPS can be computed by using the following formula:

Assuming a company has a net profit after tax of RM25, 000 and has to pay preference dividends of RM5, 000. It has 20,000 ordinary shares outstanding at this date.
Therefore EPS,

= (RM25,000 – RM5,000)/20,000 shares
= 0.75 sen

Price/Earning Ratio (P/E) – this measure is an extension of earning per share ratio and is used to determine how the market is pricing the company’s share. This is a relationship between the market price of share and that of EPS of the company. It can be expressed in the following
equation:

Therefore, to compute P/E ratio, we must first compute the EPS. Using the above EPS and extending the assumption on the above by assuming that the market price of the share is RM12.00.
P/E = RM12.00 / RM0.75 = 16
This share is said to be selling at 16 times its earnings. Historical P/E ratio is widely published in newspapers. Value investors may like to invest in shares that have low P/E ratios which indicate that the share prices may reflect their earning ability in the future, i.e., the prices of the shares are undervalued at current and have potential to grow in the future.
Gross Dividend Per Share – it has the same principle of EPS, that is, it expresses the gross dividend allocated to each unit of share. Dividend is the distribution of profit to shareholders.
How much to distribute is dependent on the profit made by the company, the dividend policy of the company and at the discretion of the board of directors. It should be noted that gross dividend is quoted as a percentage of the par value of the share. For example, a share with a par
value of RM1 that pays 10% gross dividend would pay gross dividend of 10 sen. Gross dividend per share is calculated as follows:

In the above assumption, we have earnings of RM10,000 after the preference dividend. Say RM8, 000 is being distributed as dividend; the dividend per share shall be:
Dividend per share = RM8, 000 / 20,000 shares = 40 sen
Gross Dividend Yield – this is yet another way of assessing a share by expressing the gross dividend received in percentage term of share price instead of gross dividend per share, which is in absolute terms. Gross dividend yield in effect indicates the rate of current income earned on
the investment Ringgit. It is computed as follows:

We can now compute the dividend yield on the above example.
Dividend yield = 40 sen / 1200 sen = 3.33%
Dividend Payout Ratio – this is an indicator as how generous the company is in distributing the profit earned (EPS) to the shareholders, and the proportion that is retained within the company for whatever future purposes. This is again expressed in percentage terms and can be calculated as follows:
In the above example, the dividend payout ratio is:
Dividend payout ratio = 40 sen / 50 sen = 80%
This payout rate of 80% seems rather high compared to in the U.S. business environment where on an average the payout rate is between 40% and 60%.
Although shareholders like dividends, normally they do not like too high a dividend payout ratio as this is difficult to maintain. If too much is paid out, the company might not be able to remain profitable or the operation capacity might be depleted due to reasons such as, high inflation.
Sometimes, a company may declare share dividends instead of cash dividends. This is giving “free shares” to shareholders instead of cash. For example, if the board of directors declares a 10% share dividend, each shareholder will receive 1 new share for 10 shares he already
holds. In Malaysia, this is known as „bonus issue‟.
Book Value Per Share – this is just another term for net worth or shareholders‟ equity. It is obtained by dividing the net worth by the number of shares outstanding. Book value per share can be computed by using the following formula:
In the case of DCB, book value per share.
= RM459, 392 / RM292, 630
= RM1.57 per share
Price-to-book-value – this is a convenient way to relate the book value of a company to the market price of its shares. This is another commonly used method of share valuation. This ratio shows how aggressively the shares are being priced. Most shares have a price-to-book-value ratio of more than 1.0; this simply means that the share is selling for more than its book value.
Price-to-book-value can be computed from the formula as follows:
Assuming that the market price of JMB‟s share is RM1.80, then price-to-book value is:
= RM1.57 / 1.15
= RM1.80
This means that the market price is 15% above the net book value per share.
9.4 Purification of Non-halal Capital Gains and Income
To invest according to the Shariah, investors must observe the following principles so that capital gains and dividends received are free from haram elements. The Shariah Advisory Council (SAC) of the Securities Commission has applied a standard criterion in focusing on the activities of the companies listed on Bursa Malaysia. Companies will be classified as Shariah non-compliant securities if they are involved in the following core activities
a. Financial services based on riba’ (interest);
b. Gambling and gaming;
c. Manufacture or sale of non-halal products or related products;
d. Conventional insurance;
e. Entertainment activities which are non-permissible according to Shariah;
f. Manufacture or sale of tobacco-based products or related products;
g. Stock broking or share trading in Shariah non-compliant securities; and
h. Other activities deemed non-permissible according to Shariah.
In addition, the SAC also takes into account the level of contribution of interest income received by the company from conventional fixed deposits or other interest-bearing financial instruments.
In addition, dividends received from investment in Shariah non-compliant securities are also considered in the analysis carried out by the SAC. For companies with activities comprising both permissible and non-permissible elements, the SAC considers two additional criteria:
(a). The public perception or image of the company must be good; and
(b). The core activities of the company are important and considered maslahah (“benefit‟ in general) to the Muslim ummah (nation) and the country, and the non-permissible element is very small and involves matters such as umum balwa (common plight and difficult to avoid), urf (custom) and the rights of the non-Muslim community which are accepted by
Islam.
To determine the tolerable level of mixed contributions from permissible and non-permissible activities towards turnover and profit before tax of a company, the SAC has established several benchmarks based on ijtihad (reasoning from the sources of Shariah by qualified Shariah scholars). If the contributions from non-permissible activities exceed the benchmark, the securities of the company will be classified as Shariah non-compliant.
The benchmarks are:
(a) The five-percent benchmark
This benchmark is used to assess the level of mixed contributions from activities which are clearly prohibited, such as riba’ (as those in interest-based companies like conventional banks), gambling, liquor and pork.
(b) The 20-percent benchmark
This benchmark is used to assess the level of contribution from mixed rental payment from Shariah non-compliant activities such as the rental payment from a premise that involves gambling, sale of liquor, etc.
The revised methodology by the Securities Commission of Malaysia lists the following activities within the benchmarks:
Business Activity Benchmarks
The 5% benchmark would be applicable to the following business activities:
(i) conventional banking;
(ii) conventional insurance;
(iii) gambling;
(iv) liquor and liquor-related activities;
(v) pork and pork-related activities;
(vi) non-halal food and beverages;
(vii) Shariah non-compliant entertainment;
(viii) interest income from conventional accounts and instruments;
(x) tobacco and tobacco-related activities; and
(iX) other activities deemed non-compliant according to Shariah.
The 20% benchmark would be applicable to the following activities:
(i) hotel and resort operations*;
(ii) share trading;
(iii) stockbroking business;
(iv) rental received from Shariah non-compliant activities; and
(v) other activities deemed non-compliant according to Shariah.
The contribution of Shariah non-compliant activities to the overall revenue and profit before tax of the company will be calculated and compared against the relevant business activity benchmarks.
Following these benchmarks, it appears that Shariah-compliant securities may contain some element of impermissible activities such as interest, tobacco related business and so on.
Investors who are sensitive to the requirements of Shariah have their methods of purifying their income and capital gains from disposal of securities that have the element of non-permissible activities yet regarded as Shariah-compliant. The following issues may be relevant to
achieve purified income from the investment in securities.
9.4.1 Purification of investment income received
Subject to these conditions, the purchase and sale of shares is permissible in Shariah. An Islamic Equity Fund can be established on this basis. In Shariah, the subscribers to the fund are treated as partners „inter se‟. All the subscription amounts will form a joint pool and will be invested in purchasing the shares of different companies. The profits can accrue either through dividend distributed by the relevant companies or through the appreciation in the prices of the shares. In the first case, i.e. where the profit is earned through dividends, a certain proportion of the dividend, which corresponds to the proportion of interest earned by the company, must be given to charity. Contemporary Islamic Funds have termed this process „purification‟.
9.4.2 Purification of Capital Gains of Shariah-compliant Securities
Shariah scholars have different views about whether the „purification‟ is necessary where the profits are made through capital gains (i.e. by purchasing the shares at a lower price and selling them at a higher price). Some scholars are of the view that even in the case of capital gains the process of „purification‟ is necessary, because the market price of the share may reflect an element of interest included in the assets of the company. The other view is that no purification is required if the share is sold, even if it results in a capital gain. The reason is that no specific amount of the price can be allocated for the interest received by the company. It is obvious that if all the above requirements of the „halal‟ shares are observed, then most of the assets of the company are „halal‟, and a very small proportion of its assets may have been created by the income of interest. This small proportion is not only unknown, but also ignorable as compared to the bulk of the assets of the company. Therefore, the price of the share, in fact, is against the bulk of the assets, and not against such a small proportion. The whole price of the share therefore, may be taken as the price of the “halal‟ assets only.
The first view is more cautious and less doubtful. In particular, this applies in the case of investment in open-ended equity funds. If an investor bought unit trusts and redeem them before the payment of dividend and experience capital gain from the transaction, no amount of purification has been performed on the non-halal element of the fund. In this case, capital gain purification is the only way to purify the haram element in the investment. Conversely, when a person redeems his unit after some dividends have been received in the fund and the amount of
purification has been deducted from the dividend; this will reduce the net asset value per unit.
On the contrary, if purification is carried out both on dividends and on capital gains, all the unitholders will be treated at par with regard to the deduction of the amounts of purification.
Therefore, it is not only free from doubts but also more equitable for all unit-holders to carry out purification in the capital gains and dividends received. This purification may be carried out on the basis of an average percentage of the interests earned by the companies included in the portfolio.
9.4.3 Purification of Capital Gain of Shariah-compliant Securities subsequently regarded as non-Shariah compliant
Investors sometimes face the situation of securities invested in subsequently being announced by the Shariah Advisory Council of SAC as non-compliant securities. When that happens, the investors must perform purification of income and capital gains arising from holding the securities.
If at the time the announcement is made, the value of the securities held exceeds the original investment cost, such non-compliant securities must be liquidated. This is in accordance to the Shariah principles that investors can keep their capital. They can wait until the securities reach a price that covers their cost. Capital gains arising from the disposal of non-compliant securities made at the time of announcement can be enjoyed by the investors. However, excess of capital gain from the announcement period to the time of disposal have to be donated to charity. Where some haram income accrues to the fund, it will be donated to an approved charity that is completely unconnected with the fund, the Investment Advisor, its Directors, Officers, Trustee, Shariah Advisor, Auditors or Sponsors (sometimes referred to as “purification” of fund income).
This will be done in consultation with the Shariah Advisor. To illustrate, let us examine the following example:
An investor bought 1,000 shares of Company A at RM 1.50 on 1st January 2015. The shares of Company A have been classified as non-compliant in May 2018. The share price in May 2018 was RM 2.00. The capital gain on the day of announcement is RM 0.50 if the investor sold the shares on that day. The investor has the right to keep the gain as the gain is accrued to the period of operation when it was still Shariah-compliant. If the investor waited and sold the shares the following week and the price had gone up to RM 2.50, the capital gain would have been RM 1 per share. The excess of RM0.50 capital gain from the date of announcement and the date of disposal thus, must be donated to charity. In another scenario however, if the price of the share of Company A is RM 1, that is, below the price the share was bought for, the investor would not be obliged to liquidate his holdings. He could wait until the price of the shares covered his cost and liquidate then. The acquisition cost, as determined by the SAC is the original investment cost incurred in acquiring securities, including brokerage or related transaction costs.
9.4.4 Sector Guidelines versus Financial Guidelines
Shariah-compliance strategies are based on sector and financial guidelines. Shariah clearly defines activities in which Muslims are not to be involved in, such as the consumption of alcohol and pork and activities related to gambling. Consequently, Muslims cannot invest in assets of businesses earning primarily from such activities. Sector guidelines are general prescriptions through which all companies operating in specific types of non-Shariah compliant business activities are excluded.
Financial guidelines, on the other hand, are used to analyze how deeply an individual company is involved in financial practices that are not Shariah-compliant. For that purpose, Shariah scholars define benchmark levels for specific indicators/financial ratios through the degree of compliance.
If the company that issued the asset is involved in financial practices exceeding the respective benchmark, the asset is classified as non-compliant and, as with the sector guidelines, has to be excluded from further investment.
An example of a common financial guideline using the accounts receivables, cash and short-term investments and total assets figures as published in the financial statements of the respective company is given by: (accounts receivables + cash and short-term investments) / total assets ≤ 50%. This guideline aims to ensure that the liquid assets of a compliant company as a proportion of its total assets are less than or equal to 50%. It stems from the Shariah rule that income is to be gained mainly from illiquid assets and, therefore, the majority of assets have to be of illiquid form.
Generally, such guidelines are a relaxation of the conservative Shariah requirements and a tribute paid to the complexity and the generally non-Islamic nature of the capital markets. On top of this, ex-ante screening returns obtained from portfolios constructed under any strategy may have to be cleansed through post-investment purification practices, that is, a process in which the proportion of non-compliant income is identified and donated.
9.5 Conclusion
This chapter covered the topic of Financial Statement Analysis. Among the themes discussed were: Accounting Concepts and Principles, Understanding Financial Statements, Financial Statement Analysis, Purification of Non-Halal Capital Gains and Income. And Financial Guidelines. The aspects discussed are very important in the area of investment to ensure the Shariah compliant advice on related matters.

Self-Assessment Test
Circle the letter of the correct choice for each of the following.
1. Accounting information can be used to help accountants to:
i. Practice control in the organisation
ii. Monitor performance of products and departments
iii. Assist in the financial management of the company
A. ii, iii only
B. ii and iii only
C. i, and iii only
D. All of the above
2. A financial statement is generally multipurpose. Which are the user groups of a general financial statement?
i. Government pensioners
ii. Fund managers
iii. Trade creditors
iv. Potential investors
A. ii, iii and iv only
B. i , ii and iii
C. i, and ii
D. i and iii
3. Accounting concepts include __________.
i. the standard concept
ii. the going concern concept
iii. the realization concept
iv. the utmost good faith concept
A. ii and iii only
B. i and ii only
C. i, ii and iii only
D. All of the above
4. Which of the following is not a component of a financial statement?
A. Balance sheet
B. Income statement
C. Cash flow statement
D. Budgeted Cash Flow statement
5. A balance sheet is said to be a picture of a company’s financial position at a point of time. Which of the following is not an item within a balance sheet?
A. Fixed assets
B. Contingent liabilities
C. Dividend payable
D. Current liabilities
6. Which of the following is not an item within a cash flow statement?
A. Net operating profits
B. Dividend income
C. Unutilized bank overdraft account
D. Interest expense
7. Which of the following is not a liquidity ratio?
A. Current ratio
B. Sales with inventory
C. Quick ratio
D. Net Working Capital
8. The 20-percent benchmark is used to determine the halal status of companies involved in ___________.
A. Riba’ activities
B. Receiving mixed rental payment from premise that involves gambling and sale of liquor
C. Gambling activities
D. Hotel and resort operation
9. Shares of Elmaar Berhad were considered as non-compliant by the SAC on 2nd May 2008. The market price of the shares was quoted as RM 3.00 on that date. On 1st Jun 2008, theshare price was at RM 3.50. An investor who bought the shares at RM 2.80 could
A. Dispose the shares immediately and experience loss in capital.
B. Dispose the shares and purify the element of non-Shariah compliance by donating the amount of capital gains of RM 0.50.
C. Stay in the market and wait for the price of shares to be higher, sell for better profit and donate the amount to charity.
D. Dispose the shares and purify the element of non-Shariah compliance by donating the amount of capital gains of RM 0.20.
10. Why does Shariah consider highly leveraged companies as non-Shariah compliant?
A. Highly leveraged companies pose high risk to the shareholders.
B. Highly leveraged companies use high resources within the companies thus lesser dividends distributed to the shareholders.
C. Highly leveraged companies are more likely to be involved in riba’ related activities.
D. Highly leveraged companies receive high amounts of interest.
Answer: 1-d, 2-a, 3-a, 4-d, 5-b, 6-c, 7-b, 8-b, 9-b,10-c

CHAPTER 10
TECHNICAL ANALYSIS
Chapter/Topic Outline
10.1 Introduction
10.2 The Rationale and Assumptions for Technical Analysis
10.2.1. Academic Support For and Against Technical Analysis
10.2.2. The Rationales of Technical Analysis
10.2.3. Four Underlying Assumptions of Technical Analysis
10.3 Efficient Market Hypothesis (Random Walk) and Technical Analysis
10.3.1. The Difference between the Assumptions of the EMH and TA
10.4 Behavioral Finance and Technical Analysis
10.5 Major Technical Analysis Indicators
10.5.1. Breadth of Market
10.5.2. Stocks Trading Above 200-Day Moving Averages
10.5.3. Types of Indicator Settings
10.5.4. Charts
10.5.5. Patterns
10.5.6. Channel
10.6 Conclusion
Study/Learning Objectives
Upon completion of this chapter, you should have knowledge of:
(a) The Rationale and Assumptions for Technical Analysis
(b) Efficient Market Hypothesis (Random Walk) and Technical Analysis
(c) Behavioral Finance
(d) Major Technical Analysis Indicators

10.1 INTRODUCTION
Technical analysis is the interpretation of charts using different techniques to predict the price and movement of the securities market. The use of technical analysis is one of the approaches used by investors to make investing decisions. Another method of analysis is the fundamental
analysis approach. Unlike the approach of fundamental analysis that concentrate on the financial information of the company to derive its fair value, technical analysis employs the most basic economic tool that supply and demand rule. The results of such analyses are then used to determine in what direction the market might be moving next; in other words, what is the current trend in the market. Although, technical analysis has its limitations, analysis of price movements (that is, analysis of supply and demand imbalances) could be a very valuable tool set to any trader or investor.
The basics of technical analysis were introduced by Charles Dow well in the 1900s. The influence of the Dow Theory is seen in the principles such as the trending nature of prices; prices would have discounted known information, terms like confirmation and divergence, support and resistance and the famous Dow Jones Industrial Index of 30 stocks. Charles Dow’s contribution to modern day technical analysis is on his focus on the basics of security movement that paved the way to new ways of looking at the market. Technical analysts use charts and different rules for different techniques to try and interpret the charts to make investment decisions. In the 1970s Granville made “volume” the most important
indicator to follow but this was superseded in the 1980s by the “price movement”. Today many of the charting techniques use price as the key indicator to forecast the future. The plotting of charts by hand gave way to the plotting of charts by personal computers in the 1980s and today the
powerful desktop are able to receive data via the internet or fixed line and plot them as the prices of shares, currency, commodities move resulting in the availability of “live prices”. The ability to chart price movements enhanced the ability of technical analysts to forecast future prices.
Today we see charting of securities prices in the newspapers, magazines, television and media. Charts give a visual impact on what is happening in the stock market, foreign exchange market, commodity market, the economy, money supply and other variables in the economy. The analysis of these price movements can also be presented in a pictorial form giving more visual impact. Here, we are learning to use technical analysis as a tool to help us make an investment decision, that is to buy, sell or hold. Technical analysis seems to conflict with the Efficient Markets Hypothesis which states that prices would have reflected all relevant information and that charts on prices would not be able to help us predict the future. Yet the “pockets of inefficiency” found in many markets convince analysts that not all information is reflected in prices (Reilly, 2000).
Financial planners, therefore, must be well-versed in the different aspects of technical analysis such as the different charts, patterns and techniques to interpret them. Today many financial institutions employ powerful computers to track movements on currencies, bonds, stocks, and derivatives and use technical analysis to study them in order to make the necessary investment decisions. This is a testimony on why technical analysis remains an important tool to be used before making an investment decision.
10.2.3 Four Underlying Assumptions of Technical Analysis
Technical analysis says the past performance more or less has nothing to do with future performance or asset valuations which are in opposition to the Efficient Market Hypothesis (EMH). EMH, on the other hand, claims that all market information, past and current, is quickly reflected in asset prices. Technical analysts believe on the contrary that the information
efficiency is not as fast a process as the EMH proponents claim it to be. For that reason, an examination of past prices and volumes can help estimate future trends that could be used subsequently for making investment decisions.
In addition, technicians believe that there is no need to analyze economic, industry or company information. This is because technical analysts believe it is possible to estimate future prices based on patterns and signals of the past price and volume trends.
In the operation of technical analysis, analysts rely on the following assumptions:
a. The dependence on the relationship of supply and demand
The technical analysts believe that the only relationship that matters in price determination of securities is the state of supply and demand.
b. Supply and demand level is affected by rational and irrational factors
They further assume that supply and demand are governed by a number of rational variables such as fundamental factors, as well as irrational variables, such as investors’ opinions, moods or biases. According to technical analysts, the market takes all of these variables into consideration, and it also takes some time to evaluate and absorb the new information.
c. New information takes time to be reflected in the market

This is where we get to the interesting part and where the technical analysis challenges the efficient market hypothesis the most. According to technical analysts, all asset prices tend to move in trends that are persistent in nature and that typically take time to fully develop. In other words, new information neither enters the market all at once, nor is it absorbed by the market all at once. Rather, both processes occur over an appreciable period of time.
Generally speaking, markets are considered to be broadly efficient when it comes to processing different and numerous sets of information. However, empirical evidence has uncovered that in a significant number of cases, markets have failed to absorb new information fully or quickly enough. Given this evidence and its resulting mixed signals, as well as the role that efficient markets play in the overall economic growth, it is important to compare such findings with market efficiency.
d. Prevailing price of securities shift in respond to overall shift in demand and supply Finally, technical analysis assumptions come full circle with the fourth item on the list, which states that prevailing price and volume trends allegedly shift in response to overall shifts in assets’ supply and demand. However, technical analysts could not care less why these shifts occur. All analysts care about is that these shifts can be detected sooner or later by paying close attention to assets’ price fluctuations.

10.2 Efficient Market Hypothesis (Random Walk) and Technical
Analysis
10.2.1 The Difference between the Assumptions of the EMH and TA
As already stated, efficient markets are those that absorb and process new information quickly and fully. In contrast, the philosophy behind technical analysis claims that stock markets move in trends that can last anywhere from a few days, to weeks, to months. Unlike supporters of the efficient market hypothesis, technical analysts purport that when new information reaches the market, it follows a dissemination pattern that essentially prevents its immediate integration.
According to technical analysts, information is first disseminated from informed professionals or insiders to aggressive investors, and then to the general investing public. In addition, technical analysts claim that processing new information takes time. Information is not a continuous
mobile; it cannot be reflected in market prices on its own. To be reflected in market prices,
someone has to process new information, analyze it, and draw conclusions from it. Then, if investors like what they see, they may or may not act on that information.
This is in sharp contrast to assumptions of efficient markets. With technical analysis, there is nothing immediate about new information. Rather, after the new information is released, prices tend to gradually move from the old to new equilibrium, which results in creation of trends.
Market efficiency is generally discussed within the framework presented in Fama’s 1970 survey article. The subject of stock market efficiency has been divided over the years into three separate and distinct components: the weak form, the semi-strong, and the strong form. Each of these
connotes different levels of market efficiency and has been subjected to extensive research.
Conclusions drawn from the research findings convey a variety of implications for both investors and portfolio managers. Briefly stated, the three forms of market efficiency are:
The weak form, which holds that successive changes in stock prices are essentially independent of each other and that the information content of historic market data (prices, trading volume, etc.) is already embedded in the existing price. This means that an investor will not gain from any
trading strategy based on past information (i.e. technical analysis).
The semi-strong form, which holds that stock prices adjust rapidly to all new publicly available information (not only market data, but economic, social, and political events) and that action taken after an event is known will produce no more than random results. This implies that
investors who base their trading decisions on information after it is announced or after it has become public (fundamental analysis) will not profit from their transactions.
The strong form, which holds the stock prices fully reflect not only public information but also most privately held information (insider information) which is likely to become public in the near future. This implies that investors will not be able to consistently derive above-average returns.
Empirical studies show that most developed markets, with some variation, exhibit the weak form and semi-strong form of market efficiency. However, the evidence is much less clear for emerging markets as shown in Table 10.1.

Table 10.1: Summary of Studies on Weak-Form Efficiency in Emerging Markets (AIMR)

The results clearly suggest that capital markets are not so hyper efficient as to make intelligent investment analysis worthless. This means that if investment research techniques can lead to accurate forecasts of future company earnings, they should result in better stock and bond price
forecasts.
Since it can be shown that different industries, companies, and economic sectors respond to different sets of critical factors, sound research should be aimed at identifying these factors and tracking them closely. Changes in these elements alter the profits outlook and ultimately affect
general investment expectations. Understanding this, some observers have suggested that security analysis should be carried out by those who seek insights in unconventional ways or who can follow companies and industries for which their education and experience give them a reasonable hope of superior insight.

10.3 Behavioral Finance and Technical Analysis
Hank Pruden’s theory of “Behavioral Finance” proposes that human flaws are consistent, measurable and predictable, and being aware of and utilizing this phenomenon can benefit a trader.3 This is in contrary to the theory that human decision-making ability is guided by their rationality and efficiency.
There are enough anomalies to the hypothesis of efficient market that have piled up in recent years to crack the dominance of the random walk. As a consequence, the behavioral finance theory is embraced by investors.
According to Pruden, a professor in the School of Business at Golden Gate University in San Francisco, Behavioral Finance is “the use of psychology, sociology and other behavioral theories to explain and predict financial markets. Behavioral Finance describes the behavior of investors
and money managers and their interaction in companies and securities markets. It recognizes the roles of varying attitudes toward risk-framing of information, cognitive errors, lack of self-control, regret in financial decision-making and the influence of mass or herd psychology.
Predictable human behavior can and does impact the markets. One example is the “crowd psychology” or “bandwagon” theory. For example, if a market is coming up from a basing area on the charts, “smart money” is responsible for the majority of the initial buying. As people jump on board, we see the bandwagon effect, and that bandwagon pushes prices up. Volume tends to
surge at its peak, certainly on the buy side, during the mark-up phase in the middle. Later on, toward the end of the trend, smart money is not doing the buying but in the selling. The market tops by curving over, or sometimes with a spike top. That is the reason why we can see that
expressed in price and we can see under it in volume.
Regarding the type of trading approach to the bandwagon effect, alignment of indicators to show a distribution pattern or a breaking of trend lines will indicate a post-volume peak. Volume will typically peak before a big change in sentiment. The sentiment element, argued by the proponents of behavioral finance is in the four major elements of technical analysis – price, volume, time and sentiment.
10.4 Major Technical Analysis Indicators
There are a number of momentum indicators that are often used together with contrary opinions and smart money signals, including breadth of market and moving averages.
10.4.1 Breadth of Market
The breadth of market measures the number of stocks that have increased in price on any given day, as well as the number of stocks that have declined on any given day. This technical analysis tool can help explain from a statistical point of view how a major index, such as the S&P 500
Index, lost x-amount of points on a particular day.
There are three ways of constructing an index and tracking its performance, including price weightings, market cap or value weightings, or averaged weightings. Most stock market indices are value-weighted, which means that stocks of large cap companies with billions of dollars in
market capitalisation tend to dominate the playing field.
So, for example, a stock market index can have more issuers with stocks that have appreciated in price and still report a declining overall value at day’s end because a limited number of large caps have experienced falling prices. Such a divergence can be interesting to technical analysts, who often monitor it by examining the advance/decline numbers for all stocks listed on an exchange and included in a particular index.
These advance/decline figures can typically be found in major newspapers and are published each day, indicating which stocks on Bursa Malaysia have advanced, declined, or remained unchanged. In addition, publications are also available on five-day figures for a specific population sample. So, when a technical analyst sees that Bursa Malaysia has risen for a couple
of trading sessions, along with the advance/decline ratio, the usual consensus is that market gains have been broadly based.
10.4.2 Stocks Trading Above 200-Day Moving Averages
Next, investors surely must have heard technical analysts mention moving averages of certain indices used as supporting arguments when determining an overall trend. More specifically, the 200-day moving averages appear to be among the more popular ones.
For example, Media General Financial Services usually calculates 200-day moving averages for numerous stocks included in North American indices, which are subsequently used by technical analysts to gauge overall investor sentiment.
In very general terms, note that the market is thought of as overbought and potentially subject to a downward correction when more than 80% of stocks included in an index trade above their 200-day moving averages. In contrast when less than 20% of the stocks trade above their 200-day moving averages, the market is thought of as oversold. Due to that, there is a potential for price fluctuation or at least a healthy bounce.
Technical analysis indicators are mathematical formulae that day traders use to watch their markets, and decide when to make their trades. Indicators are usually shown on a graphical chart along with the past and current market data (price, volume, etc.), and are updated in real
time (i.e. with every price change). Traders watch the graphical chart, and wait for specific patterns to form to signal the entries and exits for their trades.
10.4.3 Types of Indicator Settings
Different charting software might use different names for the settings (such as a moving average line being called a signal line), but the mathematics will be identical, and will affect the indicators in the same way.
a) Length
The length is one of the main indicator settings, and is used by almost every indicator. The length specifies the amount of market data that is included in the indicator’s calculations For example, a Moving Average with a length of seven will calculate the average of the most recent seven bars (or candlesticks, etc.).
i. Moving Average
One of the simplest techniques used in technical analysis is the simple moving average. The calculation of the simple average is to add the prices of the number of days that would be used as a moving average i.e. 7-days moving average, therefore add seven days and divide by seven and obtain the first number. This is repeated over a period of time and a graph plotted. For short term trading, 7-days and 14-days moving averages are used whilst for reading long term trends, 200-days moving average is common. The rule of thumb is that the investor would “buy” when the average cuts from below and “sell” when the average cuts from “above”. An illustration is shown below:

(ii) Support and resistance line

These are lines that are used to gauge the support or the resistance in the price trend. An illustration is shown below:

(iii) Break-out
Break-out is used to gauge whether a previous high price is currently being penetrated to establish new high prices. An illustration is shown below:

(iv) Moving Average Convergence Divergence (MACD)
The MACD is calculated by subtracting a 26-days moving average of a security’s price from a 12-days moving average of the security’s price and the result is an indicator that oscillates above and below zero.

(b) Signal Length
While technically not part of the actual indicator, many indicators provide a signal line. A signal line is usually a simple moving average of the main indicator line, which creates a slower version of the indicator. The signal length specifies the amount of indicator data that is included in the signal line’s calculation.
For example, a Relative Strength Index (RSI) with a signal length of five will include a signal line based upon the most recent five RSI values in its calculation.
The Relative Strength Index is related to the Coppock indicator (1962) which places higher weights for current stock prices compared with lower weights for distance stock prices. An illustration is shown below:

c) Input Data
The input data setting specifies what the indicator will be based on, and offers several choices
depending on the chart being used. Bar and candlestick charts allow an indicator to be based
upon any of the following:
(i) Open – The first price traded during the bar or candlestick
(ii) High – The highest price traded during the bar or candlestick
(iii) Low – The lowest price traded during the bar or candlestick
(iv) Close – The last price traded during the bar or candlestick
Most charting software also provides the following choices for most indicators:
(v) OHLC Average – The average of the opening, highest, lowest, and last prices traded
during the bar or candlestick (i.e. (Open + High + Low + Close) / 4)
(vi) HLC Average – The average of the highest, lowest, and last prices traded during the bar or candlestick (i.e. (High + Low + Close) / 3).
Some charting software also allows indicators to be based upon other indicators, and use the other indicator’s values as its input data. For example, a Momentum Indicator could use the values from an Exponential Moving Average as its input data, and the Momentum indicator would
then show the momentum of the moving average rather than the actual market prices.
(d) Configuration Examples
With most technical analysis indicators, increasing the length setting will appear to slow the indicator down, by making it less susceptible to changes in its input data. For example, a Commodity Channel Index (CCI) with a length of 7 might react to a single large bar, but the same
CCI with a length of 14 might not react to the same large bar. If you are using an indicator that appears too jumpy, try increasing the length, and the indicator should calm down.
Many charting software use the close (the last price traded during the bar or candlestick) as the default input data. If the close is the most important price for your trading system then this is the best choice, but if your trading system also uses the high and low, then either the OHLC average or the HLC average might be a better choice for the indicator’s input data.
10.4.4 Charts
(a) The line chart
Charts come in various forms and the simplest of them is the line chart. By joining the closing price of a stock over a period of time we can create a line chart. This enables us to see the trend of the stock or investment. An illustration is shown below:

(b) A high-low close bar chart
A high-low bar chart is plotted to show the highest price trade for the day and the lowest price trade for the day with the closing price. This type of chart gives more information than a line-chart as we are able to observe the price range traded and the strength of the closing price.

(c) Point and figure charts

(d) Bar charts
Time Bar charts can be used to denote the daily volume traded. The daily volume traded reflects the underlying strength of the market and gives technical analysts the “feel” of how the market would move in the future. It also signals “overheating” if high volumes are not accompanied with rising prices.

10.4.5 Patterns
(a) The Head and Shoulder pattern
The head and shoulder is the classical pattern that can be observed in many charts. They help us forecast the price movements for uptrend and downtrend. An illustration is shown below:

The graph above shows an inverted head and shoulder denoting a downtrend.

(b) Triangles and Wedges

(c) Flags

(d) Saucer

(e) Rectangles

10.4.6 Channel
A channel is used to determine if the stock price is breaking into a new trend (bullish or bearish) when it breaks the channel. An illustration is shown below:
Prices

10.5 Conclusion
This chapter covered the topic of Technical Analysis. Among the theme discussed were:
The Rationale and Assumptions for Technical Analysis, Efficient Market Hypothesis (Random Walk) and Technical Analysis, Behavioral Finance and Technical Analysis and Major Technical Analysis Indicators. The aspects discussed are relevant in the technical approach to providing Shariah compliance advice on wealth planning and investment selection.

Self-Assessment
Circle the letter of the correct choice for each of the following.
1. If stock price were RM2.30, RM2.45, RM2.50, RM 2.60 and RM2.45, what would be the 5-days moving average?
A. RM2.48
B. RM2.47
C. RM2.46
D. RM2.45
2. Technical analysts draw and to try to forecast future price movements.
A. Charts and moving averages
B. Patterns and line graphs
C. Charts and patterns
D. Point and figure chart and moving average
3. The following statements are TRUE in relation to Moving Average, EXCEPT?
A. An investor may sell when the average cuts from above
B. An investor may sell when the average cuts from below
C. An investor may buy when the average cuts from below
D. Moving average is helpful for short term trading but not for long term trading
4. There are many types of charts. Choose the types of charts available:
A. Line, point and figure, bar, pie
B. Bar, line, wave
C. Point and figure, bar, line, 5DMA
D. Line, bar, point and figure
5. The following statements are the assumptions of technical analysis EXCEPT:
A. All asset prices tend to move in trends that are persistent in nature and that typically take time to fully develop.
B. Support the empirical evidence that indicates that markets have failed to absorb new information fully or quickly enough.
C. It looks for the underlying reasons for the increase or decrease of price of securities.
D. Supply and demand level is affected by rational and irrational factors.
6. What are the patterns available in technical analysis?
A. Saucer, head and shoulder, flag
B. Inverted head and shoulder, wedge, cup
C. Channel, saucer, flag
D. Flag, pole, saucer

7. Which from the following statement is TRUE about Behavioral Finance?
A. Information is accommodated in the price of securities immediately.
B. Humans are rational when making investment decisions.
C. It recognizes the lack of self-control and the influence of mass or herd psychology of human when making investing decision.
D. It states that the transaction costs make active trading less attractive.

8. Overhead lines join the top of a line chart and lines join the bottom of a line chart.
A. Parallel/fan
B. Resistance/channel
C. Support/resistance
D. Channel/parallel

9. A right shoulder of a head and shoulder graph that has a starting point lower than the left shoulder shows that _____________.
A. the downtrend had begun.
B. the uptrend is intact.
C. the downtrend would begin after the formation of the right shoulder.
D. the uptrend would continue after the formation of the right shoulder.

10. The semi-strong form of efficient market hypothesis states that you cannot earn excess return by trading on ______________.
A. inside information.
B. publicly available information.
C. technical analysis.
D. past information
Answer: 1-d, 2-c, 3-a, 4-d, 5-c, 6-a, 7-c, 8-b, 9-c,10-b

CHAPTER 11
PORTFOLIO MANAGEMENT AND MONITORING
Chapter/Topic Outline
11.1 Introduction
11.2 The Portfolio Management Process
11.2.1. Steps in Investing
11.2.2. The Portfolio Management Process
11.2.3. Investment Policy Statement
11.3 Portfolio Objectives and Policies
11.3.1. Determination of Portfolio Policies: Individuals versus Institutions
11.3.2. Characteristics of Individual Investors
11.3.3. Integrating Policies and Expectation
11.4 Portfolio Allocation
11.4.1. Approaches to Asset Allocation
11.5 Methods of Return Calculation
11.5.1. Holding Period Return
11.5.2. Sharpe’s Measure
11.5.3. Treynor’s Measure
11.5.4. Jensen’s Measure
11.6 Timing investment transactions
11.6.1. Dollar-Cost Averaging
11.6.2. Constant-Dollar Plan
11.6.3. Constant-Ratio Plan
11.6.4. Variable-Ratio Plan
11.7 Investment Strategies
11.8 Conclusion

Study/Learning Objectives
Upon completion of this chapter, you should have knowledge of:
(a) The Portfolio Management Process
(b) Portfolio Objectives and Policies
(c) Portfolio Allocation
(d) Methods of Return Calculation
(e) Assessing Portfolio Performance
(f) Timing Investment Transactions
(g) Investment Strategies

11.1 Introduction
Portfolio management is concerned with the selection and management of a group of assets with the objective of maximizing return at the lowest possible risk. Hence, it involves a trade-off between return and risk. By nature, every investor dislikes taking unnecessary risks. He would choose lower risk for a particular return, or higher return for a particular risk. However, an investor’s risk attitude may range from risk-averse to risk-seeking.
However, much more can be done to help the investor to secure the most desirable investment opportunities. Investment opportunities can be packaged together by forming portfolios (a collection of securities typically constructed to meet investment objectives). The potential for creating portfolio changes the whole problem of investment choice. Risk-averse investors may be able to find a way to invest in common stock or real estate to earn the higher returns. These opportunities seem to offer return without a significant increase in risk exposure. This can be done by diversifying or spreading the uncertainty over a portfolio or a number of securities.
11.2 The Portfolio Management Process
According to Gitman and Joehnk (2008), the following steps can be taken when an individual wants to invest either in real property, securities or investing in other investment vehicles.
11.2.1 Steps in Investing

1. Meeting investment prerequisites. Individuals can embark on investment activities when they have provided for the necessities of life such as having a place to live, adequate clothing and the right to use transportation that are beneficial to earn a living. In the Islamic point of view, the needs of individuals can be divided into three categories.
They are the Daruriyyat, Hajiyyat and Tahsiniyat. Daruriyyat are basic needs such as housing, clothing, transportation and security. Hajiyyat, on the other hand, can be referred to as more of a “want” than “need” of human beings. These type of needs are usually found in the middle-income group. The middle-income group usually has access to health, better clothing and comfort rather than just fulfilling basic needs. Tahsiniyyat,
on the other hand are achieved when a society experiences abundance. The latter two states would be generally liable for the payment of zakah on their wealth and income.

2. Establishing investment goals. Investment goals can be either to accumulate retirement funds, enhance current income, saving for a major expenditure and minimization of tax on income. When income is invested, it will be less taxable. Most of the investment vehicles are taxable until it is realized (or sold). For example, retirement investments in the EPF account are not taxable until it is taken out from the account.
3. Adopt and investment plan: In order to adopt an investment plan, an individual need to consider each type of investment alternative and weigh its risk in comparison to the returns it may bring. This has to do with the available funds for investment. By investing in investment vehicles that have different magnitude of risks and returns, an investor is practically diversifying his portfolio.

4. Evaluate investment vehicles. Evaluation of investment alternatives, theoretically need to be done once in half a year. This is because some of the investment vehicles such as bonds pay returns once every 6 months. This is also to make sure that the investment vehicles that are performing badly are more closely monitored so that they will not adversely affect overall portfolio returns. The evaluation of investment vehicles’ performance can be done via technical analysis or fundamental analysis. An example of technical analysis is to analyse the behaviour of stock prices due to the factors affecting them. Factors that should be studied include the demand and supply of stocks purchased as well as the general performance of the economy such as interest rates and inflation
rate.

5. Select suitable investment vehicles. After the evaluation process has taken place, individuals should act by disposing or adding other types of investment vehicles. To be able to make selections, research on possible alternatives should be conducted.

6. Constructing a diversified portfolio. The key word here is to optimize returns and risks, in order to achieve investment objectives. A diversified portfolio might consist of common stocks, bonds, and cash deposits. The percentage of each investment vehicle could differ from one person to another. Some investors may simply opt for indirect investments by picking fund managers with a proven track record. When fund managers are appointed to manage the funds, investors should be advised to study the prospectus of the funds to ensure that they are in line with the objectives of the investors.
7. Review the portfolio. A proper review should include measuring the performance of the funds, regardless of whether it is direct or indirect investment. If the investment results are not in line with the objectives, there is a need to take corrective measures. These measures include switching if it is permitted under indirect investments. When there is a
need to switch funds, one will have to bear in mind the costs associated with switching.
Some unit trust funds allow free switching up to a certain number of times a year whereas some will not allow switching, meaning investors will have to liquidate their positions in order to enter into new positions. The cost associated with liquidation in order to go into a new position is definitely high.
11.2.2 The Portfolio Management Process
The portfolio management process consists of an integrated, consistent set of steps by which an investment manager creates and maintains appropriate combinations of investment assets. As depicted in Figure 11.1, it is a dynamic and flexible process, complete with feedback loops, monitoring, and adjustment. This process generally comprises the following steps:
(a) Identification and evaluation of the investor’s objectives, preferences, and constraints as a basis for developing an investment policy specific to that investor;
(b) Formulation of appropriate investment strategies and their implementation through selection of optimal combinations of financial and real assets in the marketplace;
(c) Monitoring of market conditions, relative assets values and investor’s circumstances; and

4. Adjustment of the portfolio as is appropriate to reflect significant change in any of the relevant variables.
The mechanics of the process vary from manager to manager. Each manager has a preferred modus operandi that is uniquely his or her own, which is as it should be. The process itself, however, is common to all managers everywhere.
Figure 11.1: The Portfolio Construction, Monitoring, and Revision Process

11.2.3 Investment Policy Statement
An investment policy statement is an important written document that clearly sets out the client’s return objectives and risk tolerance over the relevant time horizon along with the applicable constraints such as liquidity needs, tax considerations, regulatory requirements, and unique circumstances.
The content of a typical investment policy statement is as follow:

The client’s objectives and constraints, when considered in the light of capital market expectations, lead to the development of critical investment strategies; the most important of which is the asset allocation decision, but which may also include individual asset class optimization strategies. These strategies suggest the investment style characteristics of individual managers that are selected and how their performance should be monitored and evaluated.
The investment policy is the linkage between client objectives and the investment manager or managers. A properly developed investment policy statement supports long term discipline and helps insure against ad-hoc revisions in strategy when short term results might otherwise create
portfolio changes as a result of panic or overconfidence.

11.2 Portfolio Objectives and Policies
Investors have to evaluate their objectives and policies in investing before they could allocate their portfolios.
Common objectives of investors are as follows:

1. Current Income/Capital Preservation Objective – it is a low-risk, conservative investment strategy that emphasizes on current income and capital preservation. The portfolio will contain a majority of fixed income securities such as Sukuk, as well as investment vehicles that produce stable rates of return such as real estate investment trusts and shares that have low-beta.

2. Capital Growth Objective – it is a higher-risk investment strategy that emphasizes on more speculative investments. Normally, the securities in the portfolio contain higher-beta securities.

3. Tax Efficient Objective – This type of portfolio emphasizes on capital gains and longer holding periods to defer income taxes.
The considerations that have to be looked at when selecting portfolio objectives are as follows:
a. Individual investor characteristics and objectives determine relative income needs and ability to bear risks.
b. Investor characteristics to consider:
i. Level and stability of income, net worth
ii. Age and family factors
iii. Investment experience and ability to handle risk
iv. Tax considerations
c. Investor objectives to consider:
i. A high level of current income
ii. Significant capital appreciation
11.2.1 Determination of Portfolio Policies: Individuals versus Institutions
The objectives, preferences, and constraints of investors differ dramatically. The primary distinctions are between individual and institutional investors. One observer has identified these differences as follows:
(i) Individuals define risk as “losing money” or “doing something that feels uncomfortable,”
while institutions use quantitative concepts, such as standard deviation of returns, to define risk.
(ii) Individuals can be categorized by their personalities or psychographics, while institutions can be categorized by the investment characteristics of those who have a beneficial interest in their portfolios.
(iii) Individuals can be defined financially by their assets and goals, while institutions are generally a more precise package of assets and liabilities or endowment funding requirements.
(iv) Individuals are free to act as they see fit, while institutions are subject to legal and regulatory constraints.
Important additional differences are in time horizon and in life cycle changes. The assumption of infinite life used in planning many institutional portfolios has no parallel in individual investment planning. Also, individuals experience an economic shift between youth and old age, while institutions maintain a relatively constant economic profile over time.
11.2.2 Characteristics of Individual Investors
The characteristics of individual investors and the circumstances and opportunities that confront them are more diverse and complex than for any other class of investors. Each individual’s financial profile is unique. Each has a different liquidity need, time horizon, and set of constraints.
Many have a combination of taxable and non-taxable portfolios. Many do not have a full grasp of either their own risk tolerance or the risk characteristics of the wide array of assets available to them. Psychological characteristics also play an important role in managing investments for individuals.
A carefully planned investment policy for an individual investor must incorporate all of the unique factors pertaining to that investor. Investment objectives must be defined in terms of return requirements and risk tolerance. Constraints, such as liquidity, time horizon, taxes, and legal or regulatory matters, must be recognized explicitly and allowed for in order to achieve the investor’s objectives. Preferences, which are self-imposed constraints, must be identified and respected.
11.2.3 Integrating Policies and Expectation
The most difficult and important phase of the portfolio management process is the integration of macro- and micro-expectations with the investor’s objectives, constraints, and preferences as defined in the policy statement. Investment strategies developed from policy statements are used, together with the investment manager’s expectations for the capital markets in general and for individual sectors and assets in particular, to allocate assets.
The forming of expectations is a two-step process. The first step is forming macro- or capital market expectations. The second is forming micro- or individual asset expectations. Capital market expectations are usually provided in terms of several broad scenarios. The historical data used to represent capital market expectations on return and risk are the compound total annual rates of return and annual standard deviations for broad asset classes.

11.3 Portfolio Allocation
Asset Allocation is the process of dividing an investment portfolio into various asset classes to preserve capital by protecting against negative developments while taking advantage of positive ones. In other words, don’t put all your eggs in one basket, and choose your baskets carefully.
An asset allocation scheme must be developed before buying any investment vehicle. Investors should start by focusing on investment in various asset classes, rather than emphasizing on selecting specific securities. This is because as much as 90% or more of a portfolio’s returns come from asset allocation between various asset classes.
Portfolio revision is the process of selling certain issues in a portfolio and purchasing new ones to replace them. Periodic reallocation and rebalancing are necessary as investment objectives tend to change from time to time. The reasons to revise portfolios are:
i. Changes in economic conditions.
ii. Major life event.
iii. Proportion of one asset class increases or decreases substantially.
iv. Expect to reach specific goal within two years.
v. Percentage allocation of asset class varies from original allocation by 10% or more.
11.3.1 Approaches to Asset Allocation
A. Fixed-Weightings Approach: develops an asset allocation plan in which a fixed percentage of the portfolio is allocated to each asset category.
B. Flexible-Weightings Approach: develops an asset allocation plan in which weights for each asset category are adjusted periodically based on market analysis.
C. Tactical Approach: develops an asset allocation plan that uses stock-index futures and bond futures to change a portfolio’s asset allocation based on market behavior.
An example of portfolio weightings is provided in Table 11.2 as follows:

Table 11.2: Portfolio Weightings according to the Level of Risk

and Returns of Investors

When applying asset allocation, investors have to consider the following factors:
a. Consider the impact of economic and other factors on the investment objectives.
b. Design the asset allocation plan for the long haul (at least 7 to 10 years).
c. Stress on capital preservation.
d. Provide for periodic reviews to maintain consistency with changing investments goals.
e. Consider investing in unit trust funds, especially for portfolios under RM100,000.00.
Evaluating Performance of Individual Investments When evaluating the performance of individual investments, investors have to consider the following steps:
Step 1: Obtain Needed Data
– Returns on owned investments
– Economic and market activity
Step 2: Compare Returns with Broad-Based Market Measures
– Bursa Malaysia’s Composite Index, FTSE EMAS Shariah Index and other foreign indexes if investing in foreign market such as DJIA, S&P 500, Nasdaq Composite Index, Lipper indexes
Step 3: Compare Performance with Investment Goals
– “Am I getting the proper return for the amount of investment risk
I am taking?”
– “Do I have a problem investment?”
Step 4: Determine appropriate action on each investment
– Keep, sell, or monitor closely
11.4 Methods of Return Calculation
11.4.1 Holding Period Return
Returns include current income and capital gains/losses for specific holding period. The formula for HPR for a security and for the portfolio is provided below.

Provided is an example of the calculation of Pretax HPR on shares held by an investor named Sabirah.
Security: Ordinary shares of ABC Company
Date of Purchase: 1st May 2007
Date of Sale: 6th May 2008
Sale Proceeds: RM 32,040
Dividend Received (May 2007- May 2008): RM 2,000
HPR: 2,000 / 27,312 + (32,040-27,313)
= 24.63%

HPR for a portfolio, on the other hand, can be measured as follows:

Example:
Sabirah’s Portfolio (January 1, 2008)

Dividend Income on Sabirah’s Portfolio (Calendar year 2008)

Unrealized Gains in Value of Sabirah’s Portfolio
(January 1 to December 31, 2008)

Based on the calculation above, we can calculate the Holding Period Return on Sabirah’s Portfolio (January 1to December 31, 2008, holding period)
Data
Portfolio Value (1st January 2008): 102,626
Portfolio Value (31st December 2008): 214,000
Realised appreciation: Nil
Unrealized appreciation: 21,960
Dividend Received: 6,240
New funds invested or withdrawn: None
Portfolio HPR Calculation : (6,240 + 21,960) / 102,626
= 0.27
= 27%

11.4.2 Sharpe’s Measure
Sharpe’s Measures compare the risk premium on a portfolio to the portfolio’s standard deviation of return. In general, the higher the Sharpe’s measure, the better it is.

11.4.3 Treynor’s Measure
It uses the portfolio beta to measure the portfolio’s risk. In general, the higher the Treynor’s measure, the better it is.

11.4.3 Jensen’s Measure
It uses the Capital Asset Pricing Model (CAPM) to calculate the portfolio’s excess return (actual return compared to required return). Positive returns are preferred; negative returns indicate required return was not earned.

11.5 Timing Investment Transactions
11.5.1 Dollar-Cost Averaging
In this method, fixed dollar amount is invested at fixed intervals. To use this method, discipline in investing on regular basis is vital. According to this approach, more shares should be purchased when prices are low and fewer shares should be purchased when prices are high. The following is an example of the calculation of Dollar-Cost Averaging for investment in unit trusts in The Ripe Funds when an investor invests RM 500 per month.

Annual Summary:
Total Investment: RM 6,000 (500@ 12 months)
Total number of units purchased: 227.95
Average Cost per unit: 26.32
Year-end portfolio value: 6,881.81
11.5.2 Constant-Dollar Plan
This method assumes that the speculative portion seeks capital gains and the conservative portion seeks low risk. When the speculative portion increases to a predetermined dollar amount, profits are transferred to the conservative portion. If the speculative portion decreases, funds are added from the conservative portion.

When the speculative portion increases to a predetermined dollar amount, that is at RM12,000, profits are transferred to the conservative portion (the case when the NAV is at 12 per unit).

When the NAV decreases so that the portion can be increased again to the preset speculative portion, the units in the speculative portion is added accordingly (in the case when the NAV is at 9.50).
11.5.3 Constant-Ratio Plan
This method is similar to the constant-dollar plan; only the ratio between the speculative and conservative portions is fixed.

11.5.4 Variable-Ratio Plan
This method is similar to constant-ratio plan; only the ratio between the speculative and conservative portions is allowed to fluctuate to pre-determined levels.

11.6 Investment Strategies
There are many styles of equity investment. Some of the most common classifications are:
value, growth, market oriented and small capitalization.
Value: The “value” investor is concerned primarily with the price component of the stock and do not care much about the future earnings growth of the company. While value managers differ in how they define “value”, they consider the stock’s current price as critical. Some organizations focus on companies with low absolute or relative P/E ratios, while others stress on issues with above market yields. Additional valuation measures that these investors often consider are price-to-book value and price/sales ratios. A stock’s whole price that declines because of adverse investor sentiment (i.e. price behavior) may also attract some of these managers. Their portfolios frequently have historical growth and profitability characteristics well below market averages, contrasting sharply with the characteristics of growth managers.
Growth: Growth managers attempt to identify companies with above average growth prospects. They frequently pay above market multiples for the superior growth rate/profitability they anticipate. Other typical characteristics of growth managers include selection of higher quality companies; an emphasis on consumer, service, health care, and technology stocks; and lighter weightings in deep cyclical and defensive stocks. Regardless of the source of expected future growth or the level of the current multiple, growth not being reflected in the current price is the key focus.
Market-oriented: Market-oriented managers do not have a strong or persistent preference for the types of stocks emphasized in either value or growth portfolios; consequently, their portfolio characteristics are closer to market averages over a business cycle. A wide variety of managers with different philosophies fall into this category. Some find a “pure” growth or value orientation overly restrictive, and prefer selecting stocks wherever they might fall on the growth/value spectrum; others may purchase securities embodying both growth and value characteristics; or some wish to control non-market risk by reducing growth or value biases from their portfolio structures.
Small Capitalization: The major distinguishing feature of small capitalization managers is a focus on small companies. Many investors are drawn to this market segment because they find more opportunities to add value through research, since the companies are less widely followed
by institutional investors.
11.7 Conclusion
This chapter covered the topic of Portfolio Management and Monitoring. Among the themes discussed were: The Portfolio Management Process, Investment Policy Statement Portfolio Objectives and Policies, Portfolio Allocation, Methods of Return Calculation, Timing investment transactions and Investment Strategies. The aspects discussed are crucial to the
overall understanding of portfolio theory, and will assist significantly in providing Shariah compliant advice in a comprehensive investment policy statement.

Self-Assessment Test
Circle the letter of the correct choice for each of the following.

1. Key steps in the dynamic process of portfolio management are:
i. Specification of investor objectives, constraints, and preferences.
ii. Asset allocation, portfolio optimization, security selection, implementation, and
execution.
iii. Determination of capital market expectations.
iv. Measurements of portfolio performance.
The order of these steps in the process is:
A. i, ii, iii, iv
B. i,iii, ii, iv
C. i, iv, iii, ii
D. iii, i, iv, ii
2. A clearly written investment policy statement is critical for ______.
A. mutual funds
B. individuals
C. pension funds
D. all investors
3. The investment policy statement of an institution must be concerned with all of the following, EXCEPT?
A. its obligations to its clients
B. the level of the market
C. legal regulations
D. taxation
4. Both strategic and tactical approaches to asset allocation _______.
A. focus on the changing reward-to-variability ratio.
B. seek to capture market inefficiencies.
C. require continuing analysis of market circumstances.
D. de-emphasize consideration of changes in investor risk tolerance.
5. A major step in asset allocation is:
A. assessing risk tolerance
B. analyzing company financial statements
C. estimating security beta
D. identifying market anomalies
6. The decision is the division of fund between the equity portfolio and the money market portfolio.
A. security selection
B. stock picking
C. asset allocation
D. portfolio diversification
7. The decision is the process used to pick the securities included in the
investment portfolio.
A. portfolio diversification
B. security selection
C. asset allocation
D. risky asset
8. The base return for any portfolio is the . In addition, the investor expects to earn a in proportion to the investor’s exposure to risky assets.
A. portfolio’s fair return, risk premium
B. risk premium, market rate of return
C. risk-free rate, risk premium
D. risk-free rate, market rate
9. The following describes the ways that individual investors define risk EXCEPT?:
A. Losing money
B. Categorized by their personalities
C. Defined by their assets and goals
D. Standard deviation
10. In the portfolio construction process, the different types of asset allocation are as follows, EXCEPT:
A. Strategic
B. Diversified
C. Tactical
D. Integrated
Answer: 1-b, 2-d, 3-b, 4-d, 5-a, 6-c, 7-b, 8-c, 9-d,10-b