Mutual Funds: Are they allowed?

In the name of Allah, Most Compassionate, Most Merciful,

A mutual fund is simply a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective.  The mutual fund will have a fund manager who is responsible for investing the pooled money into specific securities (usually stocks or bonds).  When you invest in a mutual fund, you are buying shares (or portions) of the mutual fund and become a shareholder of the fund. 

Mutual funds are one of the best investments ever created because they are very cost efficient and very easy to invest in (you don’t have to figure out which stocks or bonds to buy).

By pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own.  But the biggest advantage to mutual funds is diversification.

Diversification is the idea of spreading out your money across many different types of investments.  When one investment is down another might be up.  Choosing to diversify your investment holdings reduces your risk tremendously. 

The most basic level of diversification is to buy multiple stocks rather than just one stock.  Mutual funds are set up to buy many stocks (even hundreds or thousands).  Beyond that, you can diversify even more by purchasing different kinds of stocks, then adding bonds, then international, and so on.  It could take you weeks to buy all these investments, but if you purchased a few mutual funds you could be done in a few hours because mutual funds automatically diversify in a predetermined category of investments (i.e. – growth companies, low-grade corporate bonds, international small companies).

The ruling with regards to mutual funds from an Islamic perspective can be determined by understanding the Shar’i ruling on shares and bonds.

The ruling with regards to investing in shares is that this is permissible (according to the majority of contemporary scholars), provided the following conditions are met:

1)     The main business of the company must be lawful (halal). Therefore, to purchase shares of a company whose main business is unlawful, such as interest bearing banks, insurance companies, companies manufacturing and selling liquor, etc will not be permitted.

If the main business of the company is Halal, such as a textile company or a telecommunication company, then it will be permissible to subscribe to its shares.

2)     Many companies, despite their main business being Halal may be involved in interest dealings in one way or another. Due to this, the following is necessary:

 a)     One should object to the interest dealings, preferably in the annual AGM. By doing so, the responsibility will be deemed fulfilled.

b)     When the dividend is distributed, the proportion of the company’s income which was gained by interest dealings must be given in charity without the intention of receiving reward, as is the case with unlawful money in general. This amount (interest accumulation) may be known by means of the income statement.

3)     The company whose shares one intends to purchase must have some illiquid assets in its possession. It must not all be in liquid form (i.e. cash, cheques, bonds, etc…). If all of the company’s assets are in liquid form, then the share cannot be sold or purchased except at face value.

With regards to bonds, the ruling is that, it is not permissible to invest in them. Premium bonds do not represent the ownership of the holder in a company or a financial institution; rather it only signifies giving a loan to the issuers of these bonds.

Due to this fact, the excess amount received on these bonds, which is stipulated and sought from the contract, is regarded as usury (riba), and is thus unlawful (haram).

Now, if investing in a mutual fund is regarded as purchasing the shares of the fund and becoming a share holder, then the ruling is that this is not permissible. The reason being, that one of the conditions for the permissibility of purchasing shares was that the company has some illiquid assets (see condition, 3), and the fund here is a combination of peoples investments.

If the case is that the fund is merely acting as an intermediary for the investment in shares and bonds, then this would also be impermissible. The reason being, that one is unaware what kind of companies the fund will invest into. Also, the funds normally invest in bonds, which have been declared unlawful.

And Allah knows best

Muhammad ibn Adam, UK