Britain has a growing Muslim population, and in a world of auto-enrolment the pensions industry should cater for these members

At last count there were almost 2.7 million Muslims living in the UK. Naturally there will be a spectrum of views within that population, but it would be reasonable to assume a proportion will consider themselves bound by sharia law.

Why do pension schemes need to be aware of this fact? There are features of sharia law which dictate how those who abide by it can invest.

First of all, there are certain investments which are strictly prohibited. Unsurprisingly, this category includes investments in companies which deal in alcohol, tobacco, weapons, pornography, gambling… So far, so much like any other responsible investment fund.

But sharia funds have another rule about companies where only a small proportion of the business involves prohibited items.

For example, it may be possible for a member to buy shares in a supermarket even though it sells alcohol, but the proportion of the profits gained from the sale of banned items must be given to charity.

The cut off point for how much involvement a company can have with this type of product before it is deemed unacceptable is determined by a qualified board.

Every investment must be authorised by a panel of Islamic jurists. Each sharia fund must have a supervisory panel, which will take on a strong governance role, and “issue a fatwa on the offering document, which is the Islamic equivalent of regulatory approval,” says Judith Donnelly, a partner at law firm Squire Patton Boggs. In this context, a fatwa means a legal pronouncement from a religious scholar.

Gaining approval from the supervisory board is a time consuming process as the pool of appropriate scholars is small and they have to sign off every investment to ensure it is sharia compliant.

“Short selling would be void because you can’t sell things you don’t have under sharia law”

One of the board’s principal concerns will be whether or not the asset breaches the rules on charging or paying interest. Both are banned under sharia, which has implications for the old reliable of pensions investment – fixed income. Such investments may be allowed if they are structured in a way that means they are not paying interest, but the member is buying an asset from a company and selling it back at a profit.

Derivatives are another no-go zone for sharia funds. Officially, Muslims are not allowed to invest in anything uncertain, and speculation is seen as tantamount to gambling. “Short selling would be void because you can’t sell things you don’t have under sharia law,” says Donnelly.

Equities are permitted because the transaction is certain even if the return is not – the investor is putting money into a business and taking risk in the hope of gaining a return.

One aspect of sharia compliant funds which may also appeal to non-Muslims is the overarching principle of fairness, which stands in stark contrast to English law, which emphasises freedom of contract and “buyer beware”. Sharia boards would take a very dim view of excessive charges and practices which are deemed to be punitive.

The application of this fairness principle is particularly relevant in situations like a private equity investment firm charging high penalties where the member has defaulted on a capital call (the process by which the firm can demand a proportion of the money which the investor has promised). “They are of dubious validity under sharia law because they are usually very draconian,” says Donnelly.

On the face of it members could stand to save money by investing in a sharia fund because they would be protected from disproportionate fees – but that is not the whole story. The governance structure with the board of jurists adds another layer of costs – and they do not come cheap.

“Ultimately that fee can either be paid by the fund managing group as a salary, or it will be a fee which comes out of the assets of the fund, which is the most normal way,” says Alan Durrant, chief executive at Harwood Multi Manager, who says the amount can be “very, very sizeable”. In his experience firms could be paying tens of thousands of dollars to each sharia scholar on every fund.

Individual pension schemes may be put off by the cost of offering a sharia fund unless there is significant demand from the membership. Master trusts, however, can take advantage of economies of scale.

The National Employment Savings Trust (Nest) is one of the master trusts which have taken the decision to offer members a sharia compliant option.

Nest’s sharia fund only invests in global equities using an index tracking the Dow Jones Islamic Titans 100 Index and avoids putting money in bonds.

The fund’s information sheet states that the “Islamic Titans Index consists of Sharia-compliant companies that have been endorsed by the Dow Jones Sharia Supervisory Committee, an independent board of Islamic scholars that advises Dow Jones”.

The fund also avoids companies which receive or pay large sums of interest, or are involved in: alcohol, tobacco, financial services, pornography, weapons, pork products, gambling, leisure and media.

There are lessons which other funds can learn from sharia funds, such as the principle of fairness and avoiding industries which are seen to be harmful, but ultimately the cost and bureaucracy means they are likely to remain the preserve of Britain’s growing Muslim population.