By Naushad Virji, CEO of ShariaPortfolio, Inc.
Article was originally published on LinkedIn and is available here.
One of the top questions I get from large investment management companies about Sharia-compliant investing is how to manage risk. In traditional portfolio management, investment managers will often use fixed income securities and derivative investments (ie. options) for risk management. However, these forms of investments don’t fall under the guidelines of Sharia-compliant investing, so other methods must be considered.
The three primary considerations to help manage risk in a Sharia-compliant portfolio are asset allocation, sector allocation and stock selection, and it’s important to understand all three. When these tools are effectively used, you can far better control the overall beta (risk) of the portfolio.
1. Asset Allocation: Asset allocation refers to how your portfolio is constructed, looking at the diversification of equity (stocks) versus other asset classes. It’s important to decide what percentage of a given portfolio will be in equity and what percentage will be allocated to other asset classes like precious metals (ie. gold), sukuk funds (Sharia-compliant funds), real estate and cash. For example, if your portfolio is in an aggressive strategy, then having a higher weight toward equity is a fairly common practice. But in a climate where the market is at an all-time high, it’s still prudent to diversify the asset allocation.
In more conservative or moderate strategies, it’s imperative to utilize at least one other asset class. As an example, in a moderate strategy it may be advisable to allocate 40% of the portfolio to equity, 15% to gold, 30% to sukuk funds and 15% to cash. If you are more positive about the market outlook, then it would be a good idea to change the asset allocation appropriately.
The below table illustrates how a Moderate strategy might look given different market outlooks:
2. Sector Allocation: The second risk management consideration for Sharia-compliant portfolios is sector allocation, referring specifically to the equity portion of the portfolio. Sectors represent the industries in which different stocks belong, and it’s advisable to diversify your portfolio by allocating investments to various sectors. For example, if an individual owns 10 stocks in his portfolio and they are all in the technology sector, then the portfolio isn’t diversified enough.
If you find that your portfolio performs very differently from a stock market index like the S&P 500, then it may be that your sector allocation is far off from that of the market index. As you decide to allocate your equity selections to different sectors, if you feel more bullish (positive) about a certain sector like healthcare, then this allocation should be a little higher.
Here’s an example of how you might control the sector allocation of your portfolio:
3. Stock Selection: The final ingredient in ensuring proper risk management of your portfolio is stock selection and, more specifically, understanding a stock’s “beta” and dividend considerations. Beta refers how much a given stock may react to a change in the market, which is important to understand in a more conservative strategy. A stock that has a beta of 1 moves in line with the market. So, if the stock market goes up 3%, a stock with a beta of 1 will likely also go up 3%. Conversely, a stock with a higher beta will have higher returns when the market goes up, and even lower even returns if the market goes down. Typically, in a more conservative portfolio, you want stocks that have lower betas, so that they are not as likely to move in either direction.
At the same time, you want a stock that pays out its profits to you in the form of a dividend. A dividend’s yield refers to the percentage return you are given through a dividend. A good addition to a more conservative portfolio might be a stock that has a beta of 0.6 and a yield of 3.5%. There are many other considerations when considering what stocks to buy, however, in terms of risk, you will be well served to consider the beta and yield of your stocks for a more conservative portfolio.
Managing risk in a Sharia-compliant portfolio doesn’t have to be complicated. While fixed income securities and derivative investments are off limits under the guidelines of Sharia-compliant investing, there are many ways to manage risk while also complying with Sharia. Following the three considerations above – asset allocation, sector allocation and stock selection – will help you manage risk within your own portfolio, but this is just a start.
If you’re interested in building a Sharia-compliant portfolio, consider working with a Sharia-compliant investment professional who can customize your portfolio to your specific needs.
Naushad Virji is the CEO of ShariaPortfolio, Inc., a US based wealth management firm. ShariaPortfolio offers professionally managed investment solutions for Muslims, to help achieve their financial goals while conforming to their personal values. See www.shariaportfolio.com for more information.