The Integration of ESG in Islamic Asset Management – A Practical Approach

Abstract

Islamic finance and sustainable finance (ESG) have many overlaps including asset management activities. In Islamic finance, transactions should promote equality, social justice, inclusion, and economic prosperity while sustainable finance focuses on ethical and responsible financial practices. Investments in certain industries, products, and services are prohibited, whilst ESG investing may apply absolute rules such as the exclusion of harmful products such as alcohol and weapons. As such, the incorporation of ESG in Islamic Finance should be a natural pathway for progression in the growth of the industry. However, the Islamic finance industry is fractionally smaller than the conventional space. Filtering for ESG-labelled securities limits the investible universe further and may limit the ability to form a diversified ESG investment portfolio. This paper outlines a practical approach to incorporating ESG and Islamic finance in the asset management space and explores how fund managers have been incorporating ESG into fund management via case studies and industry practice. We explore the use of a systematic ESG overlay approach, which builds upon the investible sukuk universe to construct a portfolio in line with the asset manager’s strategic positioning. The approach of both Shariah filters and ESG risk ratings act as both blacklists and whitelists for securities, removing non-compliant securities and overweighting quality securities with differentiated and sustainable business models. The approach views ESG investing as a form of risk management and monitors these risks in the same manner as traditional financial risk management. A typical criticism of ESG investing is greenwashing within sustainability-labeled products. In this regard, the proposed approach utilizes the ESG risk scores of the individual issuers and is irrespective of any green or sustainability labels, offering a practical method for ESG investing in the Islamic space.