How can a Muslim investor choose the right ETF?

What is an ETF?

Exchange Traded Funds (ETFs) are one of the best ways to begin investing. Even for veteran investors, ETFs offer a fast way to tap a wide variety of assets. Fortunately there’s never been a better time to snap them up.

In recent years, new ETFs have rolled out at a rapid clip. In 2003 there were about 276 ETFs to choose from. Today that number has soared to around 10,000 – some 520 new ETFs launched in 2023 alone.

And there’s no sign of a slowdown. ETFs worldwide held around $11.6 trillion in assets under management at the end of 2023. PwC sees global ETF assets under management hitting $19.2 trillion by June 2028.

Why are they so popular? And with a growing number of options, how can Muslim investors ensure their ETFs are sharia-compliant? Below is a guide to dipping into ETFs without compromising your Islamic values.

The rise of ETFs

The power of ETFs resides in their depth and diversity. A single ETF can unlock access to dozens, or even thousands, of stocks in a single stroke. The first ETF – the S&P 500 SPDR (SPY) – launched in 1993 to cover large-cap U.S. companies. Early ETFs often worked in a similar fashion, passively tracking major indices.

Since then ETFs have become increasingly complex and often niche. They can hold bonds or commodities and cover different geographies and sectors. You can buy ETFs that specialize in the energy sector, emerging markets, or large tech companies. Last year an ETF launched to capture companies focused on generative AI: Roundhill Generative AI & Technology ETF (CHAT). Nowadays if you can think it up, there’s likely an ETF for it.

Benefits of ETFs

At first glance, ETFs sound much like mutual funds, pooling money from investors to create a diversified portfolio. But there’s a few key differences (and benefits).

Unlike mutual funds, which permit transactions only once a day and at a closing market price, investors can buy and sell ETFs at real-time market prices, trading them as if they were stocks. That makes them highly liquid. Intraday ETF trading gives you the flexibility to be either a long-term investor or someone who makes rapid and frequent transactions.

ETFs also tend to have lower fees. That’s because ETFs are often passively managed (e.g. funds that track indices), while mutual funds are actively monitored and adjusted. The average expense ratio for an index ETF was 0.16% in 2022 versus 0.66% for an actively managed mutual fund. That said, halal ETFs (more on that below) tend to have fees that are closer to mutual funds.

In general, ETFs save time and money when compared to picking individual stocks. With an ETF there’s no need to pour over dozens of company statements and pay multiple broker fees for the shares of each one. That’s why ETFs are a boon to entry-level investors.

Which ETFs are sharia-compliant?

As a Muslim investor, what makes ETFs so attractive is also what makes them tricky: by bundling scores of assets together under a single umbrella, an ETF’s structure increases the possibility of being invested in prohibited areas like gambling, alcohol, tobacco, or usury.

Fortunately, the rise of ETFs has brought online a growing number of sharia-compliant options. These ETFs hold sharia-screened assets and are often monitored by Islamic scholars. Popular ones include the Wahed FTSE USA Sharia ETF (HLAL), which invests in common large-cap and mid-cap US stocks, and the SP Funds S&P 500 Sharia Industry Exclusions ETF (SPUS), which filters out non-compliant S&P companies.

Others include:

Screening Halal ETFs

If you don’t want to be limited to a handful of pre-approved ETFs, you will have to vet the ETF’s underlying assets yourself. Thankfully this too is getting easier. Online halal stock screening services can help you determine if an ETF is invested in prohibited assets.

Platforms like Musaffa, Islamicly, and Zoya, can screen stocks and ETFs and determine if they are halal.

If a small percentage of an ETF’s assets are ultimately invested in a prohibited area, you still have another option: you can purify the profits by donating that same percentage to charity. The above platforms can help calculate the required level of purification.

 
Read more about: Halal Investing 

Avoid synthetic ETFs

While most ETFs are directly invested in the underlying assets, about 11 percent of the world’s ETFs are what are known as synthetic ETFs.

Synthetic ETFs do not directly invest in the assets they hold. Instead, they rely on complex derivatives and swaps to mimic indices. Because they engage in speculative trading, are not transparent about their assets, and often involve interest-based transactions, these ETFs are highly problematic from an Islamic perspective. They should simply be avoided.

Your ETF is halal. But is it good?

If you avoid these pitfalls, you still face a fundamental investment question: which ETF is actually worth your money?

A simple way to gauge an ETF’s performance is to compare it to a benchmark, like the S&P 500. Did your ETF do better or worse?

That said, ETFs are often long-term investments. That means you may want to look at its Compound Annual Growth Rate (CAGR), a better measure of long-term performance. You can use an online CAGR calculator and compare different ETFs over a given time period to see which ones performed the best.

The compound growth rate will tell you how much an investment really grew over a longer time horizon, since it accounts for the reinvestment of profits.

Tax benefits of ETFs

Finally, it’s worth studying the potential tax benefits of your ETF before making a purchase. In general, ETFs are considered more tax-efficient than mutual funds. Since many ETFs track indices passively, they typically have lower turnover and therefore fewer taxable events.

In many cases selling ETF shares do not trigger capital gains taxes either. You can hold ETFs in IRAs or 401ks that allow for tax-deferred growth. Investors can often reinvest dividends and capital gains on ETFs without immediate taxes. In any case, the precise taxation of your ETF will be determined by the nature of its assets and how it’s managed, so it’s always best to consult a tax professional.