Sharia-compliant equity funds and ETFs

What you will learn

• What makes an equity fund or exchange-traded fund (ETF) Sharia-compliant beyond the stock screen.
• The role of the Sharia supervisory board and the index provider.
• How screening changes sector weights and concentration, with a calculation.
• A checklist for comparing Sharia-compliant funds.

Explanation

Fund structures, index weighting, the total expense ratio (TER) and tracking difference are explained in the course "ETFs & Long-Term Investing". This lesson covers what is specific to Sharia-compliant funds.

Four layers of compliance

1. Index or stock selection: holdings must pass the activity screen (lesson 2) and the financial ratio screens (lesson 3). Most ETFs track an Islamic version of a standard index, for example from MSCI, S&P Dow Jones Indices or FTSE Russell.
2. Fund operations: the fund must not earn interest on cash, must not use interest-based borrowing, and must not engage in securities lending (lending shares to other market participants for a fee, which many conventional ETFs do). Conventional derivatives such as futures used for cash management are usually not allowed.
3. Sharia supervision: a Sharia supervisory board (a panel of qualified scholars) approves the methodology and issues a certificate (fatwa), often reviewed annually.
4. Purification: dividends partly derived from tolerated non-compliant income must be purified. Some funds do this inside the fund and donate to charity; others publish a purification ratio and leave it to the investor (lesson 11).

How screening reshapes the portfolio

Because conventional banks and insurers are excluded and highly indebted companies fail the ratio screens, Islamic indices typically have no conventional financials, a smaller share of utilities and real estate, and a larger share of technology and healthcare. In a market-cap-weighted index the remaining stocks are re-weighted so that they again sum to 100%:

New weight = old weight ÷ share of the index that passed the screen

This can increase concentration in the largest companies, and it changes performance: an Islamic index may do better or worse than its conventional parent depending on which sectors lead. Past differences say nothing reliable about the future.

Turnover and screening changes

Because ratios are recalculated regularly, stocks enter and leave Islamic indices more often than standard indices. When a methodology changes, as with the Dow Jones Islamic Market indices in September 2026, the number of eligible stocks can shift noticeably. More turnover can mean higher hidden trading costs inside the fund.

German context

A Sharia-compliant UCITS ETF (an EU-regulated fund) is taxed like any other fund in Germany; an equity fund holding more than 50% equities on a continuous basis usually qualifies for the 30% partial exemption (Teilfreistellung) described in the ETF course. This is general orientation only; check with a Steuerberater. Several Islamic UCITS ETFs are listed on German exchanges; lesson 10 looks at providers.

Worked example

Hypothetical example: A conventional world index has these features: the ten largest companies make up 25% of the index, and all ten pass the Sharia screen. Overall, stocks representing 60% of the index weight pass. One of the top ten, Company X, has a 4% weight. You invest €20,000. Exclusions: costs other than the TER, taxes, currency effects.

• Company X's new weight = 4% ÷ 60% ≈ 6.67%. Your exposure = €20,000 × 6.67% ≈ €1,333 instead of €800.
• Top-ten concentration = 25% ÷ 60% ≈ 41.7% instead of 25%.
• TER comparison: Islamic ETF 0.30% versus conventional 0.20%: €20,000 × 0.30% = €60 per year versus €40, a difference of €20 per year before compounding.
• Purification if done by the investor: received dividends €200, published non-compliant ratio 3% → donate €200 × 3% = €6.

The calculation shows that a Sharia-compliant world ETF is less diversified than its parent index. That is not wrong, but it should be a conscious decision.

Common mistake

Practice activity

Hypothetical: In a conventional index, technology makes up 24%, financials 16% and all other sectors 60%. After screening, all financials are excluded; 80% of the technology weight and 55% of the other-sector weight pass.

1. Calculate the share of the original index that passes.
2. Calculate the technology weight in the Islamic index.
3. State one consequence for risk.

Key takeaways

• Compliance covers stock selection, fund operations, Sharia supervision and purification.
• Screening removes financials and indebted firms, which often raises sector and single-stock concentration.
• Compare methodology, Sharia board, securities-lending policy, purification and costs, not only the name.
• Islamic funds can perform better or worse than conventional ones; there is no built-in advantage.

Next step

The next lesson turns to an obligation that applies to many investors: calculating zakat on investments.