When SPUS hit $2.8 billion in assets last year, many Muslims celebrated having a major halal ETF option. But a closer look at what actually happens inside these funds reveals practices that would have troubled the Prophet Muhammad (peace be upon him), despite their shariah certification.
The Hidden Lending Revenue Stream
Most halal ETF managers engage in securities lending to boost returns. They lend out stocks from the fund to short sellers and collect interest on the cash collateral. While fund companies argue this cash gets invested in shariah compliant money market funds, the underlying transaction creates a lending relationship that generates riba.
The Prophet (peace be upon him) was explicit in his business dealings about avoiding any transaction where money was lent for a guaranteed return. In his Farewell Sermon, he declared that all riba transactions were abolished. Yet securities lending, even when wrapped in shariah compliant structures, fundamentally involves lending shares for a fee.
SPUS, for instance, earned approximately $4.2 million from securities lending in 2023. This represents about 0.15% of the fund's assets, but it's revenue generated purely from lending activities. The fund's prospectus states this income gets distributed to shareholders, meaning Muslim investors unknowingly receive riba based returns.
The Overnight Cash Dilemma
Every ETF holds cash for operational purposes, dividend payments, and managing redemptions. Where this cash sits overnight reveals another compliance challenge that most Muslims don't consider.
HLAL, one of the more popular halal ETFs, typically holds 2 to 5% of its assets in cash equivalents. During market volatility, this percentage can spike higher. The fund parks this cash in money market funds and short term Treasury bills to earn returns rather than letting it sit idle.
The Prophet's approach to business was straightforward: engage in trade, avoid guaranteed returns on cash, and ensure all transactions had clear underlying value. Parking cash in interest bearing instruments, even short term ones, conflicts with these principles.
Modern fund operations make this nearly unavoidable. But investors should understand that their halal ETF likely generates 10 to 20 basis points annually from cash management activities that involve conventional interest.
The Derivative Problem Nobody Talks About
Halal ETFs use derivatives for hedging and efficient portfolio management. UMMA, for example, uses futures contracts to maintain proper market exposure while managing large cash flows. These instruments, while not inherently haram, create speculative elements that warrant careful consideration.
The Prophet engaged in forward contracts for agricultural products, which shows derivatives aren't categorically forbidden. However, he insisted on contracts with clear underlying assets and genuine commercial purpose. Modern ETF derivatives often serve purely financial engineering purposes.
When UMMA needs to maintain market exposure while processing large redemptions, it might buy S&P 500 futures rather than purchasing individual stocks. This creates efficiency but also introduces leverage and speculative elements that didn't exist in the Prophet's commercial activities.
The fund's semi annual report shows derivative positions worth approximately $12 million on $180 million in assets. While small as a percentage, these positions can amplify both gains and losses in ways that pure equity ownership wouldn't.
The Purification Paradox
Most halal ETFs employ purification processes to donate income from non compliant sources. This sounds islamically sound, but creates practical complications that the early Muslim community never faced.
SPUS calculates that roughly 3% of its portfolio companies' revenues come from non halal sources like conventional banking or alcohol sales. The fund estimates this generates about $840,000 annually in "impure" income that gets donated to charity.
But this calculation relies on company reported revenue breakdowns that often lack precision. A company might report 2% revenue from financial services, but that could include both halal trade financing and conventional lending. The purification amount might be too high or too low.
The Prophet's business partnerships involved direct knowledge of trading activities. He knew exactly what goods were being sold and how profits were generated. Today's public companies operate with such complexity that true purification becomes nearly impossible to calculate accurately.
The Scale Versus Principle Trade Off
Large halal ETFs face institutional pressures that smaller, more nimble funds can avoid. SPUS manages nearly $3 billion, which creates operational challenges that force compromises with ideal Islamic principles.
The fund must engage with market makers, authorized participants, and prime brokers who operate conventional financial businesses. These relationships, while not directly involving riba, create dependencies on institutions whose core business models conflict with Islamic finance principles.
Smaller funds like UMMA, with about $180 million in assets, have more flexibility to avoid certain practices but lack the scale to negotiate better terms with service providers. This creates a fundamental tension between growth and maintaining strict compliance.
The Prophet's business ventures stayed relatively small and local, allowing him to maintain direct oversight and ensure all activities aligned with his values. Modern investing scale makes such direct oversight impossible.
A More Conscious Approach to Halal ETF Investing
Understanding these hidden complexities doesn't mean avoiding halal ETFs entirely. Instead, it means approaching them with greater awareness and making more informed decisions.
Start by reading the fund's Statement of Additional Information, not just the marketing materials. Look for details about securities lending policies, derivative usage, and cash management practices. SPUS publishes a detailed breakdown of its purification calculations, while other funds provide minimal disclosure.
Consider the trade offs you're comfortable making. A fund that uses derivatives for hedging might align better with your risk tolerance than one that generates income through securities lending.
Diversify beyond ETFs when possible. Direct stock ownership eliminates many of these intermediary issues, though it requires more research and higher minimum investments. Consider combining a core halal ETF position with individual stock holdings in companies you've researched thoroughly.
For more halal finance tools and research, visit SeekIslam.
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