Muslim Funds Are Rewarded for Their Faith

Courtesy Lawrence Carrel

TheStreet.com Senior Writer

12/24/2007–Islamic law prohibits the collection and payment of interest. That means mutual funds aimed at Muslim investors must avoid financial services stocks.

This proved to be a winning formula in 2007, when Wall Street finally paid the price for several years’ worth of predatory lending to financially strapped homeowners.

During the long housing boom, mortgage banks loosened their lending criteria, making it possible for people with poor credit to buy homes they ultimately couldn’t afford. Many of these mortgages had low introductory rates that reset after several years, pushing monthly payments up. Some sported onerous prepayment penalties.

Doesn’t sound very halal.

As long as housing prices kept rising, many borrowers were able to refinance before rates reset, keeping payments low. But as the real estate market softened, more and more fell behind on their payments, ultimately defaulting.

The rising number of bad loans spread like a contagion across Wall Street and the broader stock market. The mortgages were purchased by investment banks that repackaged them into securities and sold them to all kinds of investors — including other banks, brokerages, mutual funds and pension funds. As defaults spiraled, demand for this paper evaporated, and investors were forced to mark the value down on their books.

The investment banks stopped buying new mortgages, depriving lenders of the funds they had relied on to make new loans and putting some out of business.

Muslim funds’ aversion to the financial sector largely inoculated them from the mortgage crisis, keeping them healthy as the contagion spread across broad swathes of domestic stock and bond funds.

While the S&P 500 remained up 4.9% for the year through Friday, three funds that invest according to the Koran have significantly outperformed the benchmark. The Amana Trust Income Fund (AMANX) return of 13.3% through Dec. 21, beating the S&P 500 by 8.4 percentage points, while its sibling, the Amana Trust Growth Fund (AMAGX), gained 11.7%.

And the Dow Jones Islamic Index Fund (IMANX) climbed 14.7% so far this year. It is run by Allied Asset Advisors of Burr Ridge, Ill.

Among other Muslim funds, the Azzad Ethical Mid Cap Fund (ADJEX) gained 11.95% so far this year, and the Azzad Ethical Income (AEIFX) rose 8%. Both are managed out of Falls Church, VA.

The Amana funds, managed by Saturna Capital of Bellingham, Wash., are also ahead of the S&P 500’s annualized return for the past three and five years, earning them five-star ratings from Morningstar.

The Amana Trust Income Fund, with $339 million in assets, posted the fourth highest return this year of large-cap value funds tracked by Morningstar, helped by its large holdings of technology, healthcare, and commodity stocks.

Monem Salam, Amana’s deputy portfolio manager, says a lot of the money coming out of financials is entering technology. And Amana has been building this position all year long. Apple (AAPL) is the largest holding of the Amana Trust Growth Fund.

“We don’t think it’s overvalued,” says Salam. “They have a lot going for them with new products like the iPhone and a deal with China Mobile (CHL) . There is a halo affect from the iPod and Notebooks. We would buy on 10% pullbacks.”

The fund manager also likes Seagate Technology (STX) which is posting double-digit revenue growth on surging demand for more memory, both flash and RAM, which is used in hard drives. Salam says memory demand will keep increasing.

Commodities make up a large part of the Amana Trust Income fund. Freeport-McMoran Copper & Gold (FCX) is the top holding. Salam also likes natural resource company EnCana (ECA) , one of the largest Canadian natural resource companies. The company extracts oil from the sands of Saskatchewan, and as long as oil stays above $50 it’s worth it for them to continue, says Salam.

In addition to financials, Muslim funds also avoid stocks of pork producers, but this hasn’t had a noticeable effect on their performance.

Some funds that invest according to Christian principals haven’t been so blessed. The New Covenant Trust funds, were created in 1971 to give the Presbyterian Foundation a place to invest while staying true to church doctrine. Not wanting to invest in companies harmful to mankind, they avoid companies related to alcohol, tobacco, gambling and weapons. After receiving the list of no-nos, the fund managers are allowed to invest in anything else that strikes their fancy.

It just so happens that financials struck their fancy.

At around 18%, financial services is the largest sector in the company’s $981 million flagship fund, the New Covenant Growth Fund (NCGFX). The fund is up 3.0% year to date, lagging the S&P 500 by a full a percentage point. It’s also lagging the average performance of its large-blend fund peers by 1.2 percentage points, according to Morningstar.

New Covenant Growth’s top holding is Bank of America (BAC) , along with Citigroup (C) and General Electric (GE) , the latter of which receives a large share of revenue from commericial finance.

The best performer of this four-fund family is the New Covenant Balanced Income Fund , up 4.6% year to date. Morningstar gives it three stars and classifies it as a conservative allocation fund. In this case, conservative refers to risk aversion, not political leanings. All four funds failed to meet their benchmarks last year. They appear on target to continue the trend in 2007.

For portfolios with Catholic values, look to the Ave Maria funds. These funds screen out all companies with any connection to abortion. This includes pharmaceuticals, hospitals and even health insurance companies, because they offer abortion-inducing drugs. Not surprising, pornography is also a no-no. So is investing in companies that provide benefits, such as health insurance, to non-married couples.

George P. Schwartz, portfolio manager of Ave Maria Catholic Values (AVEMX), says the church believes marriage is a sacrament and that to offer these benefits is a slap in its face. While some might view this as an anti-gay investment screen, the funds don’t discriminate. They don’t want to support male-female couples living in sin either.

Since smoking, drinking and environmental destruction aren’t outlawed by the church, the fund doesn’t screen out those companies.

Still, this investment strategy severely narrows the population of possible holdings. Nearly 200 companies in the S&P 500 fail to pass muster. This has led the fund to invest in a lot of small-cap and value-oriented stocks. These two groups have provided a lethal combination of underperformance this year.

Three of the family’s four stock funds are underwater this year. The flagship $257 million Ave Maria Catholic Values has skidded 5.7% year to date. However, the Ave Maria Growth Fund (AVEGX) has posted a nice gain of 11.4% in 2007.

Among Catholic Values Fund’s top holdings are Legg Mason (LM) , Pulte Homes (PHM) and Citizens Republic Bancorp (CRBC) .

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