Aurora Borealis
1 May 2013 CFA Institute Journal Review

Islamic Equity Investing: Alternative Performance Measures and Style Analysis (Digest Summary)

  1. Sadaf Aliuddin, CFA

The authors highlight the impressive growth of Islamic financial assets, which amounted to $1.3 trillion in 2011. They expand on the existing literature on Islamic financing by focusing on the risk-adjusted performance of Islamic indices compared with that of the conventional market benchmarks, as well as differences in style analysis and sector allocation.

What’s Inside?

The authors examine the financial performance of Islamic indices versus that of conventional market benchmarks on a risk-adjusted basis for the period of June 2002–May 2012. They find that Islamic indices generally outperform in developed markets and underperform in emerging markets, but the degree of underperformance is not material. Furthermore, they examine the investment style and sector weighting of Islamic indices.

How Is This Article Useful to Practitioners?

Using traditional performance measures and nine alternative performance measures, the authors examine the financial performance, style, and sector allocation of regional Islamic indices. They find that Islamic indices generally outperform in developed markets and underperform in emerging markets on a risk-adjusted basis. The M2 measure, which shows the return relative to the market benchmark given the same standard deviation, is a positive 0.251% a month in the best-performing region, which is the developed markets of Europe. The worst-performing region (emerging markets in Europe, the Middle East, and Africa) is a negative 0.115% a month.

The methodology Islamic indices use for stock selection—an important factor for investors—is discussed at length. Furthermore, the funds’ sector allocations can be indicators of their future performance. These funds strongly underweight the financial sector compared with conventional market benchmarks, as expected, and strongly overweight energy and materials stocks in both developed and emerging markets. The authors’ style analysis reveals that Islamic funds have a strong emphasis on growth stocks in developed markets and on large-cap stocks in emerging markets.

How Did the Authors Conduct This Research?

The authors compare the performance of Islamic indices with that of conventional market benchmarks using total return time-series data from Morgan Stanley Capital International (MSCI). Excess returns are calculated using the one-month U.S. Treasury bill rate. The sample includes 120 monthly data points from June 2002 to May 2012. The authors conduct their study based on two broad regions—developed and emerging markets—and further categorize those regions on the basis of six diversified, nonoverlapping subgroups.

They analyze risk-adjusted performance from nine different measures: the Sharpe ratio, the Treynor ratio, Jensen’s alpha, the omega ratio, the Sortino ratio, the Kappa 3 measure, the Calmar ratio, excess return on the value at risk, and the M2 measure.

Furthermore, the authors use Sharpe’s (Journal of Portfolio Management 1992) style analysis—the asset class factor model—to explain the investment style and sector allocation of regional Islamic indices. This analysis reveals which asset class and sector would most closely replicate the same performance. For sector analysis, the 10-sector indices in MSCI are considered as the benchmarks.

Abstractor’s Viewpoint

It is interesting to note that there is significant underweighting of financial sector stocks and high-leverage stocks in Islamic indices. This fact is probably the driver behind strong performance in recent years, when financial markets have taken a significant plunge.

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