Aurora Borealis
1 May 2013 CFA Institute Journal Review

The Price of Faith: Performance, Bull and Bear Markets, and Screening Effects of Islamic Investing Around the Globe (Digest Summary)

  1. Ghazal Zahid Khan

Examining whether screenings that are compliant with Shari’a law affect the performance of Islamic indices, the authors find no statistically significant difference in the performance of Islamic and conventional indices. But they do find statistically significant outperformance of Islamic indices during a single bear market period included in the study.

What’s Inside?

The authors try to determine whether Shari’a-based screening of investments by Islamic indices affects the investments’ performance relative to conventional indices. They use well-known financial tools, such as the Sharpe ratio, the capital asset pricing model (CAPM), and the four-factor model, in their research. Overall, they find no statistically significant evidence of Islamic indices outperforming or underperforming conventional indices when they examine the Sharpe ratio and output from the CAPM. But they do find performance differences in some individual regions when they use the four-factor model approach. The authors also find statistically significant outperformance of Islamic indices during the bear market that occurred during the study period, a finding that contradicts previous research on the topic.

How Is This Research Useful to Practitioners?

Islamic indices avoid impermissible investments by screening stocks and focusing on both primary business activities and on financial ratios of the company in question. The screening process excludes companies involved in non-Shari’a-compliant activities, such as those related to pork, alcohol, gambling, or interest-based banking. The process also screens out companies with higher levels of interest-bearing debt, noncompliant investments, noncompliant income, or illiquid assets compared with predetermined thresholds approved by the respective Shari’a boards of the index providers. Screening criteria are more or less uniform across the Islamic investment world, although minor differences may exist in the threshold levels or basis of calculating financial ratios.

Compared with previous research on the topic, the authors include a larger number of indices covering global as well as regional markets and use three approaches (the Sharpe ratio, the CAPM, and the four-factor model) to validate their findings. Using aggregate annualized returns, the Sharpe ratio, or the CAPM, they find no significant underperformance or outperformance by Islamic indices. But the four-factor model shows statistically significant results in some individual regions. The authors find that Islamic indices invest mainly in growth stocks and positive momentum stocks, which was noted in previous research.

They also try to determine whether differences in the financial screening criteria of index providers affect performance. They analyze the performance of the MSCI and the Dow Jones indices for that purpose, and although Dow Jones’ criteria allow a larger number of companies to be included in the index, there is no major difference in performance between the two.

How Did the Authors Conduct This Research?

The authors’ sample includes 155 Islamic indices from around the world. The time period covered is January 2001–June 2012, but because of limitations on data availability for all the indices through the entire period, the average return history for the Islamic indices covers approximately 54 months.

On an aggregate basis, the authors find that the annualized raw return over all Islamic indices in the sample was 2.4% compared with an average annualized return of 2.07% for the conventional indices, a difference that is not statistically significant. Using the Sharpe ratio, they then calculate performance for all the indices. The exercise reveals that 54% of the Islamic indices have a higher Sharpe ratio than their conventional counterparts, but this result is also not statistically significant.

Using a CAPM regression, the authors find that although there is no statistically significant occurrence of positive or negative alpha for Islamic indices, they do tend to have lower systemic risk given that beta for 75% of the funds was found to be less than 1. They then apply the four-factor model to countries and regions that, apart from beta, also have differential returns attributable to size, value, and momentum. The four-factor model shows some significant alphas, including a positive alpha for a Swiss index and an Asian index and a negative alpha for a North American index. The authors find little or no tendency of the Islamic indices to invest predominantly in either large- or small-cap stocks. But they do find a tendency to invest in growth stocks, especially in Asia. The momentum factor seems to play a big role in Islamic indices, 63% of which have a significant positive coefficient for momentum.

The authors divide the time period being studied into a bull market period (February 2009–June 2012) and a bear market period (February 2007–February 2009). After comparing the returns of Islamic indices with those of the conventional indices during the bear market, they find positive alphas for almost all of the Islamic indices, of which 30% are statistically significant. The authors attribute this result to the exclusion of financial sector stocks from Islamic indices, which might have cushioned their returns when the financial sector fell during the bear market time frame. They find no statistically significant under- or outperformance during the bull market period. Their findings contradict those of previous researchers who found that Islamic indices outperformed in a bull market and underperformed in a bear market. But the chosen time period for the previous study was different and covered a different bull and bear market regime. The authors conclude that it is not possible to generalize that Islamic indices out- or underperform in bull or bear markets because performance may differ from cycle to cycle depending on the market climate.

Abstractor’s Viewpoint

The authors use a larger dataset to confirm findings of previous researchers that Islamic indices do not subject investors to any disadvantage in terms of performance. Their research shows that Islamic indices might even outperform conventional ones when the financial sector comes under stress because Islamic indices avoid financial sector stocks.

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