Does Faith Move Stock Markets? Evidence from Saudi Arabia (Digest Summary)

Relatively small and dominated by local individual investors, the stock market in Saudi Arabia presents an ideal test case to study the degree to which the tenets of Islamic faith affect investors’ portfolio selections. The authors’ analysis reveals that risk and return are positively correlated with traded companies’ compliance with Shari’a law.

The authors ask the question of whether adherence to Islamic tenets influences stock prices in environments where such religious practice is the norm. They undertake an extensive study to determine the extent of the influence. The stocks of companies that closely follow Islamic law tend to exhibit the sharpest risk–return trade-offs.

To provide background, the authors put the practice of investing in accordance with social responsibility in the context of modern portfolio theory. They review both prohibited and permissible investments in Islamic finance, and then they offer a brief discussion of the evolution of individual investor activity in the Saudi stock market. Individual investors in the country dominate what has been and continues to be a thinly traded market. There is little foreign investment, and institutional investors are more the exception than the rule.

Sectors in the Saudi market are few and ranked by degree of adherence to religious practice. The authors evaluate return distributions within and between these sectors, finding a greater positive relationship between risk and return for the more compliant shares. They then test for stochastic dominance as further proof of their initial results, considering as well the interrelationship of trade volume and volatility and the presence of herding behavior among individual investors. Multiple tests and robustness checks confirm the relevance of Shari’a law to the risk and return of company shares.

Socially responsible investing has evolved significantly over the past few decades. Perhaps nowhere has it found greater expression than in Islamic finance. The confluence of wealth and faith in the Muslim world has fueled a demand for Shari’a-compliant products. Investment management firms with a global reach need to consider that these circumstances are critical to their business model. Accordingly, portfolio managers and their analysts will find value in the implications of the authors’ research. Academics and practitioners in the field, as well as consumers, policymakers, and those who sit on Shari’a boards, will also find it valuable.

The authors consider the risk and return features of Shari’a-compliant shares. A challenge here is the lack of a risk-free rate, which makes the use of the capital asset pricing model impractical. Accordingly, they use a nonparametric approach based on stochastic dominance that is not model dependent.

Their study includes a six-year period from January 2002 to January 2008, covering the rise, collapse, and recovery of the Saudi stock market. Daily closing stock prices of the TASI (the Saudi stock exchange) and the individual sector indices have been collected for six sectors, which are in turn classified by the degree of their compliance with Shari’a law. For this purpose, the authors refer to the Al-Osaimi list, a respected resource that contains the research and opinions of Islamic financial analysts. The list ranks companies along three points on a continuum of Shari’a compliance: compliant, noncompliant, and mixed. The mixed ranking is applied to companies whose practices are compliant but who may rely on noncompliant sources of funds for certain activities. The authors acknowledge the unavailability of company-level data and their study’s reliance on industry-level information.

A preliminary review of return distributions by sector reveals greater standard deviation (volatility) for the more compliant sectors. The authors then apply stochastic dominance principles to test the validity of their initial findings by comparing returns in the different stock market sectors. Stochastic dominance does not require a normal distribution of returns and does not rely on any type of asset pricing model. The distribution of returns of agricultural companies that are entirely Shari’a compliant is compared with those of the other sectors and the TASI. The authors find that the more a company adheres to principles of Islamic finance, the more volatile its shares and the greater its returns.

They then investigate the source of this phenomenon by considering the link between trade volume and volatility. Individual investors trade on noise, affecting companies’ stock prices by the degree of their compliance with Islamic law, irrespective of fundamentals. Finally, because individual investors dominate the Saudi market, the authors apply a robustness test that looks for strength in numbers to corroborate their findings. Investors acting together in roiled markets confirm the presence of herd behavior.

Once considered a niche endeavor, environmental, social, and governance investing often figures prominently among the tools available to investors of varying levels of sophistication. The authors explore the impact of Shari’a law on equity behavior in an environment where Islam is deeply rooted. They conclude that the Saudi stock market prices socially responsible investing. Equities of firms that adhere to best practices of Islamic finance exhibit greater returns and volatility than those that are less compliant. Further investigation along these lines in an environment where Islam is not as deeply rooted as in Saudi Arabia would be warranted, both in the Islamic world and beyond.