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1 January 2017 CFA Institute Journal Review

Does Shari’ah Screening Cause Abnormal Returns? Empirical Evidence from Islamic Equity Indices (Digest Summary)

  1. Michal Szudejko

To investigate the relationship between screening criteria and the performance of Islamic equity funds versus conventional indices, the author analyzes the performance of 29 Islamic equity indices. He finds that the application of different screening criteria produces no significant variation in the results. The deviation can be attributed to the relative riskiness of the index measured against a comparable benchmark. The performance of Islamic equity investments should be at least as good as conventional investments in the long term.

What’s Inside?

The author’s focus is the performance of Islamic equity indices (IEIs). In order to be considered Shari’ah compliant, equities must pass three basic screens in the areas of revenue sources, business activity, and financial sources. The assessment criteria, however, are not universal for Shari’ah-compliant funds—particularly regarding the financial ratios used in equity evaluation.

The performance of 29 IEIs and 29 benchmark indices is analyzed against the performance of conventional indices (i.e., indices with no religious or ethical factors) from four major providers. These benchmark indices are constructed using different Shari’ah screening criteria. Each of the providers follows a slightly different screening protocol for inclusion of equities in IEIs.

The author provides a comparison of risk–return characteristics of different IEIs against conventional benchmarks—in particular, whether different screening criteria result in different risk–return payoffs. The results show that IEIs, on average, do not produce any abnormal returns except for small- and mid-cap indices from the United States. The indices in question follow quantitative Shari’ah screening criteria adopted by Dow Jones. The positive abnormal returns may be attributed to more frequent rebalancing than in the case of conventional funds.

How Is This Research Useful to Practitioners?

Shari’ah-compliant investments give faith-adhering Muslims a chance to benefit from capital markets without compromising their religious beliefs. The financial world has observed an exponential growth of Islamic equity investments over the past decade. According to the author, the recent empirical findings show that Islamic equity funds have performed relatively better than conventional funds in the last years, but in order to assess the performance of compliant IEIs correctly, appropriate equity indices must be used. Such an approach would help to isolate the screen-related performance. The application of appropriate Islamic equity benchmarks for the performance measurement of IEIs provides more-relevant information about the management skill of fund managers.

The author’s results may be of interest to policymakers, practitioners, and the general investing public. He suggests further empirical work devoted to streamlining the Shari’ah screening standards to reduce existing confusion among the investing public.

How Did the Author Conduct This Research?

The author compares the performance of 29 IEIs and their benchmarks with that of conventional indices from four major providers. He uses several performance measurement models in a single- or multi-equation framework.

The sample consists of end-of-the-month index-level data in US dollars for all 29 IEIs and their conventional benchmarks from December 2000 to May 2012. The data are from DataStream and the MSCI Index Service website. The author uses a “seemingly unrelated regression” model that takes into account contemporaneous correlations. It allows for separating differences in the relative performance of IEIs from different index providers. The model estimates the parameters of the CAPM equation and simultaneously takes the information from other equations into account, which results in greater accuracy of estimations.

The author does not consider transaction costs. This element could seriously affect the results because Shari’ah screening involves a relatively higher amount of rebalancing compared with conventional funds.

Abstractor’s Viewpoint

Considering the dynamic development of Shari’ah-compliant or—to take a broader perspective—ethically bounded investment vehicles as well as the role they play in the world’s financial markets, I think that this research appears at a timely moment. I assess the overall quality and contribution of this research to the financial literature highly, and I think it should lay a foundation for further empirical work.

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