The authors conduct an empirical study of the comparative performance of Islamic and conventional indices during various crisis and noncrisis periods. The study concludes that Islamic indices perform better than conventional ones during crisis periods because of their lower volatility and betas.
What’s Inside?
The authors use indices with both conventional and Islamic versions available to show that Islamic indices outperformed their conventional counterparts during periods of turbulence within the study period. The strength of return association between conventional and Islamic indices is relatively high for the majority of indices, but the low-debt, nonfinancial, social–ethical approach of Shari’a law may provide a hedging alternative for equity investors because of these indices’ lower volatility and betas.
How Is This Research Useful to Practitioners?
The authors contribute to the emerging empirical literature on Shari’a-compliant investments. Islamic investment products are very different from conventional equity and bond funds, but exactly how different they are—and their implications for risk management—is not well known. Financial theory would cast doubt on the ability of Islamic investments to perform as well as conventional indices because the filtering process results in a smaller, less-diversified investment pool. Shari’a indices have fewer constituent members than their conventional counterparts; the S&P 500 Shariah Index, for example, is composed of only 227 stocks.
Basing investment decisions on Islamic principles of transactions (muamalat) requires that each investment pass two broad screens. The first type of screen is sector based; these screens ensure that the businesses are not involved in pork, alcohol, or gambling because these goods and services are considered contrary to Islamic principles and thus haraam (“sinful and prohibited”). It is lawful to make an equity investment in a company, but a shareholder is a partner in the business; thus, goods and services provided by the business must be halal, or permissible. On the surface, this screen could have a detrimental impact on performance because many companies in industries that lure consumers with so-called sinful temptations have historically had consistent, healthy returns and dividends in both good and bad economic environments. By neglecting “sin stocks,” Shari’a investing may restrict a portfolio’s ability to deliver stable, volatility-buffered returns.
The second series of screens is accounting based. Conventional financial services that feature transactions based on interest and borrowing are also prohibited. Islam proposes that if capital is lent on a “loan” basis, then it must be repaid with no excess—that is, interest. This criterion means that conventional banks, investment companies, insurance companies, and other financial institutions are considered noncompliant.
Ideally, there should be no interest-based debt, but according to the Islamic legal principle “to the majority goes the verdict of the whole,” a company is a permissible investment if debt financing is less than 33% of its capital. These screens ensure that a company’s debt-to-equity ratio is less than 33%, accounts receivable to equity is less than 49%, and so on. These quantitative ratio filters remove highly leveraged firms and have the potential to produce a portfolio with lower beta than traditional indices. Quantitative ratio filters tilt the Shari’a-compliant universe toward companies with strong cash flows, robust returns on equity, and solid balance sheets. These characteristics are likely to be rewarded in periods of credit and liquidity constraints. In fact, Shari’a screening by accounting measures represents a convergence between environmental, social, and governance investing and popular new forms of fundamental indexing and smart beta.
How Did the Authors Conduct This Research?
The authors explore whether there is a difference in the mean return between Islamic and conventional indices and whether the difference is statistically significant. They use a matched-pair comparison of 12 global conventional and Islamic indices and measure the risk-adjusted performance using the Sharpe ratio, Treynor index, and Jensen’s alpha derived from the capital asset pricing model. The benchmark index for both conventional and Islamic indices is the MSCI All Country Index.
The period of study is from 2000 to 2011. The dataset is divided into five categories, each covering a different period.
Returns on Islamic indices are less drastically affected by turbulent times than are those on the conventional indices, according to all three performance measures. The point is highlighted by the fact that conventional equity funds were hit particularly hard by the subprime crisis, but 2007 was a strong year for Shari’a-compliant equities in Islamic indices.
Abstractor’s Viewpoint
Islamic investing is one of the fastest-growing segments of the global financial industry. The modern Islamic financial industry can be expected to experience substantial growth for many years to come. The volatility-buffering characteristics of these ethics-filtered investments make them of interest to risk-averse, non-Muslim, Western investors as well.
There are certain characteristics and biases to Shari’a investments. In addition to removing highly levered firms and underweighting consumer discretionary and financial services, Shari’a compliance tends to put more weight on certain industries, including technology, oil and gas, and health care. It would be interesting to explore the sector attribution of the performance figures quoted in the study—with particular attention to the exclusions that contributed to over- and underperformance.