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Does Shari’ah Screening Cause Abnormal Returns? Empirical Evidence from Islamic Equity Indices

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Abstract

Islamic equity funds are subject to the screening criteria for stock selection imposed by the principles of Islamic jurisprudence (Shari’ah). Equities must pass three basic screens: revenue source, business activity, and financial factors to be included in an Islamic fund. However, screening criteria are not universal especially for the financial factors. One can use financial ratios based on either the book-value of total assets or the market-value of equity for screening of stocks. This may not only result in a different portfolio composition but also entail diverse rebalancing and monitoring costs. The performance of 29 Islamic equity indices (IEIs) versus conventional indices from four major international index providers using different Shari’ah screening criteria are analyzed in a single as well as in a multi-equation framework. The use of a multi-equation framework has the added advantage of utilizing the information content of different screening criteria adopted by different index providers. The empirical findings suggest that the difference in screening criteria does not significantly affect the performance of IEIs. Returns deviation, if any, stems from the relative riskiness of the IEI as compared with the relevant benchmark. Work needs to done to streamline the quantitative screening criteria to avoid confusion among the investing public.

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Notes

  1. There is no stipulated provision in Shari’ah that allows investment in equities with financial leverage of 33 % or lower. It is mostly a decision by the Shari’ah board which allows for a certain level of financial leverage to be either based on total assets or market value of equity.

  2. In a recent unpublished study, Adamsson et al. (2014) compared the performance of IEIs published by different index providers.

  3. Equities of Shari’ah compliant companies include companies whose major source of revenue comes from permissible (halal) activities. All companies are excluded who are predominantly engaged in any of the following non-permissible (haram) activities: trading of alcohol, pork, pornography, gambling or from profit associated with the charging of interest on loans.

  4. The Muslim Holy book regarded by Muslims as the immutable and final revelation of Allah (Shanmugam and Zahari 2009).

  5. Authentic saying and reported actions of Prophet Mohamed (peace be upon him).

  6. A general consensus of opinion by the majority of the Muslim scholars.

  7. For a detailed discussion on the quantitative and qualitative screens for stock screening please see Obaidullah (2005), Derigs and Marzban (2008), and Rahman et al. (2010).

  8. Usmani (2002) and Obaidullah (2005) provide a detailed discussion on the rationale for financial screening criteria.

  9. See for example Hassan and Girard (2011) Dow Jones Islamic Market Indices (DJIM) covering a time period from 1996 to 2005, Guyot (2011) DJIM from 1999 to 2008, Girard and Hassan (2008) FTSE from 1998 to 2006, Hussain (2006) FTSE and Dow Jones from 1996 to 2004, Hussein (2004) from 1996 to 2003.

  10. One may argue that Muslim investors are prohibited from investing or borrowing on interest and hence would not borrow or lend at a risk free rate. The author agrees with the preposition however, the intent of the paper is to address a wider audience therefore a return excess over the risk free rate is used in this study.

  11. Market data for IEIs is available from the base date. The time period between the base date and effective launch date is used for back testing. Since index providers structure IEIs based on the same methodology and Shari’ah screening criteria, there is no sample selection bias or survivorship bias during this time. Hence using market data from the base date provide further depth to the analysis.

  12. To capture the impact for Shari’ah screening, monthly data is preferred due to the review frequency of IEIs’ constituents for compliance status. Among the index providers, only S&P review constituent list monthly while all other index providers review constituent lists quarterly.

  13. The global portfolio and additional factors consist of stock returns from 23 countries: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Switzerland, Sweden, United Kingdom, and the United States. These factors can be downloaded from: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/int_index_port_formed.html.

  14. Wald tests are approximately χ 2-distribution with n degrees of freedom and 2n in case of the spanning test.

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Acknowledgments

I thank Dr. Barbara Marie L’Huillier, Professor Ashfaque Hassan Khan, and participants of IRTI Knowledge Sharing Session, 20th Annual Conference of the Multinational Finance Society and NUST Business School workshop on Islamic finance for helpful comments. The author is grateful to the editor and two anonymous reviewers for their helpful comments and suggestions to improve the earlier version of this paper. The views expressed in this paper are those of the author and do not necessarily reflect the views of the Islamic Research and Training Institute or the Islamic Development Bank Group.

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  1. Islamic Research & Training Institute (Member of Islamic Development Bank Group), PO Box 9201, Jeddah, 21413, Kingdom of Saudi Arabia

    Dawood Ashraf

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Correspondence to Dawood Ashraf.

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Ashraf, D. Does Shari’ah Screening Cause Abnormal Returns? Empirical Evidence from Islamic Equity Indices. J Bus Ethics 134, 209–228 (2016). https://doi.org/10.1007/s10551-014-2422-2

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