Are Shariah-compliant portfolios superior?

Islamic mutual funds and other Shariah-compliant investors are restricted to investing only in Shariah-compliant instruments. Thus, while the conventional fund manager allocates between stocks, bonds and cash or money market instruments, the Islamic mutual fund would be restricted to Shariah-compliant equities, sukuk and Islamic interbank money market instruments.

Where Islamic money market instruments are unavailable, Islamic bank deposits would hold the cash. Of interest to all investors and fund managers in particular, is the question of the performance of Shariah-compliant or Islamic equity portfolios relative to conventional ones.

The emerging consensus from numerous academic studies appears to be that Shariah-compliant portfolios have lower risk relative to conventional equity portfolios. That is, Islamic portfolios tend to have lower portfolio betas. Beta being the measure of systematic risk is the relevant risk measure.

This has several implications. The most obvious being that, a lower risk portfolio must necessarily also give lower returns. However, when evaluating portfolios, one needs to think in terms of both risk and returns, not just returns. For example, if a portfolio has 30% lower risk than

the other but only 10% lower returns, then it is obviously the superior portfolio in risk-return terms.

A second implication of lower betas is the inherent defensive nature of low beta portfolios. Portfolios with low betas would underperform in relative terms during up cycles but would outperform during downturns. Beta being a measure of the correlation between a stock or portfolio’s return and overall market returns means that a low beta portfolio will rise less than the market during a bull run, but will also fall less than the market during a downturn. Thus, in comparing Islamic portfolios with conventional ones, timing or the period of com- parison matters.

The question that arises here is why do Islamic equity portfolios have lower betas? When two identical equity portfolios — for example of the same sector are compared — the Islamic equity portfolio has been shown to have lower beta. The reason for this well-documented evidence is really the result of the process by which stocks are screened for Shariah compliance.

Stock Screening

While Malaysia’s Securities Commission was the first to come up with a methodology for screening stocks to evaluate for Shariah compliance, today there are several alternative stock screening methodologies available. Though they differ in the details, they are broadly similar.

All Shariah screening methodologies share a two-phase process. In the first phase, the nature of the business is examined. Stocks of companies in non-compliant businesses, like conventional banking/ finance which is interest based, breweries, casinos, non-halal food processors etc are dropped. Stocks that have passed the first phase are then subjected to numerical analysis of their financials in the second phase. Among others, a key variable in this phase is the level of debt within the firm’s capital structure.

The Malaysian screening filter uses a 33% threshold of interest bearing debt to total assets. The Dow Jones filter, which is more universal uses the same 33% debt, but to average market capitalisation. Debt or financial leverage within a firm’s capital structure is therefore a key hurdle. Thus, even if a firm is in a Shariah-compliant business but has debt exceeding 33%, it will be deemed non-compliant and its stock ineligible. Such a stock screening process avoids not only the highly sensitive (volatile) sectors like the financial sector but firms with high gearing or leverage. It is this elimination of firms with high levels of debt that acts to minimise an Islamic portfolio’s beta.

A stock’s beta is really an aggregate of both its underlying business risk and financial risk. The latter being determined purely by financial leverage. The 33% cutoff for debt automatically eliminates highly geared firms from being included into Shariah-

complaint portfolios. The result is that when comparing the Shariah-compliant equity portfolio with conventional ones, they tend to have lower betas or risk. Since a lower beta stock and portfolio sim- ply moves less the overall market, they are deemed to be defensive.

While Islamic equity port-folios have been established to have lower risk than comparable conventional ones, whether they are indeed superior in risk-return terms is an empirical question.

One study that examined a paired comparison of a series of Dow Jones Islamic equity indexes with its conventional counterpart found the Islamic indices to have lower risk, but returns that were statistically the same. This would imply that Islamic portfolios that mimicked the index would indeed be superior. Yet, other studies have found otherwise.

As with most rule based investment criteria, there is no systematic outperformance. Performance, it appears, is really time variant. The empirical evidence therefore, is truly mixed. This is a logical outcome, for if any rule based investment criteria can consistently outperform, it will give rise to arbitrage. And arbitrage as we know is the great leveller.

  • Dr Obiyathulla Ismath Bacha is currently the professor of finance at the Malaysia-based International Centre for Education in Islamic Finance.