Does Islamic Equity Investment Offer Hedging Benefits Dawood Ashraf PhD CFA® Islamic Research & Training Institute, KSA Mohsin Khawaja King Fahad University of Petroleum & Minerals, KSA

Background – Performance Evaluation Issues Recent Empirical findings: Investments based on Islamic Shari’ah principles provided a hedging benefit during the downturn of capital markets (Abdullah et al., 2007, Ashraf, 2012, Saiti et al., 2014, Ashraf and Mohammad, 2014) However, the outperformance depends the time period chosen for performance evaluation and the benchmark used for the performance evaluation (Elfakhani et al.; 2007) literature documenting the hedging benefit, authors identified a specific period as ‘crisis period’ and draw their conclusion based on that period. However, such an approach lacks the rigor as market fluctuations are common and often we observe rising (bull phase) and declining (bear phase) trends.

Efficient frontier risk-return comparison – S&P 500 MVP are better for Islamic Islamic portfolio are less efficient

Efficient frontier risk-return comparison – S&P TSX 60 MVPs are better yet inefficient for higher risk level

Efficient frontier risk-return comparison – S&P Europe 350 Less effiecient

Efficient frontier risk-return comparison – S&P GCC

Efficient frontier risk-return comparison – S&P JAPAN

Main Findings Islamic equity portfolios are generally less risky but not efficient Minimum Variance portfolios of Islamic equities are usually better Question: How is the risk adjusted performance of IEPs as compared with conventional benchmark index?

Background - Performance Evaluation Issues Islamic mutual funds Fund management – Active Management Stock selection, market timing Islamic equity indices Different index construction methodologies Multiple Shari’ah screening standards Rebalancing frequency

Data sources Time Period: 2008 -2013 monthly data Portfolio Based approach following major Shari'ah screening standards: AAOIFI, Dow Jones, MSCI Self generated Indices & Benchmarks S&P Mathematics Methodology Portfolio based on 5 Markets: USA, Canada, Europe, GCC and Japan (1,712 equities) 15 Portfolios: 3 for each market 5 Benchmarks: 1 for each market Time Period: 2008 -2013 monthly data Financial data from Bloomberg

Research Questions Return of Shari’ah Compliant Indices does not fall as much as that of Benchmark Indices during the downfall of capital markets Shari’ah Compliant Indices following the Market Value approach provide better hedging opportunities as compared to those following Book Value approach

Proportion Shari’ah compliant companies Regions Criteria 2008 2009 2010 2011 2012 2013 Total USA MSCI 46.8% 42.6% 44.4% 45.2% 46.4% 44.8% 500   AAOIFI 50.2% 41.2% 43.8% 44.2% DJ 52.8% 47.6% 45.8% 45.6% Canada 63.3% 61.7% 60.0% 60 53.3% 46.7% 56.7% 50.0% 45.0% 55.0% 51.7% 58.3% 48.3% Europe 44.3% 43.7% 44.6% 46.6% 49.4% 50.6% 350 36.6% 23.7% 29.1% 33.4% 33.1% 34.6% 39.1% 29.4% 35.7% 36.3% GCC 34.1% 36.8% 42.7% 302 38.1% 34.8% 32.8% 36.1% 41.1% 37.1% 40.1% Japan 42.2% 36.0% 36.2% 35.8% 37.8% 23.2% 22.0% 20.2% 19.4% 25.8% 39.4% 31.0% 22.6% 20.6% 22.4% 27.8%

Descriptive Statistics No two SCIs have the same number of constituents More companies pass the filter in book value based screening (MSCI) AAOIFI is the strictest standard More sensitive with the market GCC SCIs have a financial sector which makes them more diverse than other SCIs Finance stocks are screened out in other regions

Descriptive Statistics (cont’d) SCIs generally lag behind BMIs SCI returns deviate from the benchmark returns during the upsurge in capital markets

Empirical Methodology Constant Risk Model beta coefficient is stable over the investment horizon and under different market conditions such as `bull' and `bear' markets. Conversely, the assumption of stable beta is very restrictive and it is often found that beta coefficients diverge over time under different market conditions Logistic smooth transition autoregressive (LSTAR) Model Time varying risk (DCC – GARCH is preferred) Allows for a smooth transition between the states of market rather an abrupt jump as in the case of ‘dual beta models’

Empirical Results – Constant Risk No evidence of abnormal return except from Canada and GCC where alpha is –ve  SCIs usually end up with stocks which lag benchmark performance (BMIs) Systematic risk coefficient β is significant  performance deviation of SCIs can be explained by the relative riskiness with BMIs Canadian SCIs exhibit higher systematic risk, while European report lowest risk

Empirical Results - LSTAR Abnormal return coefficient (α) is insignificant (different from CRM results) SCIs do not drift considerably from BMIs General shrinkage of β coefficient Significant shrinkage in GCC Bearish market trend (Down market beta) - Generally insignificant except USA & Japan (MSCI) – negative significant USA – AAOIFI – positive significant  hedging benefit

Robustness check Four factor model – Fama & French and Carhart models Factors are created from the same set of equities as that of SCIs and BMIs To the best of authors’ knowledge, there is no study on performance attribution of Islamic equity portfolios that used actual data for computation of additional factors from benchmark indices. Results are same as from LSTAR model Alpha insignificant Beta significant Down market beta – significant for US- AAOIFI and Europe-DJ

Conclusion SCIs following any Shari’ah screening criteria does not result in any performance deviation as compared to the BMI despite lower diversification. SCIs generally reflect a lower systematic risk as compared with the BMIs. The claimed benefit of hedging is not obvious in most of the SCIs Partial evidence that SCIs investing in the US and following MVE based Shari’ah screening criteria do offer the hedging benefits. Shari’ah compliant indices do not necessarily offer hedging benefits during a down market