Islamic Equity Investing: Alternative Performance

Measures and Style Analysis (Digest Summary)

Christian Walkshusl and Sebastian Lobe
Journal of Investing, Vol. 21, No. 4 (Winter 2012): 182-189
Summarized by Sadaf Aliuddin, CFA
DOI: http://dx.doi.org/10.2469/dig.v43.n2.15

Abstract

Full Text

Abstract
The authors highlight the impressive growth of Islamic financial assets, which amounted to $1.3 trillion in
2011. They expand on the existing literature on Islamic financing by focusing on the risk-adjusted
performance of Islamic indices compared with that of the conventional market benchmarks, as well as
differences in style analysis and sector allocation.

Whats Inside?
The authors examine the financial performance of Islamic indices versus that of conventional market
benchmarks on a risk-adjusted basis for the period of June 2002May 2012. They find that Islamic
indices generally outperform in developed markets and underperform in emerging markets, but the degree
of underperformance is not material. Furthermore, they examine the investment style and sector
weighting of Islamic indices.

How Is This Article Useful to Practitioners?

Using traditional performance measures and nine alternative performance measures, the authors examine
the financial performance, style, and sector allocation of regional Islamic indices. They find that Islamic
indices generally outperform in developed markets and underperform in emerging markets on a riskadjusted basis. TheM2 measure, which shows the return relative to the market benchmark given the same
standard deviation, is a positive 0.251% a month in the best-performing region, which is the developed
markets of Europe. The worst-performing region (emerging markets in Europe, the Middle East, and
Africa) is a negative 0.115% a month.
The methodology Islamic indices use for stock selectionan important factor for investorsis discussed
at length. Furthermore, the funds sector allocations can be indicators of their future performance. These

funds strongly underweight the financial sector compared with conventional market benchmarks, as
expected, and strongly overweight energy and materials stocks in both developed and emerging markets.
The authors style analysis reveals that Islamic funds have a strong emphasis on growth stocks in
developed markets and on large-cap stocks in emerging markets.

How Did the Authors Conduct This Research?

The authors compare the performance of Islamic indices with that of conventional market benchmarks
using total return time-series data from Morgan Stanley Capital International (MSCI). Excess returns are
calculated using the one-month U.S. Treasury bill rate. The sample includes 120 monthly data points from
June 2002 to May 2012. The authors conduct their study based on two broad regionsdeveloped and
emerging marketsand further categorize those regions on the basis of six diversified, nonoverlapping
subgroups.
They analyze risk-adjusted performance from nine different measures: the Sharpe ratio, the Treynor ratio,
Jensens alpha, the omega ratio, the Sortino ratio, the Kappa 3 measure, the Calmar ratio, excess return on
the value at risk, and the M2 measure.
Furthermore, the authors use Sharpes (Journal of Portfolio Management 1992) style analysisthe asset
class factor modelto explain the investment style and sector allocation of regional Islamic indices. This
analysis reveals which asset class and sector would most closely replicate the same performance. For
sector analysis, the 10-sector indices in MSCI are considered as the benchmarks.

Abstractors Viewpoint
It is interesting to note that there is significant underweighting of financial sector stocks and highleverage stocks in Islamic indices. This fact is probably the driver behind strong performance in recent
years, when financial markets have taken a significant plunge.

The Price of Faith: Performance, Bull and Bear

Markets, and Screening Effects of Islamic Investing
Around the Globe (Digest Summary)
Sebastian Lobe, Felix Rle, and Christian Walkshusl
Journal of Investing, Vol. 21, No. 4 (Winter 2012): 153-164
Summarized by Ghazal Zahid Khan, CFA
DOI: http://dx.doi.org/10.2469/dig.v43.n2.20

Abstract

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Abstract
Examining whether screenings that are compliant with Sharia law affect the performance of Islamic indices, the
authors find no statistically significant difference in the performance of Islamic and conventional indices. But they do
find statistically significant outperformance of Islamic indices during a single bear market period included in the study.

Whats Inside?
The authors try to determine whether Sharia-based screening of investments by Islamic indices affects the
investments performance relative to conventional indices. They use well-known financial tools, such as the Sharpe
ratio, the capital asset pricing model (CAPM), and the four-factor model, in their research. Overall, they find no
statistically significant evidence of Islamic indices outperforming or underperforming conventional indices when they
examine the Sharpe ratio and output from the CAPM. But they do find performance differences in some individual
regions when they use the four-factor model approach. The authors also find statistically significant outperformance
of Islamic indices during the bear market that occurred during the study period, a finding that contradicts previous
research on the topic.

How Is This Research Useful to Practitioners?

Islamic indices avoid impermissible investments by screening stocks and focusing on both primary businessactivities
and on financial ratios of the company in question. The screening process excludes companies involved in nonSharia-compliant activities, such as those related to pork, alcohol, gambling, or interest-based banking. The process
also screens out companies with higher levels of interest-bearing debt, noncompliant investments, noncompliant
income, or illiquid assets compared with predetermined thresholds approved by the respective Sharia boards of the
index providers. Screening criteria are more or less uniform across the Islamic investment world, although minor
differences may exist in the threshold levels or basis of calculating financial ratios.
Compared with previous research on the topic, the authors include a larger number of indices covering global as well
as regional markets and use three approaches (the Sharpe ratio, the CAPM, and the four-factor model) to validate
their findings. Using aggregate annualized returns, the Sharpe ratio, or the CAPM, they find no significant
underperformance or outperformance by Islamic indices. But the four-factor model shows statistically significant
results in some individual regions. The authors find that Islamic indices invest mainly in growth stocks and positive
momentum stocks, which was noted in previous research.

They also try to determine whether differences in the financial screening criteria of index providers affect
performance. They analyze the performance of the MSCI and the Dow Jones indices for that purpose, and although
Dow Jones criteria allow a larger number of companies to be included in the index, there is no major difference in
performance between the two.

How Did the Authors Conduct This Research?

The authors sample includes 155 Islamic indices from around the world. The time period covered is January 2001
June 2012, but because of limitations on data availability for all the indices through the entire period, the average
return history for the Islamic indices covers approximately 54 months.
On an aggregate basis, the authors find that the annualized raw return over all Islamic indices in the sample was
2.4% compared with an average annualized return of 2.07% for the conventional indices, a difference that is not
statistically significant. Using the Sharpe ratio, they then calculate performance for all the indices. The exercise
reveals that 54% of the Islamic indices have a higher Sharpe ratio than their conventional counterparts, but this result
is also not statistically significant.
Using a CAPM regression, the authors find that although there is no statistically significant occurrence of positive or
negative alpha for Islamic indices, they do tend to have lower systemic risk given that beta for 75% of the funds was
found to be less than 1. They then apply the four-factor model to countries and regions that, apart from beta, also
have differential returns attributable to size, value, and momentum. The four-factor model shows some significant
alphas, including a positive alpha for a Swiss index and an Asian index and a negative alpha for a North American
index. The authors find little or no tendency of the Islamic indices to invest predominantly in either large- or small-cap
stocks. But they do find a tendency to invest in growth stocks, especially in Asia. The momentum factor seems to play
a big role in Islamic indices, 63% of which have a significant positive coefficient for momentum.
The authors divide the time period being studied into a bull market period (February 2009June 2012) and a bear
market period (February 2007February 2009). After comparing the returns of Islamic indices with those of the
conventional indices during the bear market, they find positive alphas for almost all of the Islamic indices, of which
30% are statistically significant. The authors attribute this result to the exclusion of financial sector stocks from Islamic
indices, which might have cushioned their returns when the financial sector fell during the bear market time frame.
They find no statistically significant under- or outperformance during the bull market period. Their findings contradict
those of previous researchers who found that Islamic indices outperformed in a bull market and underperformed in a
bear market. But the chosen time period for the previous study was different and covered a different bull and bear
market regime. The authors conclude that it is not possible to generalize that Islamic indices out- or underperform in
bull or bear markets because performance may differ from cycle to cycle depending on the market climate.

Abstractors Viewpoint
The authors use a larger dataset to confirm findings of previous researchers that Islamic indices do not subject
investors to any disadvantage in terms of performance. Their research shows that Islamic indices might even
outperform conventional ones when the financial sector comes under stress because Islamic indices avoid financial
sector stocks.