Is There A Diversification “Cost” of Shari’ah Compliance? Empirical Evidence from Malaysian Equities

Kamil, Nazrol and Bacha, Obiyadulla and Masih, Mansur (2014): Is There A Diversification “Cost” of Shari’ah Compliance? Empirical Evidence from Malaysian Equities.

Abstract

Islamic equity portfolios work with a smaller investment universe given the filtering of non-Shari’ah compliant stocks. It has been theoretically argued that this culminates in suboptimal portfolio diversification which in turn adversely affects risk-adjusted returns. We employ a number of methods, namely construction of efficient frontiers, time-varying maximum Sharpe ratios, MGARCH-DCC and analysis of covariance (ANCOVA), to offer empirical evidence that such a conceived portfolio diversification “penalty” is far from a foregone conclusion, at least empirically. Our results show that Islamic portfolios are not invariably handicapped in terms of portfolio diversification. We also explored dimensions which may account for differences in relative investment performance between Islamic and conventional portfolios such as portfolio constraints, length of investment horizon and market conditions. We believe this paper is among the first to apply substantial empirical analysis of the portfolio diversification perspective on Islamic equity investments.

• Item Type: MPRA Paper
• Language: English
• Keywords: Islamic equity portfolio, portfolio diversification, efficient frontier, maximum Sharpe ratio, MGARCH-DCC, analysis of covariance (ANCOVA)
• Subjects: C - Mathematical and Quantitative Methods > C2 - Single Equation Models ; Single Variables > C20 - General; C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C61 - Optimization Techniques ; Programming Models ; Dynamic Analysis; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions

References

Abdullah, F., Hassan, T., & Mohamad, S. (2007). Investigation of performance of Malaysian Islamic unit trust funds: Comparison with conventional unit trust funds. Managerial Finance, 33(2), 142–153.

Afza, T., & Rauf, A. (2009). Performance evaluation of Pakistani mutual funds. Pakistan Economic and Social Review, 47(2), 199–214.

Alam, N., & Rajjaque, M.S. (2010). Shariah-compliant equities: Empirical evaluation of performance in the European market during credit crunch. Journal of Financial Services Marketing, 15(3), 228–240.

Al-Shakfa, O., & Lypny, G. (2011). Islamic investment and the cost of observance. Journal of Investing, 20(2), 101–109.

Annuar, M.N., Shamsher, M., & Ngu, M.H. (1997). Selectivity and timing: Evidence from the performance of Malaysian unit trusts. Pertanika Journal of Social Science and Humanities, 5, 45–57.

Baker, M., Bradley, B., & Wurgler, J. (2011). Benchmarks as limits to arbitrage: Understanding the low-volatility anomaly. Financial Analyst Journal, 67(1), 40–54.

Bauer, R., Koedijk, K., & Otten, R. (2005). International evidence on ethical mutual fund performance and investment style. Journal of Banking and Finance, 29(7), 1751–1767.

Bello, Z.Y. (2005). Socially responsible investing and portfolio diversification. Journal of Financial Research, 28(1), 41–57.

Blanchett, D.M. (2010). Exploring the cost of investing in socially responsible mutual funds: An empirical study. Journal of Investing, 19(3), 93–103.

Chiou, W.P. (2009). Benefits of international diversification with investment constraints: An over-time perspective. Journal of Multinational Financial Management, 19, 93–110.

Chong, J., Her, M., & Phillips, G.M. (2006). To sin or not to sin? Now that’s the question. Journal of Asset Management, 6(6), 406–417.

Clarke, R., de Silva, H., & Thorley, S. (2006). Minimum-variance portfolios in the US equity market. Journal of Portfolio Management, 33(1), 10–24.

Derigs, U., & Marzban, S. (2009). New strategies and a new paradigm for Shariah-compliant portfolio optimization. Journal of Banking and Finance, 33, 1166–1176.

De Santis, G., & Gerard, B. (1997). International asset pricing and portfolio diversification with time-varying risk. Journal of Finance, 52(5), 1881–1912.

Diltz, J.D. (1995). The private cost of socially responsible investing. Applied Financial Economics, 5, 69–77.

Driessen, J., & Laeven, L. (2007). International portfolio diversification benefits: Cross-country evidence from a local perspective. Journal of Banking and Finance, 31, 1693–1717.

Elfakhani, S., Hassan, M.K., & Sidani, Y. (2005). Comparative performance of Islamic versus secular mutual funds, 12th Economic Research Forum Conference, University of New Orleans, USA, Nov 2005.

Fifield, S.G.M., Power, D.M., & Sinclair, C.D. (2002). Emerging stock markets: A more realistic assessment of the gains from diversification. Applied Financial Economics, 12, 213–229.

Forte, G., & Miglietta, F. (2007). Islamic mutual funds as faith-based funds in a socially responsible context. Working Paper. Retrieved 12 Oct 2012 from http://ssrn.com/abstract=1012813.

Galema, R., Plantinga, A., & Scholtens, B. (2008). The stocks at stake: Return and risk in socially responsible investment. Journal of Banking and Finance, 32, 2646–2654.

Galema, R., Plantinga, A., & Scholtens, B. (2009). The cost of socially responsible portfolios: Testing for mean-variance spanning. Working Paper. Retrieved 26 Aug 2013 from http://ssrn.com/abstract=1086560.

Girard, E., & Hassan, M.K. (2008). Is there a cost to faith-based investing: Evidence from FTSE Islamic indices. Journal of Investing, 17(4), 112–121.

Goldreyer, E.F., Ahmed, P. & Diltz, J.D. (1999). The performance of socially responsible mutual funds: Incorporating sociopolitical information in portfolio selection. Managerial Finance, 25, 23–36.

Grossman, B.R., & Sharpe, W.F. (1986). Financial implications of South Africa divestment. Financial Analysts Journal, 42, 15–29.

Hakim, S., & Rashidian, M. (2004). How costly is investor’s compliance to Sharia?, Paper presented at the 11th Economic Research Forum Annual Conference, Beirut, Lebanon, 14–16 Dec 2004.

Hassan, A., Antoniou, A., & Paudyal, D.K. (2005). Impact of ethical screening on investment performance: The case of the Dow Jones Islamic index. Islamic Economic Studies, 12(2), 67–97.

Hassan, M.K., Khan, A.N.F., & Ngow, T. (2010). Is faith-based investing rewarding? The case for Malaysian Islamic unit trust funds. Journal of Islamic Accounting and Business Research, 1(2), 148–171.

Haugen, R., & Baker, N. (1991). The efficient market inefficiency of capitalization-weighted stock portfolios. Journal of Portfolio Management, 17(1), 35–40.

Hayat, R., & Kraeussl, R. (2011). Risk and return characteristics of Islamic equity funds. Working Paper. Retrieved 12 Oct 2012 from http://ssrn.com/abstract=1320712.

Hoepner, A.G.F. (2010). Portfolio diversification and environmental, social or governance criteria: Must responsible investments really be poorly diversified? Working Paper. Retrieved 26 Aug 2013 from http://ssrn.com/abstract=1599334. Hoepner, A.G.F., Rammal, H.G., & Rezec, M. (2011). Islamic mutual funds’ financial performance and international investment style: Evidence from 20 countries. European Journal of Finance, 17(9–10), 829–850.

Hong, H., & Kacperczyk, M. (2009). The price of sin: The effects of social norms on markets. Journal of Financial Economics, 93, 15–36.

Hussein, K.A. (2004). Ethical investment: Empirical evidence from FTSE Islamic index. Islamic Economic Studies, 12(1), 21–40.

Hussein, K., & Omran, M. (2005). Ethical investment revisited: Evidence from Dow Jones Islamic indexes. Journal of Investing, 14(3), 105–124.

Kamil, N.K.M., Bacha, O.I., & Masih, A.M.M. (2012). Do ‘sin stocks’ deprive Islamic stock portfolios of diversification? Some insights from the use of MGARCH-DCC. Capital Markets Review, 20, 43–64.

Li, K., Sarkar, A., & Wang, Z. (2003). Diversification benefits of emerging markets subject to portfolio constraints. Journal of Empirical Finance, 10, 57–80.

Lyn, E.O., & Zychowicz, E.J. (2010). The impact of faith-based screens on investment performance. Journal of Investing, 19(3), 136–143.

Mansor, F., & Bhatti, M.I. (2011). Risk and return analysis on performance of the Islamic mutual funds: Evidence from Malaysia. Global Economy and Finance Journal, 4(1), 19–31.

Martellini, L. (2008). Toward the design of better equity benchmarks: Rehabilitating the tangency portfolio from Modern Portfolio Theory. Journal of Portfolio Management, 34(4), 34–41.

Merdad, H., Hassan, M.K., & Alhenawi, Y. (2010). Islamic versus conventional mutual funds performance in Saudi Arabia: A case study. Journal of King Abdulaziz University: Islamic Economics, 23(2), 157–193.

Pesaran, B., & Pesaran, M.H. (2009). Time Series Econometrics using Microfit 5.0, Oxford University Press.

Reilly, F.K., & Norton, E. (2003). Investments. South-Western Pub.

Renneboog, L., Horst, J.T., & Zhang, C. (2008a). The price of ethics and stakeholder governance: The performance of socially responsible mutual funds. Journal of Corporate Finance, 14, 302–322.

Renneboog, L., Horst, J.T., & Zhang, C. (2008b). Socially responsible investments: Institutional aspects, performance, and investor behavior. Journal of Banking and Finance, 32, 1723–1742.

Rudd, A. (1981). Social responsibility and portfolio performance. California Management Review, 23, 55–61.

Saad, N.M., Majid, M.S.A., Kassim, S., Hamid, Z., & Yusof, R.M. (2010). A comparative analysis of the performance of conventional and Islamic unit trust companies in Malaysia. International Journal of Managerial Finance, 6(1), 24–47.

Sauer, D.A. (1997). The impact of social-responsibility screens on investment performance: Evidence from the Domini 400 Social Index and Domini equity mutual fund. Review of Financial Economics, 6, 137–149.

Sazali, M., Ariff, M., Annuar, M.N., & Shamsher, M. (2004). International portfolio diversification: A Malaysian perspective. Journal of Investment Management and Financial Innovation, 3, 51–68.

Schroder, M. (2006). Is there a difference? The performance characteristics of SRI equity indexes. Journal of Business Finance and Accounting, 34, 331–348.

Shamsher, M., Annuar, M.N., & Taufiq, H. (2000). Investment in unit trusts: Performance of active and passive funds, in: Proceedings of FEP Seminar 2000: Issues in Accounting and Finance 2, Universiti Putra Malaysia Press, Malaysia, 129–141.

Statman, M. (2000). Socially responsible mutual funds. Financial Analysts Journal, 56, 30–38.

Tularam, G.A., Roca, E., & Wong, V.S.H. (2010). Investigation of socially responsible investment markets (SRI) using dynamic conditional correlation (DCC) method: Implications for diversification. Journal of Mathematics and Statistics, 6(4), 385–394.