TAKING A LEAP OF FAITH:
ARE INVESTORS LEFT SHORT CHANGED?
Yunieta Anny Nainggolan
Bachelor of Economics University of Indonesia Master of Commerce in Finance (Hons) University of Melbourne
Submitted in fulfillment of the requirements for the degree of
Doctor of Philosophy
The School of Economics and Finance Faculty of Business
Queensland University of Technology Brisbane, Australia
November 2011
Keywords and Abbreviations
Accounting screens
Business screens
Conventional Equity Fund (CEF)
Ethical Equity Fund (EEF)
Fund performance
Islamic Financial Institution (IFI)
Religious Equity Fund (REF)
Shariah Advisory Board (SAB)
Shariah compliance
Shariah framework
Shariah-compliant Equity Fund (SEF)
Socially Responsible Investment (SRI)
i
Abstract
This dissertation examines the compliance and performance of a large sample of faith based (religious) ethical funds the Shariah-compliant equity funds (SEFs), which may be viewed as a form of ethical investing. SEFs screen their investment for compliance with Islamic law, where riba (conventional interest expense), maysir (gambling), gharar (excessive uncertainty), and non-halal (non-ethical) products are prohibited.
Using a set of stringent Shariah screens similar to those of MSCI Islamic, we first examine the extent to which SEFs comply with the Shariah law. Results show that only about 27% of the equities held by SEFs are Shariah-compliant. While most of the fund holdings pass the business screens, only about 42% pass the total debt to total assets ratio screen. This finding suggests that, in order to overcome a significant reduction in the investment opportunity, Shariah principles are compromised, with SEFs adopting lax screening rules so as to achieve a financial performance. While younger funds and funds that charge higher fees and are domiciled in more Muslim countries are more Shariah-compliant, we find little evidence of a positive relationship between fund disclosure of the Shariah compliance framework and Shariah-compliance. Clearly, Shariah compliance remains a major challenge for fund managers and SEF investors should be aware of Shariah-compliance risk since the fund managers do not always fulfill their fiduciary obligation, as promised in their prospectus.
Employing a matched firm approach for a survivorship free sample of 387 SEFs, we then examine an issue that has been heavily debated in the literature: Does ethical screening reduce investment performance? Results show that it does but only by an average of 0.04% per month if benchmarked against matched conventional funds this is a relatively small price to pay for religious faith. Cross-sectional regressions show an inverse relationship between Shariah compliance and fund performance: every one percentage increase in total compliance decreases fund performance by 0.01% per month. However, compliance fails to explain differences in the performance between SEFs and matched funds. Although SEFs do not generally perform better during crisis periods, further analysis shows evidence of better performance relative to conventional funds only during the recent Global Financial Crisis; the latter is consistent with popular media claims.
ii
Table of Contents
Keywords and Abbreviations ...................................................................................................... i
Abstract ......................................................................................................................................... ii
Table of Contents ....................................................................................................................... iii
List of Tables ............................................................................................................................... vi
List of Figures ............................................................................................................................ viii
Statement of Original Authorship ............................................................................................ ix
Acknowledgements ...................................................................................................................... x
CHAPTER 1: .......................................................................... 1 INTRODUCTION
1.1 Background ...................................................................................................................... 1
1.2 Research Aim and Questions ........................................................................................ 5
1.3 Motivations ...................................................................................................................... 7
1.4 Summary of Major Findings and Contributions ........................................................ 9
1.5 Thesis Layout ................................................................................................................ 11
CHAPTER 2: ...................... 12 THE SHARIAH-COMPLIANT INVESTMENT
2.1 Introduction................................................................................................................... 12
2.2 The Fundamental Principles ....................................................................................... 12
2.3 The Prohibitions ........................................................................................................... 15
2.4 Shariah-Compliant Equity Funds and Their Equity Screens ................................. 18
2.5 Shariah Indices and Their Ethical Screens ................................................................ 25
2.6 Chapter Summary ......................................................................................................... 31
CHAPTER 3: 32 LITERATURE REVIEW .............................................................
3.1 Introduction................................................................................................................... 32
3.2 Performance of SRIs .................................................................................................... 33
3.3 Performance of Shariah-compliant Equity Funds ................................................... 42
3.4 Chapter Summary ......................................................................................................... 52
CHAPTER 4: HYPOTHESES ............................................................................ 54
4.1 Introduction................................................................................................................... 54
4.2 The Degree of Shariah Compliance ........................................................................... 54
4.3 Fund Performance ........................................................................................................ 59
4.4 Chapter Summary ......................................................................................................... 62
iii
CHAPTER 5: ........................................ 63 DATA AND RESEARCH METHODS
5.1 Introduction................................................................................................................... 63
5.2 Data ................................................................................................................................ 63
5.3 Measurement of Shariah Compliance ........................................................................ 73
5.4 Fund and Country Level Determinants of Shariah Compliance ........................... 87
5.5 Tests of Shariah Compliance ...................................................................................... 95
5.6 Fund Performance Measurement ............................................................................... 95
5.7 Fund Performance and Shariah Compliance .......................................................... 102
5.8 Summary and Conclusion .......................................................................................... 102
CHAPTER 6: 104 EMPIRICAL RESULTS ..............................................................
6.1 Introduction................................................................................................................. 104
6.2 Tests of Shariah Compliance .................................................................................... 104
6.3 Fund Performance ...................................................................................................... 115
6.3.1 Raw Returns ................................................................................................................ 115
6.3.2 Risk-adjusted Performance ....................................................................................... 118
6.3.3 Risk-adjusted Performance in Market Downturns ................................................ 128
6.4 Fund Performance and Shariah Compliance .......................................................... 130
6.5 Chapter Summary ....................................................................................................... 138
CHAPTER 7: ............................................. 141 SUMMARY AND CONCLUSION
REFERENCES .................................................................................................... 146
APPENDICES ..................................................................................................... 155
Appendix 1: Data types retrieved ...................................................................................... 155
Appendix 2: Islamic index methodology .......................................................................... 156
Appendix 3: List of Islamic Financial Institutions .......................................................... 157
Appendix 4: Cross-sectional OLS regressions of the determinants of ........................................................................................ 160
business activity compliance
Appendix 5: Cross-sectional OLS regressions of the determinants of ............................................................................................ 161
all financial ratio compliance
Appendix 6: Cross-sectional OLS regressions of the determinants of ................................................................ 162
cash& interest bearing ratio compliance
Appendix 7: Cross-sectional OLS regressions of the determinants of .......................................................................... 163
accounts receivable ratio compliance
iv
Appendix 8: Cross-sectional OLS regressions of the determinants of .............................................................................. 164
interest income ratio compliance
Appendix 9: Cross-sectional OLS regressions of the determinants of ..................................................................... 165
mean value of cash&interest bearing ratio
Appendix 10: Cross-sectional OLS regressions of the determinants of ......................................................................... 166
mean value of accounts receivable ratio
Appendix 11: Cross-sectional OLS regressions of the determinants of ................................................................................ 167
mean value of interest income ratio
Appendix 12: Cross-sectional OLS regressions of the determinants of ..................................................................... 168
decile value of cash&interest bearing ratio
Appendix 13: Cross-sectional OLS regressions of the determinants of ......................................................................... 169
decile value of accounts receivable ratio
Appendix 14: Cross-sectional OLS regressions of the determinants of ................................................................................ 170
decile value of interest income ratio
Appendix 15: Robustness regression of alpha by domicile ............................................. 171
Appendix 16: Robustness regression of alpha by regional orientation .......................... 173
Appendix 17: Cross-sectional OLS regressions of SEF performance and alternative compliance measures (business activity and all financial ratio compliance) ........................................................................................... 174
Appendix 18: Cross-sectional OLS regressions of SEF performance and alternative compliance measures (cash&interest bearing ratio, accounts receivable ratio, and interest income ratio compliance) .......... 175
Appendix 19: Cross-sectional OLS regressions of SEF performance and alternative compliance measures (mean and decile cash&interest bearing ratio) .................................................................................................. 176
Appendix 20: Cross-sectional OLS regressions of SEF performance and alternative compliance measures (mean and decile accounts receivable ratio) .............................................................................................. 177
Appendix 21: Cross-sectional OLS regressions of SEF performance and alternative compliance measures (mean and decile interest income ratio) ................................................................................................................ 178
v
List of Tables
Table 2.1: Investment objectives of selected Shariah-compliant funds ............................. 19 Table 2.2: Summary comparison of ethically managed funds ............................................. 20 Table 3.1: A summary of the literature on the performance of Islamic funds ................. 43 Table 5.1: Distribution of Shariah-compliant equity funds by country of domicile
and regional orientation, 1984 2010 .................................................................. 68 Table 5.2: Summary statistics of Shariah-compliant equity funds by country of
domicile and regional orientation, 1984 2010 .................................................. 70 Table 5.3: Tests of differences in fund characteristics between Shariah-compliant equity funds and matched funds, 1984 2010 .................................................... 71 Table 5.4: The list of non-Shariah -compliant sector and industry codes ......................... 75 Table 5.5: Shari'ah compliance at the firm level by country for 2008 ................................. 81 Table 5.6: Shari'ah compliance at the firm level by region for 2008 ................................... 84 Table 5.7: Descriptive statistics of Shariah compliance at the fund level .......................... 85 Table 5.8: Descriptive statistics of fund level disclosure on Shariah compliance
framework ................................................................................................................ 93 Table 6.1: Univariate tests of differences in fund characteristics between SEFs with
high and low percentage total compliance ......................................................... 105 Table 6.2: Pearson correlation matrix ................................................................................... 107 Table 6.3: Cross-sectional OLS regressions of the determinants of total compliance .. 108 Table 6.4: Cross-sectional OLS regressions of the determinants of total debt ratio
compliance .............................................................................................................. 111 Table 6.5: Cross-sectional OLS regressions of the determinants of mean value of
total debt ratio ........................................................................................................ 113 Table 6.6: Cross-sectional OLS regressions of the determinants of decile value of
total debt ratio ........................................................................................................ 114 Table 6.7: Raw returns on Shariah-compliant and other funds by country of
domicile, 1984 2010 ........................................................................................... 116 Table 6.8: Raw returns on Shariah-compliant and other funds by regional
orientation, 1984 2010 ....................................................................................... 117
vi
Table 6.9: Factor loadings of Shariah-compliant equity funds, 1984 2010 .................. 119 Table 6.10: Jensen alphas of Shariah-compliant equity funds sorted by country of
domicile, 1984 2010 ......................................................................................... 121 Table 6.11: Jensen alphas of Shariah-compliant equity funds sorted by regional
orientation, 1984 2010 ..................................................................................... 124 Table 6.12: Alpha regression results from Treynor-Mazuy and Fama & French
models for Shariah-compliant equity funds sorted by country of domicile, 1984 2010 ......................................................................................... 125
Table 6.13: Alpha regression results from Treynor-Mazuy and Fama & French
models for Shariah-compliant equity funds sorted by regional orientation, 1984 2010 ..................................................................................... 127
Table 6.14: Performance of Shariah-compliant equity funds during market downturns ............................................................................................................. 129 Table 6.15: Performance of Shariah-compliant equity funds during separate three
crisis periods ......................................................................................................... 131 Table 6.16: Cross-sectional OLS regressions of SEF performance and compliance ..... 133 Table 6.17: Cross-sectional OLS regressions of SEF performance and alternative
compliance measures (mean and decile total debt ratio) ............................... 136 Table 6.18: Cross-sectional OLS regressions of SEF performance and fund
disclosure on Shariah compliance framework ................................................. 137 Table 6.19: Summary of hypotheses and results.................................................................. 139
vii
List of Figures
Figure 5.1: Total number of registered equity funds by type, 1984 2010 ...................... 67 Figure 5.2: Total asset under management (in USD million) by equity fund type, 1984 2010 ............................................................................................................ 67 Figure 5.3: Cumulative raw returns of equally-weighted (EW) and value-weighted
(VW) Shariah-compliant equity funds (SEF) portfolio relative to MSCI World and MSCI Islam World, 2004 2010 ..................................................... 73
viii
Statement of Original Authorship
The work contained in this thesis has not been previously submitted to meet
requirements for an award at this or any other higher education institution. To the best
of my knowledge and belief, the thesis contains no material previously published or
written by another person except where due reference is made.
Signature:
Date:
ix
x
Acknowledgements
This thesis would not be possible without the support and help of so many people who have contributed to various aspects of my research. First, I am deeply grateful to my principal supervisor, Associate Professor Peter Verhoeven, who has been abundantly helpful, patient and offered invaluable motivation, support and guidance in the preparation of this thesis. I also express my gratitude to my associate supervisor, Professor Janice How, who was always open and willing to provide feedback and direction on many aspects of my research. The voyage would not have been accomplished without their support.
I also acknowledge these people for their constructive feedback and comments on my thesis: my PhD panel members (Professor Gerry Gallery, Dr. Stephen Cox and Dr. Radhika Lahiri); the discussant (Assistant Professor Karen Hunt-Ahmed) and participants at the 2011 Midwest Finance Association Conference; the discussant (Associate Professor Robert Durand) and participants at the 2011 Finance and Corporate Governance PhD Symposium; and the discussant (Dr. Lorenzo Casavecchia) and participants at the 2011 Finance and Corporate Governance Conference. Travel grants from the Midwest Finance Association Conference and the Finance and Corporate Governance Conference are appreciated. An earlier draft of this thesis won the best PhD proposal award in the Fund Management Category at the Finance and Corporate Governance PhD Symposium.
I also thank QUT Business School and School of Business & Management Institut Teknologi Bandung for providing me with a scholarship during the period of study; to Professor Tim Robinson, Head of the School of Economics and Finance, for providing the financial support to acquire the Eurekahedge Global Islamic Fund database; Khaled Suheimat for his help in translating Arabic text; and my fellow PhD students for making my study a wonderful experience.
I wish to express my love and gratitude to my beloved families; my husband, Meinanda Kurniawan, and son, Bastian Noel Azarya, for their endless patience, love, care, support and help during my research journey. Thanks also to my mom, mother in law, father in law and the Nainggolan family in Indonesia who always support and remember me in their prayers. Thank you for supporting me in both the good and bad times.
Special thanks to my friends who are always there for me: Dan and Jenny Avenell, Peter and Christine Kernke, Doureige Jurdi, Phuntsho Choden, South Brisbane St Andrew's Anglican Church, Philia Indonesian gatherings, Shwetha-Raj, and all friends in Indonesia.
I dedicate this research to my dad in Heaven; he is my motivation to pursue this amazing journey.
CHAPTER 1:
INTRODUCTION
1.1 Background
Being ethically and morally responsible while investing is not a new concept and
can be traced back to the early 1900s when the Methodist Church decided to invest in
the stock market while avoiding companies involved in alcohol and gambling. However,
it is only in the last two decades that ethical investments,1 or more popularly called
Socially Responsible Investments (SRIs), have gained considerable momentum and are
now a major stream within the funds management industry. According to the US Social
Investment Forum 2010 Report (www.socialinvest.org), SRIs contribute 12.2% of total
assets under management ($25.2 trillion) in the US funds market alone, with one in
every eight dollars invested in ethical funds.2
Ethical investments are defined as a set of (investment) approaches which
include social or ethical goals or constraints as well as more conventional financial
criteria in decisions over whether to acquire, hold or dispose of a particular investment
(Cowton, 1999, page 60). Hence, in contrast to conventional investments, which almost
exclusively look at risk and return when placing firms into the portfolio, ethical
investments also apply ethical screens to limit the investment to businesses that meet
certain moral performance criteria such as environmental, social, and governance
(ESG).3
1 Other commonly used terms for ethical investments include green, sustainable, socially responsible and religious investments. These are all different names for what is collectively known as socially responsible investments (SRIs). 2 In comparison, ethical investing is still at an early stage of development in Australia. According to the Responsible Investment Report (http://www.responsibleinvestment.org), investments in SRIs in Australia through managed portfolios reached AUD 15.4 billion in 2010, up from AUD 1.8 billion in 2002; this equates to about one in every 100 dollars invested in ethical funds. 3 In his book Capitalism and Freedom, Milton Friedman refers social responsibility to a "fundamentally subversive doctrine" in a free society. He notes that in such a society there is one and only one social responsibility of business to use its resources and engage in activities designed to
1
http://en.wikipedia.org/wiki/Social_justicehttp://www.responsibleinvestment.org/
The majority of ethical screens employed can be categorized as negative or
exclusionary in nature, avoiding businesses that derive a significant amount of their
revenues directly from activities that are in direct violation to the stated ethical
principles of the fund, such as those involved in tobacco, alcohol and gambling. This
contrasts with positive or inclusionary ethical screens where funds proactively invest in
businesses that have positive activities on ethical issues. Here, businesses that
promote environmental stewardship, consumer protection, human rights, and diversity
are favored. Other approaches to ethical investing are best-of-sector portfolios and
thematic investments that involve exposure to a single sustainable investment asset
class such as clean technology.4
Ethical investing is a highly controversial issue since one may argue that ethical
investors are not obliged to contribute to the avoidance of morally harmful activities any
more than any other type of investors. While there is some support for the view that
ethical investors differ in some critical ways from conventional investors (McLachlan
and Gardner, 2004; Williams, 2007)5, the characteristic and values which distinguish
them and which lead one investor to choose and another to opt out of ethical investing
remains largely unanswered in the literature (Pasewark and Riley, 2010).
A no less controversial issue is whether investors are left short-changed when
pursuing ethical objectives. Specifically, investors may be left short-changed if they
invest in funds that do not subsequently comply with their stated ethical objectives. The
second area where investors may also be left short-changed is when the compliance
increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud" (Friedman, 1970). 4 According to the Responsible Investment report (http://www.responsibleinvestment.org), of the total asset under management of managed ethical funds in Australia in 2010, 32% is employed through negative screening, 34% through positive screening, 14% through best of sector, and 20% through thematic investment. 5 There are significant differences in terms of their beliefs of the importance of ethical issues, their investment decision-making style, and their perceptions of moral intensity. However, gender and age has no significance in determining the investment choice made (McLachlan and Gardner, 2004; Williams, 2007).
2
http://en.wikipedia.org/wiki/Environmentalismhttp://en.wikipedia.org/wiki/Consumer_protectionhttp://en.wikipedia.org/wiki/Human_rightshttp://en.wikipedia.org/wiki/Diversity_(business)http://www.responsibleinvestment.org/
cost-adjusted return is lower than that of matched conventional funds. While the former
has not been previously investigated, the relative performance of ethical funds has been
studied extensively in the literature.
Relying on modern portfolio theory, a commonly cited argument in relation to
fund performance is that the ethical screens shrink the investment universe, thus
producing a portfolio that is significantly less diversified than if those screens were not
in place. This would expose the funds to excessive unsystematic risk for which they are
not expected to be rewarded, thus reducing portfolio performance. The situation is
more severe when the screens systematically target firms with specific risk-return
characteristics, such as when a whole industry sector is excluded from the investment
universe as is typically the case with negative screening.
Another compelling argument is that differences in cost structure lead to poorer
portfolio performance. For example, while conventional fund managers have just one
overall goal to achieve the highest possible return for a specific level of risk ethical
fund managers must not only achieve the highest possible return, they must also ensure
that the businesses the fund invests in are indeed genuine and respectful of the funds
chosen ethical values. Although monitoring and compliance costs can vary significantly
between funds, depending on the number and ambiguity of the screens employed, these
costs will most certainly adversely affect the after-fee portfolio return. For instance,
socially responsible firms spend more resources on socially responsible principles than
conventional firms and this is expected to affect their profits and thus investment
return. Others suggest and find that there is a societal rule against funding operations
that promote vice and that ethical funds pay a financial cost in abstaining from these
stocks (Hong and Kacperczyk, 2009). In particular, sin stocks have been found to
generate higher expected returns than otherwise comparable stocks, consistent with
3
them being neglected by norm-constrained investors and facing greater litigation risk
heightened by social norm (Hong and Kacperczyk, 2009).
The counter argument is that there is a positive correlation between doing good
and doing well in business. The first rationale is that there is always a consequence to
every action. Short-sighted, profit-above-all-else-focused businesses create avoidable
ESG risks and ignore vital risk indicators that a socially responsible firm would
otherwise embrace. Such firms may perform worse in the long run as they run the risk
of incurring levies and legal costs to compensate or make good any damages caused by
their (socially irresponsible) actions. A case in point is the recent BPs Deepwater
Horizon oil rig explosion disaster in the Gulf of Mexico, which according to some
sources, could cost BP up to USD10 billion.6 Second, ethical principles may be a source
of competitive advantage in some situations with consumers favoring firms with high
ethical standards (Porter and Kramer, 2006). If consumers are willing to pay more for
ethically produced goods or conversely discount the price of unethically made goods,
this will affect the profit of such businesses. As per the error-in-expectations
hypothesis, it is possible that mainstream investors have systematically overlooked this
ethical factor (Derwall et al., 2011).
Finding a conclusive answer to the question Are investors left short-changed
when pursuing ethical objectives? is thus critical to those investors who are concerned
about the ethical consequences of their investments and, at the same time, want to
obtain an acceptable return on their investments. It may also be crucial to the future
prospects of the ethical fund industry. If the practice of ethical investing were to reduce
investment returns significantly, then any attempt to align investment decisions with
morals and values is unlikely to become mainstream. This is because conventional fund
managers will be violating their fiduciary obligation to their clients (i.e, maximize
6 See for example http://www.marketoracle.co.uk/Article19778.html.
4
returns) unless, of course, they have a specific mandate from the latter to follow ethical
policies. In that case, ethical investing will remain much more of a niche market
appealing solely to those investors with strong moral beliefs about the types of
businesses they want to invest in and, at the same time, are prepared to accept a lower
return in order to satisfy their concerns. On the other hand, if the answer to the
question is positive, all investors will be able to package their investment portfolio so
that it reflects their moral beliefs.
However, based on the empirical evidence to date, whether investors have to
sacrifice some returns is by no means settled (Margolis et al., 2007).7 The converse is
also true: that is, whether investors have to sacrifice some of their ethical beliefs in order
to generate higher investment returns is unconfirmed in the literature.8 This thesis tries
to shed further light on these issues using a sample of Shariah-compliant funds.
1.2 Research Aim and Questions
The aim of this PhD thesis is to provide the first comprehensive and international
evidence on the controversial issue of whether or not investors are left short-changed by
investing in an important class of ethical funds Shariah-compliant Equity Funds
(SEFs). The ethical principles underlying SEFs lie within the collection of traditional
7 Margolis et al. (2007) perform a meta-analysis of the broad literature on the connection between Corporate Social Performance (CSP) and Corporate Financial Performance (CFP). They conclude that The overall effect is positive but small ... we find that the association is strongest for the analysis of the specific dimensions of charitable contributions, revealed misdeeds, and environmental performance and when CSP (Corporate Social Performance) is assessed more broadly through observer perceptions and self-reported social performance. The association is weakest for the specific dimensions of corporate policies and transparency and when CSP is assessed more broadly through third-party audits and mutual fund screens. Although the results suggest no financial penalty for CSP, they indicate at least as strong a link from prior CFP to subsequent CSP as the reverse. 8 Basically, we have no idea where the efficient frontier of investment and ethical returns is (or what it may even look like) at least along the higher end of the efficient frontier, an investor may not be able to increase investment returns without having some negative ethical consequences. A major dilemma in resolving this issue is in developing a metric that expresses the ethical consequences of investments in financial returns. One proposed metric is Social Return on Investment (SROI), which is a principles-based method for measuring extra-financial value (i.e. environmental and social value not currently reflected in conventional financial accounts) relative to resources invested. However, this metric is still very early in its development.
5
religious teachings, i.e. the Quran and the Sunnah (Hadith or sayings of Prophet
Muhammad) and the collection of previous Fiqh judgments. A fund is said to be Shariah
compliant if it engages strictly in the permissible (halal) and abstains from the prohibited
(haram) as commanded by God.
There are a number of commonalities shared between SRIs and SEFs in terms of
an ethical overlay on investments and a set of qualitative criteria for excluding stocks
from the investment universe. However, the main advantage of investigating SEFs is
that SEFs provide a more homogenous group of ethical funds that employ very similar
equity screens which are both more stringent and far less ambiguous than those of
SRIs.9 This feature, together with the fact that SEFs are the only ethical investment that
employ accounting screens, has the benefit of allowing us to clearly identify and
measure the extent of SEFs compliance to or deviation from Shariah and examine its
impact on investment performance.
The thesis addresses three main research questions. The first question asks what
factors determine the degree of Shariah compliance by SEFs across countries and
regions. To answer this question, we carefully calibrate the degree of Shariah compliance
of the funds holdings and regress it on a number of fund-specific characteristics
including the presence and size of the Shariah Advisory Board (SAB), the disclosure
regime of the SEF with respect to the Shariah compliance framework, and the equity
screens disclosed. The results will inform us not only on the determinants of Shariah
compliance but also whether fund managers fulfill their fiduciary obligation, as
promised in the prospectus and mandated by their investors; the latter will thus shed
light on the question of whether investors are left short-changed on Shariah-
compliance.
9 First, it is difficult to precisely gauge the involvement of firms in SRI principles. Second, there is much heterogeneity in the motivations and attitudes of the various SRIs, employing a wide variety of screening standards and ranking criteria. See Sandberg et al. (2008) and Derwall et al. (2011).
6
The second question examines the investment performance of SEFs: (i) Do SEFs
perform materially worse than other matched Conventional Equity Funds (CEFs),
Ethical Equity Funds (EEFs) and Religious Equity Funds (REFs)?; and (ii) Do SEFs
provide a safer investment choice relative to conventional or other ethical funds during
market downturns, as is often publicized by the media. Controlling for Shariah
compliance costs, we do not expect SEFs to perform differently from their matched
funds. Evidence of poorer adjusted returns would suggest that SEF investors are left
short-changed in terms of financial returns.
For a sample of SEFs, our third question asks whether there is a negative
relationship between investment performance and the degree of Shariah compliance. All
else equal, we expect funds that are more compliant to have lower returns.
1.3 Motivations
Despite differences in beliefs, the investment process of SEFs is rather similar to
that of SRIs in the sense of excluding businesses that derive a significant amount of
their revenues directly from activities that are prohibited by their faith from the
potential pool of investments. While there are numerous studies on the performance of
SRIs, studies on the performance of religious funds, in particular SEFs, are scarce and
limited due mainly to the small number of such funds existing at the time of the
studies.10
Spurred by the spectacular rise in petro-dollar revenues in oil-rich Muslim
countries, recent years have witnessed Shariah-compliant finance as one of the fastest
growing financial sectors globally (Al-Salem, 2008). While the first SEF, Dana Al-Aiman
managed by Mura Unit Trust, was established as early as 1968 in Malaysia, it was not until
10 Of the few studies that have examined performance, most tend to focus on the performance of Shariah-compliant equity indices or on a very small sample of SEFs over a short time period (e.g. Wilson, 2002; Elfakhani and Hassan, 2005; Hayat, 2006; Abdullah et al., 2007; Abderrezak, 2008; Muhammad and Mokhtar, 2008) producing largely inconclusive results.
7
http://findarticles.com/p/search/?qa=Al-Salem,%20Faoudhttp://findarticles.com/p/articles/mi_qa5440/is_200803/
the early 1990s that equity investment was officially approved by the Council of the
Islamic Fiqh Academy (CIFA) (Ayub, 2007). Since then, total assets under management
of SEFs (excluding capital appreciation) have grown rapidly at an annual rate exceeding
15%, three times faster than that of non-SEFs, attracting not only Islamic but also non-
Islamic financial institutions. At the time of writing this thesis (2011), there are more
than 350 funds under management globally (www.eurekahedge.com). With more than
$25bn in assets under management and a large, expanding and untapped Muslim
population, the importance of research into the performance of SEFs is immediately
apparent.11
With the passing of time, we believe a large enough sample of SEFs over a
reasonably long time period is now available to provide a comprehensive study on their
performance, the extent of their compliance with Shariah law, and the relationship
between performance and compliance.
Research into the performance of SEFs is expected to yield more robust results
compared to SRIs because the moral screens employed by SEFs are predominantly
exclusionary in nature and are therefore more easily measurable. The fact that SEFs are
the only ethical funds that employ accounting screens in their investment also means
that we are able to more accurately calibrate the compliance level of their holdings
compared to other ethical funds. Our study is thus motivated by the fact that we are
able to document for the first time the degree of SEFs compliance to Shari'ah law and
whether it relates to fund performance.
11 About one-quarter of the world's population is Islamic, with the majority being Sunni Muslims (~90%) and the rest Shia Muslims. Asia is home to nearly 20% of the global Muslim population, and Indonesia has the world's largest Muslim population with 203 million Muslims, or about 13% of the world's Muslims. The Middle East and North Africa (MENA) make up another 20 percent of the world's Muslims. More than 50% of Muslims live in Gulf coast countries and MENA region. About one-fifth of Muslims (300 million) live in non-Muslim countries. In Australia, Muslims make up 1.7% of the total population. See Mapping the Global Muslim Population: A Report on the Size and Distribution of the World's Muslim Population", Pew Research Center, October 2009 (http://pewforum.org/docs/?DocID=450).
8
The findings of this thesis will contribute to the relatively new Islamic finance
literature, which has yet to converge on the question of whether or not SEFs
underperform non-Shariah-compliant funds. On a more general level, our findings will
shed light on whether investors are left short changed on SEFs compliance with the
Shariah law and/or financial return when they take the leap of (Islamic) faith.
1.4 Summary of Major Findings and Contributions
Based on a large sample of 387 SEFs domiciled in 32 countries with investments
in 11 regions from January 1984 to March 2010, this thesis provides a number of
significant contributions to the literature on the performance of ethical funds.
First, using a set of stringent Shariah screens similar to those of MSCI Islamic, we
report that only about 27% of the equities held by SEFs are Shariah-compliant. While
most of the fund holdings pass the business screens, only about 42% pass the total debt
to total assets ratio screen. The results are quite striking, suggesting that in order to
overcome the significant reduction in the investment opportunity set, SEFs adopt lax
screening rules so as to achieve an efficient portfolio. The finding that less than half the
SEFs fulfill their fiduciary and religious obligation, as promised in the prospectus,
suggests that investors who took a leap in Islamic faith were left short-changed on
Shariah compliance.
We then test the determinants of the degree of Shariah compliance. There is
mixed evidence of a relationship between fund disclosure of the Shariah framework and
compliance. Specifically, funds with better disclosure of the Shariah framework do not
necessarily have higher compliance, suggesting that fund managers do not always
implement what they promised in their prospectus. The exceptions are for the
9
12disclosure of total assets and the one-third rule being used in the accounting screens.
SEFs that disclose using more conservative accounting screens, i.e., total assets as the
denominator, are more Shariah-compliant. However, funds that disclose using the one-
third rule in the accounting screens are less Shari'ah-compliant. Younger funds, funds
that charge higher fees and funds that are domiciled/invest in more Islamic countries
are more Shariah-compliant.
Employing a matched firm approach for a survivorship free sample of 387 SEFs,
our second test examines the highly controversial issue of whether ethical screening
reduces investment performance. Results show that investors who took a leap of faith
(in Shariah) are indeed left short changed financially, with SEFs underperforming
matched conventional funds by an average of 0.04% per month; this however seems to
be a relatively small price to pay for investors religious beliefs. There is little evidence
showing that SEFs perform any worse or better than matched ethical or religious funds.
We also examine whether SEFs perform better during crisis periods than other
funds but find no such evidence. This finding is consistent with our observation that
SEFs do not invest in low leverage firms. Further analysis shows that, as often claimed
by the media, SEFs outperform other conventional funds only during the recent Global
Financial Crisis.
Finally, we examine whether there is an inverse relation between Shariah
compliance and fund performance. We find that such a relationship exists, with every
one percentage increase in total compliance decreasing fund performance by 0.01% per
month. However, the degree of compliance fails to explain differences in performance
between SEFs and matched funds.
12 The one-third rule used in the accounting screens is based on the conservative interpretations by Shariah scholars that any investment should have a minimum level of exposure to interest income and expenses. These are discussed in details in Chapter 2 later.
10
1.5 Thesis Layout
The remainder of this thesis is organized as follows. Chapter 2 outlines the
institutional background of the Shariah-compliant investment. This is followed by
Chapter 3, which discusses the relevant literature on fund performance. Research
hypotheses are provided in Chapter 4. Data and research methods are outlined in
Chapter 5, and Chapter 6 provides the empirical results. A summary of the major
findings and conclusions are given in Chapter 7.
11
CHAPTER 2:
THE SHARIAH-COMPLIANT INVESTMENT
2.1 Introduction
This chapter outlines the key Shariah principles and concepts underpinning
Islamic finance that are of direct relevance to the thesis. It begins with a discussion of
the fundamental Shariah principles of Islamic finance in Section 2.2. In the Islamic
framework, material pursuits have to follow the Qur'an and the Sunnah, which value total
commitment to God. Section 2.3 lists the prohibitions imparted on Islamic finance,
such as conventional interest (riba), gambling (maysir), uncertainty (gharar), and unethical
(haram) products. Section 2.4 discusses the ethical screens underlying Shariah-compliant
equity investments and Section 2.5 provides specific examples of the equity screens of
some of the major Shariah indices.
2.2 The Fundamental Principles
The Islamic financial system depends on and is derived from a religious outlook
towards life in general. It is based on Shariah, which literally means the path to a watering
hole. Shariah is a religious code that governs the lifestyle of all Muslims in the same way
that the Bible offers a moral system for Christians (Steiner, 2002). This religious outlook
provides a holistic approach to life regarding: (i) the life of a Muslim person including
the way she interacts with the society members (Muslims and non Muslims); (ii) the way
she interacts with her own families; and (iii) the means and methods by which she uses
monetary items including money notes or assets (Jackson-Moore, 2009). In this respect,
all Muslims have a legal and ethical obligation with respect to their investment activities,
which will be guided by Shariah principles.
12
Islamic law on commerce (fiqh al-mu'amalat) is derived through intellectual effort
to understand the meaning and coherence (nazm) of two main religious teachings: the
Quran and the Sunnah. The Quran is the Islamic holy book, which Muslims believe is
the direct words of God, as dictated to the prophet Muhammad by the angel Gabriel,
and contains Gods rulings and directions to humanity. Those rulings and directions
prescribe a lifestyle. In addition to what to do in prayers and religious venues, the Quran
also gives directions on every aspect of life including financial and monetary matters.
Sunnah is referred to as the collection of the utterances or deeds of the prophet
Muhammad, comprising his moral guidance on many issues as recorded in the Hadith13
(Jackson-Moore, 2009).
While Islamic law influences the legal codes of most Muslim countries one way or
another, the interpretation of the law can vary widely across the countries. Although
much of Islamic jurisprudence is derived directly from the Quran and the Sunnah, there
are areas in which the two fundamental sources of guidance for Muslims are completely
silent or at best ambiguous. In such situations, Islamic scholars use either analogy
(Qiyas), a consensus among scholars (Ijma) or individual interpretations (Ijtihad) to settle
the issue. The legal system is highly specialized with a number of ideological differences
between different regions, and each country has its own body of philosophers,
interpreting Islamic teachings in its own way. Clearly, applying classical Shariah law to
the current global finance world is a difficult task since this will be subject to human
interpretation of the law (Fiqh) (Vogel and Hayes, 1998; Kuran, 2004; Iqbal et al., 2009).
Islam prohibits harm and that which leads to the forbidden. If it is earned,
invested and spent according to the guidelines set by Shariah, the individual, family and
society as a whole will benefit. For a financial transaction, contract or instrument to be
acceptable, it has to be morally sound (Kahf, 2006). Moral soundness means that an
13 Hadith means report or narrative.
13
http://www.iis.ac.uk/glossary_list.asp?f=r&t=z&l=en
Islamic financing institution cant use its resources to support drugs, alcohol, gambling, porno industry,
environmentally harmful products, and/or any other production or distribution of any material or service
that does not have a humanly acceptable ethical foundation (Kahf, 2006).
In real life, a Muslim has to be able to relate everything she does to a religious
point of view, putting God as the ultimate judge of her actions. Hence, the concepts of
reward and punishment are essential in understanding the actions of a Muslim. Simply,
and at a basic level, God shall punish those who disobey the directions God has stated
in the Quran and/or through the Prophets Sunnah; conversely, God shall reward those
who obey Gods directions. Thus, the fear of Gods punishment and the desire for
Gods rewards both compose the most focal points of interaction with society. For
example, before embarking on a transaction, a Muslim has to ensure that the transaction
is acceptable by the Shariah this establishes the first principle of Islamic financing,
which is Shariah Permissibility.14
The second most important principle is that of Balance (mizan), requiring both
transacting parties to equally share obligations so that there is no excessive load on
either one party (Kahf, 2006): It is God Who has bestowed revelation from on high, setting forth
the truth, and (thus given man) a balance (wherewith to weigh right and wrong) Surah al Shura
(42:17). This verse of the Quran teaches that divine revelation through the various
prophets in human history is considered to be a balance by which we can weigh all
issues of conscience. The principle prohibits excessive overcharging such as riba
(interest) as it represents an unequal distribution between the lender and the borrower;
the lender charges an interest but does not share the loss with the borrower.
The third principle is Realism/Validity, which indicates that the asset being
transacted has to be founded on real, in contrast to presumed or deemed, transactions,
14 The non-permissible list, as discussed in Section 2.3 later, includes riba (interest), intoxicants, gambling, pork and other swine products, and any meat from animals not slaughtered in a manner according to the Shariah.
14
exchanges or things and assets (Kahf, 2006). Since interest is raised money from money
and not from productive assets, it is thus based on pure assumptions. Trading shares in
listed equity indices is also considered to be an unreal transaction because it is only a
calculation based on the movement in index prices that does not represent any real
ownership.
In sum, it cannot be stressed enough that Islamic finance is based solely on
Shariah rulings. Essentially, transactions are acceptable as long as they do not violate
Shariah rulings. The next section discusses the major dos and donts in the Islamic
financial system.
2.3 The Prohibitions
The first prohibition is in accepting riba (usury), which is the additional amount
collected above the lent out principal.15 This is the interest collected or the conventional
guaranteed return. The prohibition of riba is stated repeatedly in the Quran and the
Sunnah.16 Riba is considered haram as it violates the principles of Balance and Validity. It
discourages innovation and entrepreneurship by charging cost to the investment. Riba is
therefore viewed as a source of injustice rate (Sarker, 1999). As a result, investments and
income in interest bearing securities such as conventional bonds, warrants, and bank
deposits are prohibited.
15 Similarly, in the Christian tradition, many individuals refused to do business with those engaged in the practice of usury despite the potential financial benefits that could be gained from such business. 16 Those who devour riba will not stand except as one whom the evil one by his touch hath driven to madness. That is because they say: Trade is like riba, but God hath permitted trade and forbidden riba. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for God to judge; but those who repeat (the offence) are Companions of Fire: they will abide therein (forever). God will deprive riba of all blessing, but will give increase for deeds of charity: for He loveth not creatures ungrateful and wicked (Surah al-Baqarah: 275-276). Further, That they took riba (usury), though they were forbidden and that they devoured mens substance wrongfully We have prepared for those among men who reject faith a grievous punishment (4:161); O ye who believe! Devour not usury doubled and multiplied; but fear Allah, that ye may (really) prosper (3:140); and That which ye lay out for increase through the property of (other) people, will have no increase with Allah: But that which ye lay out for charity, seeking the countenance of Allah (will increase): it is these who will get a recompense multiplied (30:39).
15
The second prohibition is maysir (gambling), which can be described as a zero-sum
game: it is an exchange in which one party gains by taking away from the other partys
payoff, leading to a win-lose outcome.17 The profits accruing from such a game is
unlawful, as is the act of playing it, for it makes people unproductive and immoral.
Maysir also includes transactions that are based on dishonesty/ambiguity/ignorance
regarding materials or price. Any investments relating to the building of casinos or
venues that include, encourage and/or support gambling are also forbidden.
The third prohibition is gharar (risk/uncertainty that implies delusion and
deception)18 which involves putting ones assets or self in excessive risk. A zero-sum
exchange precisely reflects this concept (Al-Suwailem, 2000): uncertainty is what tempts
rational agents to play this game.19 The sale of gharar leads to maysir, which in turn leads
to oppression and is therefore prohibited in Islam. An example of gharar is conventional
insurance (Al-Kawthari, 2005): the contract is designed such that only chance decides
who is the winner. There is no outcome in insurance contracts whereby both parties
become better off ex post than not contracting, and thus preferences of the two parties
are in direct opposition. While taking risk with the hope of winning is not unethical, it
becomes unethical when the hope is for someone else to lose since there is no way that
both parties can win in a zero-sum game.
It is important to note however that speculation in the financial markets is not
illegal in Islam as it is considered to be neither maysir nor gharar. Speculation is not the
result of the roll of a dice (i.e. gambling) but requires a great deal of knowledge and
17 The Quran is clear about the prohibition of gambling: O you who believe! Intoxicants, and gambling, (dedication of) stones, and (divination by) arrows, are an abomination of Satan's handiwork: eschew such (abomination) that ye may prosper (Surah al-Maidah: 90). Al-Kawthari (2005, p.20) states: Gambling, as any sound minded person will tell you, is a great evil of the society and immensely harmful to the wellbeing of the human social order. As such, Islam has categorically and firmly prohibited all forms of gambling, so that the human society is saved from its ill-effects and harms. 18 This is stated in the Hadith: Verily, the Prophet s.a.w. prohibits gharar transactions. 19 In a non zero-sum game, the risk taken must be unintentional, inevitable, and negligible (Al-Suwailem, 2000).
16
analytical skills of economic and financial data. Neither is it a zero-sum game as a
speculator will play the game only if a loss is uncertain and a gain is probable.
Nevertheless, excessive speculation with a lack of information/skill may be considered
gambling since the risk associated with such transactions is highly uncertain.
The fourth prohibition is non-halal products. Islam prohibits any kind of activities
(consumption, production and providing) related to non-halal meat,20 21 intoxicants, and
adultery.22
Kahf (2006) lists four fundamental elements in Islamic financial contracts: (i)
earnings have to be justified by an asset. In this sense, the asset can be administered by a
manager (entrepreneur), leased out or resale; (ii) the asset must produce value either by
its nature (such as fruits or usufruct) or by the force of real market supply and demand
(such as goods and services); (iii) the investor who owns the property earns the
ownership of the asset growth such as in sale and lease financing, and implied in the
agency content of sharing; and (iv) moral and Shariah screening is critical for any
Shariah-compliant investments and financial contracts.
Equity investment transactions satisfy all the above requirements and are free
from riba , maysir and gharar. An equity investment23 24 is viewed as a hybrid of capital-
labor partnership (mudaraba financing) and capital-capital partnership (musharakah 20 The Quran defines non-halal meat as: Forbidden to you (food) are dead meat, blood, the flesh of swine, and that on which has been invoked other than Allahs name, that which has been killed by strangling, or by a violent blow, or by a headlong fall, or by being gored to death, that which has been eaten by wild animal, unless you are able to slaughter it (in due form), and that which is sacrificed on stone altars (Surah al-Maidah: 3). 21 Evidence from Hadith on the prohibition of intoxicants (processing, production, providing and consuming): Verily Allah s.w.t. curses intoxicants, those who squeeze grapes to produce, those who buy the grape juice for making the drinkers, suppliers of intoxicants, bearers of intoxicants, those who pour intoxicants into cups for drinkers, sellers of intoxicants, those who buy them and those who spend the money earned from the sale of intoxicants. 22 The Quran prohibits immoral activities since they are bad for the body and can bring evils to others: Nor come high to adultery: for it is a shameful (deed) and an evil, opening the road (to other evils) (Surah al-Isra': 32). 23 Although the Quran refers the word riba as haram or prohibited, it does not use the word interest. The definition of riba is therefore subjective and has led to the varying schools of thoughts. Some define interest/usury as riba. Under this school of thought, interest is prohibited no matter what. However, others look at how the word riba has been used in the Quran and look at its context. They define riba as an exuberant amount of interest charged, usually to the needy, such as credit cards charges of 18-20%. 24 The contract between investors and agency in unit trust contracts is fuqaha or al-wakalah, where there is no profit sharing but a management fee (ujrah) is paid for the skills and service of fund managers (Rosly, 2005).
17
financing) and is thus permissible under Islamic law (Wilson, 1997). As capital owners,
investors can provide either capital only (mudaraba) or both capital and managerial
partnership (musharakah). The firm is the entrepreneur (mudarib) who uses the capital
from the stockholders and may contribute only human capital (mudaraba) or both equity
and human capital (musharakah). The important point is that investors and the firm are
taking and sharing the risk of the capital invested.
In a mudaraba contract, shareholders have no voice to give opinions to the
management and bear all the losses. In contrast, they have a voice in musharakah
contracts where they share any risks and losses from the business. Therefore equity is
consistent with Shariah principles of profit and loss-sharing. It is essentially based on real
market transactions, i.e., assets, goods and/or services, and deals with the real risk of
owning goods, services and productive assets. Although equity investments are allowed,
the main business activities of these firms must not be in violation of the fourth
prohibition, and that is the business activities must be permissible (halal).
2.4 Shariah-Compliant Equity Funds and Their Equity Screens
Since its approval in early 1990s by CIFA, investment in SEFs has grown at a
phenomenal rate of about 15%-20% per annum. As at March 2010, there are more than
350 SEFs worldwide domiciling in more than 30 countries (www.eurekahedge.com)
with total assets under management (AUM) exceeding US$25 billion in early 2010.
Malaysia and Saudi Arabia have by far the largest market share, measured both by AUM
and the number of SEFs offered.
Table 2.1 shows a selection of SEFs with their investment objectives. An analysis
of the fund objectives reveals that Shariah compatibility and adherence to Islamic values
are entrenched in the mission statements of these funds with a clear reference to Islam
and the values they promote. Shareholder wealth maximization is not the only legitimate
18
http://www.eurekahedge.com/
objective, but also Shari'ah compliance and Islamic value maximization (Obaidullah,
2005). Although fund prospectuses are rather brief in detailing the SEFs ethical
objectives (since the responsibility for these are often shifted to their Shariah
supervisory boards), implicitly the funds recognize the interests of stakeholders other
than shareholders including employees, customers, and business partners. In short,
Shariah compliance is in general a largely ethical question in relation to compliance with
Islamic law.
Table 2.1: Investment objectives of selected Shariah-compliant funds
19
Source: Various fund websites
Fund NameLaunched
DateFund Manager
Fund Domicile
Fund Regional Orientation
Objective of the Fund
Amana Growth Fund
2-Mar-94 Saturna Capital Corporation
USA USA The Growth Fund invests only in common stocks, including foreign stocks. Investment decisions are made in accordance with Islamic principles. The Fund diversifies its investments across industries and companies, and generally follows a value investment style. The Fund favors companies expected to grow earnings and stock prices faster than the economy, and tend to be smaller and less seasoned companies.
Public Islamic Equity Fund
28-May-03 Public Mutual Malaysia Malaysia To achieve capital growth through a diverse selection of growth stocks that complies with Shariah principles.
PRUasia pacific Shariah equity fund
22-Nov-07 Prudential Fund Management Berhad
Malaysia Asia Pacific Seeks medium to long-term capital appreciation by investing primarily in Shariah-compliant undervalued companies with re-rating potentials in the Asia Pacific ex-Japan region.
HSBC Amanah Global Equity
14-Apr-09 HSBC Global Asset Management
Luxemburg Global The sub-fund aims to generate capital appreciation over the long term through the implementation of an active management strategy. The investments will consist of a diversified portfolio of global equity securities that comply with Islamic investment principles.
Table 2.2 shows the major differences between SEFs and other SRI and
religious funds. Of all the ethical funds, Shariah-compliant funds have the most rigorous
moral screening. For example, all major Shariah Indices25 screen out businesses which
are directly active in, or derive more than 5% of their revenue (cumulatively) from,
25 The Islamic market index is an index consisting of a selection of Shariah-compliant stocks according to specific qualitative and quantitative criteria governed by Islamic scholars on the Shariah Advisory Board.
Table 2.2: Summary comparison of ethically managed funds
Source: Partly adapted from Ghoul and Karam (2007) and Forte and Miglietta (2007).
Descriptor SRI Funds Shari'ah -compliant Funds Christian FundsSupervisory committee Social Investment Forum, Ethical Committee. Shariah Advisory Board for Islamic
Finance/Banking/Investing. This board has full authority.Christian Advisory Board depends on different denominations the funds submit to. For example: The United States Conference of Catholic Bishops sets guidelines for Catholic funds.
Unique screening criteria Promote and support performance in business that involves with the best practice of corporate governance, the protection of environment, human right, and animal welfare (people, planet, and profit), and the responsibility towards society, the environment, and the stakeholders.
Prohibit investment in financial institutions or firms that receive or pay interest (riba).
Prohibit investment in firms that are directly or indirectly involved in family planning, abortion, contraceptives. Originally, religious funds also prohibited investment in financial institutions or firms that receive or pay interest This is no longer the case.
Prohibit investment in alcohol,gambling, weapons, and tobacco.
Yes Yes Yes
Prohibits investment in stocks that involve pornography, music, and entertainment.
No Yes Yes, in particular prohibit anti-family entertainment.
Prohibit investment in oil & gas exploration and pharmaceuticals.
Yes No No
Financial ratio screens No Yes, prohibits firms with debt, accounts receivable, cash and short term investments exceeding some threshold (for example: one-third of market value of equity (or total assets)).
No
Portfolio purification No Five percent of the firms income that is non halal has to be donated to charities (Zakat).
No
Typical holdings Technology, Telecommunication, Steel, Engineering, Transportation, Health Care, Utilities, Construction, Property, Financials.
Energy, Pharmaceuticals, Materials, Technology, Telecommunication, Steel, Engineering, Transportation, Health Care, Utilities, Construction, Industrial Goods & Services, Retailing.
Technology, Telecommunication, Steel, Engineering, Transportation, Health Care, Utilities, Construction, Property, Financials.
Shareholder activism Encouraged Encouraged Encouraged
Typical performance benchmarks FTSE Kinder Lydenberg Domini 400 Social Index (DS 400), Calvert Social Index (CSI), Dow Jones Sustainability Index (DJSI).
Dow Jones Islamic Market Index (DJ Islamic), the Morgan Stanley Capital International Islamic Index (MSCI Islamic), the Financial Times Stock Exchange Shariah Index (FTSE Shariah), the Standard & Poors Shariah Index (S&P Shariah), and the Kuala Lumpur Syariah Index (KLSI).
FTSE Kinder Lydenberg Domini Catholic Values 400 Index (CV 400).
Fund Fees Normal High Normal
20
26alcohol; tobacco; pork related products; conventional financial services; defense and
weapons; gambling and casino; music;27 hotels; cinemas; and adult entertainment. The
Standard and Poors (S&P) Shariah Index also excludes firms involved in the trading of
gold and silver as cash on a deferred basis; and advertising (newspapers are however
allowed). Although Shariah-compliant funds are not known to employ inclusionary
screens, there may well be a preference for businesses which are run according to
Shariah principles, such as Islamic Financial Institutions (IFIs).28
In addition to business screens, SEFs also use financial ratios to screen out firms
that use prohibited financial instruments,29 all related to riba. The ratios include: (i) total
debt to total assets/equity; (ii) cash and short term investments to total assets/equity;
and (iii) liquid assets (cash plus accounts receivable) to total assets/equity. The rationale
behind these financial ratios is to verify that interest-bearing securities are not
predominantly used in the cash investment, that the interest-based debt does not
contribute significantly to the financing of the operations, and that the company is not
in majority composed of liquid assets. In Islam, liquid assets can only be traded at par.
Therefore the value of the company can only be negotiable if it has illiquid (real)
assets.30
26 The use of leather and fur products like garments, shoes, bags, etc. is allowed in Shariah. The prevailing view of the majority of Muslim scholars is that the hide of all dead animals which are halal to eat had they been properly slaughtered, may be made tahir (purity and clean) by way of tanning (http://roadtojannah.org/?p=20). However, the skins of animals that are haram to eat, such as pigs, dogs, carnivores, etc. are not made tahir by the process of tanning. 27 Musical instruments are forbidden by the Quran and the Sunnah: And from people are those who transact in vanities to misguide from Allahs way without knowledge. The word vanities in this verse refers to music and singing, and instruments such as flutes and violins. This is because music and singing distract one from the remembrance of Allah and incite one to follow personal vain passions and desires. 28 IFIs are institutions that offer financial products and services that comply with Shari'ah law and they include Islamic banks, Islamic insurance, Islamic mutual funds, and some conventional banks that offer not only conventional products and services but also Islamic products and services (Sundararajan and Errico, 2002; Obaidullah, 2005). 29 Catholic funds also impose accounting screens including market capitalization, earnings, liquidity, stock price and debt to equity ratios. However, these ratios are not specified in details. 30 Islamic finance recognizes the value of money only if it is backed up by economic activity, i.e., tangible assets or profits.
21
http://roadtojannah.org/?p=20
The threshold used in these financial ratios is not stated explicitly in Shariah law
although it tends to vary between 30% and 45% a result of the various interpretations
by Shariah scholars: Judgement is based on majority, not on minority, and the dividing line
between a majority and minority is one third, and the third as a portion is considered to be much
(Hadith). Since it is almost impossible for firms not to have any exposures to interest
income, a lower threshold of 5% to 10% is set for the ratio of total income derived
from interest to total revenue. This 5% or 10% threshold is based on the collective
opinion (consensus) of Shariah scholars.
Nevertheless, instilling morals into investment is not without its fair share of
controversy. While some level of compliance with Islamic law is ensured by the Board,
the exact interpretation of Shariah teachings about what is permissible (halal) and what is
not (haram) is open to debate (the International Organization of Securities Commissions
(IOSCO), 2004; Obaidullah, 2009).31 This implies that the rigorousness of the screening
process differs substantially across SEFs and indices, depending on their degree of
tolerance.32,33
The first major disagreement revolves around the choice of the denominator of
the financial ratios, which is meant to represent the total value of the firm. Some
Shariah scholars suggest that as we want to measure the proportion of debt in the value
of the firm and, since debt is based on the market, then we should use the same for the
31 Quranic exegesis is relied upon to determine the legality of different transactions within finance, and this may lead to differences in opinion at the micro level. Shia/Sunni jurisprudence differs on these topics to some extent as they can use different traditions (Hadith). 32 Although there are international bodies such as Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB), which set governance guidelines for Shariah Advisory Boards (mainly for financial institutions), there is no central regulatory body that provides unified screening rules for Shariah-compliant finance. While there have been some attempts to develop a standardized Shariah screening rules, so far, this has been largely unsuccessful. 33 Similarly, SRI funds are often defined according to their greenness or shades of green, depending on the strictness of the criteria they choose to apply. Dark green investors narrow their investment choice because of the strictness of their ethical criteria. They may only invest in funds which select firms that proactively work towards improving the environment and operate a vigorous screening process, and avoid firms that do not conform to their rigorous requirements. Light green investors tend to be less restricted in their choice of investments, excluding fewer firms from their investment selection usually by a process of negative screening (http://www.ethicalinvestment.co.uk/ Ethical_screening.htm).
22
http://www.ethicalinvestment.co.uk/%20Ethical_screening.htm
firm value. This interpretation implies taking the market capitalization as the firm value.
Others suggest total assets, which are arguably more in compliance with Islamic law
because all transactions in Islamic finance must be asset-backed; otherwise they would
be declared as riba because money was transacted on the basis of money. Those who
advocate for total assets also argue that market value is more volatile and often does not
reflect the fundamentals of the firm. This point is especially valid given the financial
turmoil over the last few years surrounding the Global Financial Crisis (GFC), where we
witnessed the market capitalization of firms becoming very volatile and not
corresponding to their financial fundamentals. The unintended consequence is that a
firm that is considered Shariah-compliant one day could be considered haram the next
day, simply due to large fluctuations in its market capitalization. This has led index
providers such as Dow Jones and S&P to change their screening methodology during
2009 from using a 12-month moving average market capitalization to using a 24-month
and 36-month window respectively to smooth out the effects of the GFC. However,
Russell continues to use the 12-month moving average market capitalization.
Besides the consideration about which is the correct denominator to use, the
treatment and the inclusion or otherwise of certain financial instruments (such as
derivatives, preferred shares, etc.) have also been the subject of debate as are the
threshold values of the financial ratios. Differing accounting rules and accounting
treatments around the globe make the calculations even more challenging and add
another level of complexity, which may compromise consistency and comparability.
There are also ambiguities about the type of business activities that are prohibited.
Some Shariah scholars argue that an investment by a fund in a hotel or a restaurant that
serves alcohol is prohibited, whereas others argue that if alcohol sales are less than a
certain percentage of the revenue of the hotel or the restaurant, then the investment
may still qualify as Shariah-compliant. The list goes on and on.
23
Unlike other ethical investments, Shariah-compliant investments also include
purification, which has two separate elements. One is a form of obligatory charitable
contribution called Zakat,34 where the act of supporting the less fortunate is considered
a spiritual purification. The other is the donation of impure (haram) profits.
Contemporary Shariah scholars tend to allow investments in stocks with a tolerable
proportion of revenues from prohibited activities, usually less than 5% of total revenue.
This 5% level is not stated in the Quran or Hadith but is based on the collective opinion
(consensus) of Shariah scholars due to the absence of a fully Shariah-compliant firm in
the world (Wilson, 1997; Derigs and Marzban, 2008).35 The charitable gift will not count
towards a Muslim investors Zakat obligation. Therefore, the total return to the investor
is the amount obtained by subtracting the impure profits from the total profits, with
the impure proportion donated to charity (Zakat).36
Finally, while a Shariah-compliant fund may engage in leverage through the use of
Islamic financing instruments (Sukuk), it may not obtain or provide conventional loans
or otherwise invest in conventional interest bearing instruments, including convertible
debt securities. Cash held by a fund may only be invested in Shariah-compliant short-
term investment products such as Islamic money market instruments. As Shariah
prohibits the payment of any predetermined guaranteed rate of return, investments in
preferred shares or fixed income securities are also restricted. Again, depending on the
various interpretations, Shariah-compliant funds should not involve excessive risk
through speculative transactions such as short selling37 and market timing.
34 Zakat, sometimes referred to as Zakah, literally means purification and is a form of religious tax for assisting the less fortunate and those who struggle for Allah. The amount of Zakat is between 2.5% and 20%, depending on the source of the wealth but is typically on the lower end of the scale. 35 Thus several scholars call this a Shariah-tolerant investment (Bastaki, 2008). 36 This donation (purification fee) is encouraged by most fund managers. However, the implementation is voluntary by investors. 37 Selling short appears to run contrary to the Quran, which prohibits the sale of what you do not own. Mohamad Toufic Kanafani, chief executive of Noriba, the Islamic banking arm of UBS Warburg and project adviser, says the team devised ways around this by enforcing a down payment (Salam transaction) towards each transaction, which must be detailed in writing.
24
2.5 Shariah Indices and Their Ethical Screens
Although details of the workings of the Shariah Advisory Board often resemble a
black box since the various screens applied by SEFs are rarely made public, the
screens of various Shariah indices are well documented. The first published market
index to employ Shariah screens is the Dow Jones (DJ) Islamic, followed in tandem by
the Financial Times Stock Exchange (FTSE) Shariah, the Standard & Poor's (S&P)
Shariah, the Morgan Stanley Capital International (MSCI) Islamic, and the FTSE Bursa
Malaysia Shariah.
DJ Islamic index family provided by Dow Jones & Company is the most popular
benchmark for Shariah-compliant investments. Established in March 1999, it currently
covers a large number of separate Shariah indices classified according to size, industry,
and region (www.djindices.com). These consist of 7 region indices, 10 industry indices,
2 titan indices, and 68 country indices. There are five Shariah Board members38,39 in the
DJ Islamic market index family: Shks. Daud Bakar, Abu-Ghuddah, Yaquby, Elgari, and
DeLorenzo. Firms whose primary business activities involving alcohol, tobacco, pork-
related and non-halal products, conventional financial services, weapons and defense,
and entertainment (hotels, casinos/gambling, cinema, and pornography) are excluded
from the DJ Islamic index family. These business activities are defined according to the
sectors in the industry classification benchmark and are examined on the basis of the
revenue allocation of each firm in the index universe. After removing firms with
38 There is no universally recognized degree or examination to acquire the status of a Shariah-compliant finance authority. Generally, the discipline in Shariah related in part to commerce is termed fiqh al muamalat. While there are jurists who specialize in this area, the qualifications for such positions are quite varied. The industry itself undertakes to create standards and structures for uniformity and transparency but it has not been successful to date. An examination of these issues can be found in Grais and Pelligrini (2006), available at http://wwwwds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2006/11 /08/000016406_20061108095535/Rendered/PDF/wps4054.pdf. 39 In addition to being knowledgeable about Shariah, modern economics and finance, global business, and legal environments, the Board members must also have the ability to speak and write in both Arabic and English (DeLorenzo, 2010). As the number of Shariah scholars with these qualifications is limited, the same person may be a member of more than one Islamic Financial Institution (IFI) thus jeopardizing independence in the decision making. To ensure independence, it is important that the Shariah Scholars do not sit on the Board or are part of the management team of the IFI.
25
http://wwwwds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2006/11%20/08/000016406_20061108095535/Rendered/PDF/wps4054.pdfhttp://wwwwds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2006/11%20/08/000016406_20061108095535/Rendered/PDF/wps4054.pdf
inappropriate core business activities, the remaining firms are further screened on three
financial ratios which must all be less than 33%: (i) total debt divided by (trailing 12-
month average) market capitalization40; (ii) the sum of cash and interest-bearing
securities divided by market capitalization; and (iii) accounts receivables divided by
market capitalization. Firm are evaluated periodically according to these qualitative and
quantitative criteria for inclusion in DJ Islamic. There are about 95 SEFs that use the DJ
Islamic family as their benchmark (Hussein and Omran, 2005).
The FTSE Shariah Global Equity Index Series provided by the FTSE Group was
first established in 1999 and currently encompasses 48 Shariah global and regional
indices, and 49 country indices (www.ftse.com). There are five members on the Shariah
Board, all of whom are from the Yasaar Shariah Board: Shks. Daud Bakar, Abdul S.A.
Ghuddah, Essam Ishaq, Yousef Alshubaily, and Akram Laldin. The FTSE Shariah
excludes firms involved in conventional banking, finance, and insurance, forward
currency transactions and derivatives; alcohol, pork-related products and non halal food
(production, packaging, and processing); entertainment (casinos, gambling, cinema,
music, pornography, and hotels), tobacco, weapons, arms and defense manufacturing;
and any other prohibited activities as decided by the Yasaars Shariah board. The
remaining firms are screened on their financial ratios: debt should be less than 33% of
total assets; cash and interest bearing items should be less than 33% of total assets;
accounts receivables and cash should be less than 50% of total assets; and total interest
and non-compliant activities income should not exceed 5% of total revenue.
The S&P Islamic Index Group provided by Standard & Poors was established in
2006 and covers three major regions (US, Europe, and Japan); Gulf Cooperation
Council (GCC); Brazil, Russia, India and China (BRIC); and Pan Asia Shariah
(www2.standardandpoors.com). There are four members on the S&P Shariah Advisory
40 In 2010, this has changed to a trailing 24-month average market capitalization.
26
Board: Shks. M. Ali El-Gari, Abdul S.A. Ghuddah, Nazih Hammad, and M. Amin Ali
Qattan. S&P Shariah implements sector- and accounting-based Shariah screens. Firms
in sectors with business activities related to pork, alcohol, gambling, financials,
advertising and media (newspapers are not prohibited), pornography, tobacco, and
trading of gold and silver as cash on a deferred basis are excluded from the index
universe. The accounting-based screens are: debt to 12-month average market value of
equity should be less than 33%; accounts receivables to 12-month average market value
of equity should be less than 49%; cash and interest bearing securities to 12-month
average market value of equity should be less than 33%; and revenue from non-Shariah-
compliant activities are allowed as long as non-permissible income other than interest
income to revenue is less than 5%. S&P Shariah indices are screened on a daily basis by
Ratings Intelligence Partners, a Kuwait-based consulting company specializing in the
Islamic investment market.
While none of the above mentioned Shariah indices provide total returns net of
dividend purification, both S&P Shariah
