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Journal of Business Ethics

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17-01-2015

Ethical Screening and Financial Performance: The Case of Islamic Equity Funds

Authors: Yunieta Nainggolan, Janice How, Peter Verhoeven

Published in: Journal of Business Ethics | Issue 1/2016

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Abstract

Whether ethical screening affects portfolio performance is an important question that is yet to be settled in the literature. This paper aims to shed further light on this question by examining the performance of a large global sample of Islamic equity funds (IEFs) from 1984 to 2010. We find that IEFs underperform conventional funds by an average of 40 basis points per month, consistent with the underperformance hypothesis. In line with popular media claims that Islamic funds are a safer investment, IEFs outperformed conventional funds during the recent banking crisis. However, we find no such outperformance for other crises or high volatility periods. Based on fund holdings-based data, we provide evidence of a negative curvilinear relation between fund performance and ethical screening intensity, consistent with a return trade-off to being more ethical.

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See for example http://goliath.ecnext.com/coms2/gi_0199-9910749/In-credit-crisis-Islamic-funds.html (Retrieved on 13 August, 2014).

While there are numerous studies on the performance of SRIs (Renneboog et al. 2008a), studies on IEF performance are relatively scarce due mainly to the small number of such funds existing up until recently. We note that only nine percent of Renneboog et al.’s (2008b) sample of 440 SRI funds employ Islamic screens, i.e., they are IEFs.

Some of the ratios include Total Debt/Total Assets; Cash & Interest-bearing Securities/Total Assets; and Accounts Receivables/Total Assets. Further details are provided in “Fund Performance and Ethical Screening Intensity” section. See also Nainggolan et al. (2014) for a discussion on Shariah screening criteria.

More than 50 percent of the world population of Muslims lives in this region (Pew Research Center 2009).

Although not reported in details in this paper, using fund returns before management fees does not change our conclusion.

We also employ country/region benchmarks and our results are robust to these (tables are available upon request).

We use Treasury Bill as the risk-free rate following other papers such as Bauer et al. (2005) and Renneboog et al. (2008b), which examine international samples of ethical funds. We also consider alternatives proxies for non-interest bearing risk-free rate of return within the Islamic context, such as a 2.5 % annual Zakat (purification) rate. Our results are robust to these.

We are grateful to Kenneth French for providing time series data for HML, SMB and UMD factors.

Using total assets as the denominator is considered to be stricter since all transactions in Islamic finance must be asset backed. Further, market value is more volatile and often does not reflect the fundamental value of the firm.

The one-third rule is based on Hadith or sayings of Prophet Muhammad which view the majority as being one-third.

MSCI Islamic is more stringent than DJ Islamic as it employs total assets as the denominator in the accounting screens and applies the dividend purification ratio; the latter is formulated as [total earnings—(income from prohibited activities and interest income)]/total earnings. This proportion would be deducted from all reinvested dividends and donated to charity (MSCI Islamic Index Series Methodology, May 2007).

We do not report the statistics for IEF compliance with business screens or other accounting screens since virtually all funds (about 90 percent) comply with these filters. Refer to Nainggolan et al. (2014) for a detailed description of the holdings data.

Although regression results for the raw portfolio returns are reported, our discussions focus only on results for the difference portfolio.

Since IEFs have a smaller investment universe than other funds, it is possible that they may have higher total risk due to lack of diversification. Therefore, it may be argued that it is more proper to test IEF performance using the Sharpe Ratio (excess return/total risk) rather than Jensen’s alpha. We perform this analysis and find similar results using the Sharpe Ratio, with IEFs performing worse on average than matched conventional funds. We also measure the timing ability of IEFs and find that on average it results in negative returns although the results are not statistically significantly different from those of matched conventional funds. Results for these results are available upon request.

Using the nonparametric partial frontier method and quantile regression techniques, Abdelsalam et al. (2014) also find IEFs perform worse than SRIs but only for the most inefficient funds.

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Title: Ethical Screening and Financial Performance: The Case of Islamic Equity Funds
Authors: Yunieta Nainggolan
Janice How
Peter Verhoeven
Publication date: 17-01-2015
Publisher: Springer Netherlands
Published in: Journal of Business Ethics / Issue 1/2016
Print ISSN: 0167-4544
Electronic ISSN: 1573-0697
DOI: https://doi.org/10.1007/s10551-014-2529-5

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