Performance Analysis between Shariah-compliant and Conventional Indices in US and Malaysia and their long-term relationships

Transcription

1 Performance Analysis between Shariah-compliant and Conventional Indices in US and Malaysia and their long-term relationships A dissertation submitted to the University of Glasgow in partial fulfilment of the requirement for the MSc. Investment Banking & Finance. Department of Economics, Adam Smith Business School Supervised by : Mr Jason Laws Student ID : Word Count : 12,523 words

2 ABSTRACT This study analyse the risk-adjusted performance of Shariah-compliant and conventional indices for US and Malaysia indices. The headline indices of Dow Jones Index, S&P Index and FTSE Bursa Malaysia are matched with their Shariah-compliant indices to capture the performance of three difference periods. Our findings reveal that there are no significant different in term of the performance for all the indices and provide a similar returns. Finally we examine the co-integration of the indices to prove if there are any long term relationships. The results indicate that all Shariah-compliant and conventional indices are dependent and not integrated following the non-existence of financial co-integration. Thus the possibility of gaining abnormal profit in these non-co-integrated markets through diversifying investment portfolio is possible. CONTENTS Abstract 2 2

3 Chapter 1: Introduction 1.0 Background of Islamic Investment Malaysia United State (US) Stock Screening Malaysia Quantitative Analysis Qualitative Analysis US Significant of Study Organisation of Study 20 Chapter 2: Literature Review 21 Chapter 3: Data and Methodology 31 Chapter 4: Results and Analysis 4.1 Performance Co-integration 44 Conclusion 47 References 49 Chapter 1 INTRODUCTION 3

4 1.0 Background of Islamic Investment Islamic finance that follows religious principles such as ban on interest payments and monetary speculation was born in its modern form in 1970s advertised as a safe alternative to conventional finance during the global credit crisis. The industry becomes popular in the Gulf Arab countries and Malaysia, accounting for around a quarter of banking assets. The developments of the industry are faster than conventional finance, which grew at double-digit annual rates for much of the past decade. The Muslim-majority nations of the Gulf and Southeast Asia influenced the booms in the market. The industry start to expand beyond its historical borders as Islamic financial assets came to exceed $2 trillion. Banks and governments in nations without Muslim majorities, from Britain to South Africa scrambled to grab some of the market by issuing Shariah-compliant products. Investment that obeys the tenets of Islam being known as Islamic or Shariah-compliant investment. Thus, an investment that is restricted by the Islamic law is considered as an Islamic or Shariah-compliant investment. There has been much development around the world in the area of conventional banking and financial markets to produce an Islamic counterpart, which will cater for Muslim population. Among the developments is the initiation of Shariah-compliant indices in any other countries around the world disregard of their main religion and population. According to (Hassan & Girard, 2011), the popularity of Islamic stock market indices has increased due to the greater potential of growth and profitability. Besides, the indices, which contain the Shariah-compliant stocks provide essential advantages of being socially responsible and ethically sound (Dharani & Natarajan, 2011). As mentioned by (Elfakhani, et al., 2005) the recognition of credible equity benchmarks by FTSE Global Islamic Index Series and Dow Jones Islamic Market Index (DJIMI), followed by the Bursa Malaysia Kuala Lumpur Shariah Index, has been a turning 4

5 point for the industry, giving both Islamic and conventional investors something to compare to. Muslims are estimated to have more than $800 billion to invest which come from approximately one fifth of the world's population. The growth rate which amount to 15 percent annually. According to(hassan, 2001), only small portions of the available funds are invested in Islamic products that are indicative that this market is, for the most part, unexploited. In Southeast Asia, GCC and MENA regions, Shariah-compliant investment is surging rapidly as an alternative investment class for all investor, both Muslim and non-muslim, for its foundation in ethical business practice, social responsibility and fiscal conservatism. While Muslim investors may be mandated to invest only in a Shariah-compliant manner, other investors do so for the benefits they derive, including transparency, better stability of returns and diversification (Saiti, 2015) Malaysia Under capital market, Malaysia comprises two biggest components, which are stock market and bond. The operation of capital market is being monitored and administered by the Securities Commissions of Malaysia and Bursa Malaysia, which is an exchange holding company, established in 1973 and listed in Today, it is one of the largest bourses in Asia, hosting just fewer than 1,000 diversified companies. For bond market, it has two types, which are the conventional bond, and the Islamic bond called Sukuk. Modern sukuk, sometimes referred to as Islamic bonds, are better described as Islamic investment certificates (Wilson, 2004). 5

6 At the moment, Malaysia has emerged as a global leader in Islamic finance and is a champion for the development of capital market-based instruments under Islamic law in the form of sukuk. Islamic finance traditionally served as an alternative channel for banking and financial transactions in accordance with Islamic practices (Trotsenburg, 2013). Malaysia s stock exchange, the Kuala Lumpur Stock exchange was incorporated on 14 December Malaysia s headline stock market index represents the top 30 companies by market capitalization; the Kuala Lumpur Composite Index (KLCI) was introduced in Kuala Lumpur Stock Exchange was renamed Bursa Malaysia on 14 April As a result of partnership between FTSE Group and Bursa Malaysia in 2006, the index, currently known as FTSE Bursa Malaysia KLCI. Malaysia s stock market consists of two markets, which are Main Market, and ACE Market as the difference between the two is the size of market capitalization. Prior to the listing, each company will be accessed before being listed on which category, industry, sector and either classified as Shariah-compliant or not. Malaysian Islamic capital markets (ICM) have been developing at a rapid pace since the 1980s as mentioned by Sy (2007). He explain further that the country now accounts for about two-thirds of the global Islamic bonds outstanding and represents the largest sukuk market in terms of outstanding size and number of issues. According to Sy (2007), the Malaysian authorities have played a key role in the development of the ICM, including through the issuance of local and global benchmark Islamic instruments. The growth in size and scope of the Malaysian ICM has also been accompanied by changes in the institutional and regulatory framework, as well as the market infrastructure and tax framework which are these developments have helped deepen the domestic capital markets and provide financing to the domestic private and public sector. 6

7 Islamic capital market in Malaysia is having a great growth as in year 2010, this potential industry grew at RM1,050.1 billion, which is at 13.6% on average per annum as compared to just RM293.7 billion 10 years before. As mentioned in the Capital Market Masterplan 2, this industry is expected to grow at an average of 10.6% per annum up to 2020 with target to achieve RM2,882.6 billion. There is a high demand for Islamic capital market products, as the industry has expended the products from equity, sukuk and derivatives, to Real Estate Investment Trust (REITs) and Exchange Traded Funds (ETFs). In addition, the tremendous growth of Malaysian Islamic equity market could also be seen from the increase of Shariah-compliant stocks in Bursa Malaysia. In 1997, there were only 371 of Shari ah compliant stocks in Bursa Malaysia which previously was known as Kuala Lumpur Stocks Exchange. This number, as of 29 May 2015, has turned into 674 experienced up and down during the period. The effort of providing a list of Shariah-compliant stocks was undertaken initially by Bank Islam Malaysia Bhd in RHB Securities formalized the Shariah equity market in Malaysia with the creation of the first Shari ah index in the world in Meanwhile, the SAC of the SC developed the screening methodology in 1995, and the first list of Shariahcompliant securities was issued by them two years later i.e. in Securities Commission (SC) under the Shariah Advisory Council (SAC) had introduced new Shariah screening methodology from four benchmarks to two-tier approach that applies the business activity benchmarks and financial ratio benchmarks on November Currently there are two indices that track the performance of Shariah-compliant securities which are the FTSE Bursa Malaysia EMAS Shariah Index (FBM EMAS Shariah) and FTSE Bursa Malaysia Hijrah Shariah Index (FBM Hijrah Shariah). The objectives of these indices are for the creation of structured products, index tracking funds and ETFs or as a performance 7

8 benchmark. The constituents are screened and tested on liquidity, market-capitalisation, and free-float US As one of the best-known icons of American culture and among stock market observers around the world, the Dow Jones Industrial Average has been widely used as a benchmark for stock market performance. It has been considered as the world s first market indicators. S&P Dow Jones Indices have created the methodology to achieve the aforementioned objective of measuring the underlying interest of each index controlled and monitored by this methodology document. The Averages Committee based on their sole judgement and discretion will govern any changes to or deviations from this methodology to conform that the index continues to achieve its objective. This index also known as The Dow, was introduced in May 1896, is a price-weighted measure of 30 US blue-chip companies. DJIA covers all industries; exclude the transportation and utilities industries, which are covered by the Dow Jones Transportation Average and Dow Jones Utility Average respectively. The stock selection process is based on their company s excellent reputation, which demonstrates sustained growth and is of interest to a large number of investors, means that it is not being measured on their quantitative rules. The company also should maintain the adequate sector representation within the indices has to be incorporated and headquarter in the US. Another US index launched on March 1957, the S&P 500 is widely regarded as the best single gauge of large-cap US equities with index assets comprising approximately USD2.2 trillion. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization that is over USD7.8 trillion benchmarked to the index. The S&P 500 also represents the market since it includes a significant portion of the total value of 8

9 the market, despite the index focuses on the large-cap sector of the market. The constituents under the S&P 500 are considered leading companies in leading industries. In US, Dow Jones Islamic Market Index (DJIMI), a subset of the Dow Jones Global Index (DJGI) was introduced in December 1995, which includes stocks from 34 countries and covers 10 economic sectors, 18 market sectors, 51 industry groups and 89 subgroups defined by the Dow Jones Global Classification Standard. According to (Ajmi, et al., 2014), the Dow Jones Islamic Market Index is used to represent the Islamic stock market, which includes shares of companies whether located in Muslim or non-muslim countries as long as they are Shariah-compliant. An equity stock or any industry group that represents a line of business that is does not comply with Islamic principles will be excluded from the index universe. The industry, for instance, the activities that include pork, alcoholic beverages, tobacco, arms, pornography, the leisure and hotel industry, gambling and conventional financial products and services. According to Kabir and Girard (2011), this also may apply to companies classified in other industry groups if they deemed to have a material ownership in, or revenues derived from, prohibited activities. The remaining stocks will be tested according to Shariah stock screening once the companies with unacceptable primary business activities have been eliminated from the universe. As to cater for the increased demand of Shariah-compliant products which has certain structures regarding finance and commercial activities permitted for Muslims over the last few years, Standard and Poor s applied Shariah screens to three headline indices; the S&P 500, the S&P Europe 350 and the S&P Japan 500. The Standard and Poor s introduced S&P Shariah Indices in 2006, recognizing the urgent need for indices, which are a real gauge of the global equity markets and well-established standards. The indices will exclude the stocks that are not compatible with the Islamic rules, which are not Shariah-compliant, thus would be an ideal investment vehicle for observant Muslims. Ratings Intelligence Partners which is 9

10 a consulting company specializing in solutions for the global Islamic investment market based in London and Kuwait, being given a mandate to provide the Shariah screens and filter the stocks based on these screens. 1.1 STOCK SCREENING There is no specific definition on Shariah stock screening. However, by referring to the definition on stock screening, it is actually a process of finding stocks that meets the investors selection criteria. It also can be interpreted as to investigate stocks for potential investment according to a predetermined set of criteria. From the conventional definitions, Shariah stock screening can be defined as a process of determining whether a stock or security is Shariah-compliant or not. There is some Shariah principles need to go through with in order to retain Shariah-compliant status. In the industry, there are many types of investors. Muslim investors however, are advised to invest in the Shariah-compliant securities although it is not compulsory by any legal body to do so. Thus, Shariah stock screening aims to ensure the stock or security that one purchases or invest in does not contain any prohibited elements that make it non Shariah-compliant. Consequently, this Shariah screening process would assists Muslim investors to avoid the prohibited elements in their investments and invest into companies that run the permissible activities in the business. According to (Wilson, 2004), similar with (Derigs & Marzban, 2008), the modern Shariah scholars have provided general rules for Islamic investors to evaluate or screen whether a particular company is halal (lawful) or haram (unlawful) for investment. Currently, there is no international Shariah standard for stock screening. Different Shariah boards have different approaches to Shariah screening. This consequently may produce 10

11 different Shariah compliant outcomes for a given stock. In Malaysia, we have the list issued by the SC, Dow Jones-RHB Islamic Malaysia, and FBM Shariah Index, whereas at the international level there are Dow Jones Islamic Market Indexes (DJIM), FTSE Global Islamic Index Series, MSCI Global Islamic Index and Standard & Poor s (S&P) Shariah Indices. The process of Shariah stock screening in general consists of sector screening, financial screening and dividend purification. Sector screening is to exclude all non-halal primary activities companies, and certain benchmarks applied for mix companies. Financial screening is to evaluate the extent interest-based financing and interest-based income using varies ratios. Dividend purification means for non-compliant portion of revenues received need to be cleansed and channelled to charities. However, up until at this point in time, Malaysia did not adopt any dividend purification standard. According to (Wahyudi & Sani, 2014), there are two types of stock screening procedure namely qualitative and quantitative stage. The former is qualitative screen, which is a process that focuses on the activity of a company that is used as the main principle in Islamic investment criteria. Meanwhile the latter is quantitative screen, where Islamic scholars have applied a principle of tolerance associated with screening criteria, namely: (1) Debt/equity ratio. Calculation of a company s debt financing which is cannot higher than 33 percent of its capital, and then it is not permissible for investment. (2) Interest-related income. The interest-related income of a company cannot exceed more than 10 percent of its total income, and then it is not permissible for investment. This income, however, should not come from its main business activities but from placing its surplus funds in investments that could yield interest income. (3) Monetary assets. This parameter refers to the composition of account receivables and liquid assets (cash at banks and marketable securities) compared to total assets. Various minimums have been set for the ratio of non-liquid assets (assets that are not in the form of 11

12 money) necessary to make an investment permissible. Some set this minimum at 51 percent while a few cite 33 percent as an acceptable ratio of non-liquid assets to total assets Malaysia In Malaysia, the Shariah compliance review in is undertaken in two stages which are quantitative and qualitatitve stage. It is compulsory that the listed security pass screening at both stages. The former is where the contribution from Shari ah non-compliant activities were computed and compared with the group turnover and the group profit before tax. Previously, the benchmarks for contribution from non-permissible activities were set at 5%, 10%, 20% and 25%. The latter is the qualitative stage where the public perception and image of the company were assessed. Hence, even if a security passed filtering in the first quantitative stage, it could not be confirmed as Shariah-compliant yet if it failed the second qualitative screening stage due to, for instance, negative image or public perception of the company. The filtering process is crucial as according to the Securities Commission Malaysia (SC), more than 60% of all companies listed on Bursa Malaysia are considered to be mixed companies where their business activities comprise both Shariah-compliant and noncompliant transactions. The list of Shariah-compliant securities is updated and published by the SC twice a year in May and November. The screening of Shariah-compliance for pre-ipo companies, the status can be made upon application (voluntary). The Securities Commission has revised the filtering methodology to further enhance the growing sophistication of Islamic capital market in Malaysia, by adopting a two-tier quantitative approach which applies the business activity benchmarks and the newly introduced financial ratio benchmarks. Generally, the Shariah stock screening process as adopted by the SAC of the Securities Commission involves several stages. The first stage is the extraction of relevant financial 12

13 information from audited financial reports and other material information. This stage involves identification of the activities of the companies and their source of revenue. The SAC, in classifying the securities, receives input and support from the SC. The SC, as the capital market regulator, is empowered to request additional information from the companies listed in Bursa to further clarify the composition of non-permissible income and dividends, which are normally not disclosed in the financial statements. This process of information extraction will help the SAC in the next stage of elimination of corporations that involved with non-permissible activities as their core business. In this stage, any company having its core business from one of the non-permissible activities will be screened out. The non-permissible activities as listed out by the Securities Commission are as follows: a) Financial products and services that include riba (interest); b) Gambling and gaming related activities; c) Production or sale of non-halal items or related items; d) Conventional insurance; e) Entertainment activities deemed non-permissible according to Shariah; f) Production or sale of tobacco-based items or related items; g) Stockbroking or trading of share in non Shariah-compliant securities; and h) Other activities deemed non-compliant to Shariah rules Based on the last item, the list is not absolute. Thus, any activities deemed to be nonpermissible by the SAC of the Securities Commission will turn the company to be non Shariah-compliant. In addition to that, the SAC also takes into account the level of 13

14 contribution of interest income generated by the company from conventional fixed deposits or other interest bearing financial instruments and also dividends generated from investment in non Shariah-compliant securities. There is a standard criterion applied by the SAC in focusing on the activities of the listed companies. It is easy to screen out those listed companies that deal with non-permissible activities as their core businesses. However, in the stock market, there are abundant companies whose business activities comprise both permissible and non-permissible elements. The holding company might deal with permissible activities as its core business, whereas the subsidiaries might get involved in those non-permissible activities. Therefore, a deep analysis and scrutiny need to be done at the holding, subsidiary and associate company levels. In other words, when it comes to this type of mixed businesses companies, they are required to undergo another two stages of screening process namely quantitative and qualitative analysis stages Quantitative Analysis In this very first stage, the SAC of the SC deals with the mixed contributions of both permissible and non-permissible income. The quantitative phase involves the CCC concept, which includes: i. Consolidating information related to the group turnover (TO) and the group profit before tax (PBT). ii. Computation of the above information in order to determine the percentage of contribution from halal, as well as non-halal activities. iii. Comparison of the above percentage of the contribution against the financial benchmark determined by the SAC. 14

15 If the contributions from non-permissible and non-permissible activities exceed the benchmark, the securities of the company will be classified as Shari ah non-compliant. The benchmarks as established by the SAC are as follows: Revised Activity-Based Benchmarks (Effective November 2013) 5% To assess the level of mixed contributions from activities that are clearly prohibited such as riba-based activities, gambling, liquor and pork; interest income from conventional accounts and instruments and tobacco-related activities. 20% To assess the level of contributions of mixed rentals from Shari ah noncompliant activities; To assess the level of mixed contributions from activities that are generally permissible according to Shari ah and have an element of maslahah (public interest), but there are other elements that may affect the Shari ah status of these activities eg. Hotel and resort operations. Financial Ratio Benchmarks (Effective November 2013) 33% Compute the financial ratios: Debt/Total Assets Cash and Cash Equivalent/Total Assets This benchmark is used to measure the level of mixed contributions from the activities that are generally permissible according to Shariah, and generally they have the element of maslahah (public interest), but there are other elements that may affect the Shariah status of these activities, because these activities may attached with other activities which are deemed 15

16 as non-permissible according to Shariah. For instance; Hotel and resort operations, share trading, and stock-broking Qualitative Analysis As for the qualitative analysis, the SAC s decision on a company s Shariah compliancy is based on several factors of the company, such as image, maslahah and others. This process does not refer to the benchmark for activities which do not comply with the Shariah in deciding the status of the listed company. The SAC has considered two additional criteria for companies with activities comprising both permissible and non-permissible elements. The two additional criteria are: a) The public perception or image of the company must be good; and b) The core activities of the company are important and considered maslahah (benefit in general) to the Muslim ummah (nation) and the country, and the non-permissible element is very small and involves matters such as `umum balwa (common plight and difficult to avoid), `uruf (custom) and the rights of the non-muslim community which are accepted by Islam. This qualitative analysis is a unique feature of screening methodology of the SAC of the SC. This process does not exist in other screening standards, such as DJIM, FTSE & S&P. This is based on their documents which enumerate the screening methodology but do not clearly reveal the qualitative analysis as per the SAC of the SC. This shows that the SAC of the SC has taken an extra step ahead of the rest to analyze a particular public listed company from another angle that is non-quantifiable but collectively important in determining its Shariahcompliancy. To give an example on this qualitative analysis, the SAC has resolved that hotel activities and manufacturing or marketing of condoms do not comply with Shariah because of image. The nature of hotel activities that involved with night clubs and bars gives a bad image on the whole activities of the hotel. Same goes to manufacturing condoms as condoms are seen to be 16

17 used more by couples who do not have legal marital relationship compared to those who have legal marital relationship. As such the activity of manufacturing condoms is deemed to be non Shariah-compliant. In addition, the qualitative analysis also will look at the public listed company and its activities from two angles. First, it will look at the nature of the instrument or transaction itself, (whether it involves any riba, gharar, or maysir); and second it will look at the nature of the contracting party. Thus, the screening process could detect or recognize the companies that run or are involved in the non Shariah-compliant activities as abovementioned. For example, if a company s core business is supplying tin, which is permissible according to Shariah, this does not necessarily mean that the company would be exempted from the Shariah screening process and deemed as Shariah compliant. If the company supplies tin to a company that produces alcohol, this will make the tin company be subjected to further screening process by the SAC of the SC. The SAC of the SC decided to implement the new Shariah screening methodology with the aim to enhance the Shariah-compliant equity and investment management in Malaysia in order to explicate the Islamic capital market globally as outlined in the Capital Market Masterplan. If we look back at the introduction of screening methodology by the SAC in 1995, it was intended to cater for the Malaysian market, taking into consideration maslahah, urf and other secondary sources of fiqh muamalat. The creation of benchmarks is the result of a pragmatic approach in recognizing the diversity within the social fabric i.e. the diverse ethnic, socio-economic and religious background in Malaysia. The barometer reflects varying degree of Shariah tolerance measured against the degree of maturity of the Islamic financial industry. What was instituted in Malaysia was the ijtihad, after assessing local market conditions. By ijtihad, it means making them relevant to modern times and within the Shariah framework. It was not meant as a strict black-and-white 17

18 screening methodology, but rather one that reflects the domestic, urf or custom. Therefore, the SAC, which were given the mandate to ensure that the running of the Islamic capital market complies with Shari ah principles, will continue to assess, revise and revisits its resolutions based on ijtihad US The basic of screening process is similar; however it has a few different methods and calculations in details. During classification stage, any company having its core business from one of the nonpermissible activities will be screened out. The non-permissible activities as listed out by the Shariah Supervisory Boards are as follows: a) Pork; b) Gambling; c) Alcohol; d) Financials; e) Pornography; f) Advertising and Media (newspaper are permissible, sub-industries are analyzed individually; g) Trading of gold and silver as cash on deferred basis h) Tobacco Then, each company s audited annual report is reviewed during the selection process to ensure that the company is not involved in any non Shariah-compliant activities. Those that involved with the above activities will be eliminated as those are considered non-permissible in Islam and would not be appropriate investment for Muslim. The companies that passed this selection will be assess for compliance in financial ratios, as certain ratios may violate compliance benchmarks which are cash, leverage and the 18

19 percentage of revenues derived from non-compliant activities. However, all of these are subject to evaluation on ongoing basis. Leverage Compliance <33% Debt / Market Value of Equity (12 months average) Cash Compliance <49% <33% Accounts Receivables / Market Value of Equity (12 months average) (Cash + Interest Bearing Securities) / Market Value of Equity (12 months average) Revenue Share from Non-Compliant Activities <5% (Non-Permissible Income other than Interest Income) / Revenue Dividend Purification Ratio Dividend * Non-Permissible Revenue / Total Revenue 1.2 Significant of Study The contribution of this paper is twofold: First, it would be interesting to investigate how two different indices between Shariah-compliant and conventional perform in the stock market during different economic situation, during the crisis and non-crisis period. Then we also examine whether the indices tested using co-integration could actually provide the diversification benefits to the investors for the indices in US and Malaysia. Second, the results of this study may provide some important implications for the investors to choose their investment preference either for the Muslim or non-muslim. For an investor, who obey the Shariah rules will bring a significant point as to view how the Shariah-compliant portfolio have performed during the past years during bull and bear market. The paper also provides some empirical evidence regarding the relationship of the 19

20 different indices. In the absence of co-integration for both of the indices, it will show that the investment might provide diversification benefits. However, if there exist the co-integration between the indices, lack or less diversification benefits will be achieve in the long run. 1.2 Organisation of Study This paper focuses on the risk-adjusted performance of Shariah-compliant and conventional indices for three sample period, namely during the crisis, non-crisis and the entire period and whether all the indices have the co-integration and relationship or not in the long run. The choice of using all the performance measurements for this study is very essential since it has a significant impact on how to analyse and examine the difference. Besides, most of them have been widely used in past studies. The paper is organized as follows. Chapter 1 explains the background of Islamic investment and include both in Malaysia and in US. Then it explains the description of Shariah stock screening from different approach for both of the markets. Chapter 2 discuss on the the literature review for this study with broad coverage of the different performance measurement and methodology used in previous studies.while chapter 3 discuss the data and methodology applied in this research in conducting the performance analysis and co-integration test. Chapter 4 presents the empirical results of the risk-adjusted performance and the co-integration result from the employment of the Augmented Dickey- Fuller (ADF) test and Engle and Granger test. The conclusion and recommendation follow next in this chapter. 20

21 Chapter 2 LITERATURE REVIEW (Kok, et al., 2009) examined the performance of Shariah-compliant indices in London and New York stock markets and their potential for diversification. They used FTSE 100 as a benchmark and returns are computed on daily basis from 1 st January 2001 to 29 th June Each mainstream indices from FTSE and Dow Jones is matched by a Shariah-compliant (FTSEIS and DJIMI) and by a sustainability index (FTSE4G and DJSI) respectively, and the risk-free rate proxy by a three-month British T-Bill. The paper aim to investigate the existence of diversification opportunities presented by investing these funds through the use of Johansen s co-integration test. Under this method, the presence of co-integrating variables would illustrate that there exists a relationship between the Shariah-compliant funds and that of non-shariah funds. The researchers realise that any number of combinations of the indices would yield a variety of outcomes and decided to carry out co-integration of only four combinations. Among the performance yardstick used was the Jensen alpha (1968), Treynor ratio (1965) and Sharpe ratio (1966) to assess the performance of the portfolios. The data then have been used to create optimised portfolios under the Markowitz portfolio optimisation framework. Four different rolling windows were done, essentially, two-years, one-year, sixmonths and three-months to enable a dynamic calculation of the ratios. The results showed that the co-integrating vectors exist for Group 1, 2 and 4 whilst Group 3 fails. As the optimisation period becomes longer, all the ratios appear to improve. What was found was the unconstrained portfolio performs better than the constrained portfolio. Their findings suggested that diversification is one reason for investors to choose Shariah-compliant funds. (Ho, et al., 2014) investigated twelve global Islamic and their respective conventional indices from US, UK, Switzerland, India, Indonesia, Malaysia, Hong Kong and France on monthly 21

22 closing prices. The authors split the sample into five sub-periods: Dotcom crisis period ( ), after a Dotcom crisis period ( ), global financial crisis period ( ), after a global financial crisis period ( ) and the overall period. However, all conventional and Islamic indices are available for comparison only during non-crisis period 2 and the overall period, and the MSCI All World Index has been used as the benchmark index. The purpose of this study is to investigate the risk-adjusted performance of indices and to compare the performances between worldwide conventional and Islamic indices. The authors used several statistics derived from the Capital Asset Pricing Model (CAPM), including beta, Sharpe ratio (1966), Treynor Index (1965) and Jensen alpha (1968) as the methodologies. Their results show that during the period of crisis ( ), the returns on Islamic indices are less drastically affected than the conventional indices, however the return performance is mixed for the after crisis period ( ). They find that during global financial crisis period ( ) the return performance for all are negative and the return for conventional indices are higher than Islamic indices after the global financial crisis ( ). It shows that the strength of return association between conventional and Islamic indices is relatively high for the majority indices because the majority of mean returns of both indices for the overall period is negative. In studying the Islamic stock market in Malaysia, (Albaity & Ahmad, 2008) compared the performance of an investment portfolio comprised of only Islamically compliant stocks, KLSI with the conventional stock market index, KLCI from April 1999 to December 2005 using daily closing prices. They examined the performance of the KLSI against the KLCI using risk-adjusted return measurements and their long-term and short-term relationships. Their initial finding from the graph showed that the returns of both indices moved together in the mentioned period. Using descriptive statistics they find that the mean return of the KLSI is less than KLCI, however the standard deviation showed the opposite result showing that 22

23 KLSI is less risky than KLCI. The authors suggest that the KLCI has a superior long-term return than the KLSI for the long-term raw return. There is a positive relationship between the indices of 40% by using the simple correlation coefficient, however not as strong as reported by (Ahmad & Ibrahim, 2002) who give a positive value of 96%. There is also no significant difference in the mean between the indices according to the t-test. This also consistent with the results of (Ahmad & Ibrahim, 2002) and (Hussein & Omran, 2005). Their results reveal that KLSI produced lower returns than the KLCI according to risk adjusted performance, namely the Sharpe ratio, Treynor Index, Adjusted Jensen s Alpha Index (AJAI) and excess standard deviation adjusted return (Esther). This result also in line with previous studies by (Hussein & Omran, 2005). Finally, they conclude that both series are co-integrated which is they have a long-term relationship. (Albaity & Mudor, 2012) in their paper examine the stock returns in two Islamic stock market indices, namely, DJIMI and FTSE Hijrah which is tracking two different criteria specific indices. The authors investigate whether there is a significant difference between Dow Jones Islamic Market Index (DJIMI) and FTSE Hijrah as well as the non-islamic indices Dow Jones Industrial Average (DJINA) and Kuala Lumpur Composite Index (KLCI). They also analysed the long-term relationship between these indices either co-integrated or not and is there any causality between them. These studies are divided into three subsamples, pre-crisis period, and post-crisis period and during the subprime financial crisis which covers from February 2007 to May They concluded that there is a long run relationship or cointegration for the Islamic indices in the pre-crisis and post crisis period. There also no significant difference in mean returns between the Islamic indices and the conventional indices. On the other hand the conventional indices were not co-integrated in any of the sub periods. As a conclusion, investing in Islamic indices has no superiority over the conventional index in terms of performance. However, the authors suggest that investor 23

24 looking for ethical investment can diversify by investing in these Islamic indices since their correlation is very low. (Hooi & Parsva, 2012) investigates the relationship between return and market risk for the Islamic stocks in Malaysia Financial Times Stock Exchange (FTSE) market. Daily closing prices of FTSE Bursa Malaysia KLCI Index (FBMKLCI), FTSE Bursa Malaysia 100 Index (FBM100), FTSE Bursa Malaysia EMAS Index (FBMEMAS) for the conventional, FTSE Bursa Malaysia EMAS Shariah Index (FBMSHA) and FTSE Bursa Malaysia Hijrah Shariah Index (FBMHS) as the proxy for Islamic portfolio have been collected. They used daily three months Kuala Lumpur Inter-bank Offer Rate (KLIBOR) as the risk-free rate and the period from 1 March 2007 to 28 February 2011 for the study. This study uses the Sharpe-Lintner CAPM version as their methods. They found that both Islamic indices have a larger standard deviation than the market indices consistent with the common argument that the Islamic stocks bear higher risk than the conventional stocks. Based on the results, beta for all models are the positive and significant infers that the Islamic stocks are moving in the same direction with the market. Obviously, in the crisis period, the Islamic indices have become more risky to the market in comparison with the entire sample period. This result weakens the hypothesis that the Islamic indices are less risky during the crisis period. The authors conclude that the Islamic indices have higher risk-adjusted returns and low risks, while after the crisis all the Malaysian Islamic indices have been converted into the risky and sensitive indices. They suggest that Shariah-compliant securities might attract and preoccupy the attention of riskaverse investors. (Hussein, 2004) investigates whether the returns earned by investors who purchase shares in the FTSE Global Islamic index are significantly different from their index counterpart, FTSE All-World Index, both in the short-run and long-run. The sample divided into two sub- 24

25 periods which are bull market, July 1996 to March 2000 and bear market, April 2000 to August 2003 in order to capture the impact of changes in economic conditions on indices performance. The authors utilize the parametric t statistic and the non-parametric signed rank test to examine whether the Islamic indices achieve abnormal returns for investors based on monthly returns and long-run performance. He also applied the risk-adjusted performance, namely, CAPM, Jensen alpha, Sharpe ratio and Treynor Index to examine the correlation between the indices. His findings indicate that the application of ethical screens does not have an adverse impact on the FTSE Global Islamic index performance. He concludes that the Islamic index performs as well as the FTSE All-World index over the entire period, according to the comparison of the raw and risk-adjusted performance. Generally, the results reject the assumption that ethical investing offer inferior investment performance compared to unscreened portfolios. A new study by (Kamil, et al., 2014) which investigate the quantum of risk-adjusted performance of Islamic equity funds in Malaysia either attributable to random acts or simply, luck conclude that a significant proportion of superior performance can be attributed to simply luck. They use the technique of fund alpha through the adoption of three common models of alpha computation namely Capital Asset Pricing Model (CAPM) as explained in Sharpe (1964) and Lintner (1965), Fama and French s (1993) 3-factor model and Carhart s (1997) 4-factor model. The study use monthly return, computed based on total returns and net of a risk-free rate. Their results reveal some tentative statistical evidence that Shariahcompliant equity funds using Malaysia as a case study does not perform significantly better than the overall market. The researchers propose a suggestion of embracing a profit-sharing mechanism that the Islamic mutual funds should explore the idea of altering the remuneration structure of their product offerings. This strategy might perhaps better embody the concept of equity, which is fundamental in Islamic finance. The reason is the mutual fund structure will 25

26 be imbued with the spirit of sharing. They further explain that when the value of the investment portfolio rises, both parties (the client-investor and the fund manager) have a share in that gain. A paper by (Saiti, et al., 2014), applying the recently developed Dynamic Multivariate GARCH approach as the first attempt to advance the frontier of knowledge particularly in the fast growing field of Islamic Finance. The paper try to examine whether Islamic stock indices provide special avenue for the US-based investors. They use MSCI conventional index of US as proxy for US based investor with close-to-close daily return data in USD for MSCI conventional and Shariah-compliant stock indices in Islamic (Indonesia, GCC region ex Saudi, Malaysia, Turkey) and Far East (Korea, Japan, Taiwan, Hong Kong, China) countries. The samples are mostly from emerging markets which are the first group is within East-Asian region and second group belongs to OIC countries. They study cover from June 2007 to December 2011 because the MSCI Islamic stock indices just started from the year Their findings suggest that both the conventional and Shariah-compliant MSCI indices of Indonesia, Taiwan, Japan, GCC ex Saudi and Malaysia based on the Dynamic Conditional Correlation (DCC) offer better diversification benefits compared to Korea Turkey, Hong Kong and China. They further explain that the correlation of the US with other conventional markets are almost similar to those of the other Islamic markets. A paper by (Hassan, 2001) examines the issues of market efficiency and the time-varying risk return relationship for the Dow Jones Islamic Index (DJIM) from 1996 to The study applies serial correlation, variance ratio and Dickey Fuller tests to investigate the market efficiency of DJIM index. They find out that DJIM returns are normally distributed and the returns of DJIM index are efficient. The authors also investigate calendar anomalies of the DJIM and their findings reveal that there is no turn-of-calendar-year, turn-of-financial- 26

27 year and month effect of DJIM index returns. The study investigate the volatility of the DJIM index returns by utilizing a GARCH econometric framework. They conclude that there is a significant positive relationship between DJIM equity index returns and conditional volatility. (Hakim & Rashidian, 2002) investigate the relationship between DJIMI, Wilshire 5000 Index from 1999 to 2002 by utilizing co-integration and causality analysis. They employ the three-month treasury bill as a risk-free rate. Their results reveal that the DJIMI is not correlated with neither Wilshire 5000 index nor the three-month treasury bill. Their findings show that the changes in the DJIMI are not caused by the Wilshire 5000 or the three-month treasury bill. As a conclusion, they mentioned that the filtering criteria adopted to eliminate non-compliant firms leads to an Islamic index with a unique risk-return characteristics that are not affected by the broad equity market. Hakim and Rashidian (2004) use capital asset pricing model (CAPM) to examine to what extent Sharia compliant index is correlated with the Dow Jones World Index (DJW) and Dow Jones Sustainability World Index (DJS) or green index. Their results show that DJIMI has done relatively well compared to DJW, but underperformed in relation to DJS. (Girard & Hassan, 2005) utilizing a variety of measures for instance Sharpe, Treynor, Jenson and Fama s selectivity, net selectivity and diversification to investigate the comparative performance of Dow Jones Islamic Indices and its seven indices vis-a-vis their non-islamic counterparts start from January 1996 to November The sample was divided into twoperiods which are, first from January 1996 to November 2000 and second from December 2000 to November Their findings state that there is no difference between Islamic and nonislamic indices. However, the Dow Jones Islamic indices outperform the conventional indices from 1996 to 2000 and underperform from 2001 to Finally, the authors reveal that there is similar reward to risk and diversification benefits for both indices. 27

28 (Jawadi, et al., 2014) examine the financial performance of Shariah-compliant and conventional indices for three major regions; the World, US and Europe. Their research period from year 2000 to year 2011, enabling them to include the impact of the global financial crisis using various computation of performance ratios and estimation of the CAPM-GARCH model to capture the financial risk time-variation in order to provide precise performance evaluations. They choose Dow Jones Islamic indices a sthe benchmark for Shariah-compliant as the indices being widely used in Islamic Finance field. As for the conventional, they use Dow Jones Industrial Index for US and the World, while for Europe they use Eurostoxx50 which enable them to examine comparable stock indices. Daily closing price have been collected from 3 January 2000 to 27 June 2011 which enable them to take into account the performance of indices before and after the subprime crisis. Their findings state that Shariah-compliant investments surge to outperform conventional, particularly during turbulent times. They conclude that the impact of global financial downturn on Islamic returns is less significant than its impact on conventional returns, despite seems both cannot escape from the crisis. A study by (Ajmi, et al., 2014) aim to examine the linear and nonlinear links between global conventional and Islamic equity markets, and between the Islamic market and several global shocks. The paper investigate a causality relationship between the Dow Jones Islamic Market Index (DJIMI), S&P stock market indices for Europe, US and Asia, the international crude oil markets, the Merrill Lynch Option Volatility Estimate (MOVE) index, the Chicago Board options exchange (CBOE) volatility index (VIX), the US Federal Funds Rate (FFR), the US Economic Policy Uncertainty Index (US EPUI) and the EMU benchmark 10-year government bond index (EMU). They compile daily price from 4 January 1994 to 8 October 2010 and perform both linear heteroscedasticity-robust (HR) and nonlinear causality testing procedures to check the relationships. Their findings state that the selection of stocks based 28

29 on the strict principles may make some difference in the causal relationships and links for the DJIM index. They further explain that Islamic market may outperform the conventional counterparts during bullmarkets but underperform in bear markets because lack of hedging. Besides, the authors claim that Islamic finance system may not provide either a good cushion against financial shocks affecting the conventional markets or large diversification benefits for portfolio managers. (Al-Khazali, et al., 2014) investigate whether Shariah-compliant stock indices outperform conventional stock indices using stochastic dominance (SD) by comparing nine Dow Jones Islamic indices to their Dow Jones conventional counterparts. The daily return used start from 2 January 1996 to 31 December 2012 for the study which cover indices from Europea, Asia Pacific, Emerging Markets, US, Canada, UK, Japan, Developed Countries and Global. The split the samples into three period which capture Asian financial crisis from 2 January 1996 to 31 December 2000, pre-financial crisis from 2 January 2001 to 31 December 2006 and the latest global financial crisis from 2 January 2007 to 31 December The results reveal that the conventional indices outperform the Shariah-compliant indices over the entire period except in Europe where the situation is reversed. On the other hand, from the study, the Global Islamic, European and US indices outperform their peers in the third sub-period. Finally they find out that the European, US and Global Shariah-compliant indices dominate their conventional counterparts during 2007 to 2012 period which is during and after the financial crisis. Therefore, they conclude that Islamic investment performs better than conventional investment during economic crisis. (Saiti, 2015) use the Engle Granger and Johansen co-integrating tests to investigate the extent of co-movement between US conventional MSCI indices and other conventional and Shariah-compliant MSCI indices. Over the periods of June 2005 to December 2011 using close-to-close daily return, the author find that there is a theorethical relationship among the 29

30 variables and that they are in equilibrium in the long-run. The test can reveals whether all the variables are theorethically related or not and if there is a co-movement among the variables in the long term, they will be co-integrated. However, these variables may move differently in the short term. As a crucial and a very useful test, co-integration also shows that a linear combination of all variables in their original form will lead to a stationary error term which is it can prove the untested hypothesis or theory which is it can rules out any spurious or accidental correlation. If the test shows that the test statistics is greater than the critical value, it shows that the error term is stationary which indicate a linear combination of all nonstationary variables become stationary. The study also find out that the actual number of cointegrating relationships show that the stock indices of Islamic countries co-integrated with the US stock index is weaker compared to those of the non-islamic countries. Lastly they conclude that there is a common force such as the arbitrage activity which brings the stock indices together in the long-run. 30

31 Chapter 3 DATA AND METHODOLOGY This section describes the data and empirical methods applied to compare performance measurements of indices. Financial investment theory suggests that the goal of any investor is to maximize utility obtained from an investment after considering the market risks. In order to adjust for investment risk, several statistics derived from the Capital Asset Pricing Model (CAPM) including beta, Sharpe ratio (Sharpe, 1966), Treynor Index (Treynor, 1965) and Jensen alpha (Jensen, 1968) are suggested as suitable methodologies and have been widely applied. The measures are built on the research work by Lintner (1965), Mossin (1966) and Sharpe (1964) where expected return of a security depends on the covariance of that security with the market portfolio. In this study, six major global Islamic and conventional indices from two countries are investigated, namely the United States and Malaysia as in Table 1. These global conventional and Shariah-compliant indices are selected due to their dual availability in both conventional and Islamic markets, which enable performance comparisons. Table 1 Country of origin United States Conventional indices Dow Jones Industrial Average (DJIA) Islamic indices Dow Jones Islamic Market Index (DJIMI) United States Standard & Poor 500 Index (S&P) Standard & Poor 500 Shariah (S&PS) Malaysia Kuala Lumpur Composite Index (KLCI) Bursa Malaysia Hijrah Shariah Index (KLCIH) 31

32 Daily closing prices of the indices are picked from DataStream database. The study restricted the period of study from 7th April 2008 to 31st December 2014 to get similar duration for both conventional and Shariah-compliant indices to provide a matched-pair comparison. The data set of the study is divided into three samples that are overall period, pre-crisis (from 7th April 2008 to 30th June 2009) and post-crisis period (from 1st July to 31st December 2014). This is similar with (Hooi & Parsva, 2012) that they created a sub-period (from 1 March 2008 to 31 March 2009) which they indicates as the crisis period in order to capture the impact of the 2008 global financial crisis on the behaviour of the indices. The Dow Jones Global is chosen as a market benchmark for both indices and used as a proxy for the market return. Furthermore, conventional US three-month Treasury-bill rates are used as a proxy for the risk-free rate of interest. Figure 1 shows the chart of closing prices of all the indices for the overall period of the study. It is clear that all these indices seem to move together during the overall period though they might not have started in the same time. It can be seen from the chart that all the indices have a downtrend from the starting of the period until the first quarter of Then all of them start to gain and moving up after the end of the crisis. From preliminary observation of the chart, all the indices correlated with each other as they tend to have similar pattern and movement. 32

33 Figure 1.The closing prices of all the indices for the overall period DJIA DJIMI S&P S&PS KLCI KLCIH We subtract the previous day s price index from the current day price index and divide the value by the previous day s price index to estimate the return as shown in Equation (1). R t = (P t -P t-1 )/P t-1 (1) Where; R t: the return at time t 33