Does the Application of Smart Beta Strategies Enhance Portfolio Performance? The Case of Islamic Equity Investments Muhammad Wajid Raza Dawood Ashraf
The main motivation: Returns & Growth
Background o Equity investment is a preferred mode for Shariah compliance investors: Risk sharing and equity participation; o Similar to usual Investments, Shariah compliance equity investments follow a two step process 1. Stock Selection based on stock screening guidelines 2. Portfolio Allocation: weight of each shariah compliant stock in the portfolio. o The existing Shariah guidelines are very clear for the stock selection however are silent on the allocation decision o Most of the world leading indices i.e. S&P 500 and DJIM use Market capitalization Market capitalization = Price * number of common shares outstanding
Stock Selection Criteria Core business must not involve: Financial Institution engaged pornography, alcohol etc in interest-based transactions, weapons, Speculation or gambling (Maisir) Excessive uncertainty (Gharar) Mutual Cooperation and risk-sharing Equity investment works well for that Financial Screening Must not violate the financial screening as prescribed by Shariah screening standard
Financial Screening process
Portfolio weights in Shariah-compliant equity portfolios Stock screening guidelines are explicit No guidance for allocation of assets Free will of the portfolio manager Most of the managers follow the market capitalization for allocation of weights to stocks in the portfolio Alternative weighting methods (Smart Beta) for asset allocation have gained popularity on the conventional side. In terms of growth the global value of Alternative weighting strategies (smart beta) increased from 58bn in 2010 to 500 bn in 2015.
Market capitalization MC t N n 1 N n 1 p p nt nb q q nt nb b Advantages: automatically rebalancing, ease of implementation, low turnover, and the capability to represent a broadly invested portfolio Disadvantages: Small cap bias: Portfolios are tilted towards large-cap firms Promote speculative and herd behavior Fuel short-termism and financialization
Smart Beta: Fundamental Weighting Mispricing exists in the market due to speculation/herding Fundamental weighting derived from financial position as the replacement value of firms for allocation of funds, instead of market price. Outcome: Allocation of more funds to firms with strong real economic activity FV can outperform the MCW strategy on a risk-adjusted basis (Arnott et al., 2005; Hemminki and Puttonen, 2008).
Smart Beta: Equal weighting & Low risk portfolio Equal weighting Lower weights to highly priced stocks and higher weights to lower priced stocks Low risk weighting Higher volatility in market has drastic effect on the market value of firms The larger the volatility, the more difficult it is to observe correct valuation A natural way to avoid such situation is by investing in low volatility stocks This can be done in two ways: 1. Minimum variance optimization (De Carvalho et al 2012) 2. Heuristic approach. Select the low risk stocks and weight the stocks inversely to their risk characteristics (S&P low volatility index)
Research questions Is there a financial gain for Shariah investors in switching from market capitalization weighting to Smart Beta strategies in Long run financial performance, and/or Lower market drawdowns during crisis
Data & Methodology for Shariah portfolios
Determination of portfolio weights The reference universe is the unrestricted market portfolio for each geographical location for each country. Assume portfolio is rebalanced at time t = 1,..., T In order to calculate the weights at each rebalancing we introduce two dummies I i,t is the dummy variable indicating whether stock i respects the qualitative/sectoral Shariah guidelines. S i,t is the dummy variable which is one if stock i at time t respects the quantitative/financial guidelines. For low risk portfolio we introduce additional dummy which ensure that the stock belongs to 100 least volatile stocks We assume that the portfolio is fully invested and no short selling is allowed
Determining the portfolio weight Fundamental weighting (Arnott et al., 2005): Book value of common equity, Net operating cast flow, Dividends, Sales Equal weighting: Equal weights to all of the Shariah stocks Low risk portfolio: First select the low risk stocks (24 months rolling window of volatility) Investing in stocks inverse to their risk characteristics We assume that the portfolio is fully invested and no short selling is allowed
Methodology for performance evaluation 1. Screening of stocks based on FTSE Criteria list of Shariah compliant stocks all geographical locations. 2. Weight Allocation: Assign weights to both unrestricted portfolios and Shariah portfolios using Market capitalization weighting Fundamental weighting Equal weighting Low risk strategy Outcome: 9 regions 4 weighting schemes = 36 SCPs and 36 conventional portfolios
Performance evaluation strategy 1. Market capitalization Shariah portfolios vs Market capitalization Benchmark 2. Smart beta Shariah portfolios vs Market capitalization Shariah portfolios Performance Evaluation Annualized returns (Raw performance ) difference in mean returns Sharpe ratio (Risk adjusted performance) Jensen alpha estimated with standard CAPM model spanning test for testing the significance of coefficients Risk Evaluation Annualized volatility Difference in volatility Historical value at risk (VaR) estimated with 95% confidence interval drawdown analysis
MC SCEP VS MC conventional (Raw performance) The Shariah restrictions tends to have positive effect on the performance of MC portfolios. In terms of annualized returns: the MC SCEPs outperform the MC conventional portfolios in all the geographical locations except for Japan where the under performance is barely 0.02% annually. The Shariah restrictions results in relatively high standard deviation in some cases but at the same time all Shariah indices display superior risk adjusted performance (high Sharpe ratio) The difference in mean does not provide enough support for difference in performance of MC SCEP s and MC conventional portfolios.
Smart beta SCEPs versus MC SCEP s We found superior performance for all the SB Shariah strategies as compared to MC SCEP s in terms of Raw performance (Annualized returns) Risk adjusted performance (Sharpe ratio) The equal weighting strategy yields the highest annualized returns in most of the geographical locations: Out-performance of 2.04% in Canada Outperformance of 12.63% in Indonesia In terms of risk adjusted performance the low risk strategy demonstrates its superiority in almost all the geographical locations. The highest Sharpe ratio of low risk portfolio is due to the allocation in more stable (low risky) stocks.
CAPM and test of Coefficients (1) MC SCEPs with conventional MC portfolio The Shariah restrictions do not result in abnormal returns in most of the cases except for Malaysia where the out-performance is 3.6% annually. The β coefficients are close to one. The regression analysis results in high R Square (Above 70% in all cases) The test of coefficients indicates that: The first hypothesis (α = 0) of abnormal returns for MCW SCEPs cannot be rejected in all geographical locations, except for Malaysia The systemic risk and spanning tests (β = 1 and α = 0 & β = 1), both hypotheses are rejected in the case of all MCW-SCEPs.
CAPM and test of Coefficients (2) SB SCEPs with MC conventional as benchmark Jensens alpha is generally positive in the case of SCEPs following any SB strategy. Among all the SB s the equal weighted results in higher positive abnormal returns in all markets The low risk strategy results in the smallest β. This shows that the low risk strategy is less exposed to market risk. The null hypothesis of zero abnormal return (α = 0) is rejected for all SB SCEPs following the equal-weighted and low-risk weighted smart beta strategies. Both hypotheses related to the coefficients of systemic risk and spanning are rejected for all SCEPs following the low-risk smart beta strategy This clearly suggests that in comparison to MC strategy the SCEP s perform much better with SB strategies.
CAPM and test of Coefficients SB SCEPs with MC SCEP as benchmark SB SCEPs yield abnormal returns in all geographical locations except for fundamental-weighting strategy in Europe. The equal-weighted SB strategy yields the highest abnormal returns of about 17 percent annually for Indonesia. While the GCC region recorded the highest abnormal return of about 16 percent for SCEPs following the low-risk strategy Summary: tests of coefficients, and spanning test strongly indicate better performance of SBs especially low-risk and equal-weighting strategies
Smart beta SCEP s and resistance to market drawdown The literature review suggests that Shariah portfolios perform better in period of crises We analyze this hypothesis by investigating the drawdown analysis and the value at risk. The major findings are The MC SCEP s experience less drawdown and VaR as compare to MC conventional portfolios. In comparison to equal weighting the fundamental-weighting and low-risk strategies experience less drawdowns and shows relatively less value at risk. This is an attribute of investment in more stable and quality firms. The equal weighting strategy shows some what higher drawdown. The worse drawdown experienced by all portfolios is in 2008-09 global financial crises periods. However in these periods too the SB SCEP s shows less losses.
Continue... We also present the value at risk and conditional value at risk estimated with 95% confidence interval. The main findings are Higher VaR results in serious losses and can lead to fund redemption. The fundamental and low-risk strategies are more prone to fund redemption and require relatively fewer assets to cover losses. Low-risk strategy successfully reduced the probability of fund redemption and result in 3.48, 3.41 and 2.96 VaR for the Global, GCC, and Malaysian markets respectively. In summary the Shariah restrictions and SB strategies both results in lower drawdowns and Value at Risk. The historical monthly drawdown of all the portfolios can be seen in the figure on next slide
Monthly drawdown analysis
Robustness analysis: Alternative choice of Stock selection methodology
Summary The Shariah guidelines are explicit on selection criteria but silent on weighting Our main contribution is to introduce the alternative weighting methods in Shariah & the analysis are based on diverse geographical locations. We analyze the effect of MC SCEP s on the performance of MC unrestricted conventional portfolios and found out performance for MC SCEP s. We further investigate the effect of weighting methods and found that The smart beta Shariah strategies outperform the MC SCEP s both in terms of raw and risk adjusted performance.
Main results We show that the choice of weighting method not only matter in terms of Compatibility with the objective of Islamic finance But also has effect on the performance of Shariah portfolios We find that for diverse geographical locations and over the period 2003-2016 the fundamental value weighted, equal weighted and low risk portfolio outperform the standard choice of market capitalization.
Disclaimer: The views expressed in this presentation are those of the author and do not necessarily reflect the views of the Islamic Research and Training Institute or the Islamic Development Bank Group.