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)

Shari’ah Advisory Board (SAB)

Shari’ah compliance

Shari’ah framework

Shari’ah-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 Shari’ah-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 Shari’ah screens similar to those of MSCI Islamic, we first examine the extent to which SEFs comply with the Shari’ah law. Results show that only about 27% of the equities held by SEFs are Shari’ah-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, Shari’ah 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 Shari’ah-compliant, we find little evidence of a positive relationship between fund disclosure of the Shari’ah compliance framework and Shari’ah-compliance. Clearly, Shari’ah compliance remains a major challenge for fund managers and SEF investors should be aware of Shari’ah-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 Shari’ah 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.

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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 SHARI’AH-COMPLIANT INVESTMENT

2.1 Introduction................................................................................................................... 12

2.2 The Fundamental Principles ....................................................................................... 12

2.3 The Prohibitions ........................................................................................................... 15

2.4 Shari’ah-Compliant Equity Funds and Their Equity Screens ................................. 18

2.5 Shari’ah 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 Shari’ah-compliant Equity Funds ................................................... 42

3.4 Chapter Summary ......................................................................................................... 52

CHAPTER 4: HYPOTHESES ............................................................................ 54

4.1 Introduction................................................................................................................... 54

4.2 The Degree of Shari’ah Compliance ........................................................................... 54

4.3 Fund Performance ........................................................................................................ 59

4.4 Chapter Summary ......................................................................................................... 62

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CHAPTER 5: ........................................ 63 DATA AND RESEARCH METHODS

5.1 Introduction................................................................................................................... 63

5.2 Data ................................................................................................................................ 63

5.3 Measurement of Shari’ah Compliance ........................................................................ 73

5.4 Fund and Country Level Determinants of Shari’ah Compliance ........................... 87

5.5 Tests of Shari’ah Compliance ...................................................................................... 95

5.6 Fund Performance Measurement ............................................................................... 95

5.7 Fund Performance and Shari’ah Compliance .......................................................... 102

5.8 Summary and Conclusion .......................................................................................... 102

CHAPTER 6: 104 EMPIRICAL RESULTS ..............................................................

6.1 Introduction................................................................................................................. 104

6.2 Tests of Shari’ah 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 Shari’ah 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

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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 Shari’ah-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 Shari’ah-compliant equity funds by country of domicile

and regional orientation, 1984 – 2010 .................................................................. 68 Table 5.2: Summary statistics of Shari’ah-compliant equity funds by country of

domicile and regional orientation, 1984 – 2010 .................................................. 70 Table 5.3: Tests of differences in fund characteristics between Shari’ah-compliant equity funds and matched funds, 1984 – 2010 .................................................... 71 Table 5.4: The list of non-Shari’ah -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 Shari’ah compliance at the fund level .......................... 85 Table 5.8: Descriptive statistics of fund level disclosure on Shari’ah 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 Shari’ah-compliant and other funds by country of

domicile, 1984 – 2010 ........................................................................................... 116 Table 6.8: Raw returns on Shari’ah-compliant and other funds by regional

orientation, 1984 – 2010 ....................................................................................... 117

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Table 6.9: Factor loadings of Shari’ah-compliant equity funds, 1984 – 2010 .................. 119 Table 6.10: Jensen alphas of Shari’ah-compliant equity funds sorted by country of

domicile, 1984 – 2010 ......................................................................................... 121 Table 6.11: Jensen alphas of Shari’ah-compliant equity funds sorted by regional

orientation, 1984 – 2010 ..................................................................................... 124 Table 6.12: Alpha regression results from Treynor-Mazuy and Fama & French

models for Shari’ah-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 Shari’ah-compliant equity funds sorted by regional orientation, 1984 – 2010 ..................................................................................... 127

Table 6.14: Performance of Shari’ah-compliant equity funds during market downturns ............................................................................................................. 129 Table 6.15: Performance of Shari’ah-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 Shari’ah 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) Shari’ah-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 fund’s

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 BP’s 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 Shari’ah-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 – Shari’ah-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 Qu’ran and the Sunnah (Hadith or sayings of Prophet

Muhammad) and the collection of previous Fiqh judgments. A fund is said to be Shari’ah

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 Shari’ah and examine its

impact on investment performance.

The thesis addresses three main research questions. The first question asks what

factors determine the degree of Shari’ah compliance by SEFs across countries and

regions. To answer this question, we carefully calibrate the degree of Shari’ah compliance

of the fund’s holdings and regress it on a number of fund-specific characteristics

including the presence and size of the Shari’ah Advisory Board (SAB), the disclosure

regime of the SEF with respect to the Shari’ah compliance framework, and the equity

screens disclosed. The results will inform us not only on the determinants of Shari’ah

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 Shari’ah-

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 Shari’ah

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 Shari’ah 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 Shari’ah-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 Shari’ah-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.

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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 Shari’ah 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-Shari’ah-compliant funds. On a more general level, our findings will

shed light on whether investors are left short changed on SEF’s compliance with the

Shari’ah 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 Shari’ah screens similar to those of MSCI Islamic, we

report that only about 27% of the equities held by SEFs are Shari’ah-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

Shari’ah compliance.

We then test the determinants of the degree of Shari’ah compliance. There is

mixed evidence of a relationship between fund disclosure of the Shari’ah framework and

compliance. Specifically, funds with better disclosure of the Shari’ah 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 Shari’ah-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 Shari’ah-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 Shari’ah) 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 Shari’ah

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 Shari’ah 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.

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1.5 Thesis Layout

The remainder of this thesis is organized as follows. Chapter 2 outlines the

institutional background of the Shari’ah-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.

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CHAPTER 2:

THE SHARI’AH-COMPLIANT INVESTMENT

2.1 Introduction

This chapter outlines the key Shari’ah principles and concepts underpinning

Islamic finance that are of direct relevance to the thesis. It begins with a discussion of

the fundamental Shari’ah 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 Shari’ah-compliant

equity investments and Section 2.5 provides specific examples of the equity screens of

some of the major Shari’ah 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 Shari’ah, which literally means “the path to a watering

hole.” Shari’ah 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 Shari’ah 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

Qu’ran and the Sunnah. The Qu’ran 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 God’s rulings and directions to humanity. Those rulings and directions

prescribe a lifestyle. In addition to what to do in prayers and religious venues, the Qu’ran

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 Qu’ran 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 Shari’ah 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 Shari’ah, 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.”

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http://www.iis.ac.uk/glossary_list.asp?f=r&t=z&l=en

Islamic financing institution can’t 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 Qu’ran and/or through the Prophet’s Sunnah; conversely, God shall reward those

who obey God’s directions. Thus, the fear of God’s punishment and the desire for

God’s 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 Shari’ah − this establishes the first principle of Islamic financing,

which is Shari’ah 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 Qur’an 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 Shari’ah.

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

Shari’ah rulings. Essentially, transactions are acceptable as long as they do not violate

Shari’ah rulings. The next section discusses the major dos and don’ts 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 Qu’ran 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 men’s 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 party’s

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 one’s 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 Qu’ran 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 Shari’ah screening is critical for any

Shari’ah-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 Qu’ran 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 Allah’s 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 Qu’ran 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 Qu’ran 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 Qu’ran 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 Shari’ah 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 Shari’ah-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 Shari’ah 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

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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 Shari’ah

supervisory boards), implicitly the funds recognize the interests of stakeholders other

than shareholders including employees, customers, and business partners. In short,

Shari’ah compliance is in general a largely ethical question in relation to compliance with

Islamic law.

Table 2.1: Investment objectives of selected Shari’ah-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, Shari’ah-compliant funds have the most rigorous

moral screening. For example, all major Shari’ah 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 Shari’ah-compliant stocks according to specific qualitative and quantitative criteria governed by Islamic scholars on the Shari’ah 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 & Poor’s 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

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26alcohol; tobacco; pork related products; conventional financial services; defense and

weapons; gambling and casino; music;27 hotels; cinemas; and adult entertainment. The

Standard and Poor’s (S&P) Shari’ah 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 Shari’ah-compliant funds are not known to employ inclusionary

screens, there may well be a preference for businesses which are run according to

Shari’ah 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 Shari’ah. 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 Qu’ran and the Sunnah: “And from people are those who transact in vanities to misguide from Allah’s 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.

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The threshold used in these financial ratios is not stated explicitly in Shari’ah law

although it tends to vary between 30% and 45% − a result of the various interpretations

by Shari’ah 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 Shari’ah 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 Shari’ah 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

Shari’ah 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 Qu’ranic 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 Shari’ah Advisory Boards (mainly for financial institutions), there is no central regulatory body that provides unified screening rules for Shari’ah-compliant finance. While there have been some attempts to develop a standardized Shari’ah 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).

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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 Shari’ah-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 Shari’ah 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 Shari’ah-compliant. The list goes on and on.

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Unlike other ethical investments, Shari’ah-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 Shari’ah 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 Qu’ran or Hadith but is based on the collective opinion

(consensus) of Shari’ah scholars due to the absence of a fully Shari’ah-compliant firm in

the world (Wilson, 1997; Derigs and Marzban, 2008).35 The charitable gift will not count

towards a Muslim investor’s 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 Shari’ah-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 Shari’ah-compliant short-

term investment products such as Islamic money market instruments. As Shari’ah

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, Shari’ah-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 Shari’ah-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 Qu’ran, 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.

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2.5 Shari’ah Indices and Their Ethical Screens

Although details of the workings of the Shari’ah Advisory Board often resemble a

“black box” since the various screens applied by SEFs are rarely made public, the

screens of various Shari’ah indices are well documented. The first published market

index to employ Shari’ah screens is the Dow Jones (DJ) Islamic, followed in tandem by

the Financial Times Stock Exchange (FTSE) Shari’ah, the Standard & Poor's (S&P)

Shari’ah, the Morgan Stanley Capital International (MSCI) Islamic, and the FTSE Bursa

Malaysia Shari’ah.

DJ Islamic index family provided by Dow Jones & Company is the most popular

benchmark for Shari’ah-compliant investments. Established in March 1999, it currently

covers a large number of separate Shari’ah 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 Shari’ah 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 Shari’ah-compliant finance authority. Generally, the discipline in Shari’ah 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 Shari’ah, 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 Shari’ah 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 i