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Shariah Equities During Credit Crunch

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  www.palgrave-journals.com/fsm/  © 2010 Macmillan Publishers Ltd. 1363-0539 Journal of Financial Services Marketing   Vol. 15, 3, 228–240   Correspondence: Nafis Alam School of Business, Monash University Sunway Campus, Jalan Lagoon Selatan, Bandar Sunway, 46150 Petaling Jaya, Selangor Darul Ehsaan, Malaysia E-mail: nafis.alam@buseco.monash.edu.my INTRODUCTION TO ISLAMIC FINANCE The teachings and guidelines in Islam encompass all aspects of human life. It governs all the daily activities of an Original Article   Shariah   -compliant equities: Empirical evaluation of performance in the European market during credit crunch Received (in revised form): 23rd May 2010 Nafis Alam is currently attached to the School of Business at Monash University Sunway campus, where he works as Lecturer in Islamic Finance. Alam has co-authored ‘ Encyclopedia of Islamic Finance ’ which is the first of its kind. He has also co-authored two Islamic finance books. He has published extensively touching on major issues concerning Islamic finance particularly in leading Islamic journals. He has also presented and participated in leading Islamic banking conferences. His main interests are in the area of Islamic banking, E-banking, ICT and national development. Mohammad Shadique Rajjaque is currently attached to Sheffield University Management School as Teaching Associate in Accounting and Financial Management. He is an Alumni of IRMA, India and has a Master’s Degree from Leeds University Business School. He has worked in financial sector for half a decade and has research interest in financial systems, institutions and banking in emerging markets. ABSTRACT Islamic finance is based on the Islamic Jurisprudence as prescribed by the Shariah   , and has witnessed significant growth and development in the recent decades. During the period of economic slowdown and following the financial crisis during FY 2007 – 2009, it was claimed that Islamic financial system seemed to be better in coping with economic slowdowns than conventional financial systems . The article analyses whether the same holds true for Shariah-   compliant equities in the market, that is, whether Shariah   -compliant equities perform better in the market as compared to the general market. Three portfolios are constructed based on the constituents of S & P Europe 350 to represent the overall market, the market without the financial firms and the market of Shariah-   compliant equities. It is found that the portfolio of Shariah-   compliant equities outperforms the other two portfolios in all aspects of analysis. However, it slightly underperforms the market portfolio when there is an upward growth trend in the economy. The findings of this article are very relevant for policymakers, investors and fund managers to determine policy matters, deciding on investment and marketing strategy for Islamic capital market products. Journal of Financial Services Marketing (2010) 15,  228 – 240. doi: 10.1057/fsm.2010.19 Keywords: Islamic finance ; Shariah   -compliant equities ; capital market ; financial crisis   © 2010 Macmillan Publishers Ltd. 1363-0539 Journal of Financial Services Marketing   Vol. 15, 3, 228–240 229   Shariah-   compliant equities individual. The Islamic Law or Shariah, as it has been derived from the Quran, 1  Fiqh 2  and Sunnah, 3  governs all aspects of life and activities thereon of Muslims. It includes everything related to social, spiritual, ethical, economic or any other aspect of life. The Islamic financial framework, as we see it today, has been developed from this all-encompassing aspect of Shariah. According to Ainley et al   , 4  the following principles form the core of Islamic financial system. First, at a broader level, the Islamic model aims for social justice and economic prosperity of the whole community. This is evident from the fact that the Shariah  rulings try to reduce concentration of wealth in a few hands, and also provide relief for the poor. Second, Islam does not forbid the motivation to make profit, rather it encourages one to get into business or other productive activities and make a profit out of these. However, a clear distinction has been made between what activities are permitted and what are not. Third, the Islamic economic model is based on risk and profit sharing, and not on interest. Interest or Riba  has been forbidden. Finally, Shariah  provides a comprehensive regulation for contracts. These rules ensure that all the parties make well-informed decisions, and that there should be no uncertainty or ambiguity. DEVELOPMENT OF ISLAMIC STOCK INDEX Islamic banking started with a focus to serve members of a particular religion. However, today it is serving a multicultural client base through a wide range of Shariah-compliant products and services. This sector has also witnessed development of Islamic mutual funds, which has been the largest and the most rapidly growing sub-sector. According to a study by Abdurrazak, 5  there were only 29 Islamic mutual funds in 1996, which grew to 700 in Q1 2009. 6  Recent studies showed that the funds managed rose from US $ 20 billion in 2003 to $ 44 billion in Q1 2009. 6  With the emergence of Islamic Finance and Islamic Equity Funds, it was needed to measure their performance against a suitable benchmark . As a result, the FTSE launched FTSE Global Islamic Index along with the Dow Jones Islamic Fund Index in 2002. Later on S & P launched a series of indices, which measure the performance of Islamic equities across industries, countries and geographical regions. Today, Islamic finance has seen the development of banks, home finance institutions, project financing and retail banking products that follow the guidelines of Shariah, and has been witnessing substantial growth in the last 10 years. Now there are efforts being made to establish an Islamic capital market and stock exchange. 7  – 9   TRADITIONAL FINANCIAL SYSTEM AND ISLAMIC FINANCE In the conventional financial system, accounting numbers act as a measure to carry information from business to other stakeholders. The seminal study by Ball and Brown 10  provided empirical evidence that only a little more than half of the total information content is incorporated in annual accounting numbers. Conventional accounting numbers have also been criticized for completely ignoring the social and economic impact of a business on society. To fill this gap, the concept of triple bottom-line reporting has emerged in academic circles, which also considers the social / environmental impact as an essential unit of measurement for defining business efficiency and sustainability. The emergence of Socially Responsible Investment (SRI), its growth and growing importance can be associated with the same. 11  Another attempt by researchers operating from a critical perspective is that, far from being a practice that provides neutral or unbiased representation of underlying economic facts, accounting actually provides the means of maintaining the powerful   © 2010 Macmillan Publishers Ltd. 1363-0539 Journal of Financial Services Marketing   Vol. 15, 3, 228–240 230  Alam and Rajjaque positions of some sectors of the community (those currently in power and with wealth) while holding back the position and interests of those without wealth. 12   OBJECTIVES OF THE STUDY The equities, which are traded under such a Shariah-based system, are compatible with the Islamic Principle of Shariah and meet Islamic Jurisprudence criteria. It is now being reported that the Shariah-based financial products have remained relatively insulated from the financial crisis as they do not invest in intangible assets and derivatives, and therefore were relatively de-linked from the sub-prime market. It is claimed 13  that because of this fact, the financial crisis has not affected the equities under Islamic Investments as badly as other equities in general. A statistical investigation of the performance of Islamic equities in the European market – which is not only one of the most developed financial markets in the world, but is also one of the most highly affected economies by the financial crisis – will provide empirical evidence of the validity of these claims. If the performance of Islamic equities is significantly different from that of conventional equities, we may conclude that these claims hold ground. This would demand further investigation into the specific reasons to find out whether the difference is due to the specific characteristics demanded by the Islamic Jurisprudence criteria. On the other hand, if the performance of Islamic equities is parallel to or less than conventional equities, we may conclude that such claims do not hold ground, and that a more detailed investigation is needed to examine the claims made by the proponents of Islamic finance. LITERATURE REVIEW The following literature review will look at the academic work focused on SRI and will then try to analyse the concept of social factors as determinants of financial performance. It will also look at the development of various indices related to Islamic finance, and their methodology to define Islamic equities or Shariah-  compliant equities. The next section of the literature review will outline the proposed linkages between Shariah  -compliant equities and their performance, and a statistical approach will be developed based on these proposed linkages to find out any departure in the performance of Islamic equities from conventional equities. SRI, Islamic mutual funds and Islamic equities Before getting into the proposed characteristics of Islamic equities and their performance, we will have a look at the research conducted to measure or evaluate the performance of SRI. The research to analyse the performance of SRI started as early as the 1970s, and extant literature in this area suggests that this issue was initially raised by Moscowitz. 14  Moscowitz ’ s article merely suggested that social issues could be considered as a criterion. Hamilton et al    15  empirically supported the view that the performance of SRI is not statistically different from the performance of conventional mutual funds. However, their analysis was limited to analysing the returns of the funds. In order to take account of factors other than performance, Bello 16  used a sample of SRI funds and examined the same in contrast with randomly selected conventional funds of similar net assets, and found that socially responsible funds do not differ from conventional funds in asset characteristics, degree of portfolio diversification or long-run investment performance. Looking at this issue from another angle, Bauer et al    17  studied the Canadian mutual fund market. The study concluded that there is no significant difference between the financial performance of SRI and conventional funds. Elfakhani and Hassan 18  created eight mutual fund categories of Islamic mutual funds on a regional basis,   © 2010 Macmillan Publishers Ltd. 1363-0539 Journal of Financial Services Marketing   Vol. 15, 3, 228–240 231   Shariah-   compliant equities and then compared their performance with respective benchmark indices for the respective region. They found that no statistically significant difference existed in the performance. However, the results showed that the performance of Islamic equity funds was better in the second period dominated by recession than the first period dominated by boom, and it was suggested that Islamic mutual funds might be a good hedging investment against market downturn. Barnett et al    19  examined 61 SRI funds to measure the linkage between financial performance and social performance. They found a curvilinear relationship existed between the two. As more and more social screens are applied, the financial performance declines first, but then improves as the number of screens used reaches maximum. Areal et al    20  analysed the performance of a sample of socially responsible mutual funds taken from seven European Countries, which were investing globally and / or in European markets. They found that the SRI funds show neutral performance, and indicated that investors (European) can add social screens to their investments without sacrificing their return. However, the opinion about the performance of SRI funds has not been always conclusive or positive. Renneboog et al    21  found that SRI funds in many European, North American and Asia-Pacific countries strongly underperform the domestic benchmark portfolio. Research was also conducted to find out whether the SRI is actually invested differently in different stocks. Karen et al    22  analysed whether the SRI fund managers pick different stocks for their portfolio than conventional investment managers by choosing different portfolio compositions. Their study found that there are ‘ differences between the weights invested among different industries among SRI and conventional funds ’ . In another empirical analysis, Kempf and Osthoff 23  analysed whether the SRI was invested according to social and ethical standards or whether they are just another mutual fund with a fancy name. They created an ethical ranking of US funds using empirical techniques, and found that SRI funds ranked above the conventional funds. Recent studies have also tried to investigate consumer behaviour behind SRI investments. Nilsson 24  analysed the final consumer of SRIs to find out why investors choose to invest in SRI funds. It was found that it is not only the pro-social or pro-ethical mindset of the investors that draws them towards SRI funds, but a significant proportion of SRI investors also chose the same in anticipation of better financial performance. Along with academicians, practitioners also believe that social issues will become more and more important decision factors in coming times. An increasing number of fund managers are finding environmental, social and corporate governance issues a prime criterion for projecting performance and investment quality. 25  According to a Mercer Investment Consultancy Survey, 65 per cent of managers worldwide consider globalization and 62 per cent consider corporate governance as very important factors in a typical investment analysis. 25  The emergence of SRI funds and their continuous growth has attracted academicians, and it continues to do so. The research in SRI, as has been outlined above, has brought out a few conclusions: (a) Theoretically, it is expected that SRI funds should underperform conventional funds, but in practice the empirical evidence suggests that SRI funds perform at par with the conventional funds. This suggests that social screening does not affect financial returns to investors. (b) The SRI fund generates similar returns, but by investing in a different set of stocks in a different composition of industry. The underlying stocks also differ significantly in social variables like corporate governance, environmental aspects, employee relations, alcohol and / or armament production, and so on.
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