Chaoudhary Wajahat Naeem Azmi, the author of this article, is a PhD scholar at INCEIF
As the mutual fund industry has developed, in more recent years it has witnessed the growth of sharia-compliant funds (SCFs) and socially responsible funds (SRFs). Both of these alternative investment tools came into existence as traditional products do not fit the criteria of Islamic and ethical principles. In addition to financial screening (for risk and return), these funds also use certain non-financial screening criteria to filter their investments along ethical and religious lines.*
Although both classes of funds employ certain screening criteria, there exists a distinction between them (Forte and Miglietta, 2007).
An SRF can be defined as an investment vehicle that combines the investors’ financial objective of monetary gain with certain non-financial objectives related to social and ethical concerns. These might include issues related to environmental protection or the societal impact of firms involved in tobacco and alcohol production, gambling and casinos etc (Hiagh and Hazelton, 2004). In respect of investment style, SRFs usually prefer small-cap firms and value stocks (Fowler and Hope, 2007).
Meanwhile, SCFs can be defined as funds that comply with Islamic principles. For instance, for profit/earnings to be legitimate, Islam requires the investments to be free from any form of riba (interest), gharar (uncertainty/speculation), maysir (gambling) and other non-approved elements, such as alcohol, pork, etc. SCFs also give consideration to debt levels and other financial ratios (such as under Dow Jones or MSCI Islamic screening criteria) while choosing stocks (Forte and Miglietta, 2007). Moreover, like SRFs, SCFs prefer small-cap firms.
Therefore, the main difference between SRFs and SCFs is that SRFs can freely choose between debt-bearing investments and profit-bearing investments, as long as the stocks chosen strictly adhere to social, moral or environmental beliefs (Abdelsalam et al, 2013). Further, SRF managers do not give consideration to investee companies’ leverage. This becomes more evident as SCFs mainly invest in growth stocks due to their lower leverage (Hoepner et al, 2011).
Both SCFs and SRFs started out to cater the needs of very niche investors, but they have both shown tremendous growth over the years. Broadly, they both fall under ethical investing, but there is a distinction between them (Forte and Miglietta, 2007). The literature on socially responsible investments is increasing, but sharia-compliant investments have been somewhat ignored, especially with regard to SCFs.**
One possible explanation for the lack of analysis could be the shortage of data. Using the Eurekahedge database, we not only investigate the risk-return profile and investment style of SCFs, but we also compare them to their closest equivalent, SRFs. With this research, we intend to add to the overall literature on ethical investment, as we provide the first attempt to examine and compare these funds. More precisely, we investigate the question: “Which creates more value for investors in equity funds: being socially responsible or sharia-compliant?”
To answer this question, we examined a sample of 963 funds (306 SCFs and 658 SRFs) for the period of 12 years from January 2002 to December 2013. Their investment focus covers Asia Pacific, emerging markets, Europe, global (with no focus on any specific country or region), Middle East & North Africa and North America. We employ the single-factor capital asset pricing model and the Carhart multi-factor model.
Our results suggest significant underperformance of both types of funds against the market, suggesting that the screening has a negative impact on them. Except in the case of global markets, both types of funds underperformed the market, whether we used the single-factor or multi-factor model. However, for the global markets, we found no performance difference between the conventional benchmark and the combined performance of both the funds. These findings may indicate that the poor performance is due to a reduced investment universe, as the global funds have a much more larger universe of stocks at their disposal.
To sum up, there is a price that an investor has to pay for being socially responsible or Islamic. Both types underperformed the market, but SCFs managed to do slightly better than SRFs.
As far as the investment style is concerned, as per the SMB (small-minus-big) coefficients, SCFs do not seem to follow any specific strategy, but SRFs are tilted towards small-cap stocks. The preference of SRFs for small-caps is understandable, as the negative screening seems to remove the large stocks as they are more diversified and can have operations that are not in line with the screening criteria. However, the results of SCFs are puzzling, as the literature suggests that the SCFs should also be investing in small-caps as large-caps are likely to be higher-beta and therefore would be screened out by the sharia criteria related to leverage.
As far as the HML (high-minus-low) factor is concerned, both types of funds substantially invest in growth stocks as compared to value stocks. These findings make sense, as most value stocks – such as those in basic industries and energy – would be screened out by the environmental criteria. For the SCFs, most of the value stocks would be screened out due to their high leverage.
On an average, the momentum-factor loadings reveal that these funds follow a contrarian strategy as opposed to a momentum strategy. Finally, in sharp contradiction to the literature, our results show that SCFs’ performance took a further dip during the crisis. They therefore dismiss the claims of many that SCFs provide a safer haven during crises and are in line with Kraeussl and Hayat (2011). On the other hand, the performance of SRFs provides weak support to the findings of Nofsinger and Varma (2014), as they manage to provide at least similar returns to the market.
Before we reach any bold conclusion that SCFs and SRFs are worse than conventional strategies, we have to acknowledge that the performance of mutual funds relies heavily on the manager’s skills. If the manager is not skilled enough in terms of picking stocks and/or timing markets, then it can lead to poor performance of these funds. We acknowledge that this is one of the limitations of this paper and we leave further assessment for future research.
* These funds have to pass certain ethical and religious criteria. For instance, SRFs have certain mandates, such as that investee companies must be environmental friendly, meet high corporate governance standards, provide a safe and hygienic workplace environment for their employees, etc. For SCFs, the criteria are laid down by Al-Quran (the holy book) and Sunnah (the prophetic traditions).
** Studies on Islamic indices are increasing (see for instance, Walkshäusl and Lobe, 2012; Al-Khazali et al, 2014; Ashraf, 2014; Ashraf and Mohammad, 2014; Jawadi et al, 2014; and Ho et al, 2014).