Shariah-compliant index derived from the FTSE100 vs. FTSE 100: 2003-2014 performance comparison
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
Shariah-compliant index derived from the
FTSE100 vs. FTSE 100:
2003-2014 performance comparison
Basheer Ahmed Moosagie
Research assignment presented in partial fulfilment
of the requirements for the degree of
Master of Business Administration
at Stellenbosch University
Supervisor: Mr Mohamed Iqbal Asaria
Confidentiality: A December 2014Stellenbosch University http://scholar.sun.ac.za
ii
Declaration
I, Basheer Moosagie, declare that the entire body of work contained in this research assignment is
my own, original work; that I am the sole author thereof (save to the extent explicitly otherwise
stated); that reproduction and publication thereof by Stellenbosch University will not infringe any
third party rights; and that I have not previously in its entirety or part submitted it for obtaining any
qualification.
B. Moosagie 31 October 2014
Copyright © 2014 Stellenbosch University
All rights reservedStellenbosch University http://scholar.sun.ac.za
iii
Acknowledgements
I would like to acknowledge the support I got from several individuals during the course of this
study:
Professor Mohamed Iqbal Asaria
Mohamed Kharwa- Nedbank
Matthew Bowler - Element Investment Managers
Shahiem Khan - Element Investment Managers
Dr. Anwah Nagia - Element Investment Managers
Abdul Basit Oldey - Kagiso Asset Managers
Niyaaz Mowser - Old Mutual
Nigel Suliman - Sanlam Investments
Mikko Ekström.
I would like to express my gratitude to the many advisors, especially Dr. John Morrison, at
Stellenbosch Business School for their support and encouragement throughout my MBA studies.
Additional recognition to Cynthia Lategan for continued support during my studies.
My thanks also extend to Aston University for providing me with an extraordinary opportunity to
study Islamic Finance.
Thank you to my mother Zaiboen, and Mohamed Allie, father and Mymoena and Allie my father
and mother-in-law for their continued support over the years and their enthusiasm as I neared my
goal.
Last, but not by any means least, I would like to thank my wife, Tasnim, for her continuous support,
love and understanding during the course of my studies. Her encouragement and support was in
the end what made this dissertation possible.
The time spent away from my family while attending classes and writing exams and, in particular,
this dissertation was truly difficult.
I could not have completed my research without all these wonderful people!Stellenbosch University http://scholar.sun.ac.za
iv
Abstract
This research study critically reviewed the performance of a Shariah-compliant index compared
with that of the UK FTSE 100 between 2003 and 2014. Two broad indices were constructed based
on business evaluation techniques, one using market capitalisation and the other total assets as a
means to value a company.
Shariah-compliant equity screening combines a financial ratio screen as well as business activity
screening, which excludes a company’s involvement in any unlawful activities in the eyes of Islamic
law.
The sample period was further broken into three sub-periods, namely the bull period (2003-2007),
the financial crisis period (2008-2009), and the post-crisis period (2009-2014), reflecting the
various stages of the business cycle.
A comparison of the risk-adjusted returns shows that the Shariah-compliant index, using market
capitalisation as the means for valuing a company, delivers superior returns at lower risk levels
than the FTSE100 over the sample period. Although the Shariah-compliant indices underperform
to the FTSE100 during the bull market period, both of the Shariah compliant indices outperform the
FTSE 100 during the era of the financial crisis. This can be explained by the fact that Shariah
screening excludes companies that are highly leveraged and therefore it remains buffered from an
economic crisis.
In general, this research contends that the application of a faith-based-screen does not have an
adverse effect on returns.
Key words:
Islamic finance
Shariah
Screening
Interest
Gearing
Index
Shariah-compliant investments
Financial performance
Risk-adjusted ratiosStellenbosch University http://scholar.sun.ac.za
v
Table of contents
Declaration ii
Acknowledgements iii
Abstract iv
List of tables viii
List of figures ix
List of acronyms and abbreviations x
CHAPTER 1 BACKGROUND 1
1.1. INTRODUCTION 1
1.1.1. Islamic finance entry 2
1.1.2. Ethical investing 2
1.2. ETHICAL SCREENING 3
1.3. ISLAMIC FINANCE 3
1.4. SHARIAH PRINCIPLES 4
1.5. GOVERNANCE 5
1.5.1. Shariah-compliant asset management 5
1.5.2. Shariah Supervisory Board 5
CHAPTER 2 LITERATURE REVIEW 7
2.1. INTRODUCTION 7
2.2. SHARIAH-COMPLIANT SCREENING 8
2.3. SECTOR BASED SCREENS 8
2.3.1. Financial ratio screens 8
2.3.2. Dividend purification 10
2.3.3. SRI funds screening 10
2.4. RATIONALE 10
2.5. OBJECTIVES 11
CHAPTER 3 RESEARCH METHODOLOGY 12
3.1. RESEARCH DESIGN 12
3.2. POPULATION OF THE STUDY 12
3.3. DATA COLLECTION 12Stellenbosch University http://scholar.sun.ac.za
vi
3.4. FTSE 100 12
3.5. PERIOD 12
3.6. SCREENING 12
3.6.1. Business activity screen (qualitative screen) 13
3.6.2. Financial ratio screening 13
3.6.3. Denominators 13
3.7. QUANTITATIVE SCREEN 13
3.8. INDEX CONSTRUCTION 14
3.8.1. Dividend purification 14
3.8.2. Calculations 14
3.8.3. Risk-adjusted return ratios 15
3.8.3.1. Jensen’s measure 15
3.8.3.2. Sharpe measure 15
3.8.3.3. Treynor measure: 15
3.8.4. Statistical tools 16
3.8.5. Weighting 16
CHAPTER 4 FINDINGS 17
4.1. BUSINESS ACTIVITY SCREEN 17
4.2. TABLE 4.2 - FINANCIAL RATIO SCREEN: INDEX 1 19
4.3. TABLE 4.3 - FINANCIAL RATIO SCREEN: INDEX 2 19
4.4. CALCULATIONS 22
4.5. DESCRIPTIVE STATISTICS 23
4.6. IDENTIFIED ISSUES 26
4.6.1. Consensus among scholars about what is and is not permissible 26
4.6.2. Non-permissible revenue cannot be separated 26
4.6.3. Supply versus collaboration 27
4.6.4. Qualitative screen 27
4.7. DISCUSSION 27
4.8. FURTHER STUDIES 28
CHAPTER 5 CONCLUSIONS 30
5.1. SUMMARY AND CONCLUSIONS 30
REFERENCES 32
Appendix A Company’s product or service 35Stellenbosch University http://scholar.sun.ac.za
vii
Appendix B: Fields searched in Bloomberg 36
Appendix C: List of constituents in the UK FTSE100 between 2003 and 2014 37
Appendix D: Companies that were excluded after the quantitative screen 40
Appendix E: Further exclusion due to second screen 42
Appendix F: Constituents of the indices 43
Appendix G: Glossary of terms 45Stellenbosch University http://scholar.sun.ac.za
viii
List of tables
Table 1.1: Difference between profit and interest 5
Table 2.1: Screening rules 9
Table 4.1: Companies excluded based on business activity 18
Table 4.2: Companies excluded based on financial ratios of Index 1 18
Table 4.3: Companies excluded based on financial ratios of Index 2 18
Table 4.4: Average quarterly constituents per index 20
Table 4.5: Total assets as the denominator (Index 1) 21
Table 4.6: Market cap as the denominator (Index 2) 21
Table 4.7: Descriptive statistics of annual returns for the indices (2003-2014) 23
Table 4.8: Risk-adjusted measurements using a three-month risk-free UK bond and the
market index is the FTSE100 (2003-2014) 25Stellenbosch University http://scholar.sun.ac.za
ix
List of figures
Figure 4.1: Average quarterly constituent number per index between 2003-2014 19
Figure 4.2: Total returns 22
Figure 4.3: Cumulative returns of £100 invested on 1January 2003 27Stellenbosch University http://scholar.sun.ac.za
x
List of acronyms and abbreviations
DJIMI Dow Jones Islamic Market Index
EIF Equity Islamic Funds
FTSE Financial Times Stock Exchange
GEIS Global Equity Index Series
IEFs Islamic Equity Funds
IFSB Islamic Financial Services Board
LSE London Stock Exchange
MSCI Morgan Stanley Capital International
PBUH Prophet Muhammad
S&P Standard and Poor’s
SRI socially responsible investments
SSB Shariah Supervisory Board
UK United KingdomStellenbosch University http://scholar.sun.ac.za
CHAPTER 1
BACKGROUND
1.1. INTRODUCTION
In today’s world an important question surfaces about whether a person practising Islam can invest
in a company that is not 100% compliant with Islamic law, or not. The quick answer is no. The
protracted answer, however, boils down to the consensus among Islamic scholars regarding
investing: that there is a dire need. What does a ‘dire need’ mean in this context?
If investing in a financial market were as simple as black and white (black being impermissible and
white meaning permissible), then investment decisions would be simple: invest in the permissible
shares and refrain from the impermissible ones. The truth of the matter is that investing in financial
markets is neither black nor white, and thus the exercise of investing poses a conundrum for
scholars.
The primary reason for the prohibition in investing in financial markets is based on Islam’s
prohibition on interest. There is unanimity among Shariah scholars that the use of interest, whether
paying or receiving, is impermissible (Vahed, 2011:170). Muslims are also not allowed to
participate in businesses earning primarily from impermissible activities, in the eyes of Islamic law,
such as alcohol beverage producers, casinos or even partially as for instance many hotels, due to
their income from the sale of alcohol. In light of this, any entity that deals in interest will
automatically make investing in these businesses impermissible.
And here is the caveat: investments that are impermissible can be made permissible if there is a
necessity (Vahed, 2011:170).
Under the legal maxim of dhurura, Arabic for necessity, Islamic scholars have agreed that there is
a need for investment in financial markets, for the preservation of wealth (Hunt-Ahmed, 2013;
Kamali, 1999). There are a few core principles that scholars use in order to gauge whether an
investment falls into the necessity-basket.
However, certain restrictions remain. Although companies might meet the requirements of this
necessity, there are limits to which investment categories should not breach. For example, since
gambling is not permitted in Islam, any provision to finance a casino must be avoided.
A company that cannot be avoided is one that has a conventional bank account, which
accumulates interest. Unfortunately, interest is an inevitable reality of the current economic system
and cannot be avoided (Usmani, 2008:246).Stellenbosch University http://scholar.sun.ac.za
2
Now, since the doors of investing in equity markets have been available for Muslims, what options
do they have? And can these investment options offer a market-related risk/reward alternative as
well?
1.1.1. Islamic finance entry
Until the 1980s, Muslims were discouraged from investing in financial markets because of Shariah
prohibition on certain business activities (Hussein & Omran, 2005:105). In the 1990s when a
majority of the Islamic scholars reached unanimous consensus regarding the acceptability of
investing in equity markets (Hayat, 2006), changes in Shariah rulings related to investment saw the
dawn of Shariah-compliant financial markets (Uddin, 2012).
The ability of Shariah-compliant investments to survive and grow during the financial crisis further
enhanced their attractiveness in the financial industry. Though some Islamic financial institutions
were hurt during the recent financial crisis, they were less affected than those in the conventional
financial industry, which saw high profile institutions collapse (Hunt-Ahmed, 2013). Since the
Shariah prohibits the use of interest as well as the investment in high leveraged firms, Shariah-
compliant investments were, to a large extent, buffered during this period.
As a result, large financial institutions established Islamic footprints that sought to take advantage
of this upswing, and use Islamic investment vehicles as a means of diversification. In February
1999, the Dow Jones launched the Dow Jones Islamic Market Index (DJIMI). It tracked the
performance of equity in over 34 countries.
Today, Muslims represent approximately one-fifth of the world’s population and are estimated to
have more than $2 trillion to invest (Gosh, 2013). With the growth in Shariah-compliant
investments, the need for having a screened universe of Shariah-compliant equity is increasing to
accommodate this opportunity.
1.1.2. Ethical investing
According to Etzioni (1988), people are guided by a sense of moral duty, in that, not only is the
maximisation of shareholder wealth an important goal, but also the maximisation of shareholder
welfare. What emerges from this concern is an awareness that the responsibilities of business
extend further than that which is owed to shareholders. Investors who adhere to this concern often
wish to invest with companies that pursue a broader ethical goal rather than those interested only
in increasing shareholder wealth. This poses a problem because trying to determine which
companies have actively incorporated social ethical standards can be a costly and time-consuming
exercise. This has led to the formation of Social Mutual Funds or Ethical Unit Trusts that were
specifically screened to meet the needs of socially sensitive investors (Cummings, 2000:79).Stellenbosch University http://scholar.sun.ac.za
3
1.2. ETHICAL SCREENING
Over the past three decades, the world has seen a positive shift in attitude towards ethical
investment. As a result, ethical funds have been some of the faster growing areas in the financial
sector (Forte & Miglietta, 2007). The use of ethical screening, however, is not a new phenomenon.
It dates back to a time when religious bodies discouraged their followers from investing in the so
called ‘sin’ industries which included alcohol, gambling and tobacco (Hussein & Omran, 2005:105;
Uddin, 2012). In the 1970s, ethical investors refrained from offering finance to those businesses
that had ties to the proponents of the Vietnamese War. In the 1980s, they disinvested in South
Africa due it its human-rights violations (Arnold & Hammond, 1994:111). Recently, ethical
screening has encompassed corporate responsiveness to the needs of human rights and the
environment in which they participate (Welford, 2002:1).
Screening is a process of scrutinising a company’s activity as part of their investment process.
Ethical screening therefore is a procedure of vetting companies as part of the ethical or responsible
investment process (Klein, Eriksen, Næss, Hammill, Tanner, Robledo & O’Brien, 2007:23).
Shariah screening determines whether a stock or security is Shariah-compliant. It consists of a
variety of Shariah principles to test for compliance.
The objective of screening is to ensure that the stock or security which is purchased does not
contain any forbidden elements that make it non-compliant in the eyes of the Shariah.
1.3. ISLAMIC FINANCE
Islamic finance can be categorised as financial transactions that are in accordance with the
teachings of Islamic jurisprudence, labelled in Arabic as the Shariah (Usmani, 2008:246). Shariah,
Islamic canon law, is derived from two primary sources, namely the Quran and traditions and
practices of the Prophet Muhammad (PBUH) known as the Sunnah (Usmani, 2008:246; Vahed,
2011:170). Though called Islamic law, it can best be described as a moral code that governs all
aspects of a Muslim’s day-to-day activities (Treasury, 2008; Usmani, 2008:246; Vahed, 2011:170).
Shariah law prohibits the following:
1. The consumption and repaying of interest;
2. The investment in companies that deal in activities that are prohibited in Islam (alcoholic
beverage production, pork-related products and ammunition);
3. Speculation and excessive risk (Usmani, 2008).
According to Iqbal and Mirakhor (2011:406), these prohibitions have a far-reaching consequence
for Muslims, and by implication it means that Muslims are not allowed to invest in futures, optionsStellenbosch University http://scholar.sun.ac.za
4
or any other speculation-based derivative and they are not allowed to have access to conventional
credit.
Though the principle of paying and receiving interest is too restrictive for investors, Islamic scholars
have applied some leniency to this.
Although Islamic finance type products are primarily designed to accommodate the Muslim
community, they are available to all. These products provide an alternative financial model to
conventional financial products and investment opportunities.
1.4. SHARIAH PRINCIPLES
Islamic financial institutions are governed by Shariah principles, which make their functioning
different to conventional financial institutions. Islamic finance can be considered as an alternative
financing method, which offers several means to handle the financing of economic activity from
rudimentary mechanisms to sophisticated instruments.
The central theme of Islamic finance is the prohibition of interest. Other principles, which shape the
tenets of Islamic finance, are as follows:
Islamic finance aims at promoting productive economic activity through asset-based type financing,
which must be linked to a tangible asset, rather than through a debt-based system (Iqbal &
Mirakhor, 2011:406).
Money does not hold any inherent value in itself, it is understood to be an accepted means of
exchange and, as a result, money cannot be created through a credit system (Usmani, 2008:246).
Productive economic activity, with business activity and the prohibition of interest, defines another
key principle for Shariah screening: uncertainty and speculation are forbidden with the objective of
achieving a stable financial system (Iqbal & Mirakhor, 2011:406).
The nature of business activity is also scrutinised. Any activity that deals in impermissible activities
in the eyes of the Shariah is limited. Any activity that causes harm to individuals, society or the
environment, such as the defence industry is also limited.
Fixed returns are prohibited, as a result of the prohibition of interest (Iqbal & Mirakhor, 2011:406).
With the prohibition of interest, Islamic finance institutes a profit and loss principle that aims to
establish fairness between work effort and return. As a result, risk sharing becomes an important
tenet in Islamic finance (Iqbal & Mirakhor, 2011:406).
Given this prescribed set of principles, Islamic scholars engineer new and sophisticated
instruments that respond to the current needs of the industry. These principles are voiced in the
Qur’anic verse that trade is “permissible and interest is forbidden”. Therefore, profit constitutesStellenbosch University http://scholar.sun.ac.za
5
indispensable revenue for business activity. For a better understanding, Table 1.1 summarises the
difference between interest and profit.
Table 1.1: Difference between profit and interest
Profit Interest
Return on the proceeds of a venture Return on capital
Profit and loss agreement Interest is guaranteed
Variable return Fixed return
Return on joint ventures and participation Return on deposit
In summary, Islamic finance is the product of religious ethics, which is moulded by Shariah law.
1.5. GOVERNANCE
Corporate governance within Islamic financial institutions operates very similar to conventional
financial institutions. However, Islamic financial institutions have the responsibility to ensure
compliance with the Shariah within in their corporate governance mandate. Thus, Shariah
governance is an additional component peculiarly exclusive to Islamic finance.
The Islamic Financial Services Board (IFSB) is an organisation that guides, regulates and issues
standards within the Islamic finance services industry. The IFSB regulates the functioning of the
Shariah Supervisory Board (SSB) (Rammal, 2006:204).
1.5.1. Shariah-compliant asset management
Using the Shariah to guide investment decisions is not a straightforward task. It needs be handled
with caution due to the complexity of financial markets and the multidisciplinary facets of global
participation of businesses.
1.5.2. Shariah Supervisory Board
A Shariah Supervisory Board (SSB) is a governing body that ensures that all activities of a financial
institution are within the boundaries as intended by the Shariah. The SSB is required to apply
research methods and use deductive, analytical knowledge as well as interpretation from the
sources of Shariah law to determine investment compliance (Asutay & Marzban, 2012:151).
The responsibility of the SSB goes beyond creating a definitive static set of rules that guide
compliant investments. Shariah compliance revolves around a continuous feedback loop, that not
only provides Shariah advice, but also ongoing data screening services and ongoing monitoring
arrangements. A member of an SSB is typically a scholar trained in Islamic jurisprudence. There is
no fixed configuration for the composition of this board.Stellenbosch University http://scholar.sun.ac.za
6
The prohibition of interest makes the investment approach adopted by Islamic institutions unique
since they operate on profit/loss sharing arrangements. This principle requires institutions to share
the profits and losses resulting from co-funded projects with their customers (Ahmad & Haron,
2002:13; Forte & Miglietta, 2007; Hussein & Omran, 2005:105).
According to Forte and Miglietta (2007:2), investors entering the Shariah-compliant investments,
and in particular the Islamic mutual funds, are increasing about 12-15% per year. With this growth
rate and with a total estimated asset value of $2 trillion, it signifies an immense investment
potential for investors.
The literature on the performance of Shariah-complainant indices against their counterparts is
scarce. This paper aims to advance the research in the field of Islamic-compliant indices using the
FTSE100 that will act as a proxy for the market.
The goal of this research study was to analyse the performance of an index that meets the
minimum standards of the Shariah and compare it with the performance of the FTSE 100.
This research also aimed to establish whether the risk/returns of a Shariah-compliant index are
significantly different from the risk/returns of the FTSE100. Thus the period from 2003 to 2014 was
chosen so that different phases of the market could be measured.
The objective was to detect whether investors would have shown higher or lower returns on an
Islamic-screened index than those who invested in conventional non-Shariah compliant indices.
This research has been divided into five chapters:
Chapter 1: Begins with a brief background of Islamic Law, defines Shariah law and delivers an
Introduction to Islamic Finance.
Chapter 2: Presents a review on relevant literature and discusses various screening devices and
the intended objectives.
Chapter 3: Deals with the methodology used to create a Shariah-compliant index. It also describes
the tools that were used to measure the indices.
Chapter 4: Presents the results and description of the results and the limitations.
Chapter 5: Provides a conclusion and discusses potential future research.Stellenbosch University http://scholar.sun.ac.za
7
CHAPTER 2
LITERATURE REVIEW
2.1. INTRODUCTION
Nobel laureate, Friedman (1970:193) argued that accepting a responsibility other than profit
maximisation will impair returns. This idea is further ratified through Portfolio Theory that suggests
as soon as investment options are restricted or screened, the performance of such an investment
might be jeopardised due to lack of diversification. It is for this reason that researchers continue to
track the performance of socially responsible investments (SRI) and Shariah-compliant activities in
order to determine whether they perform better or worse than conventional, less restrictive
investments (Forte & Miglietta, 2007).
Literature documenting the performance of SRI is diverse and therefore shows mixed results.
According to Melton (1995:18), SRI-screened funds performed better than 58% of their
corresponding non-ethical pairs over a 12-month period, ending in September 1994. Although this
transpired, a single 12-month period is too short to value the performance of SRI against non-SRI.
Kreander, Gray, Power and Sinclair (2005:1465) suggested that a basket of European funds
perform at least as well their counterparts. However, Kurtz (1997) found no relationship between
the performance of an SRI fund and conventional funds.
The literature detailing the performance and behaviour of Islamic funds is also limited and diverse.
Hussein and Omran (2005) investigated the performance of Islamic indices covering the period
from 1996 to 2003. Their findings suggest that the indices showed positive returns during the bull
period (January 1996 to March 2000), and it underperformed during the bear period (April 2000 to
July 2003). The underperformance shown during the bear period could stem from the socio-
political environment of the time such as the September 2011 attack which could have had a
negative effect on the Islamic funds and depressed the demand for Islamic investments (Hussein &
Omran, 2005).
After examining the risk-free rate, the DJIMI and Wilshire 5000 index over 1999 to 2002, Hakim
and Rashidian (2002) concluded that the screening criteria filtering non-compliant funds, had no
effect on returns.
Kräussl and Hayat (2008), after analysing the risk/return characteristics of 145 Equity Islamic
Funds (EIF) from 2000 to 2009, stated that the Islamic Equity Funds (IEFs) underperformed to the
conventional benchmarks. According to Kräussl and Hayat (2008:28), the underperformance was
further exacerbated during the financial crisis.Stellenbosch University http://scholar.sun.ac.za
8
The consensus in the literature suggests that due to the low diversification and higher volatility
within Islamic-screened portfolios, they perform poorly on average against conventional non-
screened portfolios.
2.2. SHARIAH-COMPLIANT SCREENING
Proponents against the tenets of Islamic finance argue that by excluding major sectors of
businesses from an asset universe potentially exposes such a portfolio to losing out in overall
performances. They argue that the alcoholic beverage industry is inelastic to major volatilities and
generally performs well, even during times of recession (Hussein & Omran, 2005:105). On the one
hand, Lyn and Zychowicz (2010:136) contended that investors do not sacrifice economic returns
based on their chosen ethical and social decisions based on their faith. And on the other hand,
during the recent financial crisis as well as during times before the collapse of high profile
companies like Enron, Shariah-compliant screening was able to detect signs of high leverage and
eliminated those stocks from their portfolios. Approximately a year before the collapse of
WorldCom, the Dow Jones Islamic Market Index (DJIMI) excluded WorldCom because its debt to
market capitalisation breached the 33% limit. As a result, the WorldCom’s stock was liquidated at
$14 a share. Soon after that, the share lost its entire value (Hussein & Omran, 2005:105; Usmani,
2008:246).
Enrol as well as Tyco stocks were excluded from Shariah indices before their scandals became
public. By liquidating their stances in these firms before their share prices plummeted, Islamic fund
managers were able to not only save their investors a considerable sum of money, but they also
increased their shareholder wealth (Hussein & Omran, 2005:105). Instances like these created an
environment of acceptance of Islamic finance by the conventional financial community.
In order to filter equity for Shariah compliance, two broad screening procedures are used. The first
is a sectorial-based screen, and the second is a financial ratio-based screen.
2.3. SECTOR BASED SCREENS
According to Ghoul and Karam (2007), the sector-based screen investigates business practices
that are unacceptable in the view of the Shariah which are the majority of financial institutions or
businesses involved in any aspect of alcohol, pork or non-halal meat. The rest of the screening
criteria are similar to those applied by SRI funds such as gambling, pornography, tobacco and
armaments.
2.3.1. Financial ratio screens
Financial ratio screening, on the other hand, focuses on liquidity, gearing levels, account
receivables, interest and non-permissible income. These ratios are compared to a maximumStellenbosch University http://scholar.sun.ac.za
9
threshold as shown in Table 2.1 below. Different Shariah compositions on levels of the threshold
are widespread in the industry, but the central difference between the different compositions is to
use total assets or market capitalisation as a base to value a company as well as to use as a
denominator in calculating the financial ratios (refer to Table 2.2). Certain funds, however, apply
their own restrictions on objectionable activities and only allow investing in businesses that have
5% or less of their revenue from non-permissible activities (Ghoul & Karam, 2007:96). Below are
two typical compositions that a fund manager will use to screen for Shariah compliance. The
distinguishing factor is the divisor.
Table 2.1: Screening rules
Asset-based ratios Market cap-based ratios
Non permissible incomeStellenbosch University http://scholar.sun.ac.za
10
2.3.2. Dividend purification
Dividend income is derived directly from profits of a company. If a company invests surplus cash
into interest-bearing facilities or if the company earns income from non-compliant
investments/shareholdings, the returns of this also feature in the dividends that a company
distributes. Since interest is not accepted in accordance with the Shariah, it has to be removed
(FTSE, 2014). Dividend purification is therefore an amount that is deducted from the dividends
received, and the proceeds are paid to charity.
2.3.3. SRI funds screening
Companies that are chosen for SRI eligibility must pass the following tests:
No involvement in alcohol, gambling, tobacco and armaments.
Show respect and good performance in the areas of animal welfare, board diversity, community
relations, corporate governance, environment, human rights, indigenous people’s rights, product
safety and impact, and workplace practices.
Shariah and SRI screening share many similarities (see Appendix A). The distinguishing factors
that separate Shariah screening procedures from SRI screening procedures are their oppositions
to interest income and expense and their objections to industries such as businesses that deal in
alcohol, entertainment and pork (Ghoul & Karam, 2007:96).
The performance of a Shariah-screened index vis-à-vis the FTSE 100 counterpart was done using
a variety of risk measures such as the Sharpe measure, the Treynor measure, the Jensen Alpha
and the Information ratio to gauge performance.
2.4. RATIONALE
Is participating in a faith-based investment increasing the risk profile and sacrificing returns on
religious grounds? This is the question this research has tried to answer. After all, Shariah-
compliant funds have a smaller universe of stock to select from, and have a portion deducted from
the returns for purification purposes. Portfolio theory suggests that by reducing the stock universe,
diversification is hindered, and as a result returns are inadvertently affected (Bodie, Kane &
Marcus, 2011).
Investing in accordance with Islamic law mimics the directive of SRI, and critics condemn SRI-type
of investments as they say that not only is the effect of diversification lost but SRI screening
increases the expenses and as a result hampers competiveness.
This research sought to find out whether a faith-based investment is a viable option that offers a
balance between risk and reward.Stellenbosch University http://scholar.sun.ac.za
11
2.5. OBJECTIVES
i. To determine to what extent the various screening devices can in fact create a robust
Shariah-compliant index.
ii. To identify an index of Shariah-compliant firms.
iii. To compare the performance of this index against the FTSE100 using risk-adjusted
measures.
iv. To measure the performances of these different indices when using total asset and market
cap denominators for calculating gearing and receivables.Stellenbosch University http://scholar.sun.ac.za
12
CHAPTER 3
RESEARCH METHODOLOGY
3.1. RESEARCH DESIGN
This research sought to measure the performance of a Shariah-compliant index carved from the
constituents of the UK FTSE 100 between 2003 and 2014. Three additional subgroups from the
sample period were chosen that reflect the different phases of the market. This assignment
describes the basic features of the data, and provides a summary about the risk and returns of the
Shariah-compliant indices. The research methodology chapter will conclude with a discussion on
the limitations of the research. Microsoft Excel 2011 was used for handling the data.
3.2. POPULATION OF THE STUDY
The population of the study comprised of the returns of constituent companies of the UK FTSE 100
between 1 January 2003 and 30 April 2014. A three-month United Kingdom (UK) Treasury bill
return, extracted from Bloomberg, was used as a proxy for the risk-free rate
3.3. DATA COLLECTION
This research made use of secondary data sourced from Bloomberg. Fields that were extracted
using Bloomberg can be found in Appendix A.
3.4. FTSE 100
The FTSE 100 was used as the proxy for the market. The data was subdivided so that each
quarter could be reflected on a single tab within an Excel workbook.
3.5. PERIOD
The research covered the sample period 1 January 2003 until 30 April 2014 as well as three sub-
periods that were impacted by different economic trends. The three sub-periods are:
1. From 1 January 2003 to 31 December 2007 which represents the bull period;
2. From 1 January 2007 to 31 March 2008 which represents the financial crisis period; and;
3. From 1 April 2008 to 30 June 2014 which represents the post-financial crisis period.
3.6. SCREENING
This research used the constituents of the FTSE100 to carve an index; the FTSE Shariah Index
Ground rules (FTSE, 2014) were used as an outline to evaluate the securities for Shariah
compliance. Two major screening devices were employed in order to achieve Shariah compliance,Stellenbosch University http://scholar.sun.ac.za
13
i.e. a business activity screen, which is qualitative in nature and a financial ratio screen which is
quantitative in nature.
3.6.1. Business activity screen (qualitative screen)
Companies that are primarily involved in any of the following activities were excluded from the
index:
Producers of alcoholic beverages;
Conventional finance (non-Islamic banking, finance and insurance, etc.);
Entertainment (casinos, gambling and pornography);
Pork-related products and non-halal food production, packaging and processing or any other
activity related to pork and non-halal food;
Tobacco; weapons, arms and defence manufacturing.
The Bloomberg industry sector and sector names fields were analysed in order to test for Shariah
compliance.
3.6.2. Financial ratio screening
The remaining companies were further screened on a financial ratio basis. The following financial
ratios had to be met for companies to be considered Sharia-compliant:
Accounts receivable and cash are less than 50% of total assets and market cap;
Cash and interest-bearing items are less than 33.333% of total assets and market cap;
Debt is less than 33.333% of total assets and market cap;
Total interest and non-compliant activities income should not exceed 5% of total revenue.
3.6.3. Denominators
Since scholars differ in opinion on using either market capitalisation or total assets as a
denominator, this research analysed the impact using both denominators on the FTSE 100.
Two indices were created. The first, using total assets as the denominator (Index 1), and the
second a 12-month-trailing-market-capitalisation as a denominator (Index 2). Both indices were
compared with the performance of the FTSE 100, as well as the risk-free rate
3.7. QUANTITATIVE SCREEN
Total assets as the denominator: Index 1Stellenbosch University http://scholar.sun.ac.za
14
1.Stellenbosch University http://scholar.sun.ac.za
15
3.8.3. Risk-adjusted return ratios
The performance of the Shariah-compliant indices and the UK FTSE 100 was evaluated using the
information ratio, the Jensen’s measure, the Sharpe measure and the Treynor measure. The
results of these calculations are useful in comparing indices that have varied risk-return
characteristics (Bodie et al., 2011).
3.8.3.1. Jensen’s measure
“This is the average return of the index over that predicted by the Capital Asset Pricing “Model
(CAPM), given the index’s beta and the average market return” (Bodie et al., 2011).
Where:
= Expected index return
= Risk free rate
= Beta of the index
= Expected market return
3.8.3.2. Sharpe measure
“The Sharpe’s Measure divides the average portfolio excess return over the sample period by
the standard deviation of returns over that period. It is a measurement of the reward to the
volatility trade off” (Bodie et al., 2011).
A higher Sharpe ratio is associated with better performance.
Where:
= Expected index return
= Risk free rate
= Standard deviation
3.8.3.3. Treynor measure:
“Similar to the Sharpe’s Measure, Treynor’s measure gives excess return per unit of systematic
risk” (Bodie et al., 2011).Stellenbosch University http://scholar.sun.ac.za
16
Whereas the Sharpe ratio uses total risk as the divisor, the Treynor ratio uses systematic risk as
the divisor. A higher Treynor ratio is associated with better performance.
Where:
= Expected index return
= Risk free rate
= Beta of the index
3.8.4. Statistical tools
Kurtosis: Is a measure of the peaks of a curve (Bodie et al., 2011).
Skew: Refers to the asymmetry of a distribution (Bodie et al., 2011).
Standard deviation: Is a measure of spread of data from the mean (Bodie et al., 2011).
3.8.5. Weighting
Once the Shariah-compliant universe was established, the new weighting within the index was
calculated. The new index weigh was calculated by dividing the market cap of each security by the
total market cap of the index per quarter. The Shariah-compliant index is thus a market value-
weighted index.
The returns of the Shariah indices were calculated for each quarter by multiplying the total returns
per security by their weightings within the index.
The balance was then multiplied by the returns of the following quarter’s index yield.Stellenbosch University http://scholar.sun.ac.za
17
CHAPTER 4
FINDINGS
The first step included the application of the business activity and financial ratio screens in order to
identify those that are not Shariah-compliant. Table 4.1 below gives a summary of the results of
both screening activities. Table 4.1 also details the business activity screen, while Table 4.2 and
Table 4.3 detail the financial ratio screen.
A total of 202 constituent companies existed in the FTSE100 between 1 January 2003 and 30 June
2014 (Appendix B).
Applying the qualitative screen based on the sector in which they participate, 62 companies were
excluded from the index (Appendix C).
A second qualitative screen was applied based on scrutiny of annual reports of the companies, and
a further eight companies were excluded (Appendix D).
A total of 132 companies were left after an in-depth qualitative screen had been applied.
4.1. BUSINESS ACTIVITY SCREEN
Within this universe of companies, 70 companies are excluded from the index due to their primary
or secondary business activity. Table 4.1 represents of the sectors that are excluded and the
number of companies within the sector.
From a total of 202 companies (Appendix B), 70 companies are excluded because of their primary
or secondary business activity. Of the 70 companies excluded, 46 are made up of companies
within the conventional financial services industry. Financial services is one of the bigger sectors
within the constituents of the FTSE100, amounting to 22.77%. Its exclusion amounts to 65.71% of
the number of companies excluded from the index. The financial services/insurance activity screen
is therefore the most constricting screen within the business activity screen.Stellenbosch University http://scholar.sun.ac.za
18
Table 4.1: Companies excluded based on business activity
Companies with core and secondary non-compliant activities
Financial Alcoholic Defence/ Entertainment/
Hotel Industry Tobacco Total
Services/Insurance Beverages Weapons Gambling
Number of excluded companies
46 8 7 2 3 4 70
Percentage of total number of companies
22,77% 3,96% 3,47% 0,99% 1,49% 1,98% 34,65%
Percentage of total number of excluded companies
65,71% 11,43% 10,00% 2,86% 4,29% 5,71% 100,00%
Table 4.2: Companies excluded based on financial ratios of Index 1
Average Average
Interest-
number of Accounts number of
Debt/Total bearing
companies in receivable/ total Interest/Revenue non-compliant
assets income/total
index per assets companies per
assets
year year
274 66 6 8 0 76
Percentage of total companies
Index 1 24,00% 2,25% 2,75% 0,00%
Percentage of non-compliant companies
86,52% 8,11% 9,90% 0,00%
Table 4.3: Companies excluded based on financial ratios of Index 2
Average
Average
Interest- number of
number of Accounts
Debt/Market bearing non-
companies receivable/Market Interest/Revenue
cap income/market compliant
in index per cap
cap companies
year
per year
274 112 145 45 0 152
Percentage of total companies
Index 2 40,88% 52,95% 16,39% 0,00%
Percentage of non-compliant companies
73,46% 95,17% 29,46% 0,00%Stellenbosch University http://scholar.sun.ac.za
19
4.2. TABLE 4.2 - FINANCIAL RATIO SCREEN: INDEX 1
Sixty-five percent (132) of the companies qualify for the second phase of the screening process.
As shown in Table 4.1, Panel B details the list of financial ratios. Panel B consists of two parts, the
first part uses total assets as the denominator, while the second part uses market cap as the
denominator in calculating the various ratios. When using total assets as the denominator, the debt
ratio is the most constricting ratio.
4.3. TABLE 4.3 - FINANCIAL RATIO SCREEN: INDEX 2
When market cap is used as the denominator, accounts receivable/market cap is the most limiting
ratio at excluding 145 companies, followed closely by the debt ratio at excluding 112 companies. It
is interesting to note that no companies were excluded from either index due to the
interest/revenue ratio.
As a result of the screening, the universe of companies is drastically reduced. This coincides with
the findings of Hakim and Rashidian (2004) that showed that out of 5 000 stocks that make up the
Wilshire 5000, 75% was screened out because of Shariah non-compliance.
Figure 4.1: Average quarterly constituent number per index between 2003-2014Stellenbosch University http://scholar.sun.ac.za
20
On average, the less restrictive Index 1 contains just over 48 companies per quarter, while Index 2
contains 33 companies per quarter. Index 1 contains 52.5 companies less than the FTSE 100, and
Index 2 contains 6.7% less than the FTSE 100.
Table 4.4: Average quarterly constituents per index
Percentage of
Year:
FTSE100 Index 1 Index 2 Difference the same
2003-2014
stock
Average 101.8 48.2 33.0 15.2 58.80%
Table 4.4 above displays the average number of companies in each index between the period
between 2003 and 2014.
On average, 48 companies were Shariah-compliant using total assets as the denominator, while
32.8 companies were compliant where market cap was the denominator, a difference of ±15,53
(between index 1 and index 2) companies during the period.
On average, 58.88% of the companies in Index 2 were the represented in Index 1. The full table
detailing each quarter during the period can be found in Appendix E.
Table 4.4 and Table 4.5 below refer to the average sectorial weightings ranked by their weighting
in the corresponding index between 2003 and 2014. The fourth column describes the weight of the
each sector within the FTSE 100. In both tables, the differences in weighting between the Shariah
indices and the FTSE 100 are marginal with the exception in Table 4.5 where mining has a
significantly larger footprint than the benchmark. The maximum difference in Table 4.4 is mining
with a 3.64% difference, and the minimum is media at 0.13%. The maximum difference in Table
4.5 is mining as well, with a difference of 7.07%, while the minimum difference is food services at
0.31%. The top 10 sectors make up an overwhelming majority of the companies within both
indices, with 89.70% for total assets as the denominator, and 83.17% for market cap as the
denominator.Stellenbosch University http://scholar.sun.ac.za
21
Table 4.5: Total assets as the denominator (Index 1)
Sector Index 1 FTSE Difference
1 Oil and Gas Total 33,01% 32,94% 0,07%
2 Mining Total 18,51% 14,87% 3,64%
3 Pharmaceuticals Total 10,25% 11,41% -1,16%
4 Telecommunications Total 9,78% 11,94% -2,16%
5 Food Total 9,44% 8,54% 0,90%
6 Household Products/Wares Total 2,15% 2,59% -0,45%
7 Retail Total 1,93% 1,88% 0,06%
8 Leisure Time Total 1,82% 0,72% 1,10%
9 Gas Total 1,41% 1,80% -0,39%
10 Media Total 1,41% 1,53% -0,13%
Total 89,70% 88,23% 1,47%
Important to note from an analytical perspective, that even if the sector footprint is similar, the
sectorial weightings differ widely.
Table 4.6: Market cap as the denominator (Index 2)
Sector Index 2 FTSE Difference
1 Oil and Gas Total 19,54% 16,99% 2,55%
2 Pharmaceuticals Total 18,69% 15,71% 2,99%
3 Mining Total 11,78% 18,85% -7,07%
4 Food Total 8,95% 12,41% -3,47%
5 Telecommunications Total 5,89% 5,13% 0,76%
6 Media Total 4,88% 6,57% -1,69%
7 Household Products/Wares Total 4,57% 3,68% 0,89%
8 Commercial Services Total 3,21% 2,52% 0,68%
9 Retail Total 3,12% 2,51% 0,61%
10 Food Service Total 2,54% 2,85% -0,31%
Total 83,18% 87,23% -4,05%
The time series in Table 4.6 plots the total returns per quarter of the three indices from 2003 until
2014.Stellenbosch University http://scholar.sun.ac.za
22
Total Returns
0.250
0.150
0.050
‐0.050
‐0.150
FTSE 100 Index 1 Index 2
‐0.250
Figure 4.2: Total returns
The graph in Figure 4.2 demonstrates that the returns of the Index 1 and Index 2 move in the same
direction with that of the FTSE 100, but in different magnitudes. The results are mixed, where
sometimes the Shariah Indices outperform the FTSE100, and at times it underperforms. The
highest return for the index is 32.17% and the lowest is -17.33%.
Index 1 beats the FTSE100 by 45.65% while Index 2 beats the FTSE 100 50% of the time.
4.4. CALCULATIONS
Four periods were chosen to calculate the descriptive statistics as well as the risk-adjusted
measurements. The periods are as follows:
1. 2003 to 2014 – this refers to the entire period;
2. 2003 to 2007 – the pre-financial crisis;
3. 2007 to 2010 – the period of the financial crisis; and
4. 2010 to 2014 – the post-financial crisis period.Stellenbosch University http://scholar.sun.ac.za
23
4.5. DESCRIPTIVE STATISTICS
Table 4.7 below provides the descriptive statistic of annual returns for the indices from 2003 till
2012. This is followed by explanations dealing with each of the periods indicated.
Table 4.7: Descriptive statistics of annual returns for the indices (2003-2014)
Mean Median Maximum Minimum Std.Dev. Skewness Kurtosis
FTSE100 0.023 0.348 0.219 -0.129 0.143 -0.272 0.778
Index 1 0.020 0.398 0.183 -0.216 0.159 -0.763 1.236
Index 2 0.024 0.374 0.200 -0.173 0.143 -0.601 1.365
2003-2007
FTSE100 0.035 0.195 0.124 -0.070 0.087 -0.324 0.964
Index 1 0.034 0.174 0.110 -0.065 0.105 -0.172 -0.871
Index 2 0.028 0.170 0.106 -0.064 0.093 -0.202 -0.246
2008-2009
FTSE100 -0.084 0.116 -0.004 -0.120 0.092 0.669 3.763
Index 1 -0.079 0.265 0.050 -0.216 0.197 -0.360 0.336
Index 2 -0.043 0.223 0.070 -0.153 0.174 -0.017 -0.896
2009-2014
FTSE100 0.038 0.348 0.219 -0.129 0.156 -0.263 1.587
Index 1 0.030 0.344 0.183 -0.161 0.167 -0.565 0.902
Index 2 0.036 0.374 0.200 -0.173 0.163 -0.694 1.685
2003-2014
The mean annualised returns of the entire period are in close proximity. The mean return of Index
2 is the highest, followed by the FTSE100’s mean returns and Index 1’s returns which are the
lowest, Index 2 returns are 4.16% higher than the FTSE100’s returns and 16.67% higher than that
of Index 1. Both of the Shariah-compliant indices have higher maximum returns as well as lower
minimum returns than that of the FTSE100. The standard deviation between the FTSE100 and
Index 2 are the same, which is 10.06% lower than the standard deviation of Index 1.
2003-2007
The mean returns are similar between Index 1 and the FTSE100, with the FTSE100 having a
2.85% higher return. The FTSE100 return is higher than Index 2’s return by 20% and Index 1’s
return is higher than Index 2’s return by 17.65%. The median of the FTSE100 is the highest while
Index 1 comes in second and Index 2 has the lowest median. The same order is displayed for theStellenbosch University http://scholar.sun.ac.za
24
maximum, minimum returns. The standard deviation for Index 1 is the highest followed by Index 2,
and lastly the FTSE100, with the lowest standard deviation.
2008-2009
The mean return in this period is highest for Index 1, followed by Index 2 and then the Ftse100.
Index 2’s returns are 83.72% higher than Index 1 and 95.35% higher than the returns of the
FTSE100. The median returns are higher among Index 1 and Index 2, which are 56.23 % and
47.99% respectively, higher than the FTSE 100’s median returns. The maximum return for the
FTSE100 is in negative territory, which means that all returns in this period are negative. Index 1
and Index 2 have a 225% and 275% respective increase in maximum returns over the FTSE100.
Index 1 has a 40% lower maximum return than index 2. However, both indices have lower
minimum returns than the FTSE100. Index 1 has an 80% lower minimum return than the FTSE100
while Index 2 has a 27.5% lower minimum return than the FTSE100. The FTSE100’s returns have
the lowest standard deviation, followed by Index 2 and then by Index 1 that has the highest
standard deviation.
2009-2014
The FTSE has the highest mean returns during this period, followed by Index 2’s returns and lastly
by Index 1’s return that has the lowest mean return. The FTSE100’s mean return is higher by
21.05% than Index 1’s mean return, and 5.26% higher than Index 2’s mean return. Index 2 has the
highest median return followed closely by the Ftse100’s median return, and lastly by Index 1’s
median return. Index 2’s median return is 7.47% higher than the FTSE100’s median return, and
72% higher than that of the returns of Index 1. The FTSE100’s has the highest maximum and
minimum returns during this period. Index 2 has the second highest maximum return and Index 1
has the lowest maximum return during this period. Index 2 records the lowest minimum return in
this period which is a 34.1% lower than the FTSE100’s minimum return, and Index 1 has a 24.8%
lower minimum return than the FTSE100’s minimum return. The standard deviation is close
between the three, with the FTSE100 having the lowest standard deviation, followed by Index 2’s
standard deviation, and Index 1, having the highest standard deviation.Stellenbosch University http://scholar.sun.ac.za
25
Table 4.8: Risk-adjusted measurements using a three-month risk-free UK bond
and the market index is the FTSE100 (2003-2014)
Index β Rank Sharpe Rank Treynor Rank Jensen Rank
FTSE 100 1.000 3 0.617 2 0.088 2 0.000 -
Index 1 0.933 2 0.453 3 0.077 3 -0.010 2
Index 2 0.783 1 0.642 1 0.117 1 0.023 1
2003-2007
FTSE 100 1.000 3 1.548 1 0.135 2 0.000 -
Index 1 0.918 1 1.239 2 0.141 1 0.006 1
Index 2 0.829 2 1.157 3 0.129 3 -0.005 2
2008-2009
FTSE 100 1.000 3 -3.296 3 -0.305 3 0.000 -
Index 1 1.906 1 -1.464 2 -0.151 2 0.292 2
Index 2 1.676 2 -0.980 1 -0.102 1 0.340 1
2009-2014
FTSE 100 1.000 3 0.998 1 0.155 2 0.000 -
Index 1 0.992 1 0.706 3 0.119 3 -0.036 2
Index 2 0.886 2 0.903 2 0.166 1 0.009 1
2003-2014
Both of the Shariah-compliant indices have Beta scores lower than that of the market. Index 2 has
the highest Sharpe and Treynor ratio, followed by the FTSE 100 and then Index 1, with the lowest
Sharpe and Treynor readings. Index 2’s Sharpe ratio is 3.22% higher than the FTSE100’s Sharpe
ration, and 42.22% higher than Index 1’s Sharpe ratio. Index 2’s Treynor ratio is 101.13% higher
than the FTSE100’s Treynor ratio, and has a 129.87% higher Treynor ratio than Index 1. Index 1
has a negative Jensen’s Alpha reading, while Index 2 has a positive reading which is 330% higher
than that of Index 1’s Jensen’s Alpha reading.
2003-2007
Once again, the Shariah-compliant indices have a lower Beta than the FTSE100. Index 2’s Beta is
10.73% higher than Index 1’s Beta reading. The FTSE100 has the highest Sharpe reading during
this period, followed by Index 1’s Sharpe reading and then by Index 2’s Sharpe reading which has
the lowest Sharpe reading. The FTSE 100’s Sharpe reading is 25% higher than that of Index 1’s
Sharpe ratio and 33.62% higher than Index 2’s Sharpe ratio. Index 1 has the highest Treynor ratio,
followed by the FTSE 100’s Treynor ratio and last by Index 2’s Treynor ratio. Index 1’s ratio is
4.45% higher than the FTSE100’s Treynor ratio, and 9.30% higher than Index 2’s Treynor ratio.Stellenbosch University http://scholar.sun.ac.za
26
Index 1’s Jensen’s Alpha is positive and higher by 220% over Index 2’s Jensen’s Alpha, which is
negative.
2008-2009
The Betas of Index 1 and 2 are significantly higher than the FTSE100’s Beta. Index 1 has the
highest Beta and is higher by 90.6% over the FTSE100’s Beta and is 67.6% higher than Index 2’s
Beta. Both the Sharpe and Treynor readings are negative for the three indices during this period.
Index 2 has the highest Sharpe and Treynor Ratio, followed by Index 1 and then by the FTSE 100,
which has the lowest reading for both ratios. Index 2’s Sharpe ratio is 48.97% higher than Index 1’s
Sharpe ratio, and is 236.73% higher than the FTSE100’s Sharpe ratio. Index 2’s Treynor ratio is
48.03% higher than Index 1’s Treynor ratio and 199.01% higher than the FTSE100’s Treynor ratio.
Index 1 and 2’s Jensen’s Alpha’s are in positive territory, with Index 2 having a higher reading by
16.44%.
2010-2014
Index 1 and 2’s Beta is less than 1. Index 2 has the lower Beta of the two readings. The FTSE has
the highest Sharpe ratio, which is 11.11% higher than that of the Index 2’s Sharpe ratio, and
40.84% higher than Index 1’s Sharpe ratio. Index 2 has the highest Treynor ratio, which is 7.1%
higher than the FTSE 100’s Treynor ratio and 39.5% higher than Index 1’s Treynor ratio. The
Jensen’s Alpha is positive for Index 2, and negative for Index 1. Index 2’s Jensen’s Alpha is higher
than Index 1’s Jensen’s Alpha by 125%.
4.6. IDENTIFIED ISSUES
4.6.1. Consensus among scholars about what is and is not permissible
The different criteria that the various Shariah Supervisory Boards (SSB) use to assess the
compliance of equity screening are subjective. This is largely influenced by various interpretations
of the primary sources of Shariah Law. These differences in interpretations present a challenge to
the future large-scale, cross-border development of Islamic finance.
4.6.2. Non-permissible revenue cannot be separated
The companies represented in the FTSE100 consolidate their income streams in order to simplify
the appearance on their respective financial statements. This poses an issue because the exact
sources of income are difficult to separate, and as a result, income from non-compliant activities
cannot be filtered. Although some financial reports are more informative than others, none of the
financial statements provided a detailed breakdown of the sources of revenue. Although all stock is
subject to screening devices, a company can pass both the qualitative and quantitative screen, but
have income streams from non-compliant sources.Stellenbosch University http://scholar.sun.ac.za
27
4.6.3. Supply versus collaboration
While many companies’ activities revolve around activities that are non-compliant with Shariah law,
some companies’ activities are difficult to assess, as they either collaborate or supply non-
compliant companies. An example to illustrate this is the Compass Group (a provider of food
contract catering services). Compass receives a significant amount of revenue from supplying the
military. In this instance, the catering of food is regarded as compliant, however military operations
are non-compliant. This creates ambiguity to the inclusion of such firms into the Shariah-compliant
index.
4.6.4. Qualitative screen
Sector names are not sufficient in scanning for compliance. An example of this is the company
Marks and Spencer, although grouped under retail, they have a financial services footprint. On
deep scrutiny of their financial notes, it revealed that 7% of their revenue is derived from their
financial services offering.
4.7. DISCUSSION
This research investigated the performance of a Shariah-compliant index, carved from the FTSE
100, against the performance of the FTSE100.
Two Shariah-compliant indices were created and compared with the performance of the FTSE100
between 2003 and 2014.
270.00
250.00
230.00
210.00
190.00
170.00
150.00
130.00
110.00
90.00
2003/03/01
2003/09/01
2004/03/01
2004/09/01
2005/03/01
2005/09/01
2006/03/01
2006/09/01
2007/03/01
2007/09/01
2008/03/01
2008/09/01
2009/03/01
2009/09/01
2010/03/01
2010/09/01
2011/03/01
2011/09/01
2012/03/01
2012/09/01
2013/03/01
2013/09/01
2014/03/01
FTSE 100 Index 1 Index 2 Risk Free Rate
Figure 4.3: Cumulative returns of £100 invested on 1January 2003You can also read
