Portfolio Decisions for Faith-Based Investors

The Case of Shariah-Compliant and Ethical Equities

Zaheer Anwer

• Editorial: De Gruyter
• Año: 2021
• ISBN:
  9783110612745
• Edición: 1
• Categoría: Negocios y empresa
• Categoría: Finanzas

This book examines the idiosyncratic risk, risk-return trade off and payout decisions for faith-based investors including Islamic Shariah compliant and ethical investors, who may be paying a cost for their belief system in the form of under-diversification of portfolios and additional monitoring costs owing to their unique risk profile.

There is a growing number of investors who are motivated by social, environmental, and ethical considerations in their investment decisions. They apply a set of investment screens to include or exclude assets based on ecological, social, corporate governance or ethical criteria. This socially responsible investment (SRI), ethical investment or sustainable investment style is prevalent since religious or ethical values matter to investors even if the risk-adjusted returns are lower than those of conventional investments. The author addresses these issues for Islamic and socially responsible portfolios in detail by using proprietary data of Dow Jones Indices from the United States. The findings are a unique and valuable addition to the existing corporate finance, portfolio management and Islamic finance literature.

1 Why Faith-Based Investing?

Investment decisions are not only governed by factors like investors’ anticipation of future economic, geo-political and social changes, risk aversion, investment alternatives as well as preference regarding the timing of consumption¹[a] but also religion or belief system. In recent years, a notable increase in this kind of investment decision making is observed and it has become a class of investments in its own right and plays an important role in selection of portfolios²[a]^–4[a]. The religiosity and/or ethical practices prompt investors to discard so-called sin stocks and limit their investment horizons to permissible investment alternatives. This kind of faith-based investing (both the Shariah compliant and social responsible) can be divided in two branches namely Islamic finance and socially responsible investing (SRI). Islamic finance is an example of such a belief system that is governed by Islamic Shariah rules. For the Shariah-screened portfolios, the selection of class of assets and the securities in each selected class is subjected to Shariah requirements. Islamic law prohibits charging interest on loans, gambling and trade of impermissible items like liquor, pork, pornography etc. and also imposes restrictions on capital structure of the business entity⁵[a]. The history of SRI or ethical investing is much older and dates back to the start of twentieth century⁶[a]. The ethical investors are motivated by social, environmental, and ethical considerations in their investment decisions. They apply a set of investment screens to include or exclude assets based on ecological, social, corporate governance or ethical criteria⁷[a]. The growing importance of faith-based investments can be judged by mammoth increase in the overall industry size. Islamic finance industry has observed a double digit compound annual growth rate (CAGR) of 17% between 2009 and 2013 and the size of industry is still expanding both in terms of numbers and geographical locations⁸[a]. In the similar manner, the volume of assets acquired through socially responsible investing strategies stood at 8.72 Trillion USD in 2016 and the number is expected to further increase in coming years⁹[a]. There is potential for further growth for this faith-based investments since religious or ethical values are becoming a matter of concern to most investors even if they have to earn lower risk-adjusted returns compared to returns on conventional investments with similar risk⁷[b].

Several factors can be held responsible for the proliferation of these investment styles. To begin with, Bollen¹⁰[a] points out the presence of a multi-attribute utility function for faith-based investors that is not only dependent on the standard risk-reward optimization paradigm but also takes into account a set of personal and societal values. In addition, another likely reason for growth in faith-based investment styles is the recent reporting of accounting and environmental scandals in business ethics literature¹¹[a]. Therefore, this kind of investment serves dual purpose by combining financial goals of investors with their moral and social concerns¹²[a]. Moreover, the growth drivers of Islamic finance, over the last few decades, are oil money, growing Muslim population and increased awareness about investing and financing based on Shariah requirements¹³[a].

In order to make the investment compliant to the principles of faith-based investing, the investment managers and index providers employ qualitative and quantitative filters so as to screen the investment universe and discard the stocks that do not meet the prescribed criteria. Ethical screening procedure is twofold: it excludes investment in industries like tobacco, alcohol, gambling, weapons, pornography, abortion, workforce exploitation, activities not friendly to environment, human rights violations and genetic engineering whereas it promotes investments in industries with better labour protection, environment friendliness, corporate governance, human rights, biotechnology and shareholder activism⁷[c]. Various mutual funds and equity indices follow these screen methodologies to formulate their so called socially responsible portfolios. To perform Islamic Screening, Dow Jones and other vendors employ two criteria namely ‘line-of-business screens’ and ‘financial ratio screens’ while deciding investment universe¹⁴[a]. These screens are subsequently used to constitute various Shariah indices. These Shariah screening results are endorsed by a board of highly renowned independent Shariah scholars. The first criterion is qualitative and stipulates exclusion of impermissible businesses like interest (riba), pork, activities involving extreme risk taking (gharar), gambling (maysir), weapons and defense, pornography etc. The second filter excludes the companies having 1) revenues in excess of 5% from the impermissible business activities 2) total debt and/or monetary assets accounting for 33% or more of market capitalization (24-month average) 3) account receivable more than 33% of their total assets/market value of equity (24-month average) and 4) cash to market value of equity (24-month average) higher than 33%.

This screening can affect portfolio formation in multiple ways that, in turn, influences the risk-return profile as well as dividend policy decisions of the firms:

To begin with, due to qualitative and quantitative screening, the investment universe for these two special classes of investors is restricted limiting the fund managers’ ability to exploit superior information as well as an opportunity to invest in winning markets¹⁵[a] and consequently may constrain on diversification opportunities that will lead to the persistent presence of idiosyncratic risk in these portfolios. It should be noted, however, there is evidence of unsystematic risk even in well diversified portfolios¹⁶[a]^–18[a]. To explain this issue, Merton¹⁹[a] presents investor recognition hypothesis that states that since it is costly for investors to obtain information regarding all the securities in the market, they construct their portfolios from securities on which they have information and are familiar. As they hold under-diversified portfolios, they require compensation for idiosyncratic risk of the securities. Faith based investors face similar situation and need to acquire the information regarding the permissible securities. Consequently, their portfolios may also be under-diversified due to at least two reasons: they are unable to bear this information cost required for search adequate number of acceptable securities or even when they can spend on information acquisition, the securities within available universe are insufficient to achieve the desired portfolio diversification. Still, there are possibilities that even after screening, the portfolio is well diversified and the level of idiosyncratic risk is not different from the market. Finally, although market portfolio is believed to be devoid of idiosyncratic risk, the evidence postulates that this can only be the case in frictionless markets and since, in reality, markets are not frictionless, even market portfolios possess idiosyncratic risk^18,[b]²⁰[a]. Evidently, present evidence on under-diversification issue for faith based portfolios is inconclusive and there is no firm conclusion on the presence of idiosyncratic risk in screened portfolios as well as market portfolio. It is therefore worthwhile to ascertain whether faith based and socially responsible portfolios are different from market portfolios in terms of idiosyncratic risk. At present, there is no documented evidence and this study addresses the gap on this issue.

Moving Further, possible under-diversification and presence of idiosyncratic risk could affect the relative performance of these investments. There can be various possible theoretical arguments favouring this proposition:

Firstly, the universe of stocks selection of faith based portfolios is restricted and there is a possibility that investors forgo many attractive investment opportunities due to religious or ethical restrictions. In a CAPM world, these investors are at a disadvantage owing to the fact that they cannot optimally diversify their portfolios due to restriction on certain business activities and the high correlation within the permissible stocks²¹[a]. They also need to bear cost for searching and monitoring securities that could negatively affect their returns²²[a]. There is inconclusive evidence of performance of these portfolios and studies like Cortez, Silva²³[a], Saeed and Hassan²⁴[a], and Lean, Ang²⁵[a] show that holders of faith based portfolios are not at disadvantage, whereas Al-Khazali, Lean²⁶[a], Kamil, Alhabshi²⁷[a], Merdad, Kabir Hassan²⁸[a] and Boo, Ee²⁹[a] documented that these portfolios underperform the benchmark. An important reason of this underperformance is lack of diversification opportunities for such investors^30,[a]³¹[a].

Secondly, in addition to under-diversification possibly due to negative screening, the outcomes of financial screening may also influence the performance of Shariah compliant firms³²[a] in the following ways:

1. The first ratio i.e. Debt/Market Equity ratio has a significant impact on stock returns for any firm. This ratio represents a firm’s financial structure and a high debt to equity ratio implies that the firm uses debt financing assertively. Since debt is a cheaper source of capital, the high debt firms can start more value enhancing projects as compared to the firms with low debt. On the other hand, higher debt ratio increases the financial risk and the returns are more volatile for the highly leveraged firm. Therefore, the final impact of screening, made upon the basis of debt/equity ratio, on firm’s performance and volatility remain ambiguous.
2. The second ratio i.e. Receivables/Market Equity reveals the proportion of firms’ receivables with respect to its market value. The receivables are instrumental in shaping a firm’s capability to develop long-term relationship with its clients and build strong business networks. The high value of account receivables indicates that the firm has effective sales network and loyal customers and the firms having high receivables may have sustainable sales network. However, the high amount of receivables can also be alarming if a significant portion comprises of toxic assets. Therefore, the final impact of this ratio on the firm’s performance and risk is also vague.
3. The third financial ratio i.e. Cash/Market Equity is related to the amount of cash and marketable securities available to the firm. If the amount of this asset is low, it indicates that the firm is unable to start positive net present value projects owing to its inability to make large capital expenditures. This lack of investable funds has long term implications for the future performance. However, the firms having high amount of cash are inflicted by severe agency problem owing to opportunistic behaviour of managers^33,[a]³⁴[a]. Therefore, the firms with high cash may underperform in the long run. Hence, the impact of the third ratio on firm performance is also inconclusive.

Thirdly, another strand of lit...