CHAPTER 8
Using Performance Characteristics to Build Wealth
Empirical Evidence, Proven and Tested
Learn a lesson, O ye who have eyes!
(Al Hashr: 2)9
INTRODUCTION
Some critics argue that in the years from 2006 to 2011, Islamic indices benefited from the lack of exposure to the financial sector, which has been in distress.1 As the economy recovers, financial stocks typically outperform, as they are representative of the recovering economy. Therefore, critics believe that Islamic indices will underperform conventional indices. Having gone through a full market cycle and examined the impact of different sectors on both conventional and Islamic index performances, it turns out that this is not the case. Whether it’s a bull market or bear market, as long as the recovery is driven by economic fundamentals, Shariah investing will still exhibit resilient performance. This chapter will detail the performance characteristics of Shariah investing through both bull and bear markets starting from the peak of 2005, before the U.S. mortgage crisis.
During this period there were many significant market shocks that provided an opportunity for Islamic indices to exhibit their claimed resilience. In theory, this resilience is based on the risk robustness of the equity screening process, which forms a key part of the investment process. Indeed, the screening process is the main difference between the Shariah and conventional investment process.
The actual Islamic indices’ performance characteristics show the ability to be resilient over this period, especially in bear markets.2 They are supported by the built-in quantitative risk management through the Shariah financial screening at the portfolio level itself. In this chapter we will analyze briefly the performance characteristics of Islamic Global, European, and Japanese equity indices as an outcome from the volatility of the markets from 2006 to 2012.
THE IMPACT OF BLACK SWAN EVENTS
The term black swan was popularized by Nassim Nicholas Taleb, a former Wall Street trader, in his book The Black Swan: The Impact of the Highly Improbable. It is used to describe events that are unexpected, have an extreme impact, and are rationalized in hindsight after their occurrence.3 From 2006 to 2011, a number of black swan incidences played a significant role in shaping financial markets.
In late 2006, the United States experienced the subprime mortgage crisis and credit crunch, as mortgage defaults continued to surge, fueled by inflationary fears and rising mortgage rates. This inevitably stoked fear among global investors and eventually saw a rise in crude oil prices in 2007, which peaked in mid-2008 when the global financial crisis was triggered.4 As the world recovered from its worst financial crisis since the Great Depression, another credit crisis unfolded in Dubai in late 2009 as fears loomed over the prospect of the Emirate defaulting on its quasi-sovereign debt obligations.5 Another debt crisis soon took center stage in Europe in 2010 in the aftermath of the global financial crisis, as several countries struggled to repay government debt, forcing bailouts and aid packages for Greece, Ireland, Iceland, and Portugal.
The first quarter of 2011 witnessed a 9.0 magnitude earthquake that rocked the northeastern part of Japan.6 The earthquake gave rise to a tsunami that swept through the coastal areas in Fukushima Prefecture, killing thousands and causing explosions at its nuclear plants, placing the nation and the world at the risk of nuclear radiation. This unfortunate incident came after the Middle East and North Africa unrest, which first erupted in Tunisia at the end of 2010 and cascaded to other countries such as Bahrain, Egypt, and Libya.
From 2006 to 2011, through some of the black swan incidences just mentioned, Shariah investing demonstrated resilience. Stemming from the global financial crisis in 2008, many have called for banking regulatory reforms. The need for regulatory upheaval was louder than ever, with calls for stricter banking capital requirements, standardized frameworks, and greater involvement from regulators. Such restructuring efforts would aim to establish a more prudent risk management system to prevent future financial instability leading to another financial crisis. This essentially marks a movement into the Shariah space—that is, the shifting of the free market to the fair market.
WHY SHARIAH INVESTING IS RESILIENT
The toughest time to manage portfolios is during a down-trending market. During volatile periods, Islamic indices have shown resilience by producing both higher returns and lower volatility compared to their conventional index counterparts. Even in the subsequent up-trending market starting from the end of April 2009 until the end of April 2011, the Dow Jones Islamic Market World (DJIM) Index returned a cumulative price return of 62.09 percent, outperforming the Dow Jones Global Index (W1DOW), which returned 61.03 percent for the same period.7 Through its financial screening methodology for permissible investments, the Shariah investing approach establishes a more stable portfolio, favoring stocks that have lower leverage and are deploying capital productively. This can potentially reduce a portfolio’s level of volatility in comparison to that of a conventional investment portfolio.
To be considered Shariah compliant, stocks must pass a rigorous screening process to evaluate the underlying entity’s ability to meet both its short-term and long-term obligations. Embedded in this meticulous process is a risk management facet that tends toward the selection of stocks with financial qualities that can potentially better withstand macroeconomic financial turmoil. Coupled with its greater transparency in which terms and conditions are clearly defined from the start, the Shariah investment methodology is arguably already a step ahead in risk management.
Some critics argue that Islamic indices benefit from the lack of exposure to the volatile financial sector and that as conventional markets stabilize and financials move toward recovery, Shariah investing will lose its strength and the outperformance built up by Shariah indices over the duration of the 2008 financial crisis will begin to give way. However, as long as economic recovery is primarily driven by fundamentals, Islamic indices should still hold their own against conventional indices due to their exclusion of highly leveraged and indebted stocks. Higher weightings in the basic materials, energy, health care, telecommunications, technology, and industrial sectors are expected to contribute to the strength of the Shariah investing approach, as opposed to a conventional investment portfolio, which typically has higher weightings in the financial sector.
Islamic indices could be expected to keep pace and potentially outperform conventional indices should fundamentally strong and good-quality stocks lead the economic recovery, as shown in 2012. While Shariah-compliant investments do not promise a complete immunity against future black swans, they are a viable alternative and certainly offer lower volatility than some of their conventional counterparts over the long term.
The comparative returns of Islamic and conventional indices shown in this section appear to bear out the conviction that Shariah investing is more resilient through black swan incidences. Comparing the relative performance from 2008 to 2012 of the Dow Jones Islamic Market World (DJIM), Dow Jones Islamic Market Europe (DJIEU), and the Dow Jones Islamic Market Japan (DJIJP) indices to their respective conventional counterpart grants credibility that the Shariah investing approach can outperform conventional investing while maintaining a lower or similar volatility.
Global Market Index
Figure 8.1 and Table 8.1 show that Dow Jones Islamic Market World Index outperformed the Dow Jones Global Index, with a cumulative price return of 3.83 percent compared to –6.08 percent over this period. Also if we factor in volatility, it has been observed from past years that Dow Jones Islamic and conventional markets move in a similar volatility pattern, proving better risk-adjusted returns for the Dow Jones Islamic Market World Index.
Table 8.1 Five-Year Cumulative Performance for Global Indices
| DJ Islamic Market World | DJ Global | Difference |
| 3.83% | –6.08% | 9.91% |
| Source: Bloomberg, December 31, 2012 | ||
Europe Market
Similar findings are observed in Europe, as shown in Figure 8.2 and Table 8.2, with the Dow Jones Islamic Market Europe Index returning a higher cumulative performance of –8.26 percent compared with –21.80 percent by the Dow Jones Europe Index (E1DOW) in this period. In terms of volatility, the conventional index in Europe might be expected to have a higher volatility due to the recent European debt crisis. As of December 31, 2012, the conventional Europe index held 20.71 percent in the financial sectors as opposed to the Islamic Market Europe Index, which was at 0.11 percent.8 Islamic indices by nature of debt screening are less leveraged than their conventional counterparts.
Table 8.2 Five-Year Cumulative Performance for Europe Indices
| DJ Islamic Market Europe | DJ Europe | Difference |
| –8.26% | –21.08% | 13.54% |
| Source: Bloomberg, December 31, 2012. | ||
Japan Market
In Japan, the Dow Jones Islamic Market Japan Index also outperformed the Dow Jones Japan Index (JPDOW) by 6.77 percent over this period, as displayed in Figure 8.3 and Table 8.3. Volatility at times might deviate, but usually the indices move in parallel to each other, proving Japan Islamic market’s better risk-adjusted performance characteristics.
Table 8.3 Five-Year Cumulative Performance for Japan Indices
| DJ Islamic Market Japan | DJ Japan | Difference |
| –13.20% | –19.97% | 6.77% |
| Source: Bloomberg, December 31, 2012 | ||
Referring to Figure 8.4, a closer examination between the Dow Jones Islamic Market Japan Index and the Dow Jones Japan Index during the Japanese earthquake crisis revealed that between March 10 and 28, 2011, the Dow Jones Islamic Market Japan Index still returned a higher annualized cumulative return.
Figure 8.4 Cumulative price returns during Japan earthquake crisis
Source: Bloomberg, December 31, 2012
Therefore, the question arises: Will Shariah investing continue to be more resilient, should another black swan incidence occur? It is arguable that the Shariah-compliant investment screening process has resulted in investment portfolios that have proved to be more resilient over the last five years. Companies with a stronger financial position and limited financial risk exposure in a financial crisis will be in a better position to take advantage of the improving economy and to better weather any adverse financial impact should another black swan incidence take place. Although black swan incidences are inevitable, the real question is whether the global financial system has evolved to better withstand the impact.
The comparative analyses between Islamic and conventional indices tend to show that the Shariah investing approach results in a higher cumulative performance coupled with lower volatility, not only during an economic downturn but also, potentially, during economic recovery. Its resilience through recent black swan incidences and its continued momentum through the economic recovery demonstrate that the Shariah investing approach is a viable long-term alternative to conventional investment.
CONCLUSION
The performance characteristics of these three indices prove the basic premise that Shariah investing delivers similar investment performance over the long term. Therefore, all investors, Muslim or not, can benefit from Shariah investing’s resilience and greater stability of returns, as exhibited through the volatile market years of 2006 to 2011.
Further value can be delivered with a disciplined investment process to further optimize investment performance. Similar to the conventional investment process, the investment manager can optimize a portfolio by anticipating market trends and constructing a portfolio from the available investment universe to deliver certain performance characteristics, which could be based on stock picks, sector weightings, or both. This is then applied across different investment capabilities such as global, Asia Pacific ex-Japan, and ASEAN.
The inherent benefits derived from the Shariah screening process, coupled with a disciplined investment process at the portfolio level, can yield sustainable investment return over the longer term.
NOTES
1. “Crisis-hit Islamic Funds Set for Recovery,” IslamicFinance.de (October 1, 2010). www.islamicfinance.de/?q=node/1261.
2. “Resilience during Economic Crisis Shown by Islamic Banks,” Global Islamic Finance Magazine. www.globalislamicfinancemagazine.com/index.php?com=news_list&nid=1024.
3. “Black Swan,” Investopedia. www.investopedia.com/terms/b/blackswan.asp.
4. Shafey Danish, “US Economy and Rise in Oil Prices,” Zeenews.com. http://zeenews.india.com/WorldOilCrisis/story.aspx?aid=451877.
5. Nouriel Roubini, “Lesson from Dubai World,” Forbes (December 3, 2009). www.forbes.com/2009/12/02/dubai-world-debt-default-opinions-columnists-nouriel-roubini.html.
6. Tony Hake, “Japan Earthquake Upgraded to Magnitude 9.0; Now Fourth Largest Since 1900,” Examiner (March 14, 2011). www.examiner.com/article/japan-earthquake-upgraded-to-magnitude-9-0-now-fourth-largest-since-1900.
7. Bloomberg, LP, “Comparison Between DJIM vs W1DOW,” April 30, 2009–April 30, 2011.
8. S&P Dow Jones, “Dow Jones Islamic MarketTM Europe Index Factsheet,” December 31, 2012.
9. The verse is a command to use the eyes (the intellect) to consider things and compare them. In the present context it means moving one’s thoughts between things in an effort to compare them. Therefore it is wise to look at the financial crisis and benefit from it by taking lessons for future business direction and decision.
General Reading
Associates of Merill Lynch and Capgemini, Wealth: How the World’s High Net Worth Grow, Sustain, and Manage Their Fortunes. Hoboken, NJ: John Wiley & Sons, 2008.
Jaffer, Kamar, and Sohail Jaffer. Investing in the GCC Markets: New Opportunities in a Changing Landscape CPI Financial, 2007.
Jaffer, Sohail. Islamic Wealth Management: A Catalyst for Global Change and Innovation. Euromoney Books, 2009.