Islamic Mutual Funds’ Financial Performance and Investment Style: Evidence from 20 countries

1. Islamic Mutual Funds’ Financial Performance and Investment Style:Evidence from 20 countries Andreas G. F. Hoepnerab*,Hussain G. Rammalc & Michael Rezeca a School of Management, University of St. Andrews b Academic Fellow, United Nations Principles for Responsible Investment c International Graduate School of Business, University of South Australia *Presenting Author [Tables with the paper‘s statistical results are distributed before the presentation.]

2. Summary (1) • First sophisticated, large scale analysis of Islamic equity funds‘ financial performance and especially investment style • 262 funds from 20 countries for up to 20 years • Development of a “three level Carhart model“ to simultaneously control for national, regional or global equity market and investment style exposure • Modified versions to • allow for time varying factor exposure • Investigate performance during losing markets and crises

3. Summary (2) • Findings: • Western Islamic equity funds significantly underperform • Islamic equity funds seem to have a small cap preference given their restrictions on corporate revenues from haram activities • Islamic funds from the predominantly Muslim GCC countries and Malaysia neither significantly underperform nor have a clear small cap preference • This is theoretically intuitive given the more Shari‘ah compliant economies. • Some evidence that Islamic funds exhibit a hedging function, as their universe is limited to low debt/equity ratio firms

4. Background • Islamic Investment is a multibillion dollar industry with hundreds of funds and indices (Dow Jones, FTSE, MSCI, S&P) • Islamic Funds are defined by their Shari‘ah compliance • Shari‘ah law prohibits • Riba al Nasiah (receipt of interest on capital) • Prevents from bonds, warrants etc. • Maysir and Gharar (Gambling and uncertainty) • Prevents from leverage, short selling, derivatives • Haram (forbidden) products and services • Prevents from i.e. pork, (non-medical) alcohol or weapons • Contemporary Shari’ah scholars tend to allow investment in stocks with tolerable proportions of revenues from prohibited activities under the condition of Haram purifcation (donation of impure distributions to charity)

5. Theoretical perspective on Islamic funds‘ performance and style • Shari‘ah law • prevents a pure profit focus but might be good long term risk management • restricts market risk timing abilities, which, on average, do not generate value (e.g. Bollen & Busse, 2001) • Islamic funds are less resticted in economies more affected by Shari‘ah law due to a smaller degree of intolerable stocks • Shari‘ah compliance of products and services is likely financially more beneficial in economies with a higher degree of Muslim consumers • Islamic funds‘ investment style probably • exhibits under-proportional betas, • small cap exposures, as large, diversified companies more likely have intolerable proportions of revenues from prohibited activites

6. Previous research on Islamic funds‘ financial performance and investment style • “Next to nothing“ • On financial performance the benchmarks are • CAPM for 59 funds for 5 years (Kraeussl & Hayat, 2008) • CAPM for 14 Malaysian funds for 10 years (Abdullah et al., 2007) • On investment style, the reliable benchmark is • Investigation of size and value/growth exposure of 6 US funds over 5.7 years • Hence: We claim to pursue the first sophisticated, large scale analysis of Islamic equity funds‘ financial performance and investment style

7. Research Questions • Does the financial performance of Islamic equity mutual funds significantly differ from the respective equity market benchmark? • Which investment styles are preferred by Islamic equity mutual funds? • Is Islamic mutual funds’ performance differential to their respective market benchmarks significantly better in losing markets and especially in (financial) crises? • Do national differences exist in the answers to questions (1)-(3)?

8. Data • “Data shortage in Islamic equity fund studies“ • Survivorship bias adjusted sample of 262 Islamic equity funds from Eurekahedge starting with the launch for the first fund in 09/1990 and ending in 04/2009 • We construct equal weighted national portfolios • Descriptive Stats (in Table 1) show • Asia-Pacific, GCC and Europe to be leading regions • Malaysia, Saudi-Arabia and UK (inclusive overseas Islands) to be leading countries • Attrition rates in line with conventional funds • Very diverse geographic foci require special model • Carhart (1997) model variables from Style Research Limited based on Worldscope database • Risk free asset returns from Datastream

9. National financial performance and investment style • Carhart (1997) model • Our results (in Table 2) show: • Significant underperformance in 75% of cases • Half of the national portfolios to have a significant preference for small cap stocks • Effect much more pronounced for Western countries • A tendency to prefer growth over value stocks at national level • No tendency towards momentum or contrarian stocks

10. International financial performance and investment style • To control for diverse geographic foci, we develop a three level Carhart (1997) model using Elton et al.‘s (1993) orthogonalization approach: • Our results (in Table 3) show: • In nearly all cases a substantially higher Adj. R-squared • Interesting picture of national, regional and global exposure • Model eliminates nearly 50% of the significant underperformances • Only 8, mostly Western, national portfolios significantly underperform • All GCC portfolios and Malaysia perform comparable or better • Supports theoretical perspective on relevance of „Muslim economies“ • Small cap preference remains in contrast to growth stock preferences

11. Financial performance in losing markets and (financial) crisis • To address 3rd question, we add dummies to previous model: • Our results (in Table 4) show: • Some evidence of a hedging function of Islamic funds in losing markets • No evidence of a specific, additional crisis hedging function of Islamic funds [>]

12. Conclusion (1) • Islamic equity funds, on average, trail their benchmarks • Possible (complementing) explanations: • Shari‘ah law compliance • Active investment strategy  To be differentiated, once sufficient data becomes available • Islamic equity funds have small cap preference • Theoretically intuitive given limited tolerance to revenues from prohibited activities • The density of Muslim consumers in an economy appears positively related to Islamic funds‘ financial performance and large cap exposure • Explanations: A higher Shari‘ah compliance in an economy • mitigates the restrictions on Islamic funds • increases the probability that Shari‘ah compliance is financially beneficial for corporations

13. Conclusion (2) • Islamic funds appear to have a bit of a hedging function in losing markets but are no additional hedge in crises • The hedging function theoretically intuitive, as Islamic funds are restricted to invest in companies with a low debt/equity ratio • Our three level Carhart model and its extensions appear very useful in the analysis of geographically diverse investment strategies like Islamic funds • It might hence be valuable for other analyses of asset pricing or investment performance evaluation

14. Appendix Slide(s)

15. Robustness test • We extend our three level Carhart model to allow for time varying factor exposure in line with Ferson and Schadt (1996) and Cortez et al. (2009): • Our results (in Table 5) show: • Our results of Table 3 are robust to time variations in factor exposure, as only two alpha coefficients change their significance level in opposite directions in conditional model • Most Islamic fund managers do not seem to vary their exposure over time, • The few, which do, fail to generate alpha with it