Islamic finance and environmental, social, and governance (ESG) investing are complementary in many ways and hold a number of shared principles. Though broader in nature, ESG strategies often exclude companies involved in such businesses as alcohol, tobacco and gambling that are considered Haram in the Muslim world. However, there are also fundamental Shariah compliance exclusions, such as conventional financial services and pork, that are not considered problematic in general ESG strategies.
This article will explore the similarities and differences of broad-based ESG and Islamic indexing through a real-world example of an innovative index that combines both frameworks — the S&P Global 1200 ESG Shariah Index. This index also allows us to examine the impact of applying ESG and Shariah screens on the general investment characteristics of the S&P Global 1200 — a conventional global equity benchmark.
Understanding ESG and Shariah screening criteria
Because Islamic and ESG investors seek to avoid companies involved in certain activities, it is necessary to apply various quantitative screens to identify and exclude companies violating specific ESG or Shariah compliance criteria. While these involve a number of overlapping themes, there are also some distinct areas that only fall in the Islamic or ESG space. Figure 1 provides a general overview of typical screens relevant for ESG and Islamic indices.
It is important to note that while many ESG indices apply all of the aforementioned criteria — including several published by S&P Dow Jones Indices — the S&P Global 1200 ESG Index takes a more inclusive approach, as it is designed to serve as a broad alternative to conventional global benchmarks. Given this, it does not exclude companies with involvement in alcohol, gambling or adult entertainment (these areas are often chosen for exclusion by investors for ethical reasons). Likewise, while an alternative framework provided under the Dow Jones Islamic Market Indices excludes companies that produce weapons, the S&P Shariah Indices do not exclude all companies involved in weapons production. The combined approach allows the exclusions to meet the needs of both ESG and Shariah requirements in a comprehensive way.
The S&P Global 1200 ESG Shariah Index — an overview
Introduced in August 2019, the S&P Global 1200 ESG Shariah Index is designed to be a measure of large-cap global equities meeting both ESG and Shariah standards. From a technical standpoint, the index is constructed by including members of the S&P Global 1200 ESG Index that pass rules-based screens for Shariah compliance as defined by the S&P Shariah Index Series. Figure 2 describes the index construction process.
Compositional impact of S&P DJI ESG and Shariah screens
As illustrated in Figure 3, the application of ESG and Shariah screens results in a narrowing of the index universe, but also an increase in ESG performance. As of the 30th September 2021, the S&P Global 1200 ESG Shariah Index included 299 companies, representing about 45% of the market cap of the benchmark S&P Global 1200. It is noteworthy that the Shariah screening resulted in a significantly greater portion of the exclusions by market cap and stock count than that caused by the ESG methodology.
As depicted in Figures 4 and 5, the S&P Global 1200 ESG Index has similar sector and country weights as the benchmark S&P Global 1200. However, the introduction of the Shariah screening results in a near elimination of the financials sector and significant overweighting to information technology in the S&P Global 1200 ESG Shariah Index. Because the information technology sector is overweight in the US market and the financials sector is relatively underweight, the S&P Global 1200 ESG Shariah Index also has meaningfully higher exposure to the US compared with the conventional S&P Global 1200.
By design, the S&P Global 1200 ESG Index maintains similar risk/return characteristics compared with the benchmark S&P Global 1200. However, because the Shariah screening introduces differences in sector and country exposures relative to the benchmark, the returns of the S&P Global 1200 ESG Shariah Index have been more differentiated. Over the past year, the S&P Global 1200 ESG Shariah Index underperformed primarily due to its underweight to financials. However, over longer time periods, the index outperformed due to its relatively high exposure to outperforming sectors such as information technology and healthcare. An overweight to the US also contributed to outperformance.
|Figure 6: Risk/return characteristics|
|Period||S&P Global 1200||S&P Global 1200 ESG Index||S&P Global 1200 Shariah Index||S&P Global 1200 ESG Shariah Index|
|Annualized returns (%)|
|Risk (standard deviation) (%)|
As the Islamic investment community increasingly seeks to integrate ESG considerations into the investment process, the need for indices that merge Shariah and broad-based ESG has developed. The S&P Global 1200 ESG Shariah Index aims to meet this need while serving as a unique dataset to examine the interconnections between Islamic finance and ESG.