In 2014, we were the first Shariah compliant and the first asset management firm in Saudi Arabia to become a signatory of the UN Principles for Responsible Investment. We have integrated both methodologies and referred to the integration as Prudent Ethical Investing (PEI). Besides ethical considerations, PEI bridges Islamic and responsible investment approaches by stressing the importance of due diligence and transparency of investment structures, processes and reporting and thus relating to environmental, social and governance (ESG) integration and active ownership principles. We will discuss key elements and potential benefits of PEI in this article.
A commonality for Shariah compliant and socially responsible investment (SRI) approaches is the exclusion of activities considered unethical, so-called sin sectors such as, inter alia, tobacco, alcohol, gambling and defense sectors. A few years ago, academic research still considered sin-sector exclusions as a source for potential underperformance and limitation to the risk-adjusted returns of diversified portfolios (such as Adler and Kritzman (2008) or Fabozzi, Ma and Oliphant (2008)). While still supporting the initial paradigm, newer research such as Blitz and Swinkels (2021) suspects that a loss in expected returns from sin stocks might arise in the future. This could materialize if exclusion policies reach the scale needed to significantly raise the cost of capital of sin stocks. We believe that market developments in previous years support the notion of challenging the underperformance assumption or even indicate a turnaround. Anecdotal evidence supports the indication of sin stock underperformance, for example tobacco stocks relative to the broad stock market in the last five years. While ESG integration has recently overtaken exclusionary (also called negative) screening as the largest responsible investment approach, the overall size of the assets managed according to responsible investment criteria has substantially grown, reaching 35.9% of global assets under management in 2020 according to Global Sustainable Investment Alliance (2021).
A differentiating element of Islamic finance is the incorporation of balance sheet screening, such as, inter alia, leverage, cash, interest-bearing assets and receivables. A 2017 study published by Christian Gueckel, Chief Risk Officer of SEDCO Capital, showed that balance sheet ratios have been a reason for risk-adjusted outperformance of Shariah compliant portfolios driven by biases toward quality and growth factors. Furthermore, the exclusion of the financial sector and a resulting overweight of technology and healthcare stocks contributed to the outperformance of Islamic portfolios relative to the market.
The integration of ESG criteria as a differentiating element of SRI approaches, which was previously not part of Islamic finance approaches, is predicted to positively contribute to expected corporate financial and stock (risk-adjusted) performance. Many meta studies on the relationship of ESG and corporate financial and stock level performance show overwhelming evidence for positive contribution of ESG integration (for example, Whelan et al. (2021)). Evidence from our investment practice shows that the positive performance impact of ESG integration, particularly environmental and social considerations, has grown in recent years.
In conclusion, we see PEI as an evolution of both Islamic finance and SRI approaches, which share many similarities. Key elements such as sin-sector exclusions, balance sheet screening and ESG integration result in objective, measurable advantages for investors beyond preferences and investor beliefs.
Adler, Timothy, Mark Kritzman (2008), The cost of socially responsible investing, The Journal of Portfolio Management, Fall 2008, pp 52-56.
Blitz, David and Swinkels, Laurens (2021), Does Excluding Sin Stocks Cost Performance?, https://ssrn.com/abstract=3839065.
Fabozzi, Frank J., K.C. Ma, Becky J. Oliphant (2008), Sin stock returns, The Journal of Portfolio Management, Fall 2008, pp 82-94.
Global Sustainable Investment Alliance (2021), Global Sustainable Investment Review 2020, http://www.gsi-alliance.org/wp-content/uploads/2021/08/GSIR-20201.pdf.
Gueckel, Christian (2017), How Can Responsible Investors Benefit from Islamic Criteria?, https://ssrn.com/abstract=2918849.
Whelan et al. (2021), ESG and Financial Performance: Uncovering the Relationship by Aggregating Evidence from 1,000 Plus Studies Published between 2015–2020, https://www.stern.nyu.edu/sites/default/files/assets/documents/ESG%20Paper%20Aug%202021.pdf.