Investments into the Shariah space have often been regarded as being safer than in its conventional counterpart. NORIPAH KAMSO provides evidence to support this fact.
The term ‘black swans’ – popularized by Nassim Nicholas Taleb, a former Wall Street trader – is used to describe events that are unexpected, have an extreme impact and are rationalized in hindsight after their occurrence. In the past five years, the world has been affected by a number of black swan incidences that have played significant roles in shaping current financial markets.
In late 2006, the US experienced the subprime mortgage crisis and credit crunch, as mortgage defaults continued to surge, fuelled 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.
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 emirates defaulting on its quasi-sovereign debt obligations.
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.
Meanwhile, in the first quarter of 2011, the world witnessed a 9.0 magnitude earthquake that rocked the north-eastern part of Japan.
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’s unrest, which first erupted in Tunisia at the end of 2010 and later cascaded to other countries such as Bahrain, Egypt and Libya.
In the past five years, through some of the black swan incidences mentioned above,
Shariah investing has demonstrated resilience. After 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 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, i.e. 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 to the end of April 2011, the
Dow Jones Islamic Market (
DJIM) Index returned a cumulative price return of 62.09%, outperforming the
Dow Jones Global (W1DOW) Index, which returned 61.03% over the same period.
Through its financial screening methodology for permissible investments, the
Shariah investing approach establishes a more stable portfolio, favoring stocks which have lower leverage and deploy capital productively.
This can potentially reduce a portfolio’s level of volatility in comparison to that of a conventional investment portfolio.
In order 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 which tends towards the selection of stocks with financial qualities that can potentially better withstand macroeconomic financial turmoil.
Coupled with a greater transparency in
Shariah investing in which terms and conditions are clearly defined from the start, the
Shariah investment methodology is arguably a step ahead in risk management.
Some critics argue that Islamic indices benefit from the lack of exposure to the volatile financials sector, and as conventional markets stabilize and financials move towards recovery,
Shariah investing will lose its strength and the excess alpha 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, healthcare, 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 financials 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 in 2011.
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.
The comparative returns of Islamic and conventional indices shown below support our conviction that
Shariah investing is more resilient through black swan incidences. Comparing the relative performance over the last five years of the
DJIM, the
Dow Jones Islamic Market Europe (DJIEU) and the
Dow Jones Islamic Market Japan (DJIJP) indices to their respective conventional counterparts grants credibility, in our view, that the
Shariah investing approach can outperform conventional investing while maintaining a lower volatility.
Exhibit 1 and Exhibit 2 show that
DJIM Index outperformed the W1DOW Index, with a cumulative price return of 22.26% compared to 6.37% over the past five years. The
DJIM Index was also less volatile by 1.35% compared to the W1DOW Index over the same period, as shown in Exhibit 3.
Similar findings are observed in Europe, as shown in Exhibit 4 and Exhibit 5, with the DJIEU Index returning a higher cumulative performance of 12.43% compared with 0.08% by the
Dow Jones Europe Stock (E1DOW) Index over a five-year period. The DJIEU Index also fared better in terms of volatility, recording a slightly lower volatility of 2.10% than its conventional counterpart.
In Japan, the DJIJP Index also outperformed the
Dow Jones Japan Stock (JPDOW) Index by 11.4% over the last five years, as displayed in Exhibit 7 and Exhibit 8. Similarly, the DJIJP Index returned lower volatility by 0.43% over the JPDOW Index.
Referring to Exhibit 10, a closer examination between the DJIJP Index and the JPDOW Index during the Japanese earthquake crisis revealed that between the 10th and 28th March 2011, the DJIJP Index still returned a higher annualized cumulative return together with a lower annualized volatility by over 25.44% and 10.84% respectively. With about 17% of the JPDOW Index invested in the financial sector as opposed to a mere 0.05% in the DJIJ Index, it is not surprising that the DJIJ Index has outperformed the JPDOW Index during this period.
Conclusion
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.
While black swan incidences are inevitable, the real question is whether the global financial system has evolved to better withstand the impact.
The comparative analyzes 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 demonstrated that the
Shariah investing approach is a viable long-term alternative to conventional investment.
Noripah Kamso is the CEO of CIMB-Principal Islamic Asset Management and she can be contacted at
[email protected].