Dynamic co-integration and portfolio diversification of Islamic and conventional indices: Global evidence

Abstract

Abstract A major issue in both Islamic and conventional finance is the performance of their respective stock indices. Using the stochastic dominance (SD) analysis, we examine whether Islamic stock indices outperform the conventional indices over the period from 2002 to 2014. We also examine the behavior of both risk averters and risk seekers with regard to the preference for Islamic or conventional indices. Moreover, employing the VARMAX procedure and Johansen’s co-integration approach we analyze the long term association of indices (co-integration), efficiency of Islamic indices, the existence of diversification benefits and portfolio optimization opportunities. Our sample consists of 32 conventional and 32 Islamic stock indices from FTSE, DJ, MSCI, S&Ps and Jakarta series. To capture the impact of the subprime global financial crisis of 2007 on indices performance, we split the overall sample period into pre crisis (2002–2006), crisis (2007–2009), and post crisis (2010–2014) periods. Results show an absence of co-integration links over the long term between 31 pairs of Islamic and their respective conventional benchmark indices. This suggests that in the long-run most Islamic indices may offer a great diversification potential, for attracting global portfolios, which become critically more significant during distressed financial times. Results from the SD analysis reveal that conventional indices are first-order stochastically dominant during pre-crisis and the financial crisis periods. In the post crisis period no evidence of dominance orders is observed between the two types of indices. During the entire sample period almost all conventional indices give relatively higher monthly returns than Islamic indices at a distinct S-Shape second order stochastic dominance. Findings suggest that the risk-averse investors could increase their wealth and utility by switching from their current Islamic investments to the risky conventional indices to gain a “risk premium”. A clear incentive appears however, for risk seeker investors to optimally investing more in conventional indices in exchange for anticipated higher returns. However, the dominance of conventional indices over Islamic indices offers diversification opportunities for global investors who will hold both types of indices in one portfolio.