Performance of Shari’ah based Investment: Evidence from Pakistani Listed Firms

Abstract

The investment universe of Shariah Compliant (SC) equities is relatively smaller compared to the investment universe of Non-Shari’ah Complaint (NSC) equities due to the imposition of Shari’ah specific filters. Therefore, under the diversification theory, it is argued that portfolios constructed by using SC equities are sub-optimal. To empirically test this notion, the main purpose of this study is to investigate that either the SC portfolios (faith bound investors) forego some part of returns or hedged against market risks while fulfilling their religious obligations. To test the foregoing, we imply simple asset pricing techniques which are in vogue in conventional finance. Firstly, we segregate the firms listed at Pakistan Stock Exchange (PSX) into SC and NSC stocks. Then, we form two portfolios within each group based on market capitalization and volatility. The purpose is to analyze and compare the performance of these two groups while controlling for firms related characteristics such as size and volatility. The data coverage is from January 2004 until June 2016. Our results indicate that in most of the cases the risk-adjusted returns (alphas) for the returns differential between SC and NCS firms are positive. This is mainly because the SC firms in comparison to their counterparts in PSX, provides excess returns that are hedged against market, size and value based systematic risks factors. Overall, these results reconcile with one prevailing notion that the SC stocks that have lower financial leverage and higher investment in real assets are lesser exposed to market risks. Further, the SC firms that are more capitalized and lesser volatile, perform better than lower capitalized and higher volatile SC and NSC firms. To sum up our results, we do not find any substantial evidence for opportunity loss due to limited diversification opportunities in case of SC firms. This paper highlights that Islamic funds have potential to fulfill the demands of risk averse investors who are also faith bound.