Risk, Return, and Mean-Variance-Efficiency of Islamic and Non-Islamic Stocks

Abstract

This study finds that Islamic stocks are more mean-variance efficient than non-Islamic stocks and the market because they reduce risk for the same level of returns. I combine a unique Malaysian data-set that identifies individual Islamic stocks since 1997 with a new method where I apply Islamic business activity and financial ratio screens to the universe of Malaysian stocks. Both data-sets show that Islamic stocks have an annualized standard deviation that is on average 3.43-3.78 percentage points lower compared to non-Islamic stocks. This is due to financial ratio screens which dominate the results with 65.12% of firms excluded from the Islamic portfolio due to failure to comply with financial ratio screens, as opposed to 6.98% which fail both screens and 4.02% which fail business activity screens. While stocks that fail financial ratio screens have equal returns and higher standard deviation than Islamic stocks, stocks that fail business activity screens have higher returns and equal standard deviation to Islamic stocks. Therefore, the lower variance of Islamic stocks is exclusively driven by financial ratio screens. Results are robust to the choice of data-set, sample period and currency, to financial crises and to adjusting the data for outliers.