Shariah screening and corporate governance: The case of constituent stocks of Dow Jones US Indices

Abstract

Shariah screening discards the firms that belong to impermissible business sectors (or sin industries) and follow capital structure with high debt and current assets. This study tests whether the firms passing Shariah screening have better (or worse) governance quality as compared to firms not subjected to Islamic screening. The screened firms may have lesser governance quality as they cannot use debt to discipline managers or achieve optimal capital structure. On the contrary, they may be better governed as these firms get higher presence of institutional investors and better analyst coverage. This paper provides comparison of governance quality of Shariah compliant (SC) firms in United States by using proprietary dataset of Dow Jones US Indices. The screened firms offer ground for a natural experiment as they pass negative ethical screening and meet financial criteria for the inclusion in the index. The findings suggest that the SC firms have lesser governance quality than Shariah Non-Compliant firms. The lower level of governance can be attributed to lower Size, lower Profitability, higher Dividend Payout, higher Total Risk and lower Free Cash Flow. Various robustness tests are performed to validate the findings and the results remained robust. These findings provide useful insights about the governance mechanism of SC firms that are emerging as an important alternative investment class in the last two decades.