Abstract
Shariah-compliant investment guidelines, while explicit on screening criteria for stock selection, are silent on the weighting methods to be used in the construction of Shariah-compliant equity portfolios. The market capitalization-weighted strategy and smart beta strategies (fundamental value-weighted, equal-weighted, and low-risk weighted strategies) exhibit different risk and return characteristics. This paper investigates whether the choice of weighting strategy affects the performance of Shariah-compliant equity portfolios under different market conditions. The sample consists of active constituent data from S&P 500 for the period 1986-2016. By utilizing the Markov-regime switching model, it is possible to categorize market returns into two regimes — high regimes for bullish market conditions and low regimes for bearish market conditions. The empirical results indicate a significant difference between the performances of Shariah-compliant equity portfolios in high and low regimes following different weighting strategies. The evidence suggests that market capitalization and fundamental value-weighted strategies perform better during market rallies. On the other hand, a low-risk strategy can be used as a hedge during periods of maximum drawdown and is associated with relatively lower value-at-risk and expected shortfalls as compared to alternative strategies.
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