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Journal of Banking & Finance 33 (2009) 1166–1176

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Journal of Banking & Finance


journal homepage: www.elsevier.com/locate/jbf

New strategies and a new paradigm for Shariah-compliant portfolio optimization


Ulrich Derigs*, Shehab Marzban
University of Cologne, Department of Information Systems and Operations Research, Pohligstrasse 1, Cologne, Germany

a r t i c l e i n f o a b s t r a c t

Article history: In this paper we analyze the effects of different strategies to construct Shariah compatible financial port-
Received 24 April 2008 folios. The difference between conventional and current Shariah portfolio management is the application
Accepted 21 December 2008 of sector screens and financial screens by which the asset universe is reduced. Yet, here different schools
Available online 1 January 2009
of scholars define different screening rules leading to significant differences with respect to compliance,
but also with respect to performance. After analyzing this discrepancy we propose several new strategies
JEL classification: to apply the inconsistent rule systems and a new paradigm for defining Shariah-compliance. Under this
C61
new paradigm compliance is attributed to the portfolio and not to the individual assets of the universe.
G11
G15
We report results of an empirical study analyzing the potentials of these strategies and of the paradigm.
We can show that under the proposed concepts Shariah-compliant portfolios can be realized which have
Keywords: return and risk profiles comparable to the conventional non-constrained portfolios.
Shariah guidelines Ó 2008 Elsevier B.V. All rights reserved.
Islamic funds
Portfolio models
Empirical analysis

1. Introduction called Shariah-compliance strategies to be followed within asset


selection. Here a compliance strategy is simply a set of computable
The increasing capital value of the Muslim population and the or executable rules by which non-compliant assets are identified.
demand of these investors to invest their capital in financial prod- Derigs and Marzban (2008) have shown that different opinions
ucts that do not conflict with the Shariah triggered the develop- and inconsistencies exist among the Shariah scholars and their
ment of Shariah-compliant investment products such as Islamic compliance strategies. These can mainly be attributed to the differ-
equity funds. Due to the fact that Shariah prohibits the involve- ent Shariah perceptions of the scholars and to the ‘‘complexity of
ment in interest-based assets such as conventional bonds, specula- transforming the historical and verbal Shariah sources into quanti-
tive investments such as derivatives and specific prohibited fiable and formal guidelines to be used within a modern guideline
industries such as the armaments industry (Wilson, 2004), specific evaluation and portfolio management system” (Derigs and Marz-
guidelines need to be introduced as additional constraints into ban, 2008). The area of Shariah Finance is a specific instance of a
(optimization) models for constructing Shariah-compliant broader appearance, the so called socially responsible investments
portfolios. (SRI) which have been discussed in the finance literature only re-
These guidelines stem from the main Shariah sources Quran, cently (Renneboog et al., 2008; Galema et al., 2008).
Hadith and Ijtihad. The Quran is the primary source of Islam In this paper we introduce several new approaches to motivate
including the words of God as delivered to the prophet Mohammed and initiate a discussion on developing concepts for defining differ-
whereas the Hadith consists of narrative records of the actions and ent levels of compliance and standardization of interpretation. In
sayings of the prophet himself. The third Shariah source Ijtihad is Section 2 we first describe a set of new strategies for Shariah-com-
the derivation and formulation of Shariah laws or guidelines by pliant asset selection. While so far all strategies consider compli-
qualified scholars to deduct further knowledge from the Quran ance as an attribute of single assets, we then propose to consider
and Hadith. Since there is no higher institution responsible for reli- compliance as an attribute of the portfolio leading to what could
gious opinions to be followed by all Muslims, experienced Shariah be called a new ‘‘paradigm” in Shariah portfolio theory and prac-
scholars (DeLorenzo, 2000) interpret these sources and specify so tice. This new paradigm can be combined with the different Shari-
ah-compliance strategies and offers several new compliance
options. In Section 3 the proposed strategies and the new paradigm
* Corresponding author. Tel.: +49 221 4705328; fax: +49 221 4705329.
are formalized leading to a set of different portfolio optimization
E-mail addresses: ulrich.derigs@uni-koeln.de (U. Derigs), smarzban@
idealratings.com (S. Marzban). models which are all practical in the sense that they are comput-

0378-4266/$ - see front matter Ó 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankfin.2008.12.011
U. Derigs, S. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 1167

able. The effect of the proposed strategies and paradigms on com- mic Fund (ANON). As reference asset universe we have chosen the
pliance consistency and on portfolio performance (return and risk) Standard and Poor’s 500 index constituents of the 17th of Septem-
will then be empirically investigated and interpreted in Section 4. ber 2007.
The alternative strategies and the new paradigm proposed in Fig. 1 gives an overview of the sizes of the asset universes after
this paper are justified and formulated based on Shariah practices applying these basic Shariah strategies individually as well as the
and reasoning. The practicability and effectiveness is demonstrated variation in classification. Variation or what we will refer to as
in the paper, yet, the decision regarding their Shariah-compliance ‘‘compliance inconsistency” is measured by the percentage of as-
and practical use needs to be checked and decided upon by Shariah sets which are differently classified between two compliance strat-
scholars. egies (i.e. one strategy considers the asset to be compliant and the
other considers it as non-compliant).
2. New Shariah-compliance approaches One reason for these variations can be attributed to the type
and semantic of the financial ratios used within the Shariah guide-
Generally, Shariah-compliance strategies are based on two lines. While S&P and DJIM use average market capitalization as
types or sets of guidelines: sector guidelines and financial guide- divisor for their financial ratios the other Shariah strategies use to-
lines (Nisar and Khatkhatay, 2006). Shariah clearly defines activi- tal assets as divisor.
ties in which Muslims may not be involved in such as the Motivated by these findings on inconsistencies in current
consumption of alcohol and pork and activities related to gam- compliance strategies, we propose and describe in the next sec-
bling. Consequently, Muslims are not allowed to invest in assets tion four new Shariah-compliance strategies which establish a
from businesses earning primarily from such activities such as system of different levels of compliance and on the other hand
alcohol producers, casinos or even partially as for instance many contribute to a standardization and integration of different basic
hotels due to their income from bars and clubs. Now, sector guide- strategies.
lines are conservative prescriptions through which companies
operating in non Shariah-compliant business activities are 2.1. New Shariah-compliance strategies
excluded.
Financial guidelines on the other hand are used to analyze how Conventionally Islamic investment trusts use a specific Shariah-
deeply companies are involved in financial practices not compliant compliance strategy to define a compliant asset universe. Such a
with Shariah. For that purpose Shariah scholars define threshold ‘‘basic” Shariah-compliance strategy is either defined by an in-
levels for specific indicators/financial ratios through which the de- house Shariah board supervising the trust or the trust subscribes
gree of compliance is measured. If the company that issued the as- to the service of an externally-supervised Islamic index such as
set is involved in financial practices exceeding the respective the S&P Islamic Index. As we have seen in Fig. 1 these basic com-
threshold, the asset is classified as non-compliant and as with pliance strategies if compared to each other are characterized by
the sector guidelines has to be excluded from further investment high inconsistencies in the size of asset universe as well as in the
consideration. Generally, the use of such guidelines is a relaxation constituents considered to be compliant.
of the conservative Shariah rules and a tribute paid to the complex- The Shariah scholars who supervise the different Islamic funds
ity and the generally non-islamic nature of the current capital mar- and index providers and who defined the different Shariah strate-
kets. In order to claim Shariah-compliance, return obtained from gies can be considered as being the major and most qualified Sha-
portfolios constructed under these relaxations has to be cleansed riah scholars. Thus, the inconsistencies between these strategies as
through post-investment purification practices (Elgari, 2000), i.e. all inconsistencies among expert opinion call for what can be
a process in which the proportion of non-compliant income is called compromises or view integration. The following four strate-
identified and donated. gies to combine the expertise suggest themselves and are more or
To study the diversity of Shariah strategies Derigs and Marzban less self explanatory.
(2008) have analyzed the impact of six different Shariah strategies
on a unique reference asset universe. These basic strategies were 2.1.1. ‘‘Best of” strategy
based on the guidelines defined by the Shariah boards of the Stan- The basic Shariah strategies are defined by different Shariah
dard and Poor’s Islamic Index Group (S&P), the Dow Jones Islamic boards, with each of these boards claiming that their strategy
Index Group (DJIM), the Financial Times Islamic Index Series and the defined guidelines ensure Shariah-compliant asset selec-
(FTSE), the Morgan Stanley Capital International Islamic Index Ser- tion. Now, the ‘‘Best of” strategy selects from the pool of basic com-
ies (MSCI), the HSBC Amanah Fund (HSBC) and an anonymous Isla- pliance strategies the one which results in the best portfolio

Compliant Asset
S&P DJIM MSCI ANON FTSE HSBC
Universe Size

S&P 271 1.30% 24.40% 24.60% 24.90% 21.60%

DJIM 266 25.70% 26.00% 26.20% 22.90%

MSCI 247 0.30% 1.60% 8.00%

ANON 246 1.30% 7.80%

FTSE 241 6.50%

HSBC 232

Fig. 1. Asset universes and variation in classification among basic compliance strategies.
1168 U. Derigs, S. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176

performance in terms of some objective function based on return as a whole if the mixture of companies (interpreted as business
and risk. lines of the fund) does not violate the guidelines of the same Sha-
riah strategy.
2.1.2. Consensus/Ijmaa strategy Also, for the investor of a portfolio the overall portfolio return
The consensus strategy considers an asset to be compliant if and and portfolio risk is crucial and not the return and risk of the single
only if all basic Shariah strategies consider the respective asset to assets. Using the same argumentation, an Islamic investor should
be compliant. The Shariah foundation of this compliance strategy focus on the overall Shariah-compliance of his portfolio and its re-
can be attributed to the Ijmaa principle, which is the unanimous turn netted by purification rather than looking at single asset com-
consensus of all major qualified Shariah scholars on a certain Sha- pliance and returns.
riah issue at a given time. Under the Ijmaa strategy, asset compli- The new portfolio compliance paradigm can be used in conjunc-
ance is defined through considering all basic Shariah strategies and tion with any asset compliance strategy as for instance those de-
their respective guidelines simultaneously within the portfolio scribed in Section 2.1, i.e. it can be combined with any basic
optimization model. strategy from an Islamic index, or, the best of, Ijmaa, liberal or
majority compliance strategy, respectively. This results in a large
2.1.3. Liberal strategy variety of new options for compliance specification. These combi-
Under the liberal strategy an asset is considered to be compliant nations vary from very conservative to rather liberal. Obviously,
if at least one basic Shariah strategy considers the asset to be com- the use of an asset-based compliance strategy may result in a sig-
pliant. The liberal compliance strategy results in a larger asset uni- nificant reduction of the asset universe but it does not restrict the
verse and therefore higher returns and lower risks can be expected amount to be invested in a compliant asset. On the other hand,
under this strategy. within a portfolio-based compliance strategy no asset is excluded
from the asset universe per se, but, the control of the entire port-
2.1.4. Majority/Kasra strategy folio through the financial ratios may put limitations on the pro-
The majority (in Arabic Kasra) strategy is motivated by the Isla- portional wealth to be invested in certain assets implicitly.
mic juristic principle which states that ‘‘the majority deserves to be The new paradigm might be considered as too liberal or even
treated as the whole thing”. Thus, an asset is compliant under this non-Islamic, but it is deduced by logical reasoning from current
strategy if and only if the majority of the basic Shariah strategies compliance strategies. Of course, this paradigm should be applied
consider this asset to be compliant. only to specific products and after some preprocessing:

2.2. A new paradigm for Shariah-compliance  First, the fund should only invest in Shariah-compliant asset
classes such as equity or products structured in a Shariah-com-
The compliance strategies described above consider compliance pliant way such as sukuks (Islamic bonds).
as an attribute of the single assets. If an asset satisfies the respec-  Secondly, no investment should be allowed in assets from com-
tive guidelines it is considered compliant, else the asset is deemed panies whose primary activities are not compliant with Shariah.
non-compliant and has to be eliminated from the asset universe. Thus the conventional sector guidelines, through which those
The following proposal leads to a new paradigm which if accepted assets are excluded from the asset universe, should be applied
by current Shariah scholars will revolutionize Islamic equity beforehand.
management.
‘‘Funds are investment vehicles, which are financially indepen- The hotel example reveals a problem which is not only relevant
dent of the institutions that establish them.” Therefore, a fund for the new paradigm: the complexity to identify the compliance of
takes the form of an independent company, such as a limited liabil- companies operating in different business segments. Most Shariah
ity company (Norman, 2004), in which investors act as sharehold- providers use an industry classification standard such as the global
ers. Now, we simply argue that with respect to compliance a fund industry classification benchmark (GICS) or the industry classifica-
which itself invests in multiple companies has to be evaluated in tion benchmark (ICB) through which companies are assigned to a
the same way as a conventional independent company. We will single business segment based on the core business activity they
justify this point of view and illustrate it by an example. operate in. Using such a classification standard makes it impossible
Consider, for example, a hotel, then a critical Shariah guideline to identify the different compliant and non-compliant business
is the following: segments companies operate in. Therefore the automated use of
GICS or ICB standards if used in the hotel example would result
 Income from the casinos, bars, night clubs and alcoholic beverages in the classification of the hotel as being compliant since no indica-
has to be less than 5% of the total revenue generated by the hotel. tion is made to the revenue generated by non-compliant activities
such as the sales of alcohol and revenue from casinos and night
Since the core business of the hotel is considered compliant, this clubs. This problem can be solved using a different industry classi-
guideline is used to restrict the investment to only those hotels fication standard which is the standard classification system (SIC)
with a non-compliant income less than the threshold. Thus, a hotel through which each company is assigned multiple SIC codes based
can be considered as a company operating in three business lines on the different industries or businesses it is operating in. But,
which are: accommodation and Shariah-compliant hotel services, since not all companies report the revenue generated by each SIC
the sale of alcohol and casinos and night clubs. If a hotel has an classification business segment it is almost impossible to identify
overall non-compliant income from the second and third business the amount of non-permissible revenue generated without further
lines which is less than 5% of the accumulated revenue generated research and analysis.
by the three business lines together, then, according to the guide-
line, it is considered to be compliant for investment. Accordingly, if
the investment in a company like a hotel that generates negligible 3. Modeling Shariah-compliance
income (which will also be purified later on) from some non-com-
pliant activities is considered to be compliant as such under some In this section we outline how Shariah-compliance can be mod-
strategy, then analogously an investment in a fund which invests eled within the framework of portfolio optimization. We consider
in different companies, should also be considered to be compliant the standard situation, i.e. an asset universe I = {1, . . ., n} from
U. Derigs, S. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 1169

which a portfolio can be constructed and we assume that the total cessing phase in which the asset universe for a conventional portfo-
wealth has to be invested and short-sellings are not allowed, which lio optimization model is specified.
is realistic since short-sellings are generally not allowed under An alternative, yet inefficient way to model compliance with re-
Shariah. Then every portfolio can be represented by a share vector spect to a guideline is to formalize conditions (7) as set of mathe-
x = (x1, ...., xn) where x1 e [0,1] represents the weight or fractional matical inequalities which are introduced as constraints into the
P
wealth invested in each asset ieI and ni¼1 x1 ¼ 1 holds. portfolio model.
For the following we also assume an objective function f(x) by Obviously, a financial guideline can be modeled by a set of log-
which the performance of a portfolio is measured and a set C of ical constraints of the following type
constraints stemming from investment guidelines other than Sha-
xi ¼ 0 if ri ðgÞ > TðgÞ 8i 2 I ð8Þ
riah guidelines, legal guidelines for instance. The objective function
is reflecting the investment strategy as well as the return/risk Now (8) can be transformed into a set of mathematical inequalities
tradeoff and could stem for instance from the mean-variance mod- as follows:
el (Markowitz, 1952; Dentcheva and Ruszczynski, 2006) or index For each asset i 2 I we define a binary variable zi with
tracking concepts (Corielli and Marcellino, 2008). The specific type 
1 if i is complaint
of objective function and constraint set C is irrelevant for the fol- zi ¼ ð9Þ
lowing discussion and thus we keep these components on an ab-
0 otherwise
stract level to reduce complexity and focus on the essential and we introduce the constraints
aspects. Thus we assume that before or without regarding Shari-
ah-compliance we have the following conventional portfolio opti- xi  z i 8i 2 I ð10Þ
mization model: ri ðgÞ  zi  TðgÞ 8 i 2 I ð11Þ
Min f ðxÞ ð1Þ Constraints (10) ensure that for every asset i 2 I
xi > 0 only if zi ¼ 1 ð12Þ
Subject to x fulfils constraints in C ð2Þ
Since constraints (11) ensure that zi is 0 if the guideline (7) is not
X
n
fulfilled i.e. the ratio is above the respective threshold, investment
xi ¼ 1 ð3Þ in asset i 2 I, i.e. xi > 0, is possible only if the guideline is fulfilled.
i¼1
In the following we show how these techniques can be used to
xi  0 8i 2 l ð4Þ model the different compliance strategies introduced in Section 2.
Irrespective whether compliance is measured as an attribute of the
single assets or the whole portfolio, sector guidelines have to be ful- 3.1. Modeling asset compliance strategies
filled i.e. they have to be applied to exclude assets of those compa-
nies operating in Shariah non-compliant business activities from Consider S as the set of basic Shariah strategies and G as the set
the asset universe. Using the fact that the assignment of each com- of all financial Shariah guidelines defined by the different basic
pany issuing an asset to a specific sector is indicated by industry Shariah strategies, then a specific basic Shariah-compliance strat-
classification codes such as GICS or ICB the set of non-compliant as- egy s 2 S is formulated using a specific subset Gs  G and the asso-
sets INC  I can be specified easily and the sector guidelines can be ciated portfolio optimization problem is given by
modeled by exclusion constraints Min f ðxÞ subject to ð2Þ—ð4Þ; ð10Þ and
xi ¼ 0 8i 2 INC ð5Þ r i ðgÞ  zi  TðgÞ 8 i 2 I; 8 g 2 Gs ð13Þ

Note that these exclusion constraints need not to be included into Now we introduce the new strategies:
the portfolio optimization model, if the model is instantiated with
I :¼ I n INC :  Best of Shariah strategy
An example for a prominent financial guideline using the ac-
counts receivables ARi, cash and short-term investments CSIi and In the ‘‘best of” Shariah strategy we have to solve the model for
total assets TAi figures as published in the financial statements of each s 2 S independently and the optimal portfolio with respect to
the company issuing the asset ieI is given by this strategy is the one generated by the model yielding the best
portfolio performance.
ARi þ CSIi
 0:5 ð6Þ
TA
 Consensus/Ijmaa Shariah strategy
This guideline ensures that the liquid assets of the company as pro-
portion of total assets are less than or equal 50% and stems from the Within the Ijmaa strategy, asset compliance is defined through
Shariah rule that income should be mainly gained from illiquid as- considering all basic Shariah strategies s 2 S and their respective
sets and therefore the majority of assets have to be of illiquid form. guidelines g 2 G simultaneously within the portfolio optimization
Formally, given a financial guideline g 2 G we have to calculate problem. Such a strategy can be formulated within the model by
a financial ratio ri(g) for each asset i 2 I which measures the level of replacing (13) by:
involvement in a non-compliant financial activity, and to compare
ri ðgÞ  zi  TðgÞ 8i 2 I; 8s 2 S; 8g 2 Gs ð14Þ
the value with a maximum permissible value T(g), the so called
threshold value. Thus we have to control a set of constraints of The model is very similar to the model for a basic strategy with the
the following type only difference that the constraints for all Shariah strategies s 2 S
r i ðgÞ  TðgÞ ð7Þ are added to the model.

Obviously, these guidelines result in a further reduction of the asset  Liberal strategy
universe and thus their fulfillment can be secured in a preprocess-
ing phase analogously to the sector guidelines and thus Shariah- The liberal compliance strategy reduces the asset universe by
compliance of a portfolio can be operationally obtained by a prepro- those assets which are jointly defined non-compliant by all basic
1170 U. Derigs, S. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176

Shariah strategies considered. The identification of these assets and  Liberal strategy
their exclusion from the solution domain is accomplished through
introducing a binary variable To model the liberal compliance strategy we introduce the bin-
 ary variables
1 if i is complaint w:r:t: s 2 S
zi ðsÞ ¼ ð15Þ 
0 otherwise 1 if the portfolio x is compliant for s 2 S
zpðsÞ ¼ ð25Þ
0 otherwise
and by introducing the following set of constraints:
and we replace (23) by:
r i ðgÞ  zi ðsÞ  TðgÞ 8i 2 I; 8s 2 S; 8g 2 Gs ð16Þ !
X X
xi  zi ðsÞ 8i 2 I ð17Þ zpðsÞ  r i ðgÞ  xi  TðgÞ 8s 2 S; 8g 2 Gs and ð26Þ
s2S i2I
X
The constraints (17) ensure that zpðsÞ  1 ð27Þ
s2S
xi > 0 only if zi ðsÞ ¼ 1 for at least one s 2 S 8i 2 I ð18Þ
Constraints (26) are nonlinear and with respect to solvability of the
0
and thus if xi > 0 for at least one s 2 S; s say, then all constraints of optimization model should be linearized as follows:
X
type (13) are fulfilled for g 2 G0s . r i ðgÞ  xi  ð1  zpðsÞÞ  M þ TðgÞ 8s 2 S; 8g 2 G s ð28Þ
i2I
 Majority/Kasra strategy
with M a sufficiently large number. Now due to (27) at least for one
s 2 S; s0 say, we obtain zp(s0) = 1 and thus (28) and/or (26) hold for
This strategy can be modeled using the binary variables zi for
at least one s 2 S.
i 2 I and zi(s) for i 2 I and s 2 S which have been introduced before
as follows:
 Majority/Kasra strategy
r i ðgÞ  zi ðsÞ  TðgÞ 8i 2 I; 8s 2 S; 8g 2 Gs ð19Þ
X  
jSj To model the majority strategy we replace in the model for the
zi ðsÞ   zi 8i 2 I ð20Þ liberal strategy (27) by
s2S
2
X  
jSj
The constraints (10) and (20) ensure that if zps  ð29Þ
s2S
2
0
x0i > 0 for an asset i 2 I then which ensures that at least the majority of basic strategies s 2 S
zi ðsÞ ¼ 1 for the majority of s 2 S; ð21Þ consider the portfolio as being compliant.

i.e. i0 is compliant for the majority of strategies.


4. Implementation – empirical results

3.2. Modeling portfolio compliance strategies


In the following empirical analysis we report results concerning
the impact of the different compliance strategies on expected port-
A portfolio x fulfills a specific guideline g if the sum of the ratio
folio return, risk and compliance consistency. The main purpose of
values over all assets i 2 I weighted by their share values xi is less
this analysis is to make the potentials of the new strategies trans-
than the threshold, i.e.
X parent, i.e. we can show that the Shariah-compliance strategies
ri ðgÞ  xi  TðgÞ ð22Þ which we have developed and proposed in Section 2 perform bet-
i2I ter than portfolios following one of the basic Shariah strategies.
The analysis is based on the assets included in the Standard &
Now a portfolio x is compliant with respect to a strategy s 2 S if x
Poor’s 500 (S&P500) index on the 17th of September 2007, which
fulfils all guidelines g 2 Gs . Thus, for a basic strategy s and the set
will be from now on referred to as the asset universe. To measure
of guidelines Gs we obtain the following portfolio optimization
the Shariah-compliance of the assets included in the asset uni-
model:
X verse, the detailed financial figures for the financial year 2006 of
Min f ðxÞ subject to ð2Þ—ð4Þ and r i ðgÞ  xi  TðgÞ 8g 2 Gs the companies issuing the respective assets, as published in their
i2I annual financial statements, were retrieved using the software sys-
ð23Þ tem MarketIQ. Additionally, the monthly total returns (annualized)
The portfolio-based compliance strategies can now be modeled as and market capitalization values of the considered assets were re-
follows: trieved from Bloomberg.
We have considered the following set of basic Shariah strategies
 Best of Shariah strategy S = {S&P, DJIM, FTSE, MSCI, HSBC, ANON}. Based on the type of finan-
cial ratios used these strategies can be categorized into two
Again for the ‘‘best of” strategy the optimal portfolio is the one groups: the set of market capitalization (MC) based strategies
generated by the basic strategy s yielding the best portfolio SMC = {S&P, DJIM} and the set of total assets (TA) based for the asso-
performance. ciated portfolios of minimal risk strategies STA = {FTSE, MSCI, HSBC,
ANON}.
 Consensus/Ijmaa Shariah strategy For our study we have assumed an active portfolio management
and we have implemented and based our comparison on the
To define Shariah-compliance under the Ijmaa strategy, we Markowitz mean-variance approach (Markowitz, 1952) construct-
have to replace (23) by: ing the efficient frontier and the set of efficient portfolios from
X which the user can then choose an appropriate portfolio according
ri ðgÞ  xi  TðgÞ 8s 2 S; 8g 2 G s ð24Þ to his risk profile. Here a portfolio is efficient if it has minimal risk
i2I
U. Derigs, S. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 1171

among all portfolios of the same return (or vice versa). In a practi- 4.1. Performance of basic Shariah-compliance strategies
cal situation the efficient frontier can only be approximated and
due to the possibly large number of efficient solutions only a rep- First, we have run the portfolio model with the guidelines/con-
resentative subset of efficient portfolios should be constructed and straints from the six basic strategies. As a reference we have also
presented to the investor to reduce complexity. We have imple- run the conventional model i.e. without any further reduction of
mented this approach as follows: For every model instance we first the asset universe. The resulting efficient frontiers are depicted
calculate the possible return spread by constructing the two ex- in Fig. 2. In Section 2 we have already shown that the variations
treme portfolios which are efficient: the portfolio with maximal with respect to Shariah-compliance among basic strategies belong-
(expected) return and the portfolio with minimal (expected) risk. ing to the same class, SMC or STA, are almost negligible. This explains
Then we approximate the efficient frontier by constructing the why in Fig. 2 the efficient frontiers for the different strategies with-
portfolio of minimal risk for ten equidistant return values between in one class are almost identical. Due to the fact that the basic
these extreme values. strategies s 2 SMC result in a larger asset universe than the strate-
To show that the models are practical, i.e. can be solved within a gies s 2 STA (see Fig. 1) all the efficient frontiers of the basic strate-
practical environment we have included two constraints which gies s 2 SMC are above the efficient frontiers of the basic strategies
represent aspects which on top of Shariah-compliance have to be s 2 STA , i.e. with the first class of strategies we can obtain higher re-
considered in real investment situations: a constraint limiting turn at lower risk. Of course, the frontiers of all basic Shariah strat-
the weight of an asset to at most 10% which can be interpreted egies are below the frontier for the conventional model without
as an example for a legal guideline (Derigs and Nickel, 2003) and Shariah-compliance guidelines. It is worth noting that strategies
a constraint limiting the number of assets to be included in the s 2 SMC perform only slightly worse with respect to return. Yet, to
portfolio to at most 40 assets which is a common internal guideline realize the maximal possible return much higher risk has to be
reducing the complexity of management (Jobst et al., 2001). Also, taken.
in a preprocessing step we have reduced the asset universe by A closer look at the set of efficient portfolios reveals that the dif-
applying unified Shariah sector guidelines. Now we report the re- ference in performance is not only attributable to the larger asset
sults of our analysis for the different strategies and paradigms. universe but stems from the fact that the constituents included

Fig. 2. Performance of basic Shariah strategies.

Optimal Weights of Assets per Sector compliant under MC and not compliant under a TA Strategy
Sectors / Sample Portfolios P-1 P-4 P-5 P-7 P-9 P-11
Information Technology 0.60% 9.40% 12.94% 18.22% 21.78% 40.00%
Health Care 13.50% 14.05% 12.91% 10.51% 10.00% 10.00%
Consumer Staples 21.59% 17.26% 14.95% 9.07%
Consumer Discretionary 5.00% 3.94% 3.42% 3.88% 5.01% 10.00%
Materials 0.78% 8.39% 8.06% 7.51%
Energy 10.00%
Sum of Weights 41.48% 53.04% 52.28% 49.18% 36.79% 70.00%

Optimal Weights of Assets per Sector compliant under TA and not compliant under a MC Strategy
Sectors / Sample Portfolios P-1 P-4 P-5 P-7 P-9 P-11
Utilities 13.94% 12.62% 14.32% 18.31% 9.77%
Consumer Discretionary 2.56% 8.85% 10.00% 10.00% 3.80%
Health Care 2.03% 0.48%
Materials 3.16%
Sum of Weights 21.69% 21.95% 24.32% 28.31% 13.57% 0.00%

Fig. 3. Weights of assets aggregated by sector compliant under DJIM and not under MSCI and vice versa.
1172 U. Derigs, S. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176

in the different asset universes and consequently the assets To further analyze this phenomenon we calculated for each sec-
selected for investment portfolios differ highly among the efficient tor the percentage of companies whose market capitalization is
portfolios of different strategies. This is reflected in Fig. 3. Here we significantly larger or smaller than total assets. As you can see from
have clustered the assets of the efficient portfolios into six repre- Fig. 4, most of the companies belonging to sectors such as informa-
sentative sectors. Then, for DJIM as representative for a MC-based tion technology (85%), health care (79%) and consumer staples
strategy and MSCI as representative for a TA-based strategy we (72%) have a market capitalization value which is larger than their
have calculated the proportion of investment which is not compli- total assets value. Contrary, companies belonging to the utilities
ant with respect to the other strategy and we have allocated the (94%) and telecommunication (89%) sectors have a total assets va-
amount to the respective clusters. The last line (sum of weights) lue larger than their respective market capitalization value. One of
of the upper part of Fig. 3 shows that overall a significant fraction the main reasons for this property is that in general the value of
of the optimal investments under the MC-strategy DJIM are into intangible assets such as intellectual properties, patents and pro-
assets which are not compliant under the TA-strategy MSCI jects under development is not accounted for in the balance sheet
whereas the last line of the lower part shows that the reverse of the respective companies and thus total assets are undervalued.
inconsistency is much less. An information technology company such as Microsoft for in-
This means that assets which contribute positively to the port- stance is not capital intensive since most of the assets are in intan-
folio performance for DJIM are non-compliant under the MSCI gible form and currently valued on the market four times the total
strategy. assets value. The same also applies to companies in the health sec-
If we consider the individual figures we can note that for instance tor whose in-house developed intellectual property and projects in
DJIM results for almost all return levels in efficient portfolios with a the pipeline do not appear on the balance sheet. Thus, for such
high proportion of wealth invested in assets belonging to the infor- companies market capitalization is usually significantly larger than
mation technology, health care and consumer staples sectors which total assets and if two Shariah guidelines differ in terms of the divi-
are not compliant under the TA-strategy MSCI. sor only, which is almost the case for DJIM and MSCI, then system-

Fig. 4. Sector-based comparison market capitalization vs. total assets.

Fig. 5. MC–TA mixed strategy.


U. Derigs, S. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 1173

atically the use of TA-based guidelines results in an exclusion of the modified strategy the performance difference between MSCI
companies from intellectual property sensitive sectors from the as- and DJIM diminishes.
set universe which means the exclusion of assets with good return
and risk profiles. This exactly could be observed in this analysis 4.2. Performance of the new asset-based Shariah-compliance
where assets of good performance were excluded from the asset strategies
universe by TA-based strategies resulting in an overall underper-
formance compared to the MC-based strategies. First, we analyze the degree of inconsistency between the new
These sector-specific findings motivate to apply modified strategies and the base strategies i.e. the difference between the
screening guidelines in which the type of divisor of the financial ra- asset universes analogously to the analysis shown in Fig. 1 with
tios is decided upon based on the company’s sector. Thus, we be- the only difference that the inconsistency is partitioned into type
lieve that a more realistic evaluation would be achieved if the I error (classifying an asset compliant by a new strategy and
financial ratios for companies from information technology, health non-compliant by a basic strategy) and type II error (classifying
care and consumer staples are based on their market capitalization an asset non-compliant by a new strategy and compliant by a basic
value whereas for companies from the utility and telecommunica- strategy).
tion sector their total assets values are used. As can be seen in Fig. 6 the Ijmaa strategy achieves lowest type I
In Fig. 5 we show the impact of this modified screening ap- error since no asset is included in its asset universe which is con-
proach compared to the common approaches which are based on sidered to be non-compliant by any basic strategy and the majority
either total assets or market capitalization. As can be seen, the usu- strategy has a type I error which is lower than the inconsistencies
ally total assets based strategy MSCI now shows a much better among the basic strategies. With respect to type II error, the liberal
risk/return profile since a number of companies from the formerly strategy shows no inconsistencies and the majority strategy is
excluded sectors are now eligible and contribute positively to the more or less consistent with the TA-strategies.
portfolio performance. Such an effect does not show up for the usu- Fig. 7 reveals that these different levels of Shariah-compliance
ally market capitalization based strategy DJIM, since the efficient of the new strategies are reflected in performance, i.e. the return
portfolios contain already all favorable companies. In fact, under and risk profile as expressed by the efficient frontier. Less conser-

Fig. 6. Inconsistency in classification of new strategies vs. basic strategies.

Fig. 7. Performance of proposed strategies – Asset-based.


1174 U. Derigs, S. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176

vative strategies such as the liberal and ‘‘best of” strategy perform using the Ijmaa or the majority strategy. As expected, the most
very similar and their frontiers are close to the conservative port- conservative Ijmaa strategy performs worst, which is a logical re-
folio model and they clearly dominate the portfolios constructed sult of the small asset universe (197 assets).

Fig. 8. Asset versus portfolio-based compliance strategy.

Fig. 9. Portfolio-based versus basic asset-based compliance strategies.


U. Derigs, S. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 1175

Fig. 10. Basic strategies – Portfolio-based compliance.

4.3. Performance of the portfolio-based compliance strategies oped including a new paradigm which considers Shariah-compli-
ance as an attribute of the portfolio constructed rather than
When analyzing the effect of the new paradigm i.e. considering measuring compliance on an asset level as is done in all current ap-
compliance as an attribute of the portfolio rather than the single proaches. All concepts have been formalized such that they can be
assets we can see that for every new strategy the portfolios con- incorporated in every conventional portfolio optimization model
structed under the portfolio-based compliance paradigm outper- by simply introducing appropriate sets of constraints.
form their asset compliance counterparts (see Fig. 8). Yet, there Our empirical analysis has clearly shown that if fund managers
is a significant difference: while the asset-based Ijmaa and Major- stick to the current Shariah strategies then they are better off
ity strategies are clearly dominated by their portfolio-based coun- employing market capitalization based ratios which outperform
terpart, we can observe such an outperformance for the ‘‘best of” strategies which use total assets based ratios. We have proposed
and the liberal strategy only on the extreme ends of the spread new concepts for defining Shariah-compliance leading to strate-
i.e. for low risk and high return levels. gies by which portfolios can be constructed that achieve better
The added-value of the portfolio-based compliance paradigm portfolio performance than current Shariah strategies. We also
compared to the basic strategies currently used by Islamic funds have proposed and justified a new paradigm which measures
and index providers can be identified in Fig. 9. The portfolios of compliance on a portfolio level rather than individually for each
the portfolio-based compliance strategies outperform the basic asset. Our analysis shows that applying this paradigm results in
TA-based strategy MSCI significantly whereas the MC-based strat- portfolios which perform much better than their asset-based
egy DJIM is outperformed slightly. counterparts in terms of return and risk. Another significant effect
Another effect could be observed which has not been expected of the portfolio-based compliance strategies is that not only the
at all. Applying the new portfolio-based compliance paradigm the performance differences between market capitalization based
significant differences in performance between the two classes of and total asset-based compliance strategies are almost eliminated
basic Shariah strategies, s 2 SMC and strategies s 2 STA , diminish but even more important Shariah-compliant portfolios can reach
(see Fig. 10). This means that under the new paradigm the use of the performance of conventional portfolios on the same asset
market capitalization does not lead to better performance anymore universe.
i.e. the total assets based strategies which suffered from eliminat- Considering compliance as an attribute of the portfolio forces
ing more assets from the universe are now comparable. Also, all compliance control to take place during portfolio optimization in-
frontiers constructed under the new portfolio-based compliance stead of a preprocessing phase as can be done with the current
paradigm are much closer to the frontier for the conventional port- strategies. This requires a shift from the purely extensional
folio model. Thus the new paradigm offers investors the opportu- description of compliance in terms of specifying the asset universe
nity to achieve nearly the same risk-return options as to an intentional description of compliance in form of checkable
conventional funds but being Shariah-compliant. guidelines which can be incorporated into the portfolio optimiza-
tion model. Besides the necessary provision of such guidelines by
5. Conclusion the Shariah scholars the availability of modeling tools for setting
up the Shariah-compliant portfolio optimization model is an
Within this paper we have considered the problem of Shariah- important prerequisite, though not mandatory for applying the
compliant portfolio construction. The analysis revealed that on new paradigm in practice. Such a supporting system has been
the same asset universe current basic Shariah-compliance strate- developed by the authors.
gies result in much lower portfolio performance than portfolios Certainly and most importantly, the eligibility of the new port-
without considering Shariah-compliance. folio-based compliance paradigm has to be analyzed from a Shari-
To overcome these short comings a number of new concepts for ah perspective by experienced Shariah scholars whose opinion and
defining Shariah-compliance at different levels have been devel- judgment decides on the practical acceptance.
1176 U. Derigs, S. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176

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