Impact of Sharia-Based Screening on Equity Risk: International Evidence

Abstract

This paper investigates the impact of mainstream Sharia-based screening methodologies on equity risk. The study is based on the daily returns of 23 pairs of stock indices belonging to different index providers, namely Dow Jones, FTSE, and S&P. For risk measurement, the study uses five Value at Risk (VaR) methods. Moreover, the conditional VaR (CVaR) is used to analyze the tail behavior of return distributions. The results show that Sharia-based screening is a source of significant differences in risk. There is strong evidence that Islamic stock indices (ISIs) tend to be less risky than their conventional peers. Also, the screening process allows for keeping extreme negative returns at a lower level relative to unscreened indices. The analysis during the Dotcom and Subprime crises shows that, globally, the results are time-invariant. In sum, Islamic screening is tantamount to prudential rules that lead to low-risk portfolios; it is, in its essence, a risk-reduction strategy. Findings suggest that Sharia-compliant stocks would be of great attractiveness to risk-averse investors. They will find their claim in this asset class, as its riskiness is relatively low. For banks, a lower VaR of Islamic investing implies fewer capital requirements for market risk when holding portfolios that include Sharia-compliant stocks. Fewer capital requirements will enhance the banks' ability to invest and make profits, which will, in turn, result in reducing the cost of capital.