PACFIN-00788; No of Pages 10

Pacific-Basin Finance Journal xxx (2015) xxx–xxx

Contents lists available at ScienceDirect

Pacific-Basin Finance Journal

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

Islamic vs conventional equities in a strategic asset allocation framework

Zaghum Umar
Suleman Dawood School of Business, Lahore University of Management, Sciences Sector U, DHA, Lahore Cantt., 54792, Pakistan

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

Article history: This paper extends the existing literature by analysing the performance of Islamic vs conven-
Received 28 June 2015 tional equities in a strategic asset allocation framework. I consider two types of investors: a
Received in revised form 22 August 2015 faith-based investor and a conventional investor. The faith-based investor invests in shariah
Accepted 27 October 2015
complaint equities only and excludes conventional equities from the asset menu. The conven-
Available online xxxx
tional investor's asset menu comprises of both Islamic and conventional equities. The findings
show that on a standalone basis Islamic equities exhibit both short-run and long-run desirable
JEL classification: attributes for the faith-based investor. However, the results for the conventional investor show
G11
that the inclusion of conventional equities in the asset menu reduces the desirability of Islamic
G15
equities for short-run only. Thus, conventional equities are more desirable for long-run inves-
G19
tors. The results are consistent for various levels of risk aversion. Another important finding
is that exclusion of conventional equities from the asset menu of faith based investor results
Keywords:
in substantial welfare losses.
Strategic asset allocation
Portfolio choice
© 2015 Elsevier B.V. All rights reserved.
Myopic demand
Intertemporal hedging demand
Islamic equities
Conventional equities

1. Introduction

The last decade has witnessed a surge in investors' interest in Islamic finance with an increase in asset under management
from USD 200 billion in 2003 to USD 1.8 trillion in 2013. However, the size of Islamic financial assets is much smaller than its
conventional counterpart, with a total asset value of approximately USD 294 trillion. For a faith-based (Muslim) investor, one
of the main motivations for investing in Islamic financial assets stems from religious beliefs i.e., compliance with the Shariah
principles of Islam. Therefore, a faith-based investor tries to maximise wealth by choosing among various Shariah compliant
investments (stocks, bonds etc.). However, faith is not the only motivation for investing in Islamic financial assets. A large propor-
tion of (conventional) investors worldwide evaluate investments based upon their risk-return characteristics. For such investors,
Islamic financial assets can be a desirable investment option, if they can get a better return or reduce their overall risk (for
instance, through diversification) from these investments. Therefore, for such investors, it is important to analyse and compare
the risk-return performance of Islamic financial assets with the conventional financial assets.
Equities are one of the most common financial asset classes for investors worldwide. In recent years, a number of studies have
analysed the performance of Islamic (Shariah complaint) equities and compared them with their conventional counterparts. These
studies maybe categorised into two categories. The first category comprises studies analysing the performance of Islamic equities
in a static-setting by employing sample statistics or the classical mean-variance/CAPM framework. (See for instance; Ho et al.,
2014; Hayat and Kraussl, 2011; Girard and Hassan, 2008; Abdullah et al., 2007; Hussein and Omran, 2005). The second category

E-mail address: zaghum.umar@lums.edu.pk.

http://dx.doi.org/10.1016/j.pacfin.2015.10.006
0927-538X/© 2015 Elsevier B.V. All rights reserved.

Please cite this article as: Umar, Z., Islamic vs conventional equities in a strategic asset allocation framework, Pacific-Basin Finance
Journal (2015), http://dx.doi.org/10.1016/j.pacfin.2015.10.006
2 Z. Umar / Pacific-Basin Finance Journal xxx (2015) xxx–xxx

comprises studies employing dynamic approaches such as stochastic dominance, wavelet squared coherency, copula, and multi-
timescales analysis etc.1 (See for instance, Al-Khazali et al., 2014; Aloui et al., 2015; Hammoudeh et al., 2014; Dewandarua
et al., 2015).
This paper contributes to the second category of literature on Islamic equities. It analyses the portfolio choice problem of an investor
in a multi-period strategic asset allocation framework proposed by Campbell et al. (2003). The asset menus of the investor include both
Islamic and conventional equities. It quantifies the welfare losses due to ignoring the demand for Islamic and/or conventional equities in
the optimal portfolio of the investor. To the best of my knowledge, this is the first study to document a comparative analysis of the
welfare losses incurred by an investor due to ignoring Islamic and/or conventional equities in the optimal portfolio.
The desirability of an investment varies depending upon the investment horizon i.e., an investment may have attractive portfolio
characteristics in the short run, whereas, another might be a better option in the long run. Therefore, it is important to analyse the
attributes of conventional and Islamic equities for both short-term and long-term investment horizons. In order to analyse the
short-run and the long-run dynamics of the demand for Islamic and conventional equities, this study decomposes the total demand
for equities into myopic (single-period) and intertemporal hedge (long-term) demand.2 It gives us insight into the short-term and
long-term portfolio characteristics of Islamic and conventional equities. The economic significance of the short-term and long-term
demand for equities is quantified by calculating the welfare losses incurred by ignoring the short-term and/or the long-term demand
for Islamic and conventional equities.
In addition to the investment horizon, risk aversion is another important dimension of an investor's portfolio choice decision.
The restrictive nature of Islamic investments may render them less prone to crisis and, thus, makes them more desirable for risk-
averse investors. This argument is supported by studies that document better performance of Islamic equities during the global
subprime financial crises (Ho et al., 2014; Arouri et al., 2013). On the contrary, others argue that Islamic equities do not exhibit
such investment attributes (Yilmaz et al., 2015; Dewandarua et al., 2015; Charles et al., 2015). As mentioned above, the desirabil-
ity of an investment for an investor may vary depending upon the risk appetite of the investor. Therefore, it is important to an-
alyse the portfolio choice characteristics of Islamic vs conventional investments for investors with different levels of risk aversion.
This helps us to compare the desirability of these investments for risk-tolerant vs the risk-averse investor.
I employ Dow Jones Islamic equity indices for world, developed countries, emerging market and United States for the period ranging
from January 1996–April 2015. I consider two types of investors, categorised based upon their asset menus. The first investor's asset
menu comprises benchmark asset and Islamic equities and is termed as the faith-based investor. The second investor's asset menu com-
prises conventional equities, Islamic equities, and the benchmark asset and is termed as the conventional investor. The faith-based in-
vestor invests in Islamic equities because of their adherence to the principles of Shariah. On the other hand, the asset allocation for
conventional investor is not subject to any faith-based restriction. A conventional investor will invest in Islamic equities only if they per-
form better than the conventional equities and vice versa. The analysis of the portfolio choice problem of the faith-based investor allows
us to analyse the risk-return characteristics of Islamic equities on a stand-alone basis. Thus, we can evaluate the performance of Islamic
equities for a faith-based investor for short-term and long-term time horizons, as well as, for varying level of risk aversion. The analyses
for the portfolio choice problem of the conventional investor shed light on the performance of Islamic equities vis-a-vis their conven-
tional counterpart. In addition, the results for the conventional investor can be used to, qualitatively, analyse the (opportunity) cost in-
curred by a faith-based investor due to the exclusion of conventional equities form the asset menu.
The results for a faith-based investor show that Islamic equities do exhibit desirable short-run and long-run portfolio charac-
teristics on a stand-alone basis. However, faith-based investor incurs sizable welfare losses by excluding the conventional equities
from the asset menu. For the conventional investor, Islamic equities are more desirable in the short-run, whereas, the convention-
al equities exhibit better long-run attributes. Thus, conventional equities are a better investment option for long-term investors.
The rest of the paper is organised as follows: Section 2 presents the methodology employed for quantifying the welfare affects
and portfolio weights, followed by a description of the data employed in Section 3. The empirical results are presented in
Section 4, followed by a conclusion in Section 5.

2. Methodology

In this section I give a brief description of the methodology used in this paper, which is drawn extensively from Campbell et al.
(2003).
Let Rp,t + 1, R1,t + 1 and Ri,t + 1 denote the real return of a portfolio of n assets, real return on benchmark asset and real return
on remaining (n − 1) assets, respectively and αi,t is the portfolio weight for asset i, such that;

X
n  
Rp;tþ1 ¼ α i;t Ri;tþ1 −R1;tþ1 þ R1;tþ1 : ð2:1Þ
i¼2

1
I thank an anonymous reviewer for pointing it out to me.
2
Myopic demand is the demand for equities in a static setting i.e. when the investing opportunities are assumed to be constant throughout the holding period. The
myopic demand is the demand of an asset in a static setting such as the Markowitz (1952) problem.
Merton (1973) introduced the concept of intertemporal hedging demand and pointed out the importance of horizon effects for long-term investors due to variation in
expected returns over time.

Please cite this article as: Umar, Z., Islamic vs conventional equities in a strategic asset allocation framework, Pacific-Basin Finance
Journal (2015), http://dx.doi.org/10.1016/j.pacfin.2015.10.006
 Z. Umar / Pacific-Basin Finance Journal xxx (2015) xxx–xxx 3

The vector of excess return xt + 1 is;

h i0
xtþ1 ¼ r 2;tþ1 −r 1 ; :::; rn;tþ1 −r 1 ð2:2Þ

where ri ,t+1 = log (1+ Ri,t+1) ∀ i.

Let st + 1 is the vector of other state variables (the predictor variables) such as book-price ratio, dividend yields etc.
The state vector zt + 1 is
h i0
ztþ1 ¼ r 1;tþ1 ; xtþ1 ; stþ1 : ð2:3Þ

Campbell et al. (2003) document that the dynamics of the system given in Eq. (2.3) can be captured by an unrestrictive first
order vector auto-regressive model, given as;

ztþ1 ¼ ϕ0 þ ϕ1 zt þ υtþ1 ð2:4Þ

where; ϕ0 and ϕ1 are the vector of intercept and the matrix of slope coefficients, respectively and υt + 1 is the vector of i.i.d in-
novations with mean zero and variance–covariance matrix Σv given as;

0 2 0 0
1
σ1 σ 1x σ 1s
∑v ¼ @ σ 1x ∑xx ∑xs
0 A
ð2:5Þ
σ 1s ∑xs ∑ss

where σ12 is the variance of innovation to the benchmark asset, σ1x and σ1s are the covariance vectors of the innovations to the
benchmark asset with the other asses and the other state variables, respectively. Σxx and Σss are the variance–covariance matrices
of the innovations to the excess returns and state variables, respectively. Σxs is the variance–covariance matrix of excess returns
and state variables.
Following Epstein and Zin (1989, 1991), the utility function for an investor with an infinite investment horizon and recursive
preferences is given by;

 h  i1=θ θ=1−γ
   ð1−δÞ=θ 1−γ
U C t ; Et U tþ1 ¼ ð1−δÞC t þ δ Et U tþ1 ð2:6Þ

where; Ct is consumption at time t, δ is the time discount factor with value between 0 and 1, γ N 0 is the coefficient of relative
risk aversion, θ = (1 − γ) / (1 − ψ−1), ψ is the elasticity of intertemporal substitution.
Given Eqs. (2.4) and (2.6), Campbell et al. (2003) show that the portfolio weights αi,t can be calculated as3;

α t ¼ A0 þ A1 zt ð2:7Þ

where;

. X   X−1
1 −1 2
A0 ¼ xx
Hx ∅0 þ 0:5σ x þ ð1−γ Þσ 1x þ ð1−ð1=γ ÞÞ xx ð−Λ 0 =ð1−ψÞÞ ð2:8Þ
γ

and

. X X−1
1 −1
A1 ¼ xx
H x ∅1 þ ð1−ð1=γÞÞ xx ð−Λ 1 =ð1−ψÞÞ ð2:9Þ
γ

where γ N 0 is the coefficient of risk aversion; Hx is the selection matrix that selects the vector of excess returns (xt) from zt;ψ is
the elasticity of intertemporal substitution, Λ0 and Λ1 are matrices with values dependent upon γ, ψ, δ, ϕ0, ϕ1 and ∑v. The sum of
the first two elements of Eqs. (2.8) and (2.9) equates to the myopic demand, while the sum of the two later terms equates to the
intertemporal demand.4 The myopic demand is the demand of an asset in a static (single-period) setting, whereas, the
intertemporal hedge demand is the long-term demand for an asset.

3
For full details, please refer to Campbell et al. (2003).
4
 −1  −1
Myopic demand = ð1 γ Þ∑xx ðH x ∅0 þ 0:5σ 2x þ ð1−γÞσ 1x Þ þ ð1 γ Þ∑xx H x ∅1 :
−1 −1
Intertemporal hedge demand = ð1−ð1=γÞÞ∑xx ð−Λ 0 =ð1−ψÞÞ þ ð1−ð1=γÞÞ∑xx ð−Λ 1 =ð1−ψÞÞ:

Please cite this article as: Umar, Z., Islamic vs conventional equities in a strategic asset allocation framework, Pacific-Basin Finance
Journal (2015), http://dx.doi.org/10.1016/j.pacfin.2015.10.006
4 Z. Umar / Pacific-Basin Finance Journal xxx (2015) xxx–xxx

Table 1
Sample statistics.

Mnemonic Mean Std dev. SR

Benchmark asset FRTBS3M(RI) 0.02 0.32 0.06

World DJIMKT$(RI) 0.46 4.80 0.09
Developed world DJIWDD$(RI) 0.46 4.74 0.10
Emerging markets DJIWEM$(RI) 0.29 7.38 0.04
Excess return Islamic equities United States DJIMUS$(RI) 0.52 4.86 0.11
World DJWRLD$(RI) 0.36 4.67 0.08
Developed world DTWDEV$(RI) 0.37 4.59 0.08
Emerging markets DJWEMR$(RI) 0.25 7.39 0.03
Excess return conventional equities United States TOTMKUS(RI) 0.50 4.58 0.11
World TOTMKWD(BP) −5.35 0.23
Developed world TOTMKDV(BP) −5.36 0.24
Emerging markets TOTMKEK(BP) −5.17 0.19
Log book price United States TOTMKUS(BP) −5.64 0.30
Inflation rate United States USCONPRCE 0.18 0.29

Notes: This Table shows the monthly percentage mean and standard deviation (std. dev) and Sharpe ratio (SR) for benchmark asset and excess equity return for
Islamic and conventional equities along with the monthly mean and standard deviation for log book price ratio and US inflation rate.

The welfare losses associated with suboptimal asset allocation can be given by (Campbell and Viceira, 1999; Campbell et al.,
2003; Spierdijk and Umar, 2014)5;
 
E V restricted
t
EVLðExpectedValueLossÞ ¼ 1−   ð2:10Þ
E V optimal
t

where;
Vt is the value function expressed as a power function of the consumption-wealth ratio, derived by Epstein and Zin (1989, 1991)
as6;
.
. 1=ð1−ψÞ
¼ ð1−δÞ =ð1−ψÞ
−ψ
Ut Ct
Vt ¼ Vt ¼ ð2:11Þ
Wt Wt

Vrestricted
t is the value function corresponding to the suboptimal or restricted asset allocation and Voptimal
t is the value function
corresponding to the optimal asset allocation.
The point estimates are subject to parameter and sampling uncertainty. To give a quantitative measure of this uncertainty, I
report 95% confidence intervals for both the portfolio weights and the welfare losses. The confidence intervals are calculated
using a wild bootstrapping procedure (Mammen, 1993).

3. Data

Table 1 shows the sample statistics along with the mnemonic codes for each data series. All the data series are downloaded
from Thompson Reuters DataStream. The sample period is from January 1996–Apil 2015 and is composed of monthly observa-
tions. Following extant literature, I employed the Dow Jones total return Islamic indices encompassing world, developed countries,
emerging markets, and United States to analyse the portfolio characteristics of Islamic equities.
Dow Jones Islamic indices comprise stocks of the companies that meet the Shariah requirements on various parameters such
as acceptable products, business activities, debt levels, and interest income and expenses. The screening methodology is devised
based upon the input from an independent Shariah supervisory board. For instance, companies involved in industries such as al-
cohol, pork-related products, conventional financial services, entertainment, tobacco, weapons and defence are excluded. Similar-
ly, the financial screening ensures exclusion of companies for which any of the following three parameters are greater than 33%;
the total debt divided by trailing 24 month average market capitalisation; the sum of a company's cash; and interest-bearing se-
curities divided by trailing 24-month average market capitalisation and the accounts receivables divided by trailing 24-month av-
erage market capitalisation.
For the conventional equities, I employed Dow Jones global total return indices for world, developed, and emerging markets. I
used DataStream total return index data for United States because Dow Jones index for United States was unavailable for the en-
tire sample period. Also, I employed the total return index for US 3 months T-bills as benchmark asset for both the faith-based
(Islamic) and conventional asset menus. I used book-price ratio as the predictor variable.7 All returns are denominated in US
5
EVL ranges between 0 to 100%. An EVL of 0 implies that the welfare losses due to the sub-optimal allocation are lowest, while an EVL of 100% implies the welfare
losses due to sub-optimal allocation are the largest.
6
The value function reaches a finite limit for ψ → 1.
7
The reason for using book-price ratio as the predictor variables are explained in Section 4.

Please cite this article as: Umar, Z., Islamic vs conventional equities in a strategic asset allocation framework, Pacific-Basin Finance
Journal (2015), http://dx.doi.org/10.1016/j.pacfin.2015.10.006
 Z. Umar / Pacific-Basin Finance Journal xxx (2015) xxx–xxx 5

Table 2
Welfare losses for an investor whose asset menu includes Islamic equities and benchmark asset.

Developed Emerging United Developed Emerging United Developed Emerging United

World world markets States World world markets States World world markets States

Welfare loses from ignoring Welfare loses from ignoring Welfare loses from ignoring
γ Total demand Myopic demand Intertemporal hedge demand

2 93.4 93.5 85.3 84.4 91.4 91.2 85.0 81.2 23.7 25.8 1.6 17.0
L 82.6 82.9 60.7 69.6 79.4 80.4 60.1 68.4 5.5 5.9 0.1 2.5
U 99.8 99.8 99.4 99.3 99.7 99.7 99.3 98.7 50.6 54.0 17.3 49.4
5 77.0 77.6 54.6 64.1 65.3 64.9 53.7 53.0 33.7 36.0 2.0 23.5
L 57.2 58.5 32.1 42.3 51.3 51.6 31.4 38.5 7.9 8.6 0.1 2.7
U 95.2 95.3 88.4 92.5 89.9 89.3 86.0 82.9 62.9 65.1 23.7 59.1
7 68.3 69.1 43.3 54.8 54.4 54.1 42.3 43.3 30.6 32.7 1.6 20.4
L 47.6 48.6 24.1 33.0 40.9 41.4 23.9 29.6 6.1 7.3 0.1 2.1
U 90.1 90.8 79.0 86.6 80.4 79.9 75.2 72.0 58.2 61.0 21.1 54.6
10 58.5 59.5 32.8 45.1 44.1 44.0 32.0 34.7 25.8 27.7 1.1 16.0
L 37.5 38.1 17.7 24.3 31.4 32.1 17.2 21.7 4.9 5.3 0.1 1.4
U 82.4 83.3 67.1 78.0 68.6 68.1 62.5 59.6 51.8 53.6 17.9 47.7

Notes: This table shows the percentage welfare losses from ignoring the total, myopic and intertemporal hedge demands for different values of (Coefficient of rel-
ative risk aversion). The values in bold are the parameter estimate and the values in regular text are the bounds of 95% confidence intervals (“L” is the lower bound
and “U” is upper bound of the confidence interval).

dollars. The excess equity returns are calculated as the difference between the log equity return and log T-bill return. The real re-
turn on benchmark asset is calculated as the difference between the log T-bill return and log inflation rate.
A quick look at Table 1 shows that the mean monthly percentage excess return and Sharpe ratios for Islamic equities are
higher than those for the conventional indices. The highest mean return and Sharpe ratio is for United States. Thus, based
upon sample statistics Islamic equities appear to be a slightly better choice than conventional equities.

Table 3
Portfolio weights for an investor whose asset menu includes Islamic equities and benchmark asset.

World Developed world

Islamic equities Benchmark asset Islamic equities Benchmark asset

Total Myopic Hedge Total Myopic Hedge Total Myopic Hedge Total Myopic Hedge

2 207.38 128.02 79.36 −107.38 −28.02 −79.36 217.12 132.37 84.75 −117.12 −32.37 −84.75
L 107.50 70.27 30.14 −253.73 −117.44 −145.89 109.82 69.11 31.78 −268.11 −121.93 −159.66
U 353.73 217.44 145.89 −7.50 29.73 −30.14 368.11 221.93 159.66 −9.82 30.89 −31.78
5 127.30 51.34 75.97 −27.30 48.66 −75.97 135.11 53.07 82.03 −35.11 46.93 −82.03
L 55.45 28.22 19.19 −125.64 12.79 −150.70 58.37 27.57 22.44 −145.77 10.88 −164.32
U 225.64 87.21 150.70 44.55 71.78 −19.19 245.77 89.12 164.32 41.63 72.43 −22.44
7 98.97 36.73 62.24 1.03 63.27 −62.24 105.57 37.97 67.60 −5.57 62.03 −67.60
L 37.72 20.27 12.56 −82.59 37.62 −129.63 41.14 19.75 15.57 −97.13 36.30 −138.88
U 182.59 62.38 129.63 62.28 79.73 −12.56 197.13 63.70 138.88 58.86 80.25 −15.57
10 72.10 25.77 46.33 27.90 74.23 −46.33 77.42 26.64 50.78 22.58 73.36 −50.78
L 22.71 14.19 5.17 −42.49 56.24 −104.11 25.97 13.89 7.64 −53.14 55.36 −111.53
U 142.49 43.76 104.11 77.29 85.81 −5.17 153.14 44.64 111.53 74.03 86.11 −7.64

Emerging world United States

Islamic equities Benchmark asset Islamic equities Benchmark asset

Total Myopic Hedge Total Myopic Hedge Total Myopic Hedge Total Myopic Hedge

2 65.65 53.37 12.28 34.35 46.63 −12.28 202.38 137.08 65.30 −102.38 −37.08 −65.30
L 2.65 2.96 −2.41 −45.30 −12.03 −42.24 108.92 78.50 19.96 −247.54 −118.36 −139.76
U 145.30 112.03 42.24 97.35 97.04 2.41 347.54 218.36 139.76 −8.92 21.50 −19.96
5 29.89 21.53 8.36 70.11 78.47 −8.36 110.14 54.92 55.22 −10.14 45.08 −55.22
L 0.39 1.52 −3.47 24.72 55.08 −35.13 49.98 31.37 8.04 −117.31 12.68 −140.21
U 75.28 44.92 35.13 99.61 98.48 3.47 217.31 87.32 140.21 50.02 68.63 −8.04
7 21.56 15.46 6.09 78.44 84.54 −6.09 81.75 39.27 42.49 18.25 60.73 −42.49
L −0.65 1.24 −3.93 43.76 67.86 −29.04 33.80 22.45 1.91 −73.79 37.64 −120.19
U 56.24 32.14 29.04 100.65 98.76 3.93 173.79 62.36 120.19 66.20 77.55 −1.91
10 14.89 10.92 3.98 85.11 89.08 −3.98 56.32 27.53 28.79 43.68 72.47 −28.79
L −1.54 0.97 −4.22 58.50 77.45 −22.61 19.23 15.75 −2.56 −32.08 56.40 −96.34
U 41.50 22.55 22.61 101.54 99.03 4.22 132.08 43.60 96.34 80.77 84.25 2.56

Note: This table shows the percentage portfolio weights for different values of (Coefficient of relative risk aversion). The values in bold are the parameter estimate
and the values in regular text are the bounds of 95% confidence intervals (“L” is the lower bound and “U” is upper bound of the confidence interval).

Please cite this article as: Umar, Z., Islamic vs conventional equities in a strategic asset allocation framework, Pacific-Basin Finance
Journal (2015), http://dx.doi.org/10.1016/j.pacfin.2015.10.006
6 Z. Umar / Pacific-Basin Finance Journal xxx (2015) xxx–xxx

Table 4
Welfare losses for an investor whose asset menu includes conventional equities, Islamic equities, and benchmark asset.

World Developed Emerging United World Developed Emerging United World Developed Emerging United
world markets States world markets States world markets States

Welfare loses from ignoring total demand Welfare loses from ignoring myopic demand Welfare loses from ignoring hedge demand

Effect_Islamic
2 86.9 87.7 83.4 83.0 86.3 87.3 82.0 81.5 3.8 3.6 7.7 7.7
L 66.2 67.9 56.5 61.0 64.2 65.4 54.9 55.2 0.8 0.7 1.2 1.0
U 99.6 99.6 99.5 99.7 99.4 99.5 99.0 99.5 42.2 42.8 56.1 43.6
5 53.7 54.9 49.3 50.7 52.0 53.3 45.8 41.5 3.5 3.3 6.4 15.7
L 34.7 35.9 27.5 31.3 24.1 25.7 21.9 0.0 1.1 1.1 1.1 1.3
U 85.7 86.3 84.5 88.5 81.3 82.2 77.5 84.9 39.9 39.5 41.0 61.8
7 41.9 42.9 38.1 39.8 40.3 41.4 34.8 28.9 2.7 2.5 5.1 15.3
L 26.4 27.0 20.4 23.6 12.9 15.3 15.1 0.0 0.9 1.0 0.9 1.2
U 74.7 75.5 73.0 78.5 68.4 69.4 64.3 72.8 36.0 34.7 33.4 59.7
10 31.1 32.0 28.4 30.1 29.8 30.8 25.5 19.1 1.8 1.8 3.9 13.6
L 19.3 19.7 14.4 17.3 5.6 7.8 8.7 0.0 0.7 0.8 0.7 1.1
U 61.4 62.4 59.5 66.3 54.6 55.1 50.8 58.4 31.3 30.4 26.0 53.7

Effect_Conventional
2 92.3 93.1 87.1 90.5 88.8 89.7 86.2 83.7 31.5 33.3 6.1 41.7
L 71.7 73.5 61.6 70.0 49.3 52.7 52.3 36.3 12.5 13.3 2.2 13.7
U 99.8 99.8 99.6 99.9 99.6 99.6 99.4 99.7 73.3 74.1 51.3 81.5
5 68.0 69.3 57.3 67.5 40.8 41.5 53.6 35.5 45.9 47.5 8.0 49.5
L 43.1 43.9 31.9 42.0 0.0 0.0 11.0 0.0 20.3 20.5 2.6 18.1
U 91.5 92.2 87.9 93.9 81.2 81.9 83.8 83.5 77.9 79.3 49.6 84.2
7 57.7 59.0 46.3 57.9 25.9 26.3 42.2 23.9 42.9 44.3 7.1 44.7
L 34.6 35.5 24.3 33.4 0.0 0.0 3.5 0.0 19.8 19.4 2.3 15.4
U 83.7 84.6 77.8 87.5 67.8 68.3 72.1 71.0 72.7 74.3 42.2 79.6
10 47.4 48.5 36.1 48.3 15.5 15.7 32.1 16.7 37.7 39.0 5.9 37.9
L 26.6 27.8 18.1 25.7 0.0 0.0 0.0 0.0 16.5 15.9 1.8 11.9
U 73.1 74.7 65.4 78.5 53.7 55.3 58.7 57.4 65.1 67.1 34.4 72.6

Notes: This table shows the percentage welfare losses from ignoring the total, myopic and intertemporal hedge demand for different values of (coefficient of rel-
ative risk aversion). The first (Effect_Islamic) and the second (Effect_Conventional) panel shows the welfare losses from ignoring the total, myopic and hedge de-
mand of Islamic and conventional equities, respectively. The values in bold are the parameter estimate and the values in regular text are the bounds of 95%
confidence intervals (“L” is the lower bound and “U” is upper bound of the confidence interval).

4. Empirical results and discussion

I employed the VAR (1) model in Eq. (2.4) to capture the time varying dynamics of equity returns and used the log book-price
ratio as the predictor variable. I estimated the model by employing other commonly used predictors mentioned in the literature
such as dividend yields and nominal interest rates.8 However, the demand for equities with the larger VAR model containing
three predictor variables (book-price ratio, dividend yield and nominal interest rate) was similar to the one containing only
one predictor variable (book-price ratio). Therefore, in the spirit of parsimony, I opted for the book price ratio as the only predic-
tor variable.9
In order to analyse the effect of risk aversion on portfolio decision, the welfare losses and portfolio weight are calculated for
different values of γ (coefficient of relative risk aversion). Campbell et al. (2003) use γ = 1, 2, 5 and 20, whereas, Rapach and
Wohar (2009) use γ = 4, 7 and 10. Similarly, both these studies employ an annual discount factor of δ = 0.92. I report the results
for γ = 1, 2, 5 and 20, δ = 0.92 (monthly value of δ = 0.921/12) and the intertemporal elasticity of substitution, ψ = 1.10 The
portfolio weights and welfare losses are calculated using Eqs. (2.7) and (2.10), respectively.
I considered two types of investors, categorised based upon their asset menus; an investor whose asset menu comprises
Islamic equities and the benchmark asset and an investor whose asset menu includes conventional equities in addition to the Is-
lamic equities and the benchmark asset. The first type of investor is termed as a faith-based investor, who excludes conventional
equities from his asset menu because of their non-compliance with Shariah principles. The second type of investor is termed as a
conventional investor, who can invest in both Islamic and conventional equities based upon their portfolio attributes.
In the following sections, I discuss the welfare effects from optimal and restricted asset allocation for both the faith-based and
the conventional investors.

8
Rapach and Zhou (2013) document a recent literature survey on predictors of equity returns.
9
The estimated VAR(1) model along with correlation matrices are shown in Tables 6-8.
10
As a robustness check, I calculated the welfare losses and portfolio weights for γ = 50, 100, 200 and 300; δ = 0.85, 0.92 and 0.95. The results are consistent for
various model parameters.

Please cite this article as: Umar, Z., Islamic vs conventional equities in a strategic asset allocation framework, Pacific-Basin Finance
Journal (2015), http://dx.doi.org/10.1016/j.pacfin.2015.10.006
 Z. Umar / Pacific-Basin Finance Journal xxx (2015) xxx–xxx 7

4.1. Welfare effect and demand for a faith-based investor

In this section, I discuss the welfare effects for the faith-based investor whose asset menu comprises Islamic equities and
benchmark asset. Table 2 shows the welfare losses for the faith-based investor from ignoring the total, myopic and intertemporal
hedge demand for Islamic equities. In general, ignoring the demand for Islamic equities in the portfolio leads to sizable welfare
losses for both risk-tolerant and risk-averse investors. The confidence intervals show that all the welfare losses are statistically
different than zero.

Table 5
Portfolio weights for an investor whose asset menu includes conventional equities, Islamic equities, and benchmark asset.

Islamic Conventional Bills

Total Myopic Hedge Total Myopic Hedge Total Myopic Hedge

World
2 366.4 390.0 −23.6 −191.6 −279.2 87.6 −74.9 −10.8 −64.0
L −280.7 −299.5 −101.3 −1072.3 −1,142.8 −7.1 −266.4 −105.0 −167.7
U 1,150.7 1,202.3 34.2 576.1 459.4 205.5 90.7 71.2 26.6
5 142.1 156.5 −14.4 −18.3 −112.1 93.8 −23.8 55.6 −79.4
L −116.0 −119.4 −63.5 −406.8 −458.3 8.8 −152.2 17.5 −177.3
U 451.1 481.8 30.8 316.5 183.1 192.9 92.1 88.6 6.5
7 101.5 112.0 −10.5 0.6 −80.2 80.8 −2.1 68.2 −70.3
L −83.0 −85.1 −49.1 −286.2 −328.0 6.1 −108.1 41.0 −155.4
U 321.1 344.4 27.6 244.9 130.5 168.5 93.2 91.7 3.8
10 71.6 78.6 −7.1 7.9 −56.3 64.2 20.5 77.7 −57.2
L −56.6 −59.4 −36.7 −195.9 −230.2 4.6 −65.9 58.6 −127.8
U 225.0 241.5 22.7 187.8 91.0 138.3 94.2 94.4 2.4

Developed
2 354.0 376.9 −22.9 −167.5 −262.3 94.8 −86.5 −14.5 −72.0
L −277.1 −290.6 −98.5 −1,042.6 −1,094.8 1.4 −289.9 −115.2 −180.5
U 1,106.7 1,151.2 35.1 602.3 444.6 215.1 87.6 72.1 20.1
5 137.1 151.3 −14.2 −3.2 −105.4 102.3 −34.0 54.1 −88.1
L −117.0 −115.1 −63.0 −382.2 −438.5 14.5 −175.5 13.9 −195.7
U 428.6 460.7 31.1 330.2 177.7 213.7 85.4 88.8 2.3
7 98.0 108.4 −10.4 12.9 −75.5 88.4 −10.9 67.2 −78.1
L −83.3 −82.2 −48.8 −266.8 −313.8 10.7 −128.1 38.5 −173.0
U 305.2 329.0 26.7 258.9 127.5 183.9 86.3 92.0 1.4
10 69.2 76.2 −7.0 17.4 −53.1 70.6 13.4 77.0 −63.6
L −58.8 −57.6 −35.9 −183.4 −220.0 7.9 −83.9 57.0 −144.2
U 215.9 230.3 22.3 199.3 89.4 152.6 90.5 94.3 2.2

EM
2 87.1 94.7 −7.6 −21.4 −42.6 21.2 34.3 47.9 −13.6
L −389.8 −430.5 −69.7 −484.6 −520.4 −14.8 −51.4 −6.6 −58.2
U 536.6 580.4 51.0 492.8 481.7 72.0 101.0 95.6 26.8
5 33.7 37.4 −3.7 0.4 −16.4 16.8 65.8 79.0 −13.1
L −150.6 −172.2 −38.6 −182.4 −207.7 −5.8 19.2 57.2 −46.8
U 212.3 231.0 31.3 202.2 193.4 50.2 101.4 98.0 13.1
7 23.8 26.5 −2.8 2.3 −11.4 13.7 73.9 84.9 −10.9
L −105.3 −122.6 −28.8 −128.2 −148.1 −4.2 37.8 69.4 −38.4
U 149.8 164.8 24.0 146.2 138.5 39.7 101.1 98.5 10.2
10 16.3 18.4 −2.1 3.0 −7.7 10.7 80.7 89.3 −8.6
L −73.0 −85.4 −21.1 −88.7 −102.8 −2.7 53.3 78.5 −30.1
U 104.0 115.0 18.0 102.2 97.3 30.1 100.7 98.8 7.4

United States
2 45.0 70.2 −25.1 189.0 73.8 115.2 −134.0 −43.9 −90.1
L −474.1 −419.8 −91.0 −373.2 −458.0 23.4 −296.2 −132.3 −182.5
U 561.9 576.7 26.4 788.3 611.7 255.3 −12.0 14.7 −30.6
5 3.5 29.1 −25.6 146.8 28.4 118.4 −50.3 42.4 −92.7
L −214.6 −167.4 −92.9 −109.7 −185.1 23.9 −181.8 7.4 −198.1
U 228.4 232.2 22.0 443.8 242.3 272.7 33.5 66.1 −28.9
7 0.5 21.3 −20.8 118.8 19.8 99.0 −19.4 58.9 −78.2
L −161.0 −119.6 −80.7 −76.8 −133.1 14.0 −134.3 33.8 −178.5
U 165.9 166.6 18.6 362.5 171.9 239.5 49.9 75.9 −21.0
10 0.8 15.5 −14.7 88.2 13.3 74.8 11.1 71.2 −60.2
L −116.1 −83.2 −65.1 −50.3 −94.1 5.4 −87.0 53.8 −148.9
U 119.5 117.3 16.2 277.9 119.1 202.6 66.5 83.2 −11.9

Note: This table shows the percentage portfolio weights for different values of (Coefficient of relative risk aversion). The values in bold are the parameter estimate
and the values in regular text are the bounds of 95% confidence intervals (“L” is the lower bound and “U” is upper bound of the confidence interval).

Please cite this article as: Umar, Z., Islamic vs conventional equities in a strategic asset allocation framework, Pacific-Basin Finance
Journal (2015), http://dx.doi.org/10.1016/j.pacfin.2015.10.006
8 Z. Umar / Pacific-Basin Finance Journal xxx (2015) xxx–xxx

Next, let us look at the decomposition of the welfare losses stemming from ignoring the myopic and hedge demand for Islamic
equities. The welfare losses from ignoring myopic demand are again sizable for all the investors. The sizable welfare losses maybe
attributable to the higher Sharpe ratios of Islamic equities. The welfare losses due to ignoring hedging demand for equities, al-
though not as high as the myopic losses, are moderately sizable for United States, world and developed countries. The welfare
losses from ignoring the hedge demand for emerging markets Islamic equities are the lowest.
In Table 2, a risk tolerant investor (lower level of risk aversion) has a higher proportion of myopic demand in the composition
of their total demand for Islamic equities. Thus, we see higher welfare losses from ignoring the myopic demand for Islamic equi-
ties. Such a risk tolerant investor might look for higher returns without giving much importance to the hedging objective. On the
contrary, the welfare losses for a risk-averse investor (higher level of risk aversion) exhibit a higher proportion of total welfare
losses attributable to the intertemporal hedge demand. A risk-averse investor is a conservative investor, and thus the hedging mo-
tive is much more important for such an investor. This hedging motive is attributable to the higher proportion of welfare losses
due to ignoring the hedge demand for equities.
The welfare losses reported above show the economic significance of the total, myopic and hedge demands for Islamic equities.
I extend my analysis and calculate the mean asset allocation for Islamic equities and benchmark asset. Table 3 reports the mean
allocation for Islamic equities along with the allocation attributable to the myopic and the hedge demands. The mean allocation
shows the percentage amount of wealth that an investor chooses to invest in Islamic equities and benchmark asset. The negative
demand for benchmark asset implies that the investor takes a short position in the benchmark asset and invests that wealth in
equities. The decomposition of total demand into its myopic and intertemporal hedge components enables us to analyse the de-
mand for equities attributable to their short-term and long-term desirability, respectively. Here again, for lower level of risk aver-
sion (risk tolerant investors) the total demand for Islamic equities attributable to the myopic demand is substantially higher.
However, for higher level of risk aversion (risk-averse investors) hedge demand is the main contributor to the total demand
for Islamic equities.
The empirical results for the faith-based investor shed light on the short-run and long-run desirability of Islamic equities in the
portfolio of a faith-based investor. The results show that Islamic equities exhibit desirable attributes for both short-term as well as
long-term investors and for both risk-tolerant as well as risk-averse investors.
However, another important question is, whether there are any welfare losses (the opportunity cost) for the faith-based inves-
tor by excluding the conventional equities from the asset menu? This question and the asset allocation choices for the convention-
al investor will be discussed in the next section.

4.2. Welfare effect and demand for conventional investor

In this section, I discuss the welfare effects and asset allocation for an investor who can invest in both Islamic and conventional
equities and the benchmark asset. In this way, I compare the performance of the Islamic equities with the conventional equities.
In addition, it also gives us an opportunity to analyse the diversification benefits, if any, of Islamic equities.
The top and bottom panel of Table 4 show the welfare losses from ignoring the demand for Islamic and conventional equities,
respectively. The top panel shows the welfare losses for an investor who can invest both in Islamic and conventional equities but
chooses to invest in conventional equities only. The bottom panel shows the welfare losses for an investor who chooses to invest
in conventional equities only and ignores Islamic equities. The total welfare losses are further decomposed into the welfare losses
stemming from ignoring the myopic and intertemporal hedge demand for equities.
The welfare losses from ignoring the conventional equities are, in general, larger than those from ignoring Islamic equities. The
difference in the welfare losses increases with an increase in risk aversion level, implying that risk averse investors incur more
economic losses by not investing in conventional equities. Another striking pattern in Table 5 is that the welfare losses incurred
by ignoring the intertemporal hedge demand for conventional equities are substantially higher than those from ignoring the
intertemporal hedge demand for Islamic equities. These results show that conventional equities are more desirable for long-
term investors than their Islamic counterpart.
Next, let us analyse what proportion of the total wealth an investor may allocate to Islamic, conventional, and benchmark
asset. Table 6 reports the percentage wealth allocated to each of these assets. The total demand for Islamic equities is higher
than that for the conventional equities for all regions except United States. However, the main driver for this demand is the

Table 6
Estimation results for the investor whose asset menu includes Islamic equities and benchmark asset.

World Developed Emerging markets United States

rbill xst bp R2 rbill xst bp R2 rbill xst bp R2 rbill xst bp R2

0.42 −0.02 0.00 0.35 0.42 −0.02 0.00 0.35 0.47 −0.01 0.00 0.33 0.42 −0.01 0.00 0.33
rbill (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.00) (0.11) (0.00) (0.01) (0.00)
1.64 0.10 0.03 0.04 1.57 0.09 0.03 0.04 2.29 0.15 0.04 0.04 1.00 0.04 0.02 0.02
xst (0.06) (0.30) (0.04) (0.07) (0.33) (0.04) (0.09) (0.08) (0.08) (0.24) (0.68) (0.11)
−0.38 −0.83 1.00 0.99 −0.30 −0.85 1.00 0.99 −0.20 −0.65 0.98 0.97 0.06 −0.91 1.00 0.99
bp (0.50) (0.00) (0.00) (0.62) (0.00) (0.00) (0.74) (0.00) (0.00) (0.94) (0.00) (0.00)

Notes: This table shows the VAR(1) coefficient along with the P-values(in parenthesis). “rbill” is the real return on benchmark asset, “xst” is the excess return on
Islamic equities and “bp” is the book-price ratio.

Please cite this article as: Umar, Z., Islamic vs conventional equities in a strategic asset allocation framework, Pacific-Basin Finance
Journal (2015), http://dx.doi.org/10.1016/j.pacfin.2015.10.006
 Z. Umar / Pacific-Basin Finance Journal xxx (2015) xxx–xxx 9

Table 7
Residual correlation in VAR model for the investor whose asset menu includes Islamic equities and benchmark asset.

World Developed Emerging markets United States

rbill xst bp rbill xst bp rbill xst bp rbill xst bp

rbill 1.00 −0.04 −0.07 1.00 −0.04 −0.08 1.00 −0.08 0.03 1.00 −0.03 −0.06
xst −0.04 1.00 −0.01 −0.04 1.00 0.00 −0.08 1.00 0.07 −0.03 1.00 0.04
bp −0.07 −0.01 1.00 −0.08 0.00 1.00 0.03 0.07 1.00 −0.06 0.04 1.00

Notes: This table shows the residual correlation for the VAR(1) model. “rbill” is the real return on benchmark asset, “xst” is the excess return on Islamic equities
and “bp” is the book-price ratio.

myopic demand, which stems from the higher Sharpe ratios for the Islamic equities. Nevertheless, for all these regions, conven-
tional equities have a positive hedge demand, implying the long-term desirability of conventional equities in the long run.
Thus, Islamic equities might be a desirable investment option for shorter investment horizons. However, for longer investment
horizons conventional equities are more desirable to investors.

Table 8
Estimation results and residual correlation for the investor whose asset menu includes conventional equities, Islamic equities, and benchmark asset.

VAR coefficients Correlation matrix

World

rbill xst_i xst_c bp R2 rbill xst_i xst_c bp

rbill 0.42 −0.02 0.00 0.00 0.35 rbill 1.00 −0.04 −0.03 −0.08
(0.00) (0.30) (0.95) (0.00) xst_i −0.04 1.00 0.97 −0.02
xst_i 1.62 0.19 −0.10 0.03 0.04 xst_c −0.03 0.97 1.00 −0.03
(0.06) (0.52) (0.73) (0.04) bp −0.08 −0.02 −0.03 1.00
xst_c 1.35 0.07 0.05 0.04 0.05
(0.15) (0.80) (0.86) (0.02)
bp −0.56 −0.05 −0.83 1.00 0.99
(0.21) (0.57) (0.00) (0.00)

Developed Markets

rbill xst_i xst_c bp R2 rbill xst_i xst_c bp

rbill 0.42 −0.02 0.00 0.00 0.35 rbill 1.00 −0.04 −0.03 −0.09
(0.00) (0.29) (0.96) (0.00) xst_i −0.04 1.00 0.97 −0.01
xst_i 1.56 0.16 −0.07 0.03 0.04 xst_c −0.03 0.97 1.00 −0.03
(0.07) (0.59) (0.81) (0.04) bp −0.09 −0.01 −0.03 1.00
xst_c 1.27 0.03 0.09 0.03 0.05
(0.17) (0.91) (0.75) (0.03)
bp −0.46 −0.05 −0.85 1.01 0.99
(0.31) (0.58) (0.00) (0.00)

Emerging markets

rbill xst_i xst_c bp R2 rbill xst_i xst_c bp

rbill 0.47 0.00 −0.01 0.00 0.33 rbill 1.00 −0.09 −0.10 0.02
(0.00) (0.64) (0.41) (0.15) xst_i −0.09 1.00 0.97 0.05
xst_i 2.01 0.46 −0.32 0.05 0.05 xst_c −0.10 0.97 1.00 0.05
(0.14) (0.12) (0.27) (0.06) bp 0.02 0.05 0.05 1.00
xst_c 1.41 0.34 −0.19 0.06 0.05
(0.31) (0.20) (0.47) (0.02)
bp −0.55 −0.25 −0.42 0.98 0.97
(0.32) (0.04) (0.00) (0.00)

United States

rbill xst_i xst_c bp R2 rbill xst_i xst_c bp

rbill 0.42 −0.02 0.01 0.00 0.33 rbill 1.00 −0.03 0.00 −0.04
(0.00) (0.07) (0.46) (0.00) xst_i −0.03 1.00 0.97 0.04
xst_i 1.00 0.08 −0.05 0.02 0.02 xst_c 0.00 0.97 1.00 0.03
(0.25) (0.77) (0.86) (0.12) bp −0.04 0.04 0.03 1.00
xst_c 0.59 0.11 −0.03 0.02 0.03
(0.51) (0.69) (0.91) (0.11)
bp −0.05 0.23 −1.26 1.00 1.00
(0.90) (0.05) (0.00) (0.00)

Notes: The left half of this table shows the VAR(1) coefficient along with the P-values(in parenthesis). The right half shows the residual correlation of the
VAR(1) model. “rbill” is the real return on benchmark asset, “xst_i” is the excess return on Islamic equities, “xst_c” is the excess return on conventional equities
and “bp” is the book-price ratio.

Please cite this article as: Umar, Z., Islamic vs conventional equities in a strategic asset allocation framework, Pacific-Basin Finance
Journal (2015), http://dx.doi.org/10.1016/j.pacfin.2015.10.006
10 Z. Umar / Pacific-Basin Finance Journal xxx (2015) xxx–xxx

The welfare effects for the conventional investor can be, qualitatively, used to assess the gains/losses for the faith-based inves-
tor. The welfare losses incurred by the conventional investor due to ignoring the conventional equities, in the optimal portfolio,
can also be termed as an opportunity cost incurred by the faith-based investor due to the exclusion of conventional equities
from the faith-based asset menu. The sizable welfare losses from ignoring the demand for conventional equities in the optimal
portfolio show that a faith-based investor incurs substantial welfare losses by excluding conventional equities from the asset
menu.

5. Conclusion

In recent years, Islamic equities have attracted a lot of interest from academics and practitioners. This study takes into consid-
eration, the time-varying nature of investment opportunities and the analyses of the portfolio choice problem of two types of in-
vestors. The portfolio problem is analysed by quantifying the welfare affect and portfolio weights for short-term and long-term
investment horizons and for varying level of risk aversion.
The results for the faith-based investor show that on a standalone basis, Islamic equities exhibit desirable short-run and long-
run portfolio characteristics. However, the analysis of the portfolio choice problem of the conventional investor shows that Islamic
equities have desirable attributes for short-run and conventional equities are more desirable in the long-run. Thus, from a strate-
gic asset allocation perspective, conventional equities are more desirable to long-run investors than their Islamic counter parts.
Due to their higher Sharpe ratios, Islamic equities are desirable to investors in the short-run. However, in the long-run, conven-
tional equities are more desirable owing to their intertemporal hedging demand. Another important finding is that faith based
investor incurs welfare losses by excluding conventional equities from their asset menu. The results are consistent for both risk
averse and risk tolerant investors.
The results of this study have important implications for individual as well as institutional investors such as pension funds and
insurance companies.

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Please cite this article as: Umar, Z., Islamic vs conventional equities in a strategic asset allocation framework, Pacific-Basin Finance
Journal (2015), http://dx.doi.org/10.1016/j.pacfin.2015.10.006