Marzban Thesis

See discussions, stats, and author profiles for this publication at: https://www.researchgate.
net/publication/280622849
Shariah-compliant Portfolio Management: Processes, Methodologies, and

Performances
Chapter · January 2011

DOI: 10.1002/9781119206040.ch19
CITATIONS READS
0 1,493
1 author:
Shehab Marzban
Shekra Crowdfunding
17 PUBLICATIONS 450 CITATIONS
SEE PROFILE
All content following this page was uploaded by Shehab Marzban on 20 September 2018.
The user has requested enhancement of the downloaded file.

Strategies, Paradigms and Systems for
Shariah-Compliant Portfolio
Management
Doctoral Dissertation
Submitted in Partial Fulfillment of the Requirements
for the
Degree of Doctor of Philosophy
in the
Faculty of Economics, Management and Social Sciences
of the
University of Cologne
2008
submitted by
Shehab Marzban, MSc.

from Cairo - Egypt
Referent: Prof. Dr. Dr. Ulrich Derigs
Koreferent: Prof. Dr. Thomas Hartmann-Wendels
Tag der Promotion:
To my father and mentor Abdallah Marzban (1947-2007)
iv
Contents
1 Introduction 1
1.1 Islamic Finance and Equity Management . . . . . . . . . . . . . . 1
1.2 Motivation and Hypotheses . . . . . . . . . . . . . . . . . . . . . 3
1.3 Structure of the Thesis . . . . . . . . . . . . . . . . . . . . . . . . 6
I Fundamentals of Portfolio Management and Shariah 9
2 Portfolio Management 11
2.1 Introduction to Portfolio Management . . . . . . . . . . . . . . . 11
2.1.1 Portfolio Management Strategies . . . . . . . . . . . . . . 12
2.1.1.1 Active Portfolio Management Strategy . . . . . . 12
2.1.1.2 Passive Portfolio Management Strategy . . . . . . 13
2.1.1.3 Active versus Passive Portfolio Management . . . 14
2.2 Portfolio Optimization Modeling . . . . . . . . . . . . . . . . . . . 14
2.2.1 Portfolio Representation . . . . . . . . . . . . . . . . . . . 14
2.2.2 Measuring Portfolio Return and Risk . . . . . . . . . . . . 15
2.2.3 Classical Portfolio Models . . . . . . . . . . . . . . . . . . 17
2.2.3.1 Markowitz Mean-Variance Model . . . . . . . . . 17
2.2.3.2 Index Tracking Model . . . . . . . . . . . . . . . 18
2.2.4 Portfolio Model Extensions . . . . . . . . . . . . . . . . . . 19
2.2.4.1 Constraints . . . . . . . . . . . . . . . . . . . . . 19
2.2.4.2 Rebalancing - Optimization over Time . . . . . . 22
2.2.4.3 Transaction Costs . . . . . . . . . . . . . . . . . 23
v
CONTENTS
3 Shariah Issues in Portfolio Management 25

3.1 General Shariah Issues . . . . . . . . . . . . . . . . . . . . . . . . 25
3.1.1 Riba . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.1.2 Gharar, Quimar and Maysir . . . . . . . . . . . . . . . . . 26
3.1.3 Shariah Ruling . . . . . . . . . . . . . . . . . . . . . . . . 28
3.1.4 Shariah-Compliant Fund Management Contracts . . . . . . 31
3.2 Shariah Compliance Screening . . . . . . . . . . . . . . . . . . . . 32
3.2.1 Qualitative Screening . . . . . . . . . . . . . . . . . . . . . 33
3.2.2 Quantitative Screening . . . . . . . . . . . . . . . . . . . . 34
3.2.2.1 Liquidity Screens . . . . . . . . . . . . . . . . . . 35
3.2.2.2 Interest Screens . . . . . . . . . . . . . . . . . . . 36
3.2.2.3 Debt Screens . . . . . . . . . . . . . . . . . . . . 36
3.2.2.4 Non-Permissible Income Screens . . . . . . . . . . 36
3.2.3 Analysis of Shariah Screens . . . . . . . . . . . . . . . . . 37
3.2.3.1 Ratio Divisors: Market Cap and Total Assets . . 38
3.2.3.2 Range of Threshold Values . . . . . . . . . . . . 39
3.3 Shariah Purification . . . . . . . . . . . . . . . . . . . . . . . . . . 41
3.3.1 Dividend-based Purification . . . . . . . . . . . . . . . . . 43
3.3.2 Capital Gain and Dividend Purification . . . . . . . . . . . 45
3.3.3 Investment-based Purification . . . . . . . . . . . . . . . . 46
II New Concepts for Shariah-Compliance and Devel-

opment of an SPMDSS 49
4 New Strategies and Paradigms for Shariah Portfolio Manage-

ment 51
4.1 Shariah Screening Strategies and Paradigms . . . . . . . . . . . . 51
4.1.1 New Shariah Compliance Strategies . . . . . . . . . . . . . 51
4.1.1.1 Best of Strategy . . . . . . . . . . . . . . . . . . 52
4.1.1.2 Consensus / Ijmaa Strategy . . . . . . . . . . . . 53
4.1.1.3 Liberal Strategy . . . . . . . . . . . . . . . . . . 54
4.1.1.4 Majority / Kasra Strategy . . . . . . . . . . . . . 54
4.1.2 A New Paradigm for Shariah-Compliance . . . . . . . . . . 54
vi
CONTENTS
4.2 Strategies for Shariah Purification . . . . . . . . . . . . . . . . . . 58

4.3 Shariah Sustainability . . . . . . . . . . . . . . . . . . . . . . . . 60
4.4 The Shariah Portfolio Management Process . . . . . . . . . . . . 62
4.4.1 Shariah Issues in Investment Policy Analysis . . . . . . . . 63
4.4.2 Shariah Issues in Financial Analysis . . . . . . . . . . . . . 65
4.4.3 Shariah Issues in Portfolio Construction . . . . . . . . . . 65
4.4.4 Shariah Issues in Performance Analysis and Portfolio Revision 66
5 Shariah Portfolio Optimization Model 67

5.1 Modeling the Shariah Portfolio Problem . . . . . . . . . . . . . . 67
5.1.1 Modeling Asset Compliance Strategies . . . . . . . . . . . 70
5.1.1.1 Best of Strategy . . . . . . . . . . . . . . . . . . 70
5.1.1.2 Consensus / Ijmaa Strategy . . . . . . . . . . . . 71
5.1.1.3 Liberal Strategy . . . . . . . . . . . . . . . . . . 71
5.1.1.4 Majority / Kasra Strategy . . . . . . . . . . . . . 72
5.1.2 Modeling Portfolio Compliance Strategies . . . . . . . . . 72
5.2 Solving the Shariah Portfolio Optimization Models . . . . . . . . 74
6 Shariah Portfolio Management DSS 77

6.1 Decision Support Systems . . . . . . . . . . . . . . . . . . . . . . 77
6.1.1 DSS Technologies . . . . . . . . . . . . . . . . . . . . . . . 78
6.1.2 DSS Architecture . . . . . . . . . . . . . . . . . . . . . . . 79
6.1.3 DSS for Portfolio Management . . . . . . . . . . . . . . . . 80
6.2 DSS for Shariah Portfolio Management . . . . . . . . . . . . . . . 81
6.2.1 Architecture of SPMDSS . . . . . . . . . . . . . . . . . . . 81
6.2.2 Data Component . . . . . . . . . . . . . . . . . . . . . . . 82
6.2.3 Model / Method Component . . . . . . . . . . . . . . . . . 83
6.2.4 Dialog Component . . . . . . . . . . . . . . . . . . . . . . 85
6.3 Examples of Specific SPMDSS . . . . . . . . . . . . . . . . . . . . 88
6.3.1 SPMDSS I - A Screening System . . . . . . . . . . . . . . 88
6.3.2 SPMDSS II - Active Portfolio Management . . . . . . . . . 89
6.3.3 SPMDSS III - Passive Portfolio Management . . . . . . . . 91
vii
CONTENTS
III Empirical Analysis 93
7 Empirical Analysis 95
7.1 Analysis I: Shariah Compliance Comparative Analysis . . . . . . . 95
7.1.1 Basics and Assumptions . . . . . . . . . . . . . . . . . . . 95
7.1.2 Sector Compliance . . . . . . . . . . . . . . . . . . . . . . 97
7.1.3 Financial Compliance . . . . . . . . . . . . . . . . . . . . . 98
7.1.3.1 Size of the Asset Universe . . . . . . . . . . . . . 99
7.1.3.2 Different Classifications among Islamic indexes and
funds . . . . . . . . . . . . . . . . . . . . . . . . 100
7.1.4 Conclusion of Analysis I . . . . . . . . . . . . . . . . . . . 103
7.2 Analysis II: Shariah Compliance in Active Portfolio Management . 104
7.2.1 Data and Portfolio Optimization Model . . . . . . . . . . . 105
7.2.2 Performance of Basic Shariah Strategies . . . . . . . . . . 107
7.2.3 Performance of New Asset-based Shariah Compliance Strate-
gies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
7.2.4 Performance of Portfolio-based Shariah Compliance Strate-
gies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
7.2.5 Conclusion of Analysis II . . . . . . . . . . . . . . . . . . . 115
7.3 Analysis III: Purification and Shariah Sustainability . . . . . . . . 116
7.3.1 Impact of Purification on Portfolio Performance . . . . . . 116
7.3.2 Empirical Analysis of Shariah Sustainability . . . . . . . . 117
7.3.3 Conclusion of Analysis III . . . . . . . . . . . . . . . . . . 119
8 Conclusion 121
8.1 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
8.2 Validating the Hypotheses . . . . . . . . . . . . . . . . . . . . . . 122
8.2.1 Hypothesis H1 . . . . . . . . . . . . . . . . . . . . . . . . . 122
8.2.2 Hypothesis H2 . . . . . . . . . . . . . . . . . . . . . . . . . 122
8.2.3 Hypothesis H3 . . . . . . . . . . . . . . . . . . . . . . . . . 123
8.2.4 Hypothesis H4 . . . . . . . . . . . . . . . . . . . . . . . . . 123
8.3 Future Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
viii
CONTENTS
A Survey of Shariah Guidelines 125

A.1 Dow Jones Islamic Index Group . . . . . . . . . . . . . . . . . . . 126
A.2 Financial Times Islamic Index Series . . . . . . . . . . . . . . . . 127
A.3 Standard and Poor’s Islamic Group . . . . . . . . . . . . . . . . . 129
A.4 Morgan Stanley Capital International Islamic Index Series . . . . 130
A.5 Dubai Islamic Bank . . . . . . . . . . . . . . . . . . . . . . . . . . 131
A.6 HSBC Amanah Fund . . . . . . . . . . . . . . . . . . . . . . . . . 132
A.7 Meezan Islamic Fund . . . . . . . . . . . . . . . . . . . . . . . . . 133
A.8 Amiri Capital Islamic Fund . . . . . . . . . . . . . . . . . . . . . 134
A.9 Azzad Asset Management Islamic Fund . . . . . . . . . . . . . . . 136
A.10 Malaysian Securities and Exchange Commission . . . . . . . . . . 136
B Glossary of Shariah Terms 141
References 154
ix
CONTENTS
x
Chapter 1
Introduction
1.1 Islamic Finance and Equity Management
One type of investor which is globally present and currently increasing in number
as well as in capital value is the Islamic investor. In addition to usual investment
requirements and conventional portfolio management practices, Islamic investors
are only willing to invest their capital if the investment does not conflict with
their religious beliefs, namely with Islam.
For an Islamic investor, a number of Islamic rules and laws need to be adhered to.
These rules and laws are called Shariah and stem from three sources: the Quran,
the Hadith and the Ijtihad. The Quran is the primary source of Islam including
the words of God as delivered to the prophet Mohamed whereas the Hadith con-
sists of narrative records of the actions and sayings of the prophet himself. The
third Shariah source Ijtihad is the derivation and formulation of Shariah laws or
guidelines by qualified scholars to deduct further knowledge from the Quran and
Hadith. It is crucial that in Islam, there is no unique higher institution responsi-
ble for religious opinions to be followed by all Muslims, like the Catholic Church,
for instance. The existence of such an institution would of course simplify the
decision on the Shariah-compliance of a financial product. Instead, Islamic funds
and index providers have to hire experienced Shariah scholars (Delorenzo, 2000)
to interpret the different Shariah sources and to specify a set of checkable Shariah
1
1. INTRODUCTION
guidelines or screens to be used to distinguish between the set of halal (Shariah-

compliant) and haram (non-compliant) investments.
According to a recent report (Vayanos & Wackerbeck, 2008) the global Islamic-
based assets are estimated at USD 400 billion and the potential market for Islamic
financial services is close to ten times this number. In another survey done by
McKinsey about 70 to 90 percent of investors from the Gulf countries are only
willing to invest in Islamic products or prefer Islamic products if in par with
conventional products. The demand for Islamic products attracted international
financial institutions such as Deutsche Bank, HSBC, Citibank, Barclays, UBS,
Dow Jones, FTSE, S&P, MSCI and many others to structure and offer a variety
of products tailored for the needs of Islamic investors such as Islamic funds which
as stated by Booz & Company (Vayanos & Wackerbeck, 2008) witness a rapid
growth (see Figure 1.1).
925
706
539
414
319
233
183
102 105 126
2000 2001 2002 2003 2004 2005 2006 2007 2008E 2009E
NumberofIslamicMutualFunds
Figure 1.1: Growth of Islamic Mutual Funds
Islamic equity funds fall into the category of ethically or socially responsible funds
in which investments are restricted to companies which are not involved in for
instance the tobacco or weapon industry. Thus, the step of reducing the asset
universe to a set of compliant assets is constitutive for Islamic funds.
2
1.2 Motivation and Hypotheses
The increasing worldwide demand of the Muslim population to invest their capital
in financial products that do not conflict with the Shariah as well as the attractive
capital value of these investors triggered the development of Shariah-compliant
investment products such as Islamic equity funds. Since the area of Islamic fi-
nance is relatively new and investment trusts wanted to respond to the rising
demand as quickly as possible, Shariah-compliant equity products found their
way into practice without being researched in depth (the number of published
papers or books analyzing current Shariah-compliance practices used in Islamic
asset management is very limited). The main reason for this may be attributable
to the fact that the development of such issues was driven by the industry which
wanted to gain from the capital value of Islamic investors and therefore was not
deeply analyzed and researched by both financial and Islamic researchers. The
drawback of the industry-driven definition of Shariah-compliance procedures re-
sulted in the development of different and non-standardized methodologies used
across the Islamic equity management industry. Therefore this work focuses on
the:
Analysis of current industry-driven Shariah procedures

The different Shariah-compliance procedures used across Islamic investment trusts
are surveyed and analyzed to explore the effect of using diversified procedures
on both the size of the asset universe and the constituents considered Shariah-
compliant. Through this analysis the superiority of using specific Shariah-compliance
procedures on portfolio performance in terms of return and risk are identified and
interpreted.
Development of research-driven Shariah procedures

The conventional portfolio management is adjusted to encompass different Shariah-
specific issues so that an Islamic portfolio management process is formalized.
Shariah-compliance procedures are analyzed from a research perspective and new
paradigms and compliance strategies are developed using currently used Shariah
jurisdictions and considering both portfolio return and risk. Additionally, cur-
3
1. INTRODUCTION
rent Shariah-specific measures are redefined and new measures are introduced to
enhance the expected performance of Shariah portfolios.
Extension of practical portfolio models by Shariah requirements

Classical portfolio optimization models, such as the Mean-Variance model intro-
duced by Markowitz (1952) are extended by both practical portfolio requirements
as well as Shariah requirements. Practical portfolio requirements include the con-
sideration of internal investment guidelines, manager preferences, initial portfolios
that need to be rebalanced based on newly available information and the con-
sideration of transaction costs. From a Shariah-perspective the compliance of
a portfolio has to be continuously ensured and therefore a feasible portfolio is
identified formulating Shariah-compliance procedures (paradigms and strategies)
assigned to the specific fund as constraints embedded within the portfolio opti-
mization model.
Development of a DSS prototype for dynamic and customized Port-

folio Management
Due to the existence of diverse perceptions about Shariah issues, different Shariah-
compliance strategies and paradigms are proposed in this research. Based on
the existence of different Shariah strategies, the investment strategy employed
and internal and legal guidelines the portfolio manager has to comply with, no
standardized portfolio optimization model can be used. Thus, we develop a (pro-
totype) DSS with advanced model management functionalities to manage and
construct specific portfolio management models to support portfolio managers in
the management of the unstructured and dynamic portfolio management process.
Portfolio management is unstructured since the results of portfolio optimization
models need to be interpreted and refined by portfolio managers and the dynam-
ics of the process stem from the fact that portfolio management is a continuous
process in which portfolios have to be revised and rebalanced based on newly
available information.
Empirical Analysis of Developed Concepts

Since current Shariah practices lack standardization, an empirical analysis is per-
4
formed to quantify the impact of non-standardization on Shariah consistency and

portfolio performance. The results are compared with the results achieved using
the new concepts, strategies and paradigms developed in this research.
Therefore the overall goal of this research is to develop and formalize consis-
tent and justifiable Shariah-compliance paradigms and strategies to be used
within a Shariah Portfolio Management Decision Support System (SPMDSS)
to support portfolio managers in the definition, manipulation and analysis of ad-
vanced Shariah portfolio optimization models using available optimization meth-
ods. Thus, this research work is multidisciplinary in nature since it encompasses
elements from Operations Research, Information Systems, Finance and Islam.
To measure the added value of this research the following hypotheses are tested
throughout this work:
• Hypothesis H1: Shariah-compliance procedures currently used across the

industry are if compared to each other highly inconsistent resulting in dif-
ferent compliant asset universe sizes and different constituents within the
compliant asset universes.
• Hypothesis H2: The development of new paradigms and strategies for

Shariah-compliance checking if considered within portfolio optimization yields
better portfolio results and / or less inconsistencies compared to Shariah
procedures currently used.
• Hypothesis H3: The consideration of existing and newly developed Shariah

measures within portfolio optimization results in better portfolio perfor-
mance compared to an optimization done without these measures.
• Hypothesis H4: The development of a Decision Support System with ad-

vanced model management capabilities and clear data model independence
simplifies the task of portfolio managers to analyze and implement different
strategies.
5
1. INTRODUCTION
1.3 Structure of the Thesis

Based on the motivation statement and the hypotheses defined this research con-
sists of three main parts:
• Part I: Fundamentals of Portfolio Management and Shariah
• Part II: New Concepts for Shariah-Compliance and the Development of

SPMDSS
• Part III: Empirical Analysis
Part I: Fundamentals of Portfolio Management and Shariah

In the first part of this research the classical portfolio concept and several Shariah
concepts relevant for this research are reviewed.
In chapter 2 general portfolio management concepts, the classical investment pro-
cess and different portfolio management strategies are introduced. Since portfolio
modeling is a crucial component of the investment process alternative portfolio
models as well as classical and advanced model aspects such as constraints (legal
and internal), transaction costs and the consideration of initial portfolios are re-
viewed and formalized.
The Shariah issues relevant for Shariah-compliant portfolio management are re-
viewed in chapter 3. First, the general characteristics of Shariah-compliant invest-
ment practices as found in the different Shariah sources are introduced. Further
on, current Shariah interpretations and practices used to deduce quantifiable mea-
sures through which Shariah compliance can be identified are discussed in depth.
Part II: New Concepts for Shariah-Compliance and the Development

of SPMDSS
In chapter 4 new strategies, paradigms and indicators for Shariah compliance
checking and improved portfolio performance are conceptually developed and
introduced. The chapter ends with the definition of a conceptual Shariah Port-
folio Management process encompassing both classical investment process con-
cepts and Shariah requirements. Within Chapter 5 the conceptual strategies
6
1.3 Structure of the Thesis
and paradigms are mathematically formulated so that the Shariah requirements

can be considered within portfolio optimization. Chapter 6 gives an introduc-
tion to the conceptual ideas and the architecture of the developed prototype of
a Shariah-compliant Portfolio Management Decision Support System (SPMDSS).
Part III: Empirical Analysis

In the last part of this research current Shariah practices are evaluated empirically
and compared to the results achieved using the new strategies and paradigms de-
veloped. The performance of current and new practices is evaluated based on
portfolio performance in terms of risk and return and the contribution of the
practices to standardization or reduced Shariah inconsistency.
The results achieved and the validation of the hypotheses defined are summa-
rized in the conclusion of this research in chapter 8.
7
1. INTRODUCTION
8
Part I
Fundamentals of Portfolio
Management and Shariah
9
Chapter 2
Portfolio Management
2.1 Introduction to Portfolio Management
Due to the variety of asset classes and the exposure to global markets the portfolio
management process is a complex and dynamic process which generally has to be
done by professional institutions and not individual investors. Such institutions
normally follow a clear multi-stage portfolio management process which consists
of planning, implementing and revising portfolios (Auckenthaler, 1994).
Within the planning stage the investor’s preferences are formulated in a policy
statement in which the investor’s risk and return perceptions, liquidity require-
ments, preferred investment strategy as well as other requirements such as fol-
lowing specific Shariah guidelines are identified and stated. Based on this policy
statement portfolio managers start to define an appropriate asset universe and
deduce financial indicators through a detailed financial and economic analysis.
Using the policy statement and the results of the financial analysis portfolios
are constructed using portfolio optimization models and are then implemented
by portfolio managers through placing orders.
Due to the dynamic nature of the market (price changes and availability of new
information) the portfolio performance and mixture is evaluated based on the
11
2. PORTFOLIO MANAGEMENT
requirements defined in the policy statement and may be revised through placing
buy and / or sell orders.
The classical portfolio management process extended by Shariah requirements

is discussed in depth in section 4.4 of this research.
Based on investors’ preference different portfolio management strategies can be

used. In the following subsection the major portfolio management strategies used
in practice are introduced, evaluated and compared.
2.1.1 Portfolio Management Strategies

Asset allocation and selection is a crucial factor within the portfolio manage-
ment process. The manner in which asset classes and specific assets are selected
for investment is called portfolio management strategy or style. Portfolio man-
agement styles can broadly be classified as being either an active or a passive
portfolio management strategy. The strategies employed by portfolio managers
are mainly attributable to their perception of the validity of the efficient mar-
ket hypotheses. The efficient market hypothesis (Fama, 1991) states in its three
forms (weak, semi-strong and strong) that the analysis of historical market prices,
publicly available information (financial statements) and even insider information
are already reflected in current asset prices and therefore neither technical nor
fundamental analysis is of any practical use. In the following paragraphs active
and passive management strategies are shortly described and compared to each
other.
2.1.1.1 Active Portfolio Management Strategy
Portfolio managers using active portfolio management strategies do not believe

that the efficient market hypothesis holds. Within an active management strat-
egy, portfolio managers make use of fundamental and technical analysis for appro-
priate asset selection and timing decisions. Portfolio managers use such methods
with the purpose to detect mispriced assets so that undervalued assets are added
to the portfolio and overvalued assets are liquidated. Through detecting under-
12
2.1 Introduction to Portfolio Management
valued and overvalued assets, active portfolio managers expect to identify the
appropriate mixture of assets to perform better than the market or a specific
index benchmark.
2.1.1.2 Passive Portfolio Management Strategy
Passive portfolio managers on the other hand are strong believers of the efficient
market hypotheses and therefore believe that assets are fairly valued in the mar-
ket which means that technical and fundamental analysis cannot yield valuable
information for asset selection. Since portfolio managers cannot actively detect
any valuable information, a passive strategy is employed which focuses on repli-
cating the market rather than selecting specific assets. Index tracking is used
to manage a passive portfolio with the purpose to reproduce or mimic the per-
formance of a benchmark portfolio or index (for instance the S&P 500 index).
Such a tracking portfolio can be constructed either through full replication or
sampling. Poddig et al. (2003) discussed different approaches for constructing a
tracking portfolio. The simplest approach is to fully replicate (naive replication)
the index with all its constituents and their respective weights in the benchmark
index. Full replication eliminates the possibility of having any differences be-
tween the tracking portfolio and the index. Beasley et al. (1999) describe as
drawbacks of using full replication that the inclusion of assets in the portfolio
with low weights increases both transaction costs and the administrative effort
and that if an index is revised this implies that the tracking portfolio also has
to be revised. Derigs & Nickel (2003) show that full replication is not realistic
because such a strategy most likely violates legal investment guidelines imposed
on investment trusts by national law. Therefore a more adequate and feasible
approach is to approximately replicate the benchmark using a sample of assets
which minimizes the dispersion or tracking error between the tracking portfolio
and the tracked benchmark. The selection of an adequate sample can be done
either using heuristic methods or through using optimization models1 (Poddig
et al., 2003) as done within this research work.
1
Poddig et al. (2003) discuss three optimization model formulations (linear optimization,
quadratic optimization and constrained regression) which can be used for index tracking
13
2.1.1.3 Active versus Passive Portfolio Management
There is no consensus whether one of the two strategies is superior to the other.
From a cost perspective actively managed portfolios are exposed to higher man-
agement fees due to the extensive analytical work done and the frequent trading
done by portfolio managers which results in higher transaction costs. Passively
managed funds on the other hand are much more cost efficient since the manage-
ment overheads and costs are much less and trades occur less frequently compared
to an actively managed portfolio. Sharpe (1991) argues that the average net re-
turn of actively managed portfolios is less than the return of a passively managed
portfolio due to higher costs of active management. From a performance perspec-
tive if actively managed funds succeed in detecting overvalued and undervalued
assets and take right timing decisions the return achieved may be worth the addi-
tional costs occurred whereas a passively managed portfolio has as disadvantage
that a bearish and decreasing market means that the return of the tracking port-
folio decreases at approximately the same level. It is noteworthy that since active
managers seek excess return compared to the market such a strategy is antici-
pated with a higher risk. Beasley et al. (1999) state that passive management is
superior because historical analysis revealed that passively managed funds out-
performed their actively managed counterparts on the long-run.
2.2 Portfolio Optimization Modeling

In the following subsections the portfolio modeling concepts used within this
research are introduced. First alternative portfolio representations are shown
and used to model the classical active or passive portfolio management strategy.
To ensure the practicality of the classical portfolio models in real-life investment
situations relevant constraints, transaction costs and the issue of rebalancing
existing portfolios are reviewed and considered within this research.
2.2.1 Portfolio Representation

Consider an asset universe I = {1, ..., n} of n assets from which a portfolio can be
constructed. A portfolio can be represented by the number of units or the nominal
14
volume of the assets included in the portfolio. Given the nominal volume yi ∈
of each asset i ∈ I the portfolio can be represented by the vector
y = (y1 , ..., yn ) (2.1)
Alternatively, a more frequently used portfolio representation form is to represent

the portfolio using the proportional budgets xi invested in each asset i ∈ I. Then
the portfolio is represented by the so-called share vector
x = (x1 , ..., xn ) (2.2)
Since xi is the proportional budget invested in each asset i ∈ I, xi ∈ [0, 1] holds

if short-sellings are not allowed.
Most mathematical optimization models are formulated using the share formula-
tion. Yet, there are specific constraints which are more natural to model using
the nominal volume formulation. Now it is easy to see that a portfolio repre-
sented by its nominal volume formulation can easily be transformed into a share
formulation and vice versa. Consider the Price Pi (t)1 of each asset i ∈ I and the
net asset value NAV (y, t)2 of the portfolio y at time t then the weight of a given
asset i is given by
yi · Pi (t)
xi = (2.3)
NAV (y, t)
2.2.2 Measuring Portfolio Return and Risk
Investments are made to yield return. Therefore the returns of the single assets
and their effect on the overall return of the portfolio is a major criterion within
1
Within this research prices are considered to be adjusted for dividends else the return has
to be calculated through adding the dividends received in the respective time period
2
The Net Asset Value of a portfolio y at time t ∈ T is given by N AV (y, t) = yi · Pi
15
the portfolio selection decision problem. The return reti (τ ) of asset i ∈ I for time
period τ ∈ {1, ..., t} can be measured using discrete compound returns:1 :
Pi (τ ) − Pi (τ − 1)
reti (τ ) = τ = 1, ..., t (2.4)
Pi (τ − 1)
Portfolio management is about making allocation decisions under risk since the
future performance of an asset is uncertain and needs to be predicted. Thus, the
future return of an asset i is modeled as a random variable with expected return
μi and covariance of returns σi,j where i and j ∈ I. Using the historical price
movements of the respective assets, the expected asset return and covariance of
each single asset can be estimated by
1
t
μi = reti (τ ) ∀i ∈ I (2.5)
t τ =1
1
t
σi,j = (reti (τ ) − μi ) (retj (τ ) − μj ) ∀i, j ∈ I (2.6)
t − 1 τ =1
Now, the expected return μ(x) of the portfolio x is a linear function calculated
as weighted average of the single expected returns μi (i ∈ I):

n
μ(x) = xi μi (2.7)
i=1
Additionally, the risk of the portfolio is the variance σ 2 (x) of the portfolio return
μ(x) which is calculated as follows:

n
n
σ 2 (x) = xi xj σi,j (2.8)
i=1 j=1
The function σ 2 (x) is a quadratic (nonlinear) function which adds complexity to

the overall model. In literature different approaches for estimating return and
risk can be found such as estimating asset returns using macroeconomic indica-
1
An alternative return calculation using continuous compounding is given by reti (t) =
Pi (t−1)
ln Pi (t)
16
tors within a multifactor model (Derigs & Nickel, 2003). Variance is a symmetric
risk measure where positive and negative discrepancies are both considered risky.
From an investor’s perspective this is not realistic since a positive deviation from
the expected return is adding value and therefore is not a real risk. Therefore in
literature a number of alternative risk measures are introduced which are asym-
metric and consider only negative deviations as risk such as the semi-variance
(Poddig et al., 2003), Sharpe ratio (Nickel, 2005), Value at Risk (Gaivoronski &
Pflug, 2000) and Conditional Value at Risk (Rockafellar & Uryasev, 2000).
2.2.3 Classical Portfolio Models

Based on the portfolio strategy used and the risk and return preferences of the
respective investors different portfolio selection models can be used. For an active
management strategy the classical Markowitz Mean-Variance portfolio selection
model is introduced whereas an index tracking model is introduced for a passive
management strategy.
2.2.3.1 Markowitz Mean-Variance Model
Markowitz (1952) introduced modern portfolio theory and studied the effects of
asset risk, correlation and diversification on expected investment portfolio re-
turn. One of the basic assumptions of the Mean-Variance approach developed by
Markowitz states that investors are rational which means that an investor prefers
for a given level of return the lowest possible risk and for a given level of risk
the highest possible return. The Mean-Variance theory states that a portfolio is
efficient if and only if for a given portfolio return the risk is minimized or vice
versa. Therefore it is possible to obtain a set of efficient portfolios through solving
the Mean-Variance model for different return values (Guertler & Mendi, 2001).
A portfolio model yielding the minimum risk for a given target return tr is given
by

n
Min σ 2 (x) | μ(x) = tr, xi = 1, xi ≥ 0 ∀i ∈ I (2.9)
i=1
Since the optimal investment is defined using more than one criterion (risk and
return), the problem has to be solved for different return levels rather than for a
17
single target return. This means that there exists a set of optimal solutions from
which the respective investor selects the one which represents his individual risk
and return preferences. Such portfolios are called pareto-optimal or efficient port-
folios. An efficient portfolio can be constructed minimizing a linear combination
of portfolio return μ(x) and portfolio risk σ 2 (x):

n

Min λ · σ 2 (x) − (1 − λ) · μ(x) xi = 1, xi ≥ 0 ∀i ∈ I, λ ∈ [0, 1] (2.10)

i=1
Here the parameter λ is called risk aversion parameter. Through solving the
model for different λ ∈ [0, 1] the efficient frontier of non-dominated portfolios can
be constructed.
2.2.3.2 Index Tracking Model
Under a passive portfolio management strategy such as index tracking, a portfolio

is constructed which replicates the performance of an underlying benchmark or
index. The measurement quantifying the quality of replication is called tracking
error. In literature different definitions are found for measuring tracking errors
(Beasley et al., 2003). While in the classical approach the tracking error is mea-
sured using the covariance of return differences between the index and the tracking
portfolio (Franks (1992); Larsen & Resnick (1998); Rudd (1980); Derigs & Nickel
(2003)), Beasley et al. (2003) use as tracking error the absolute value of the differ-
ence in returns between the benchmark and tracking portfolio. Some approaches
extend the index tracking model with excess return requirements (Beasley et al.,
2003), so that a tracking portfolio is constructed that yields a return higher than
the benchmark. Using the classical index tracking approach, the tracking error
T E is formulated using the weights of the assets included in the tracking portfolio
x and the weights of the assets included in the benchmark or index portfolio x
and the covariance matrix of asset returns C as follows:
T E = (x − x)T C(x − x) (2.11)
18
Based on this tracking error formulation the basic index tracking optimization
model is given by
n

Min T E xi = 1, xi ≥ 0 ∀i ∈ I (2.12)

i=1
2.2.4 Portfolio Model Extensions
2.2.4.1 Constraints
A major criticism of classical Mean-Variance portfolio optimization models is that

the optimal portfolios generated are not well diversified and are concentrated on a
limited number of assets (Walters, 2007). A real portfolio can not be constructed
solely based on return, risk and budget limitation. In practice a number of addi-
tional requirements which take the form of guidelines or mathematical constraints
have to be considered so that diversification is assured and feasible and applicable
investment portfolios are constructed. Derigs & Nickel (2003) formulated such
guidelines in the form of rules to check the legal compliance of actual portfolios.
Such guidelines can either be:
• Legal Guidelines
These are guidelines enforced on funds by the respective capital market
authorities. Such guidelines are legally binding and have to be frequently
reported to the respective regulatory authority.
• Contractual Guidelines
In the fund prospectus an investment trust defines the investment strategy
to be followed such as target investment markets, sectors and asset classes
which constitutes a set of contractual constraints or guidelines to be followed
by the respective fund. An example for contractual guidelines is the restric-
tion to social investments or specifically in our case to Shariah-compliant
investments. In that case the investment trust contractually ensures that
all investments done comply with Shariah based on the Shariah jurisdiction
and controlling body defined in the fund prospectus.
19
• Internal Guidelines
This type of guidelines is defined by the respective investment trust and
encompasses specific investment and trading strategies which the trust fol-
lows based on previous experiences or to meet specific internal requirements
concerning risk exposure, minimum diversification in asset classes and max-
imum transaction costs for instance.
In the following paragraphs the most relevant and frequently used constraint
types are shortly described and formalized:
Budget and Cash Constraint

The general budget constraint as used in classical portfolio models (as in Equation
2.10) is given by
n
xi = 1 ∀i ∈ I (2.13)
i=1
Fund managers who are willing to ensure that a minimum liquidity level is main-
tained can still use the conventional budget constraint through extending the
asset universe I by a cash asset with xcash ∈ [0, 1] such that a portfolio x is given
by x = (x1 , , xn , xcash ).
The minimum and maximum proportion of the budget to be kept in the form of
cash can be defined using floor and ceiling constraints.
Floor / Ceiling
Through using floor / ceiling constraints fund managers are defining their prefer-
ences and binding requirements in terms of maximum (ceil) and minimum (floor)
permissible investment in each of the assets considered for investment. The floor
/ ceiling restrictions are formulated as follows
li ≤ xi ≤ ui ∀i ∈ I (2.14)
where li is the lower limit (floor) and ui is the upper limit (ceiling) of asset i.
Additionally ceiling constraints can be used to model legal guidelines as shown
by Derigs & Nickel (2003). One of the guidelines enforced by the German capital
investment companies law (KAGG) on their respective investment trusts states
20
in article 8a of the KAGG that a maximum level of 10 percent can be invested

in any asset included in the portfolio. Such a legal guideline is formulated math-
ematically using a ceiling constraint where the upper bound ui is equal to 0.1
for all assets i ∈ I. A different floor / ceiling guideline used in practice groups
assets into different sets, sectors or markets for instance, so that a minimum and
maximum investment in specific subsets is assured. Consider the set of assets
belonging to a respective sector I Sec ⊂ I. Then the maximum and minimum
permissible investments for each sector can be limited by

lsec ≤ xi ≤ usec (2.15)
i∈I Sec
where lsec is the minimum share and usec indicates the maximum share to be
invested in the respective sector.
Cardinality
The cardinality measures the number of assets i ∈ I included in the portfolio x
for which xi > 0 holds. A minimum and maximum cardinality can be defined
to achieve the minimum required portfolio diversity and to limit the number of
assets to be included, respectively. To model this constraint a new binary variable
vi for each asset i ∈ I has to be introduced such that vi = 1 if and only if xi > 0
otherwise vi = 0. The cardinality guideline is modeled using the following set of
constraints:
n
CardM in < vi < CardM ax (2.16)
i=1
xi ≤ vi ∀i ∈ I (2.17)
vi ∈ {0, 1} ∀i ∈ I (2.18)
It is worth mentioning that index tracking models with cardinality restrictions

are NP-hard (Coleman et al., 2006) and therefore in section 5.2 a simple approx-
imative algorithm to overcome this problem of computational intractability is
introduced.
Buy-in Threshold
21
This constraint defines for each asset i ∈ I the minimum portfolio weight bmini
to be invested in if asset i is to be included in the portfolio. Thus, the buy-in
threshold is used to ensure that no portfolio is constructed which includes assets
with too small, unrealistic and undesired weights. Assets with low weights have
a negative impact on transaction costs and increase the overall number of assets
included in the portfolio. This set of constraints can be formulated using the
previously introduced binary variable vi as follows:
xi ≥ vi · bmini ∀i ∈ I (2.19)
2.2.4.2 Rebalancing - Optimization over Time
Portfolio management is an ongoing management process which means that fund

managers take on a highly frequent basis (hourly, daily or weekly) decisions about
which assets to keep, reduce, increase or add to their respective portfolio. Even
within a passive management strategy tracking portfolios have to be revised and
rebalanced if new risk and return information becomes available and if due to
price changes the current portfolio structure becomes infeasible with respect to
legal, contractual or internal guidelines.
The above stated models are useful only for the construction of a portfolio from
scratch. But, if within an active or passive investment strategy the composite
structure of an existing portfolio is to be changed these models have to be ex-
tended.
Consider a portfolio y(t − 1) at time t − 1 ∈ T where the volumes of the assets
i ∈ I are y(i, t − 1). Assume that the portfolio y(t − 1) has been constructed
based on an optimization run made at time t − 1.
Let y B (i, t) and y S (i, t) denote the volumes bought and sold of each asset i ∈ I
at time t ∈ T . Then we obtain
y(i, t) = y(i, t − 1) + y B (i, t) − y S (i, t) ∀i ∈ I, t ∈ T (2.20)
22
If short sellings are not allowed then it has to be assured that the volume sold
is less than the volume available. This requirement can be formulated using the
following set of constraints :
y S (i, t) ≤ y(i, t − 1) ∀i ∈ I (2.21)
Another requirement which has to be considered when rebalancing a portfolio is

that buying an asset should exclude the possibility of selling it and vice versa to
ensure that trading is rationale. Therefore the following conditions have to hold
y S (i, t) = 0 if y B (i, t) ≥ 0 (2.22)
y B (i, t) = 0 if y S (i, t) ≥ 0 (2.23)
To model this requirements a new binary variable bs(i) for each asset i ∈ I has
to be introduced and a parameter M which is a sufficient large number. Then we
require:
y S (i, t) ≤ M · bs(i) ∀i ∈ I (2.24)
y B (i, t) ≤ M · (1 − bs(i)) ∀i ∈ I (2.25)
It is obvious, how these constraints can be transformed using the share formula-
tion.
2.2.4.3 Transaction Costs
Another essential characteristic of practical portfolio management is the consid-

eration of transaction costs. Transaction costs can be in the form of brokerage
and commission fees, bid-ask spreads and taxation costs. Transaction costs need
to be considered within portfolio revision to ensure that the benefit generated
from rebalancing the portfolio exceeds the transaction costs that occur due to
the rebalancing. The issue of considering transaction costs within portfolio op-
timization is excessively discussed in literature. Nickel (2005) for instance uses
turnover volume to model transaction costs. Portfolio problems with both linear
23
and fixed transaction costs are not solvable using convex optimization methods
(Lobo et al. (2007) ; Gilli & Kellezi (2001)). Kellerer et al. (2000) review differ-
ent approaches found in literature to solve portfolio optimization problems with
linear and / or fixed transaction costs.
Since in the above-stated rebalancing formulation the volumes sold and bought
are measured explicitly, it is possible to define different proportional transaction
costs for buying and selling an asset i ∈ I respectively. Let cB and cS denote
the proportional transaction cost rate of buying and selling an asset i ∈ I, re-
spectively, then the total transaction cost rate T CR of the rebalanced portfolio
is
n
T CR = (cB · y B (i, t) + cS · y S (i, t)) (2.26)
i=1
Mitchell & Braun (2002) propose an adjusted objective function to be used for
the Markowitz Mean-Variance model to consider proportional transaction costs.
Another approach (Nickel, 2005) is to adjust the expected portfolio return μ(x)
by the transaction cost rate, i.e. defining
μadj (y) = μ(y) − T CR (2.27)
With respect to an index tracking model, the objective function can be reformu-
lated as a linear combination of tracking error and transaction cost rate (Derigs
& Nickel, 2003) and is given by
Min {ω · T E + (1 − ω) · T CR} (2.28)
The parameter ω is used to define the relative relevance of tracking error and
transaction costs. Through solving the problem for different ω multiple pareto-
optimal solutions are identified.
24
Chapter 3
Shariah Issues in Portfolio

Management
3.1 General Shariah Issues

An investment trust that offers Shariah-compliant products contractually ensures
that the entire investment process and the underlying companies of the assets in
which the trust invests comply with Shariah. The Shariah is the legal framework
governing the practices and activities of Muslims. Such practices can be classified
into ibadat and muamalat. Ibadat refers to the relationship between mankind
and God whereas muamalat encompasses activities between man kinds in term
of social, economic and political activities. Such economic activities include of
course banking and financial activities in which Muslims are involved. There-
fore an investment can only be considered Shariah-compliant and accessible to
Islamic investors if it does not conflict with the muamalat principles defined by
the Shariah. The main requirements of Shariah-compliant investments are to be
free from riba, gharar and quimar and maysir.
3.1.1 Riba
The Arabic word riba means usury or excess return and is considered by most
scholars’ equivalent to interest rates. Since in Islam excess return such as interest
without bearing risk is not halal, Islamic investors are generally not allowed to
25
3. SHARIAH ISSUES IN PORTFOLIO MANAGEMENT
earn or pay interest. The interest ban is stated clearly in a number of verses of
the holy Quran such as:
”O you who believe, you shall not take usury (interest), com-
pounded over and over. Observe God that you may succeed.” (Al-
’Imran 3:130)
”Those who charge usury (interest) are in the same position as

those controlled by the devil’s influence. This is because they claim
that usury is the same as commerce. However, God permits com-
merce, and prohibits usury (interest). Thus, whoever heeds this com-
mandment from his Lord, and refrains from usury, he may keep his
past earnings, and his judgment rests with God. As for those who
persist in usury, they incur Hell, wherein they abide forever.” (Al-
Baqarah 2:275)
Therefore interest-based assets such as conventional interest-based bonds are def-

initely not compliant under Shariah.
3.1.2 Gharar, Quimar and Maysir

The word gharar refers to high or excessive uncertainty which is attributable to
speculative activities. Since conventional derivative instruments are highly specu-
lative in nature they are also considered by most Shariah scholars as being haram.
Since every business transaction involves an element of risk and uncertainty, the
Islam differentiates between uninformed speculation (gharar) which is compara-
ble to quimar and maysir (Arabic words for gambling and game of chance) and
business transactions where the uncertainty is minimized through in-depth anal-
ysis of the risks faced. Since the gharar, quimar and maysir characteristics can
be attributed to conventional derivative instruments (such as options and future
contracts) which are highly speculative in nature they are also to be considered
non-compliant under Shariah laws per se (Ketell, 2008). One of the Quran verses
banning such speculative practices states:
”They ask thee (O’ Prophet) about khamr (intoxicants) and maysir
(gambling). Say: In both of them there is great harm, although there
26
is some advantage as well in them for men, but their harm is much
greater than their advantage.” (Al-Baqarah 2:219)
Thus, this verse clearly states that maysir may have advantages such as the ad-
vantage provided by derivative products for risk management and diversification
purposes but overall the Quran states that the harm is larger than those advan-
tages and therefore such kind of activities are deemed non-compliant.
Obaidullah (2002) argues that to claim Shariah-compliance additional Islamic
ethics norms have to be considered such as for instance
• Ban of price control and manipulation

In Islam prices are to be defined by the forces of demand and supply and
therefore monopolistic activities (ihtikar) are highly condemned.
• Entitlement of equal and adequate information

Islam clearly forbids the circulation of incorrect information to mislead
(ghish) business participants.
The possibility to invest in different asset classes provides investment trusts with
diversification and hedging opportunities affecting the overall risk exposure of
the portfolio. Equity investments are considered by most Shariah scholars to be
a Shariah-compliant asset class since they present a partnership in a company
where the investor shares both profits and losses whereas other asset classes such
as bonds and derivatives are considered non-compliant due to the existence of
elements of riba, gharar, quimar and maysir. To overcome this problem, Shariah
scholars worked together with financial institutions to analyze how to overcome
the riba, gharar, quimar and maysir characteristics found in conventional inter-
est and speculation-based financial instruments such as bonds, options, futures,
forwards and swaps. Using specific Shariah jurisdictions and compliant contract
types some of these conventional products were restructured to adhere with the
Shariah using specific jurisdictions and compliant contract types. An example
for a conventional financial instrument that has been restructured to adhere to
Shariah is an Islamic bond or sukuk. Sukuks are asset backed securities were the
sukuk holders lease the asset to receive a halal return instead of yielding haram
interest as with conventional bonds.
27
Irrespective of the compliance of the asset classes (such as equities, bonds or

derivatives) another condition which has to be fulfilled is that the business activ-
ities and financial operations of the company issuing the assets do not contradict
with Shariah. Thus, the issuing company itself has to be operating in a Shariah-
compliant manner, i.e. the company has to be free from practices related to
riba and gharar for instance. Another essential requirement is that companies
considered for investment are not involved in business activities contradicting
with the ibadat principles of the Islamic investor. Since Muslims are for instance
not allowed to consume or sell alcohol, gamble or provide gambling facilities the
companies considered for investment should not be involved in such practices.
Since the Shariah-compliance status of asset classes is mainly agreed upon and
resolved through categorizing asset classes either as being compliant (such as
equities or restructured conventional bonds or sukuks) or non-compliant (such
as conventional bonds), the focus of this research is to identify and validate the
Shariah-compliance status of the underlying companies within one compliant as-
set class, i.e. equities. To decide upon the compliance of a specific company
experienced Shariah scholars define procedures or strategies with which the in-
volvement in non-compliant practices and business activities can be quantified.
Such a strategy consists of a set of qualitative (sector) guidelines and quantitative
(financial) guidelines which are discussed in depth in section 3.2 of this research.
3.1.3 Shariah Ruling

Since fund managers normally are not acquainted with Shariah issues and how
to define something as being permissible for an Islamic investor or not, it is an
essential prerequisite for a trust offering an Islamic product to define a Shariah ju-
risdiction source on which basis compliant investment practices are defined. This
task is normally done by Shariah scholars who are experienced both in Shariah
issues and finance. Their task is to interpret the different Shariah sources and
to define a strategy or procedure through which Shariah-compliant investments
can be identified. So to offer an Islamic investment fund the strategies defined
by Shariah scholars need to be considered by the issuing trust and this can be
achieved either through
28
• the appointment of a Shariah Board,
• the subscription to an Islamic Index or
• the subscription to a flexible Shariah screening system.

If an Islamic investment trust appoints a Shariah board their major tasks in-
clude the definition of Shariah principles and strategies to follow, the periodic
monitoring of fund operations and to certify that the investment procedures and
net profits generated comply with Shariah. The major advantage of appoint-
ing a Shariah board is the increased credibility since fund management can be
consulted and monitored by the Shariah board in the entire investment process
(Delorenzo, 2000). Since Shariah scholars with adequate experience in Shariah
and finance are a rare resource the cost of appointing a Shariah board is very
high which increases the total management cost of the respective fund. Addi-
tionally, due to the rarity of scholars some of them supervise a large number of
Islamic investment trusts (one of them for example is a member of more than
40 boards) which may affect their capability to actively monitor the on-going
compliance of the funds they supervise. Another disadvantage is that Shariah
scholars are normally following a specific Islamic school of thought and therefore
through the appointment of a Shariah board, investment trusts will only be able
to serve Islamic investors following the same school of thought as the one followed
by the appointed Shariah board. This of course will hinder the investment trust
to provide different Islamic funds tailored for different Islamic groups (the differ-
ent schools of thoughts and their impact on defining different Shariah strategies
is shown in section 3.2) since the same Shariah board cannot issue two different
fatwas (Arabic word for religious opinion or interpretation issued by an Islamic
scholar) or strategies to follow.
The second alternative for an Islamic investment trust is to subscribe to an Is-

lamic index. Professional financial services providers such as Dow Jones (DJ) and
Standard and Poor’s (S&P) have observed the market potentials of Islamic prod-
ucts and hired Shariah scholars to develop Islamic indexes. It is worth mentioning
that the development of Islamic indexes positively contributed to the enhance-
ment and dissemination of Islamic investments since a large number of Islamic
29
trust funds outsource the Shariah jurisdiction of their investments to an index

provider such as Dow Jones. Thus, the investment trusts periodically receives
a list of companies in which the fund manager can invest. The main advantage
of subscribing to an Islamic index is that first the ethical responsibility regard-
ing Shariah compliance moved from the investment trust to the institution and
Shariah board issuing the index. Another advantage is that the cost of subscrib-
ing to an Islamic index is much lower compared to appointing an own Shariah
board. One of the disadvantages of this alternative is that no Shariah scholars can
be consulted for questionable Shariah issues and that no on-going Shariah mon-
itoring exists. Another problem is that generally Islamic index constituents are
derived from a conventional parent index issued by the same service provider and
this means that if for any non-Shariah specific reason constituents are eliminated
from the parent index they are automatically excluded from the Islamic index.
So companies not included in the Islamic index for reasons different than Shariah
requirements cannot be considered for investment. For instance Standard and
Poor’s Islamic Index constituents are a subset of the S&P500 index and therefore
investment trust funds using the S&P Islamic index to invest in US equities can
only diversify their portfolio using a limited number of companies (maximum 500
if all S&P500 constituents are Shariah compliant) whereas the rest of the US
market will not be accessible. Similar to the first alternative an Islamic index is
based on a single school of thought and therefore also here it is not possible to
offer funds for different groups of Islamic investors.
The last alternative which we propagate with our research is a flexible Shariah
screening system through which alternative Shariah compliance strategies can be
defined and used on a global asset universe. Such a system would contain a knowl-
edgebase with all the Shariah strategies defined by different Shariah scholars and
different schools of thoughts and based on the investors religious perceptions cus-
tomized strategies can be employed. The major advantage is that the demands
of different Islamic investor groups can be met easily through assigning the ap-
propriate Shariah strategy to the respective fund. Another advantage compared
to index subscription is that there is no limitation on the index constituents since
the Shariah strategies can be exercised on all companies fund managers are in-
30
terested in as long as the system has access to the financial data of the respective
companies. The major disadvantage is that as in the case of the subscription to
an index there is no Shariah consultation accessible.
Concluding this comparison the appointment of a Shariah board or the sub-

scription to a flexible screening system is superior to subscribing to an Islamic
index which provides fund managers only with the scope of a limited universe and
hinders the structuring of alternative perception-based funds. Yet, by appointing
a Shariah board only half of the work is done since the Shariah board just defines
the Shariah strategies to follow and is not responsible for the operational screening
of the companies. Therefore even if a Shariah board is appointed a computer-
based system is needed through which the asset universe can be screened for
Shariah compliance. And since investment trusts should focus on their primary
business which is ”investing” the subscription and use of a flexible Shariah screen-
ing system is an efficient and crucial alternative through which the strategies of
the appointed Shariah scholars or alternative and customized strategies can be
defined and used. Within this research work such a screening system is developed
and introduced in section 6.2.
3.1.4 Shariah-Compliant Fund Management Contracts

Since the muamalat principle governs the activities and relations between mankind,
it is also used to define the Shariah-compliant contractual agreement between an
investor and the investment trust. From a Shariah perspective three different
contractual agreements can be made between Islamic investors and the invest-
ment trust managing a Shariah-compliant fund:
Mudaraba Contract
Within a mudaraba contract the investment trust or entrepreneur (mudarib) will
manage the capital provided by the investor (rab-ul-maal) whereby the invest-
ment trust is compensated based on a previously defined percentage of the profit
generated. In the case that loss occurs, the loss is covered by the investor only
whereas the investment trust will not be compensated at all. A mudaraba con-
31
tract ensures that investment trusts do their best to achieve good results because
else they are not rewarded for their work.
Wakala Contract
A different contractual approach compliant under Shariah is to consider the in-
vestment trust acting as an agent for the investors. This type of contract is called
wakala contract. The agent (wakeel) can either be compensated on a fixed fee
basis or based on the opinion of contemporary Shariah scholars (c.f. Usmani
(2002)) the compensation can also be calculated as a percentage of the value of
the fund.
Mudaraba and Wakala Mix Contract

The third option for Shariah-compliant equity funds is a combination of the first
two. This means that the compensation of an investment trust consists of a basic
fee (monthly or annual) and a performance fee which is only paid if a predefined
target growth in the net asset value has been reached or a benchmark return is
outperformed (Norman, 2004). Independently from the contract type used, Us-
mani (2002) clearly states that investment relations have to be based on mutual
agreement which have to be stated and agreed upon before the fund is launched,
such as the disclosure of compensation procedures in the fund prospectus as done
in conventional funds.
3.2 Shariah Compliance Screening

1
As described in the previous sections capital investment institutions and Shariah
scholars involved in Islamic investment fund management propose different pro-
cedures and guidelines to decide upon the Shariah compliance of an investment.
One reason behind these discrepancies is the complexity of modern capital mar-
kets, the existence of complex investment instruments and the multidisciplinary
and global involvement of companies.
Conventional interest and speculation-based financial instruments such as bonds,

1
This section has been partially published in Derigs & Marzban (2008b)
32
options, futures, forwards and swaps are either not permissible under Shariah or
have to be restructured in a Shariah-compliant manner. The focus of this section
is to identify Shariah-compliant equity investments which is usually obtained by
applying a set of qualitative (sector) screens and quantitative (financial) screens
defined by the Shariah scholars who supervise the respective Islamic fund or in-
dex.
3.2.1 Qualitative Screening
Qualitative screens are sector screens through which companies operating within
specific business areas that are non-permissible under Shariah are excluded. Shariah
clearly defines a number of aspects which are not permissible for Muslims such
the consumption of alcohol and pork, and thus compliant companies are not al-
lowed to participate in businesses earning primarily or even partially from such
activities. The main business activities considered non-compliant under Islam
include the manufacturing and sales of alcohol and pork, conventional interest-
based financial services, conventional insurances, pornography, casinos and night
clubs (Iqbal & Mirakhor, 2007).
Since besides Quran and Hadith also Ijtihad (interpretation) is involved, some
minor differences may occur among the qualitative guidelines defined by the re-
spective Shariah boards. Especially with respect to defining a company as haram
due to the fact that the company is to a certain extend engaged in a non compliant
business. An example for a qualitative screen is for instance:
• If the company is generating any revenue from the sales of alcohol exclude
it from the permissible asset universe.
Alternatively a more moderate Shariah board may consider a company being com-
pliant if the proportional revenue generated by the non-compliant activity does
not exceed a given threshold level (for example 5 percent). Yet, this relaxation
is partially absorbed through the condition that the non-compliant proportion
needs to be purified and donated from the income received by the investor.
33
3.2.2 Quantitative Screening
After the asset universe has been reduced through applying qualitative screens, in
a second step a number of quantitative or financial screens are applied to further
clean the asset universe from non-Shariah-compliant assets. This phase is most
relevant and debatable for this study since remarkable differences exist between
the different financial screening methods used by the Islamic funds and index
providers.
The reason for using quantitative screening on top of qualitative screening is

the fact that Shariah forbids the involvement in riba (the Arabic word for inter-
est) and the trading of money for money and thus it is necessary to analyze how
deeply companies are involved in such practices. Since money in itself is not a
permissible asset in Islam that can be traded for money, especially the level of
cash and cash equivalents of a company has to be measured and compared to
a maximum allowable threshold. The reasoning behind this requirement stems
from the fact that the value of the company has to be negotiable and this is only
possible if the company owns some illiquid assets since in Islam liquid assets can
only be traded at par (Iqbal & Mirakhor, 2007). On the other hand, the in-
volvement in riba is measured by how much interest-based income the company
receives and how much interest the company pays for its debt.
The use of financial guidelines is a relaxation of the puristic application of the

riba ban (as stated in the holy Quran) and a tribute paid to today’s complex
financial world in which it is almost impossible to find any company that is not
involved in any interest payments due to the existence of cash deposits, loans or
credits with the consequence that if Islamic scholars are extremely dogmatic and
intolerant, Muslim investors would not be allowed to participate in the capital
market at all (Wilson, 2004). Instead, Shariah scholars use the different sources
of Shariah to further interpret such situations resulting in the definition of thresh-
olds which limit the amount of riba acceptable from an Islamic perspective as well
as instructions on what to do with these non-Shariah earnings which will be ex-
plained in detail in section 3.3. The rationale for using thresholds is derived from
34
the fact that in general Islamic investors are only minority shareholders in these
companies without voting power to force the company to operate completely in
a Shariah-compliant manner.
Obviously the Holy Quran and the Hadith do not explicitly state which thresholds
for financial analysis are acceptable. Since the thresholds defined are based on
interpretation in the form of Ijtihad and Shariah statements that are not directly
related to capital markets there is some degree of freedom that scholars might
use to specify their quantitative criteria.
To quantify to what extent companies are involved in non-compliant activities

such as riba, a thorough financial analysis has to be carried out using the financial
statements published by the respective companies. Since in most countries com-
panies are only obliged to publish financial results on an annual, semi-annual or
at most quarterly basis, the Shariah screening process and compliance duration
definition depends highly on the frequency of the reports published.
Formally, quantitative Shariah screens are financial ratios which are compared
to a maximum allowable threshold level. Those ratios focus on different aspects
of an investment like liquidity, interest, debt and non-permissible income. Each
Shariah board uses a bundle of ratios for screening the assets and an asset is com-
pliant if and only if it passes all screens included in the bundle. In appendix A an
explicit list of financial measures and a precise definition of the most important
ratios used by professional Shariah funds is shown. In the following paragraphs
the different types of financial screens are described.
3.2.2.1 Liquidity Screens
Liquid assets are current assets and may include cash and cash equivalents, short-
term investments and accounts receivables. For conventional analysts, a high
liquidity ratio is generally a positive signal showing that the company is able
to cover its short-term financial obligations more easily compared to a company
with a lower ratio. But since from a Shariah perspective returns should be gained
35
from the illiquid assets only, assets of a Shariah-compliant company should be to

a high extent in illiquid form. An example for a Shariah screen measuring the
maximum permissible liquidity level of a company is:
• The sum of accounts receivables, cash and short-term investments may not
represent more than 50% of the total assets of a company.
3.2.2.2 Interest Screens
As described above, earnings from interest are generally not permissible. Yet,
since all companies are cooperating with banks and this relationship might gen-
erate interest, Islamic scholars defined thresholds indicating to which extent in-
terest is permissible. Interest permissibility is measured in two different ways.
Either the amount of interest income generated or the amount of liquid assets
(cash and short-term investments) that could generate interest income is limited.
A sample interest screen is for instance:
• Interest income may not represent more than 5% of the total revenue of a
company.
3.2.2.3 Debt Screens
Since not only receiving interest is banned but also interest payments, the level
of interest payments for debt is also measured and limited by a threshold level.
Here, Islamic and conventional analysis coincide and favor lower debt ratios, since
in general a lower leverage level is interpreted as a positive investment signal. An
example of a debt screen is:
• The proportion of total debt to total assets of a company may not exceed
30%.
3.2.2.4 Non-Permissible Income Screens
Other less-frequently used financial screens measure the level of income gener-
ated from Non-Shariah-compliant activities. These screens are important in the
case that the qualitative screens which are used exclude only those companies
36
whose primary business is not Shariah-compliant. Such screens can be applied

for instance to measure for a hotel, whose primary business is Shariah-compliant,
how much income has been generated by alcohol sales and an associated casino.
If this income exceeds a given threshold, then the hotel is marked as being non-
Shariah-compliant. An example for a screen is for instance:
• Income from any Shariah non-compliant activity has to be less than 5% of

the total revenue generated by a company.
3.2.3 Analysis of Shariah Screens

To illustrate the wide diversification of Shariah screens, a detailed survey contain-
ing the different qualitative and quantitative screens used by the different Islamic
funds and indexes can be found in appendix A. The figures contain the Shariah
guidelines defined by the Shariah boards of the Dow Jones Islamic Index Group
(Dow Jones, 2007), the Financial Times Islamic Index Series (FTSE, 2007), the
Standard and Poor’s Islamic Index Group (Standard and Poor’s, 2007), the Mor-
gan Stanley Capital International Islamic Index Series (Morgan Stanley Capital
International, 2007), Dubai Islamic Bank (Nisar, 2007), the HSBC Amanah Fund,
the Meezan Islamic Fund (Usmani, 2002), the Amiri Capital Islamic Fund (Asaria,
2007) and the Azzad Islamic Fund (Azzad Asset Management, 2007). Another
well-known and cited Shariah screening process is the one used by the Malaysian
Security and Exchange Commission (Khatkhatay & Nisar, 2006), which differs
from the others since the process used is unique to Malaysia.
After analyzing the different sector and financial screens used by the Islamic
funds and index providers (see section 7.1) it can be noted that only minor
differences exist with respect to qualitative sector screens. A minor difference
among the providers is whether the weapon and biotechnology industry is to be
considered halal or not. Another considerable difference in sector screens is that
one group eliminates companies with any involvement in non-compliant activities
whereas the other group allows the inclusion of companies whose core business
is halal but receive a negligible portion of revenue from non-compliant activities.
If companies involved only slightly in non-compliant activities are excluded, the
37
Shariah-compliant asset universe is reduced highly in size since businesses such as

airlines, hotels and wholesalers, who all sell alcohol, are considered non-compliant.
On the contrary, there exist significant differences between the quantitative fi-

nancial screens used by the different Islamic funds and index providers (c.f. Table
A.2 in Appendix A). The major differences are described in the following subsec-
tions and concern the type of divisor used in the financial ratios and the range of
threshold levels.
3.2.3.1 Ratio Divisors: Market Cap and Total Assets
The most significant difference is whether market capitalization or total assets is

selected to value a company and used as divisor for the different financial screens.
The funds and indexes using market capitalization as divisor argue that it reflects
the real worth of a company as valued by the market and they use a trailing av-
erage to smooth the measure and to eliminate any seasonality effects.
On the other hand, the funds and indexes that use total assets as divisor consider
it as being the more appropriate measure since here companies are valued from
a trusted accounting perspective and each measurement is independent from any
external market influences or speculations. To overcome this debate, the Dubai
Islamic Bank for instance uses both measures as divisors for its screening ratios.
A considerable advantage of using market capitalization rather than total as-

sets is that the use of market capitalization enables continuous Shariah screening
since market capitalization is independent from the publication of financial state-
ments and can be directly calculated from market prices. This means that if total
assets are used, Shariah-compliance can only be defined when detailed financial
statements are published, which is most often on an annual basis only. Another
advantage of using market capitalization rather than total assets is that if the
financial information provided by the different companies is not accumulated us-
ing the same accounting principles, the total assets value is not an appropriate
measure because depending on the accounting principles used, total assets may
38
be inconsistently valued. Examples for such problems are the use of either the
LIFO or FIFO method to value inventories and the revenue recognition methods
used by the company. If for instance a company reports its balance sheet using
the LIFO method, in periods of rising prices inventories are undervalued which
then also undervalues total assets. The effect on a financial screen, such as total
debt over total assets is that the ratio becomes bigger and this may result in
the exclusion of a company that was likely to pass the same screen if the FIFO
accounting method was used.
3.2.3.2 Range of Threshold Values
As can be seen from Table A.2 in Appendix A the thresholds that are used to
limit a common ratio may vary among the different Islamic funds and indexes.
Since these thresholds are used to define a Shariah-compliant asset universe it is
for an Islamic investor important to understand how those threshold values are
deduced, since it is obvious that equity investments and screening processes are
not mentioned and quantified explicitly in the holy Quran or Hadith. Concerning
the interest ratios and debt ratios, independently from the different screening rules
used, the threshold levels used are very close to each other and no large differences
exist. The most frequently applied threshold used for interest and debt ratios is
at a level of 33 percent. The reasoning behind this rule (Obaidullah, 2005) is
most probably based on the
• Hadith: The Prophet (peace be upon him) advised Abu Bakr not to donate
more than one-third of his wealth, and commented that
”One third is too much”.
• Fiqhy (derived knowledge from Shariah) rule:
”Whether a commodity that is part gold and part brass qualifies

as gold for purposes of applying the rules of riba is resolved by
the percentage of gold in the commodity, i.e., if greater than a
third, it is gold”.
39
Obaidullah (2005) considers the use of the above stated Hadith and Fiqhy rule
as debatable and used out-of-context since the situations described differ widely
from the screening processes in which they are used.
On the other hand, the use of 5 percent as threshold level for non-compliant
income or interest income has no real foundation in the holy Quran or Hadith.
It is mainly founded on pure Ijtihad of the Shariah scholars and is based on the
fact that the individual Islamic investor has no control over the whole business
practices of companies that are managed in a Non-Islamic manner. Since con-
ventional companies usually have cash deposits or short-term investments that
generate interest income whereas their core business is completely halal, some of
the Shariah scholars agreed to consider this non-compliant income as negligible
if it does not exceed 5 percent of the total revenue generated. Only if the portion
of non-compliant income generated is purified, the investment is considered halal.
Concerning the threshold values used to measure the liquidity level of compa-
nies, a larger threshold variance ranging from 33 to 80 percent is found among
the different screening guidelines. Independently from the liquidity rule used it
is important to understand the reasoning behind this high variance which is dis-
cussed by Usmani (2002) in detail and can be summarized and further interpreted
as follows:
• Liquidity threshold of 33%
Is used for instance in the liquidity screens of Dow Jones and is based on
the same above-stated Hadith and Fiqhy rule that defines a portion of less
than one-third to be insignificant.
• Liquidity threshold between 45% and 50%

The Shariah boards of the FTSE, S&P, HSBC and Azzad Islamic funds and
indexes, have the opinion that the portion of illiquid assets has to be larger
than the portion of liquid assets. So, if the illiquid assets are larger than
50% of the total assets (or market capitalization value), the investment in
such a company is considered permissible based on the juristic principle:
”The majority deserves to be treated as the whole thing.”
40
3.3 Shariah Purification
• Liquidity threshold of about 70%

Based on the approach used by MSCI and Amiri Capital even if only one-
third of the assets of a company are in illiquid form, this company is to be
considered permissible. The interpretation is most probably based on the
above-stated Hadith but in a reverse way since ”one third is too much” or
sufficient from the point of view of the Shariah board.
• Liquidity threshold of more than 80%

This liquidity threshold level is only used by Meezan, which is based on
the opinion of Shariah scholars from Pakistan and India who follow the
Hanafi school of thought (one of the major and most liberal Islamic schools
of thoughts followed mainly in Central Asia) while the scholars of the other
Islamic funds and indexes mostly follow the Hanbali school of thought (an-
other major Islamic school of thought dominating in the Arabian Penin-
sula). The basic argumentation of the scholars using this threshold level is
that the proportion of liquid or illiquid assets to total assets is not critical
if and only if the illiquid proportion of total assets is not an insignificant
quantity (here at least 20 percent) and the value of liquid assets per share
of the company is less than the market price of the company. The two
requirements ensure that the price difference is a result of the value of the
illiquid asset. If the value of liquid assets per share is greater than the mar-
ket price this is considered non-compliant since money can only be traded
at par from a Shariah perspective. Of course it is a relative aspect how
liquidity is defined. In the case of Meezan, net liquid assets are used, which
is the difference between current assets and current liabilities.

The use of quantitative screens is a relaxation of the absolute ban to generate
earnings from interest or any other Shariah non-compliant activities. Since this
relaxation which is established to enable Islamic investors to participate in capital
markets is generally not compliant with Shariah the fraction of earnings gener-
ated from non-permissible activities need to be deducted. This relaxation is only
41
of temporary nature and is afterwards corrected. The process of deducting non-

permissible earnings such as interest or the earnings generated from the sales of
pork or alcohol from the total investment is referred to as purification. Only after
investments are purified from non-compliant earnings they are referred to as being
Shariah-compliant. Shariah forbids Islamic investors to take any advantage from
the non-permissible income that is to be purified. Therefore Islamic investors are
not allowed to use the purified amounts for any tax benefits or to account it as
Zakat, which is the Islamic obligation to donate 2.5 percent of certain wealth an-
nually to the poor as stated in the holy Quran. Purification is either reported to
the investors, so that they purify the amounts themselves, or are purified by the
supervising Shariah board who define for which purpose or humanitarian institu-
tion the impure income will be donated. The advantage of reporting purification
amounts to investors instead of deducting the amounts directly by the fund is
that an Islamic fund may attract other investors interested in ethical investment
instruments who consider interest income for instance not being unethical.
A major problem with purification is the measurement of non-permissible income.
Interest earnings on the one hand are identifiable through the detailed financial
statements published by the companies. But, on the other hand the identification
of the portion of earnings generated by non-compliant activities such as the sales
of alcohol or pork products is a highly complex task and almost impossible to
measure if these numbers are not reported by the companies themselves.
The lack of standardization found in Shariah screening can also be recognized
in purification practices recommended by different Shariah scholars. Purification
in itself, a practice that corrects temporary Shariah relaxations, is not debated
by the Scholars. The main reason behind discrepancies between Shariah scholars
with respect to purification is attributable to the argumentation used in defin-
ing from which investment return the non-permissible income is to be deducted.
There exist a number of Islamic funds, such as the ones found in Egypt that do
not apply quantitative screening for Shariah-compliance checking and base the
compliance decision on qualitative screens only. Such funds generally do not pu-
rify their earnings. In the following subsections the different existing purification
practices are described.
42
3.3.1 Dividend-based Purification

A large number of Shariah scholars and the respective funds they supervise (such
as the HSBC Amanah Fund and Standard and Poor’s Shariah Index) purify only
return which is directly received in the form of dividends whereas capital gains
do not need to be purified since the impact of non-permissible income on capital
gain is hard to measure and capital gains are the result of complex and different
market influences (Elgari, 2000).
Consider the quarterly income statements for each sector-compliant asset i ∈ I
for the last trading day in the quarter t ∈ Tquarter where Tquarter ⊂ Tday and let
• Di (t): Dividends paid
• T Ri (t): Total revenue
• NIi (t): Net income
• GPi (t): Gross profit
• NP IIi (t): Non-permissible income including interest
Now we can calulate the Dividend Purification Value DP Vi(t) of i at time t:
Di (t) · NP IIi (t)

DP Vi(t) = (3.1)
T Ri (t)
or

DP Vi(t) = (3.2)
NIi (t)
The reason behind having the two possible divisors for DP Vi (t) is that different
opinions exist about whether to define the percentage of non-permissible income
relative to total revenue or to net income. In practice most funds use total revenue
as divisor. Normally, the non-permissible element is comparable to total revenue
only if it is also a revenue element. An example for such non-permissible revenue
is the financial services revenue generated by some automotive companies. On
the other hand interest gained from cash deposits or through holding bonds is
43
an income element that has to be compared with net income. If interest income
is compared to total revenue, this is a highly moderate approach and a smaller
adjusted threshold should be used since the large revenue element is reducing the
overall fraction compared to a similar ratio using net income as divisor. Elgari
(2000) argues that the reason for using total revenue as divisor is based on the fact
that net income is a less reliable measure which could turn negative (Obaidullah,
2005). An alternative purification ratio used by MSCI for instance compares the
non-permissible interest income to gross profit as follows:

DP Vi(t) = (3.3)
GPi (t)
Through using gross profit the ratio is less affected by total revenue, since gross
profit GPi (t) is the difference between total revenue and cost of goods sold.
There exist a number of drawbacks to base purification on dividends only. Net

income is generally divided into payments made to investors in the form of div-
idends whereas the remaining amount is added to the retained earnings of the
company for reinvestment purposes. This means that using the above-stated
formulas only a fraction of impure income is purified whereas a non-compliant
portion remains in the company in the form of retained earnings. Additionally,
purification of dividends only does not consider the impact of dividend policies.
Growth companies for instance usually do not pay out dividends and use the
generated income for investment purposes that will help the company to grow
and increase its market value. Therefore, based on the dividend only purification
approach, a company may have a large portion of impure income that has to be
purified but based on its dividend policy it increases in value and provides a high
capital gain to the Islamic investor without obligation to purify at all.
This problem can be solved if purification is based on the overall earnings of

the company instead of dividends only. Using the earnings per share EP Si (t)
44
ratio for a specific asset i at time t, the overall amount which has to be purified
is given by
EP Si(t) · NP IIi (t)
EP SP Vi(t) = (3.4)
GPi (t)
So independently from the fact that dividends are paid or not, the earnings per
share purification amount has to be deducted from the cash deposit of the fund
or reported to Islamic investors for purification.
3.3.2 Capital Gain and Dividend Purification
Most Shariah scholars do not require to purify capital gains. They believe that
the movement in prices cannot be directly related to the fraction of impure income
contained in the retained earnings of the company. Elgari (2000) reviews a simple
calculation based on the Net Asset Value NAV (y, t) of a given portfolio y for a
given fixed holding period where the Portfolio Purification Ratio P P F (t) at time
t considers both capital gains and reinvested dividends:

i NP IIi (t)
P P F (t) = (NAV (y, t) − NAV (y, t − 1)) · (3.5)
i GPi (t)
Through using the purification formula 3.5, the impact of the proportional weights
of the assets included in the portfolio is not taken into account. Consider a port-
folio consisting of asset I and II with the date given in Table 3.1.
Asset I Asset II
࢚െ૚ ࢚ ࢚െ૚ ࢚
Quantity 100 100 500 500
Price adjusted for dividends $ 10.00 $ 12.00 $ 20.00 $ 30.00
ࡺࡼࡵࡵ࢏ ሺ࢚ሻ $ 50.00 $ 0.00
ࡳࡼ࢏ ሺ࢚ሻ $ 1000.00 $ 5000.00
Table 3.1: Example Data
45
Then based on the purification formula 3.5 the amount to be purified is given by:

i NP IIi (t)
P P F (t) = (NAV (y, t) − NAV (y, t − 1)) ·
i GPi (t)
= ($16, 200 − $11, 000) · ($50 + $0)/($1000 + $5000)
= $40.833
This formula requires the purification of return from both assets; ignoring the
fact that asset II has no non-permissible income at all. Thus, more adequate is
the modified purification formula MP P F using the market value MVi (y, t) for
each asset i ∈ I at time t ∈ T :

NP IIi (t)
MP P F (t) = (MVi (y, t) − MVi (y, t − 1)) ·
i
i∈I i GPi (t)
$0
= ($1, 200 − $1, 000) · ($50)/($1000) + ($15, 000 − $10, 000) ·
$5000
= $10.00
Using the proposed formula the amount to be purified is much less than the one
defined using the conventional formula.
3.3.3 Investment-based Purification
The previously mentioned purification practices force investors to purify if and

only if a positive return is generated by the investment. Investment-based purifi-
cation can be considered the most strict purification approach. Here, purification
has to be done even in the case of loss. The reasoning behind this approach
can be attributed to the rule that the Islamic investor is not allowed to use the
purification amount for tax benefits or Zakat and therefore he should also not be
allowed to use impure income to reduce any loss. One of the most prestigious
Shariah scholars Mohamed Ali Elgari, recommends investment purification of a
portfolio y = (y1 , .., yn ) in the following way(Elgari, 2000):
46
• Step I: For each asset i = 1, .., n identify NP IIi (t) and calculate NP IIT Ni(t)
the non-permissible income including interest netted from tax payments as
follows:
NP IIT Ni (t) = (1 − tax) · NP IIi (t)
If tax has been paid for the total income including the non-permissible
income amount, only the remaining amount is considered for purification.
• Step II: For each asset i = 1, .., n calculate (NP IIT Ni(t))/(T CSi (t)), which
gives the non-permissible earnings per share that need to be purified.
• Step III: For each asset i = 1, .., n calculate the non-permissible amount
N P IIT Ni (t)
NP A(i) = yi · T CSi (t)
n
• Step IV: Calculate the total amount to be purified NP P = i=1 NP A(i).
The different purification approaches described so far are all ex-post accounting
calculations. In section 4.2 an approach is proposed in which purification is
considered ex-ante, i.e. within portfolio construction.
47
48
Part II
New Concepts for

Shariah-Compliance and
Development of an SPMDSS
49
Chapter 4
New Strategies and Paradigms

for Shariah Portfolio
Management
4.1 Shariah Screening Strategies and Paradigms

1
Generally, Shariah compliance strategies are based on two types or sets of
guidelines: sector guidelines and financial guidelines (Khatkhatay & Nisar, 2006).
The Shariah concepts reviewed in Chapter 3 and the empirical analysis reported
in Chapter 7 reveal that current Shariah compliance practice is not standardized.
In the following subsections current Shariah concepts are used to develop and
define new Shariah strategies, paradigms and indicators.
4.1.1 New Shariah Compliance Strategies

Conventionally Islamic investment trusts use a specific Shariah compliance strat-
egy to define a compliant asset universe. Such a Shariah compliance strategy is
either defined by an in-house Shariah board supervising the trust or the trust
subscribes to the service of an externally-supervised Islamic index such as the
S&P Islamic Index. The latter provides them with a frequently updated list of
1
This section has been partially published in Derigs & Marzban (2008c)
51
4. NEW STRATEGIES AND PARADIGMS FOR SHARIAH
PORTFOLIO MANAGEMENT
compliant assets which are specified using the Shariah compliance strategy. As
will be shown in the empirical analysis in section 7.1 the asset universes resulting
from these compliance strategies if compared to each other are characterized by
high inconsistencies both in universe size and constituents considered to be com-
pliant.
The Shariah scholars who supervise the different Islamic funds and index providers
and who defined the different Shariah strategies can be considered as being the
major and most qualified Shariah scholars. Thus, the inconsistencies between
these strategies as all inconsistencies among expert opinion call for what can be
called compromises or view integration.
In the following we propose four strategies to combine the expertise of these

”basic” strategies:
• Best of Strategy
• Consensus / Ijmaa Strategy
• Liberal Strategy
• Majority / Kasra Strategy
The effect of using these new strategies on an asset universe is shown in Figure
4.1. Each of the circles represents a compliant asset universe defined using some
basic Shariah strategy such as the ones used by the Islamic index providers Dow
Jones, Standard and Poor’s, MSCI and FTSE. The shaded areas represent the
compliant asset universes resulting from the new Shariah strategies.
4.1.1.1 Best of Strategy
The basic Shariah strategies are defined by different Shariah boards, with each
of these boards claiming that their strategy and the defined guidelines ensure
Shariah-compliant asset selection. Now, the Best of strategy selects from the pool
of basic compliance strategies the one which results in the best portfolio perfor-
mance in terms of some objective function based on return and risk. Therefore,
52
A. Best of Shariah Strategy B. Ijmaa Shariah Strategy
C. Liberall St
C Lib Strategy
t B.
B Majority
M j it Strategy
St t
Figure 4.1: Asset Universes based on diverse Asset Compliance Strategies
under this strategy the portfolio optimization model has to be solved individu-
ally for each asset universe and then the ”best” among the optimal portfolios is
chosen.
4.1.1.2 Consensus / Ijmaa Strategy
The consensus strategy considers an asset to be compliant if and only if all basic
Shariah strategies consider the respective asset to be compliant. The Shariah
foundation of this compliance strategy can be attributed to the Ijmaa principle,
which is the unanimous consensus of all major qualified Shariah scholars on a
certain Shariah issue at a given time. Under the Ijmaa strategy, asset compliance
is defined through considering all basic Shariah strategies and their respective
guidelines simultaneously within the portfolio optimization model. The Ijmaa
strategy has the major property that only those assets are compliant for invest-
53
ment that are jointly considered compliant by all basic Shariah strategies, hence
only the intersecting asset universe is compliant (Figure 4.1) which means that
no asset is included in the asset universe which is considered to be non-compliant
by any of the basic Shariah strategies. A drawback of this strategy is that the
compliant asset universe may be significantly smaller than every asset universe of
a basic strategy (Figure 4.1) and this may affect portfolio performance in terms
of risk and return.
4.1.1.3 Liberal Strategy
Under the liberal strategy an asset is considered to be compliant if at least one

basic Shariah strategy considers the asset to be compliant. The liberal compliance
strategy results in a larger asset universe (see Figure 4.1) and therefore higher
returns and lower risks can be expected under this strategy. This strategy might
seem to be too moderate for some readers/investors, but due to the fact that
all basic Shariah strategies claim to discriminate between compliant and non-
compliant, every asset considered compliant by at least one basic strategy can be
considered to be compliant.
4.1.1.4 Majority / Kasra Strategy
The majority (in Arabic Kasra) strategy is motivated by the Islamic juristic prin-
ciple which states that ”the majority deserves to be treated as the whole thing”.
Thus, an asset is compliant under this strategy if and only if the majority of
the basic Shariah strategies consider this asset to be compliant. This strategy is
obviously more conservative than the liberal strategy where compliance has to
be stated by just one basic Shariah strategy. Some scholars might say that this
principle is used out-of-context but most Shariah principles used to justify com-
pliance practices in capital markets are considered as being used out-of-context
by some Islamic researchers (Obaidullah, 2005).
4.1.2 A New Paradigm for Shariah-Compliance

The compliance strategies described above consider compliance as an attribute
of the single assets. If an asset satisfies the respective guidelines it is considered
54
compliant, else the asset is deemed non-compliant and has to be eliminated from
the asset universe. The following proposal leads to a new paradigm which if
accepted by current Shariah scholars will revolutionize Islamic equity manage-
ment. Based on the Accounting and Auditing Organization of Islamic Financial
Institutions (AAOIFI), Islamic investment funds are defined as follows (Norman,
2004):
”Funds are investment vehicles, which are financially indepen-

dent of the institutions that establish them. Funds take the form
of equal participating shares/units, which represent the shareholder’/
unit holders’ share of the assets, and entitlement to profits or losses.
The funds are managed on the basis of either Mudaraba or agency
contract.”
Management
ShariahBoard Investors
Company
Management Supervision Redeemable

Shares Shares
LimitedLiability
Company
Assets
A t
(InvestmentPortfolio)
Figure 4.2: Structure of Shariah-Compliant Funds
Therefore, a fund takes the form of an independent company, such as a limited

liability company (Norman, 2004), in which investors act as shareholders (see
Figure 4.2). Now, we simply argue that with respect to compliance a fund which
itself invests in multiple companies has to be evaluated in the same way as a
conventional independent company. This point of view is justified and illustrated
it the following example.
55
Consider, for example, a hotel, then a critical Shariah guideline is the follow-
ing:
• Income from the casinos, bars, night clubs and alcoholic beverages has to
be less than 5% of the total revenue generated by the hotel.
Since the core business of the hotel is considered compliant, this guideline is
used to restrict the investment to only those hotels with a non-compliant income
less than the threshold. Thus, a hotel can be considered as a company oper-
ating in three business lines which are: accommodation and Shariah-compliant
hotel services, the sale of alcohol and casinos and night clubs. If a hotel has an
overall non-compliant income from the second and third business lines which is
less than 5 percent of the accumulated revenue generated by the three business
lines together, then, according to the guideline, it is considered to be compliant
for investment. Accordingly, if the investment in a company like a hotel that
generates negligible income (which will also be purified later on) from some non-
compliant activities is considered to be compliant as such under some strategy,
then analogously an investment in a fund which invests in different companies,
should also be considered to be compliant as a whole if the mixture of companies
(interpreted as business lines of the fund) does not violate the guidelines of the
same Shariah strategy. Also, for the investor of a portfolio the overall portfolio
return and portfolio risk is crucial and not the return and risk of the single assets.
Using the same argumentation, an Islamic investor should focus on the overall
Shariah-compliance of his portfolio and its return netted by purification rather
than looking at single asset compliance and returns. The new portfolio compli-
ance paradigm can be used in conjunction with any asset compliance strategy as
for instance those described in section 4.1.1, i.e. it can be combined with any
basic strategy from an Islamic index, or, the Best of, Ijmaa, liberal or majority
compliance strategy, respectively.
This results in a large variety of new options for compliance specification
as illustrated in Figure 4.3. These combinations vary from very conservative to
rather liberal. Obviously, the use of an asset-based compliance strategy may result
in a significant reduction of the asset universe but it does not restrict the amount
to be invested in a compliant asset. On the other hand, within a portfolio-based
56
AssetCompliance PortfolioCompliance
Single BestOf Ijmaa Majority

Liberal
Provider Provider Consensus Kasra
Paradigm
Strategy
Figure 4.3: Shariah-Compliance Options
compliance strategy no asset is excluded from the asset universe per se, but, the
control of the entire portfolio through the financial ratios may put limitations
on the proportional wealth to be invested in certain assets implicitly. The new
paradigm might be considered as too liberal or even non-Islamic, but it is deduced
by logical reasoning from current compliance strategies. Of course, this paradigm
should be applied only to specific products and after some preprocessing:
• First, the fund should only invest in Shariah-compliant asset classes such
as equity or products structured in a Shariah-compliant way such as sukuks
(Islamic bonds).
• Secondly, no investment should be allowed in assets from companies whose

primary activities are not compliant with Shariah. Thus the conventional
sector guidelines, through which those assets are excluded from the asset
universe, should be applied beforehand.
As a first summary we claim, that the proposed new strategies do not con-
flict with the Shariah jurisdictions used for the basic Shariah strategies. On the
contrary, most of the proposed strategies (except the liberal strategy) are either
more conservative or equally conservative compared to the basic Shariah strate-
gies. The portfolio-based compliance paradigm on the other hand is somewhat
”out of the box” giving new compliance options. After formalizing the new strate-
gies and the new paradigm in section 5.1, the new options are analyzed in section
57
7.2 and the results are compared with the basic strategies. These results should
then be used and interpreted by Shariah scholars who have to decide upon ac-
ceptance of the new approaches.
The hotel example reveals a problem which is not only relevant for the new
paradigm: the complexity to identify the compliance of companies operating in
different business segments. Most Shariah providers use an industry classifica-
tion standard such as GICS (Global Industry Classification Benchmark) or ICB
(Industry Classification Benchmark) through which companies are assigned to
a single business segment based on the core business activity they operate in.
Using such a classification standard makes it impossible to identify the different
compliant and non-compliant business segments companies operate in. There-
fore the automated use of GICS or ICB standards if used in the hotel example
would result in the classification of the hotel as being compliant since no indi-
cation is made to the revenue generated by non-compliant activities such as the
sales of alcohol and revenue from casinos and night clubs. This problem can be
solved using a different industry classification standard which is the SIC (Stan-
dard Industry Classification) classification system through which each company
is assigned multiple SIC codes based on the different industries or businesses it is
operating in. But, since not all companies report the revenue generated by each
SIC segment it is almost impossible to identify the amount of non-permissible
revenue generated without further research and analysis.
4.2 Strategies for Shariah Purification

Purification is a crucial element within the Islamic Equity Management process
which if done appropriately ensures the overall Shariah-compliance of the invest-
ment. Current purification accounting practices and appropriate modifications
were presented in section 3.3 of this research. Conventionally, purification is con-
sidered after investment and deducted from the Net Asset Value of the portfolio
or from dividend payments received from the single assets.
Purification is a spiritual obligation to deduct impure income from the total
income generated. Therefore purification sounds very similar to taxation, which
58
4.2 Strategies for Shariah Purification
is a legal obligation to purify specific incomes generated. Since the consideration

of taxes and their impact on net return within the portfolio construction deci-
sion process is highly consequential, one of the hypothesis of this research claims
that the ex-ante consideration of purification within portfolio optimization may
increase the shareholder value in terms of net return compared to a portfolio
construction strategy in which purification is only considered ex-post after in-
vestments are done. The actual amount which has to be purified is not known
in advance and therefore the proportion ρ(i) to be purified for each asset i ∈ I is
estimated using the historical impure incomes by
1 NP II(i, t)
t
ρ(i) = ∀i ∈ I (4.1)
t τ =1 T R(i, t)
As described in section 3.3 different purification approaches can be found in

practice which can be broadly categorized as follows:
• Investment-based Purification
• Capital Gain and Dividend Purification
Given the expected return μ(i) of each asset i ∈ I then the expected purified net
ˆ of an asset is as follows
return μ(i)
Investment-based Purification Approach

⎧ ⎫
⎪
⎨ ⎪
⎬
μ̂(i) = min μ(i) · (1 − ρ(i)), μ(i) · (1 + ρ(i)) ∀i ∈ I (4.2)
⎩
⎪ ⎪⎭
if μ(i)≥0 if μ(i)<0
Capital Gain and Dividend Purification Approach

⎧ ⎫
⎪
⎨ ⎪
⎬
μ̂(i) = μ(i) − max μ(i) · ρ(i),
0 ∀i ∈ I (4.3)
⎩ if μ(i)<0⎪
⎪ ⎭
if μ(i)≥0
Since the return of an asset can be either negative or positive (or zero) the formu-
lation in equation 4.2 ensures that the net return is calculated appropriately. A
59
negative asset return based on the investment purification approach also needs to
be purified since the existence of impure income reduces the overall losses faced
by the investor.
Thus, if purification is to be considered the different model elements (objective

functions and constraints) that include the expected return μ(i) as a parameter
are modified to include the purification-adjusted return μ̂(i) instead for each asset
i ∈ I. The impact of using purified returns is empirically investigated in section
7.3 of this research.
4.3 Shariah Sustainability

Since the Islamic equity investment process is dynamic in nature and new financial
information and corporate news are published over time, the financial results as
well as the sectors in which companies operate change over time. Companies
may change the business segment they are operating in, change substantially in
nature through mergers or acquisitions or may become highly leveraged through
rising capital in the form of debt. All these events have an impact on Shariah-
compliance. An asset may turn from compliant to non-compliant which results
into forced liquidation of the asset position from the portfolio if included. On
the other hand a non-compliant asset may turn compliant and therefore turn
to a possible investment (see Figure 4.4). But, current practices take investment
decisions on a purely static basis instead of analyzing and considering the Shariah-
compliance of an asset over time and its historical Shariah-compliance level.
The major advantages of measuring the Shariah-compliance of an asset over
time and to consider it within the portfolio selection decision problem are:
• Sustainable Shariah Compliance

Islamic investors are investing in Islamic products because they want the
investment to comply with their beliefs and religious principles. So this
means that Islamic investors prefer Shariah-compliance over return and
risk. Thus, for an Islamic investor it is important that the company he or
she is investing in is conventionally compliant over time and not accidentally
60
4.3 Shariah Sustainability
t1 t2 t3 tn-1 tn 100% Sustainability
t1 t2 t3 tn-1 tn High Sustainability
t1 t2 t3 tn-1 tn Low Sustainability
t1 t2 t3 tnn-11 tn 0% Sustainability
y
Compliant
p within t
Non-Compliant within t
Figure 4.4: Shariah Sustainability of an Asset over Time
compliant over the current time period only (as it is the case with the low
sustainability asset in Figure 4.4). It may occur that a company which is
historically not compliant through reduced leverage level operates closely
below the accepted thresholds of Shariah guidelines. Therefore the labeling
of this asset as being compliant is questionable.
• Better Fund Performance

Shariah scholars have defined specific rules to follow when assets switch
from being compliant to non-compliant. Fund managers are generally given
a limited time window to liquidate any asset included in the portfolio which
turned to be non-compliant with Shariah. Thus, if the market is bearish
it may happen that an asset has to be sold with a significant loss. So if
it is predictable that an asset included in the portfolio may have to be
liquidated, the fund manager may decide ex-ante and pro-actively the right
time to sell the asset. Further on, within portfolio management transaction
costs play a crucial role. So if compliance of an asset is predictable based
61
on the historical compliance levels, fund managers are able to consider the
risk of obliged liquidation and respective transaction costs.
Therefore a new ”Shariah sustainability” indicator is introduced which is cal-

culated using historical compliance levels of assets. Through using the Shariah
sustainability measure it is possible to identify for each asset its potential risk to
turn non-compliant after the release of new financial statements.
The compliance status cs(i, t) for any asset i ∈ I at a given time t ∈ T is a binary
variable taking either the value 0 (if haram) or 1 (if halal). The value of cs(i, t)
is determined based on the Shariah compliance procedure used as follows:
⎧
⎨1, if all guidelines are fullfiled for asset i at time t
cs(i, t) = (4.4)
⎩0, otherwise
These values are then used to estimate for each asset i ∈ I the probability ss(i)
that asset i stays / is halal:
1
T
ss(i) = cs(i, t) ∀i ∈ I (4.5)
T t=1
A more realistic approach is to scale the compliance stati of the assets, so that re-
cent compliant stati are weighted higher than older observations. In any case, as-
sets with a sustainability probability less than a preferred level can be eliminated
prior optimization. These Shariah sustainability requirements can be consid-
ered in a preprocessing phase before portfolio optimization using simple database
operations through which assets with a sustainability level less than a specific
threshold are excluded from the asset.
The relevance and impact of using Shariah sustainability on portfolio performance
is discussed within the empirical analysis in section 7.3.
4.4 The Shariah Portfolio Management Process

Investment trusts which are willing to offer Shariah-compliant investment prod-
ucts have to adjust their conventional portfolio management processes by the
62
introduced concepts so that the entire investment process operates in a Shariah-

compliant manner. Figure 4.5 summarizes how the different stages in the portfolio
management process are extended by Shariah-specific or Islamic issues.
Investment Policy Analysis

Conventional
Requirement analysis
Investment Strategy selection
Benchmark selection
Islamic Considerations Portfolio Construction

Shariah-compliant partnership
t
type selection
l ti
Shariah Compliance Perception Conventional Performance Analysis
Portfolio Optimization And Portfolio Revision
Return / Risk
Constraints Conventional
Portfolio Implementation Performance measurement
Feasibility compliance
Financial Analysis
Islamic Considerations
Shariah-compliance checking Islamic Considerations
Conventional Considering Purification losses Purification reporting
Asset universe definition
Quantitative measures for risk
and return
Islamic Considerations
Shariah compliance procedures
Shariah-compliance
Quantification of Purification
Shariah Sustainability
Planning Implementation Controlling1
Figure 4.5: Islamic Equity Management Process
4.4.1 Shariah Issues in Investment Policy Analysis

Within investment policy analysis a Shariah-compliant partnership either on a
Mudaraba or agency basis has to be agreed upon with the respective investor.
Another important and crucial aspect is to determine the Shariah requirements of
the investors. Generally compliance is defined using either an internally appointed
Shariah board or through the subscription to an external index provider. The
investment policy analysis includes identifying investors’ preferences and require-
ments, which also requires to analyze the investors’ perception about Shariah
issues and which Islamic school of thought he or she follows. Then, after the
Shariah perception has been identified the trust should provide these investors
with the appropriate compliance strategy. This can easily be achieved by using
63
a flexible and customizable Shariah screening system. Using a screening system

encompassing the diverse Shariah guidelines defined by different Shariah scholars
has a number of advantages:
• Tailored funds. The investment trust is capable to provide different prod-

ucts for different Islamic investors groups. The perception of Islamic in-
vestors from Arab countries differs from that of Muslims from Pakistan and
India or from South East Asia for instance. Thus, funds can be tailored to
match specific client preferences.
• Independence from index provider. Indexes have two major disad-

vantages: the limited asset universe they consider and the frequent index
revision. Indexes change their constituents over time based on criteria inde-
pendent from Shariah issues. Thus, a compliant asset may be deleted from
an index and thus has to be eliminated from the portfolio. Using a flexible
screening system makes trust funds capable to check the compliance of an
asset they want to include in their asset universe and to become unaffected
by index revisions on the parent index.
• Lower costs. If a screening system is used, fund management does not

need to appoint a Shariah board as it is the case with most conventional
Islamic funds. Since all Shariah guidelines which have been defined by
different scholars are included in the knowledgebase of the screening system
it is sufficient to have a Shariah officer who monitors the entire investment
process from a Shariah perspective.
• Using new Shariah Strategies and Paradigms. The Shariah compli-

ance strategies and paradigm developed and proposed in section 4.1 resolve
current inconsistencies in Shariah compliance definition through combining
guidelines from multiple Shariah sources together. Such strategies and the
portfolio compliance paradigm introduced are only applicable if the Shariah
guidelines and their logic resided within a computer-based system accessible
by the investment trust.
64
4.4.2 Shariah Issues in Financial Analysis
The investment policy statement defined in the policy analysis is used as input to
further analyze and identify the appropriate investment strategy and to explore
potential asset classes and assets to be considered for investment. To improve the
performance of Islamic equity funds we propose to extend the financial analysis
phase to include the appropriate selection of a Shariah-compliance strategy and
paradigm, considering purification losses in expected return calculation and mea-
suring the Shariah sustainability of assets. The selection of a Shariah-compliance
procedure (see Figure 4.3 in section 4.1) has to be based on the investor prefer-
ences identified in the policy analysis phase. The Shariah-compliance procedure
consists of a paradigm (compliance on portfolio level or asset level) and of a strat-
egy (single provider, best of providers, Ijmaa, majority, liberal). The impact of
using different strategies and paradigms on portfolio performance and Shariah
consistency are discussed in detail in the empirical analysis of section 7.2. Mea-
suring Shariah sustainability in the presented way makes only sense to be used in
conjunction with the asset compliance paradigm. Within a portfolio compliance
paradigm the financial compliance of a portfolio over time is less significant since
the portfolio structure may be changed continuously. Shariah sustainability has
to be measured and considered in financial analysis to account for either investor
preferences defined within the investment policy analysis or for transaction costs
that may occur due to the probability of an asset to switch from compliance to
non-compliance.
4.4.3 Shariah Issues in Portfolio Construction
Based on the definition and analysis reached in the planning phase the conven-
tional portfolio requirements (objectives, legal and internal guidelines) and the
Shariah requirements identified are encompassed into the portfolio optimization
model. This includes the mathematical constraints of the Shariah paradigm and
strategy selection and the use of purification adjusted returns within portfolio
optimization. Based on the portfolio optimization results and the interaction of
the portfolio manager a final portfolio is implemented through placing orders.
65
4.4.4 Shariah Issues in Performance Analysis and Portfo-

lio Revision
Shariah compliance is dynamic in nature and therefore with the availability of
newly published financial information and the change in asset prices which modi-
fies the relative weights of assets within a portfolio, an investment may turn from
compliant to non-compliant. Therefore exactly as it is the case with conventional
guidelines the Shariah feasibility of the portfolio is not a constant and has to be
frequently checked and the portfolio has to be rebalanced if compliance does not
hold anymore. Another relevant Shariah issue is the periodic reporting of purifi-
cation amounts to investors, to finalize the Shariah compliance requirements of
the proposed Shariah-compliant portfolio management process.
66
Chapter 5
Shariah Portfolio Optimization

Model
5.1 Modeling the Shariah Portfolio Problem

1
This section outlines how Shariah compliance can be modeled within the com-
mon framework of portfolio optimization. We consider the standard situation,
i.e. an asset universe I = {1, , n} from which a portfolio can be constructed
and it is assumed that the total wealth has to be invested and short-sellings are
not allowed, which is realistic since short-sellings are generally not allowed under
Shariah. Then every portfolio can be represented by a share vector x = (x1 , ..., xn )
where xi ∈ [0, 1] represents the weight or fractional wealth invested in each asset

i ∈ I and ni=1 xi = 1 holds.
For the following assume an objective function f (x) by which the performance
of a portfolio is measured and a set C of constraints stemming from investment
guidelines other than Shariah guidelines, legal guidelines for instance. The spe-
cific type of objective function and constraint set C is irrelevant for the following
discussion and thus these components are kept on an abstract level (since they
have been explained in depth in section 2.2.4.1) to reduce complexity and focus
on the Shariah-specific aspects.
1
This section has been partially published in Derigs & Marzban (2008c)
67
5. SHARIAH PORTFOLIO OPTIMIZATION MODEL
Thus neglecting Shariah compliance the following conventional portfolio opti-

mization model is used:
Minf (x) (5.1)
subject to
x fulfills constraints in C (5.2)

n
xi = 1 (5.3)
i=1
xi ≥ 0 ∀i ∈ I (5.4)
Irrespective whether compliance is measured as an attribute of the single assets

or the whole portfolio, sector guidelines have to be fulfilled i.e. they have to be
applied to exclude from the asset universe I assets of those companies operating
in Shariah non-compliant business activities. Using the fact that the assignment
of each company issuing an asset to a specific sector is indicated by industry
classification codes such as GICS or ICB the set of non-compliant assets I N C ∈ I
can be specified easily and the sector guidelines can be modeled by exclusion
constraints
xi = 0 ∀i ∈ I N C (5.5)
Note that these exclusion constraints need not be included in the portfolio opti-
mization model, if the model is instantiated with I := I\I N C .
Now we discuss how Shariah-compliance guidelines can be introduced as con-
straints into the model. An example for a prominent financial guideline using the
accounts receivables ARi , cash and short-term investments CSIi and total assets
T Ai figures as published in the financial statements of the company issuing the
asset i ∈ I is given by
ARi + CSIi
≤ 0.5 (5.6)
T Ai
This guideline ensures that the liquid assets of the company as proportion of
total assets are less than or equal 50 percent and stems from the Shariah rule
that income is to be mainly gained from illiquid assets and therefore the majority
of assets have to be of illiquid form. Formally, given a financial guideline g ∈ G
a financial ratio ri (g) for each asset i ∈ I has to be calculated which measures
68
the level of involvement in a non-compliant financial activity, and to compare

the value with a maximum permissible value T (g), the so called threshold value.
Thus a set of constraints of the following type has to be controlled
ri (g) ≤ T (g) (5.7)
Obviously, these guidelines result in a further reduction of the asset universe and
thus their fulfillment can be secured in a preprocessing phase analogously to the
sector guidelines and thus Shariah compliance of a portfolio can be operationally
obtained by a preprocessing phase in which the asset universe for a conventional
portfolio optimization model, is specified.
An alternative, yet inefficient way to model compliance with respect to a guide-

line is to formalize conditions (5.7) as set of mathematical inequalities which are
introduced as constraints into the portfolio model. We describe this formaliza-
tion in detail since it is a necessary approach when implementing the portfolio
paradigm.
Obviously, guideline (5.7) can be modeled by a set of logical constraints of the
following type
xi = 0 if ri (g) > T (g) ∀i ∈ I (5.8)
Now (5.8) can be transformed into a set of mathematical inequalities in a standard

way as follows:
For each asset i ∈ I a binary variable zi is defined with
⎧
⎨1, if i is compliant
zi = (5.9)
⎩0, otherwise
and the constraints

xi ≤ zi ∀i ∈ I (5.10)
ri (g) · zi ≤ T (g) ∀i ∈ I (5.11)
69
are introduced. Constraints (5.10) ensure that for every asset i ∈ I
xi > 0 only if zi = 1 (5.12)
Since constraints (5.11) ensure that zi is 0 if the guideline (5.7) is not fulfilled i.e.
the ratio is above the respective threshold, investment in asset i ∈ I, i.e. xi > 0,
is possible only if the guideline is fulfilled. In the following it is shown how these
techniques can be used to model the different compliance strategies introduced
in section 4.1.
5.1.1 Modeling Asset Compliance Strategies

Consider S as the set of basic Shariah strategies and G as the set of all financial
Shariah guidelines defined by the different basic Shariah strategies, then a spe-
cific basic Shariah compliance strategy s ∈ S is formulated using a specific subset
GS ∈ G and the associated portfolio optimization problem is given by
Min f (x)
subject to (5.2),(5.3),(5.4),(5.10) and
ri (g) · zi ≤ T (g) ∀i ∈ I, ∀g ∈ GS (5.13)
In the following subsections we show how the new strategies can be modelled.
5.1.1.1 Best of Strategy
In the best of Shariah strategy model (5.13) has to be solved for each s ∈ S
iteratively and the optimal portfolio with respect to this strategy is the one
generated by the model yielding the best portfolio performance.
70
5.1.1.2 Consensus / Ijmaa Strategy
Within the Ijmaa strategy, asset compliance is defined through considering all
basic Shariah strategies s ∈ S and their respective guidelines g ∈ GS simul-
taneously within the portfolio optimization problem. Such a strategy can be
formulated within the model by replacing (5.13) by:
ri (g) · zi ≤ T (g) ∀i ∈ I, ∀s ∈ S, ∀g ∈ GS (5.14)
The model is very similar to the model for a basic strategy with the only difference
that the constraints for all Shariah strategies s ∈ S are added to the model.
5.1.1.3 Liberal Strategy
The liberal compliance strategy reduces the asset universe by those assets which
are jointly defined non-compliant by all basic Shariah strategies considered. The
identification of these assets and their exclusion from the solution domain is
accomplished through introducing a binary variable
⎧
⎨1, if i is compliant w.r.t s ∈ S
zi (s) = (5.15)
⎩0, otherwise
and by introducing the following set of constraints:
ri (g) · zi (s) ≤ T (g) ∀i ∈ I, ∀s ∈ S, ∀g ∈ GS (5.16)

xi ≤ zi (s) ∀i ∈ I (5.17)
s∈S
The constraints (5.17) ensure that
xi > 0 only if zi (s) = 1 for at least one s ∈ S, ∀i ∈ I (5.18)
and thus if xi > 0 for at least one s ∈ S, s0 say, all constraints from (5.16) for
g ∈ Gs0 are fulfilled.
71
5.1.1.4 Majority / Kasra Strategy
This strategy can be modeled using the binary variables zi for i ∈ I and zi (s) for
i ∈ I and s ∈ S which have been introduced before as follows:
ri (g) · zi (s) ≤ T (g) ∀i ∈ I, s ∈ S, g ∈ Gs (5.19)

|S|
zi (s) ≥ · zi ∀i ∈ I (5.20)
s∈S
2
The constraints (5.10) and (5.20) ensure that if
xi0 > 0 for an asset i0 ∈ I then zi (s) = 1 for the majority of s ∈ S,

(5.21)
0
i.e. i is compliant for the majority of strategies.
5.1.2 Modeling Portfolio Compliance Strategies

A portfolio x fulfills a specific guideline g if the sum of the ratio values weighted
by their share values is less than the threshold, i.e.

ri (g) · xi ≤ T (g) g∈G (5.22)
i∈I
Now a portfolio x is compliant with respect to a strategy s ∈ S if x fulfills all

guidelines g ∈ GS . Thus, for a basic strategy s and the set GS of guidelines the
following portfolio optimization model has to be solved:
Min f (x)
subject to (5.2),(5.3),(5.4) and

ri (g) · xi ≤ T (g) ∀g ∈ GS (5.23)
i∈I
The other portfolio-based compliance strategies can now be modeled as follows:
Best of Strategy
72
Again for the best of strategy the optimal portfolio is the one generated by the
basic strategy s yielding the best portfolio performance.
Consensus / Ijmaa Strategy

To define Shariah-compliance under the Ijmaa strategy, (5.23) has to be replaced
by:

ri (g) · xi ≤ T (g) ∀s ∈ S, ∀g ∈ GS (5.24)
i∈I
Liberal Strategy
To model the liberal compliance strategy we intrdocuce the binary variables
⎧
⎨1, if the portfolio x is compliant for s ∈ S
zp(s) = (5.25)
⎩0, otherwise
and replace (5.23) by:

zp(s) · ri (g) · xi ≤ T (g) ∀s ∈ S, ∀g ∈ GS and (5.26)
i∈I

zp(s) ≥ 1 (5.27)
s∈S
Constraints (5.26) are nonlinear and with respect to solvability of the optimization
model should be linearized as follows:

ri (g) · xi ≤ (1 − zp(s)) · M + T (g) ∀s ∈ S, ∀g ∈ GS (5.28)
i∈I
with M a sufficiently large number. Now due to (5.27) at least for one s ∈ S, s0
say, zp(s0 ) = 1 is obtained and thus (5.28) and / or (5.26) holds for at least one
s ∈ S.
Majority / Kasra Strategy
73
To model the majority strategy we replace in the model for the liberal strategy
(5.27) by
|S|
zp(s) ≥ (5.29)
s∈S
2
This ensures that at least the majority of basic strategies s ∈ S consider the
portfolio as being compliant.
5.2 Solving the Shariah Portfolio Optimization

Models
Portfolio models are usually computationally complex and therefore they were
frequently solved approximatevly using heuristics rather than exact algorithms
(Derigs & Nickel, 2003). But, due to the the recent improvements in the area of
commercial optimization solvers it is now possible to solve Mean-Variance models
with complex constraints (such as cardinality and min-buy-in constraints) exactly
in adequate time.
Therefore within this research Mean-Variance models with complex constraints
have been solved using the ILOG CPLEX solver which is able to solve Mixed
Integer Quadratic Optimization problems (MIQP) of the required size.
Yet, index tracking models (which are NP-hard if containing with cardinality re-
strictions (Coleman et al., 2006) and (Derigs & Nickel, 2004b)) can be solved by
relaxing the quadratic problem to a linear programming problem using a Sequen-
tial Linear Programming approach (SLP). SLP is a general relaxation concept
and has been used for instance for solving layout problems (Bhowmik, 2008) and
cargo allocation problems (Brosh, 1981). Chalermkraivuth et al. (2005) have pre-
sented this approach to solve complex portfolio optimization models for General
Electric Asset Management.
The algorithm proposed by Chalermkraivuth et al. (2005) assumes a model for
74
5.2 Solving the Shariah Portfolio Optimization Models
constructing an efficient solution of the following form:
Max μ(x)
subject to
σ(x) ≤ σ target
x fulfills constraints in C
and works as follows:
Algorithm 1 Sequential Linear Programming Algorithm
Specify LRisk a lower bound for risk and LReturn a lower bound for return
Eliminate risk constraint and solve LP to generate an initial portfolio x0
i←1
i ← small value
while σ(xi−1 ) ≥ LRisk and μ(xi−1 ) ≥ LReturn do
Compute ∇f (xi−1 ) · xi−1 the tangent to the risk contour at xi−1
Add linear constraint ∇f (xi−1 ) · x ≤ ∇f (xi−1 ) · xi−1 − i to the model
Solve the new LP to obtain next portfolio xi on the efficient frontier
i←i+1
end while
The performance of this algorithm for approximating the efficient frontier de-
pends on the value of . The smaller the closer is the approximation. As shown
in Figure 5.1 we have empirically analyzed the results obtained using the SLP
algorithm compared to the solution with an exact Quadratic Programming al-
gorithm for the problem of generating the efficient frontier for a Mean-Variance
model. The solutions obtained are promising but not yet practical.
75
Quadratic Programming Sequential Linear Programming Relaxation

Return
60.00%
50.00%
40 00%
40.00%
30.00%
20.00%
10.00%
0.00%
0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% Risk
Figure 5.1: Comparison of SLP approximation and exact MIQP solution for
constructing an efficient frontier
76
Chapter 6
Shariah Portfolio Management

DSS
6.1 Decision Support Systems
One of the main tasks of decision makers is to choose among a set of alternative
actions the one through which the organization’s goals are attained and achieved
best. Operations Research provides a variety of models and mathematical solvers
which can be used to evaluate and select the best alternative course of action
such as the optimal portfolio structure in portfolio management problems. But
due to the complexity of these mathematical models they did not find their way
into practice without the evolvement of model-based Decision Support Systems
through which models and methods can be interactively and easily managed and
manipulated by decision makers.
In the following subsections the main DSS principles (Sprague, 1980) which are
also used to develop the Shariah Portfolio Management DSS (SPMDSS) are in-
troduced.
77
6. SHARIAH PORTFOLIO MANAGEMENT DSS
6.1.1 DSS Technologies

Sprague (1980) distinguishes three DSS technologies: DSS Tools, DSS Generators
and Specific DSS (see Figure 6.1). On the lowest level of DSS technologies are the
DSS tools which are software tools through which system developers can develop
DSS Generators or Specific DSS. The tools encompass basic programming lan-
guages (such as Visual Basic and C#), Query languages (such as SQL), reporting
tools and modeling languages (such as AMPL). The DSS Generator, which is a
product of one or multiple DSS tools, is a medium equipped with functionalities
that enable the customization and configuration of problem-specific DSS. DSS
Generators provide end-users with modules through which specific data sources
and instances, models and methods and data views can be easily customized to
develop Specific Decision Support Systems. A Specific DSS is the actual system
SpecificDSS
DSSGenerator
DSS Tools
DSSTools
Figure 6.1: DSS Technologies
or application which is used by an end-user to solve a specific decision problem.

It is worth mentioning here that the type of user differs from one technological
level to another. Whereas the DSS tools are used by system developers who do
not need to be acquainted with the domain knowledge of the decision problem,
the users of the Specific DSS are managers who are experts in the problem domain
but need not to be familiar with technological aspects.
78
6.1 Decision Support Systems
6.1.2 DSS Architecture

According to the DDM paradigm (Sprague & Watson, 1995) a Decision Support
System consists of a Dialog, a Data and a Model / Method subsystem or com-
ponent (see Figure 6.2). The Data subsystem of a DSS contains all the relevant
Data Model / Method

Subsystem Subsystem
Dialog Subsystem
En
nd User
r
Figure 6.2: Classical DSS Architecture
data required for the decision problem. The data is retrieved from different data
sources (internal and external) and stored in the database of the DSS. A Database
Management System (DBMS) enables the manipulation and access of the data
stored in the database and provides an interface to the model and dialog compo-
nent so that the end-user can retrieve, store and view the data easily.
The Model / Method subsystem of a DSS consists of a Modelbase and a Mod-

elbase Management System (MBMS). The Modelbase contains a set of mathe-
matical models and building blocks as well as a set of mathematical methods or
solvers which are used to solve the respective models. Based on the specific de-
cision problem the Modelbase may be equipped with optimization solvers (such
as LP or MIP solvers) and statistical and financial evaluators. Analogously to
the functionalities provided by the DBMS to handle the databases the MBMS
facilitates the management and manipulation of the models / methods stored in
79
the Modelbase of the system. The MBMS is the core engine of the DSS through
which the problem-specific models are created / configured, the relevant data is
retrieved from the database, and a solver-readable model is generated and trans-
ferred to the appropriate solver. Further on the MBMS facilitates the selection
and execution of the problem-specific model and retrieves the solver output and
transfers the output to the data subsystem for storage purposes and / or to the
dialog subsystem for output presentation, reporting and further model analysis.
Through the dialog subsystem the end-user (for example a fund manager) is able
to interact with the Decision Support System in a user-friendly manner while the
technical and non-trivial aspects of the data and models / methods subsystems
are completely hidden. Therefore for an end-user the dialog subsystem represents
the whole DSS through which he / she is able to define, execute and analyze the
problem-specific and customized models.
6.1.3 DSS for Portfolio Management

The use of Decision Support Systems in portfolio management goes back to the
70’s and its impact is shown for instance by Gerrity (1971) who presents a Man-
Machine Decision System for portfolio management.
Due to the technological progress achieved in the last two decades new DSS types
such as web-based Decision Support Systems (Power, 2002) and data-centered
DSS using OLAP technologies evolved (Dong et al., 2004) which can be used in
portfolio management.
This work does not intend to survey the use of Decision Support Systems in port-
folio management in depth and therefore only the Portfolio Management Decision
Support Systems having a direct impact on this research will be briefly mentioned.
At the Department for Information Systems and Operations Research (WIN-

FORS) of the University of Cologne a number of DSS for portfolio manage-
ment have been developed and found their way into practice. Derigs & Nickel
(2004c) developed a model-based Portfolio Management Decision Support Sys-
tem (PMDSS) which solves complex portfolio problems using metaheuristics.
80
6.2 DSS for Shariah Portfolio Management
Influenced by the work of Dong et al. (2004) advanced data analysis features
using OLAP technologies were introduced and integrated into the system. In an-
other work of Derigs & Alparslan (2007) a web-based Decision Support Generator
PMDSS.Net was developed through which fund managers can easily customize,
parameterize and solve specific portfolio models remotely. Finally, Derigs et al.
(2007) developed a spreadsheet-based portfolio management DSS focusing on
strategic issues for a German bank.
The prototype for a Shariah Portfolio Management DSS (SPMDSS) developed

within this research is based on these developments and the experiences gained.

Using the DSS terminology introduced in the previous sections our Shariah port-
folio management Decision Support System can be regarded as a DSS Generator.
The reason for designing and implementing the SPMDSS as a DSS Generator is
that the portfolio management problem in general as described by Nickel (2005)
can be characterized as being highly unstructured such that no standard model
can be used for all decision problems faced by the fund managers.
Since the problem is unstructured its solution can not be fully automated. The
portfolio management process requires fund managers to continuously interact
with the system within problem formulation, model construction, interpretation
of results especially the analysis of the sensitivity and robustness of the alter-
native solutions generated as well as re-optimization. Since the users of Specific
DSS are managers with no or limited technical background the user interface (or
dialog subsystem) needs to be highly user-friendly and easy to use.
6.2.1 Architecture of SPMDSS
The SPMDSS architecture is based on the classical DDM paradigm (Sprague &
Watson, 1995) and consists of a data, model / method and dialog component (see
81
Figure 6.3). In the following subsections the functionalities and subcomponents

of each of the DSS components are described.
Figure 6.3: SPMDSS Architecture
6.2.2 Data Component

The data component of the SPMDSS contains all the data required for Shariah-
compliant portfolio optimization such as the detailed financial data on the com-
panies and the historical prices of the assets. The data is retrieved from external
data sources (such as Thomson and Reuters databases, Bloomberg and others)
and stored in the database of the SPMDSS. An SQL-DBMS enables the manip-
ulation and access of the data stored and provides an interface to the model and
dialog component so that data can be retrieved, stored and viewed easily. The
data contained in the data component can be broadly categorized into:
82
• Imported Data
This includes mainly the data imported from external systems and encom-
passes the list of assets to be considered for investment (asset universe) with
detailed information regarding the business segments in which the compa-
nies operate, detailed financial figures (from the balance sheets and income
statements) and historical prices of the company.
• Intermediate Data
Based on the imported data specific indicators relevant for both Shariah-
compliance checking and portfolio evaluation are calculated. Here, relevant
portfolio measures such as expected asset returns (such as the arithmetic
mean or geometric mean) and expected asset risks (such as the standard
deviation) are calculated using historical asset prices. Other indicators
which need to be calculated include the Shariah ratios (see section 3.2.2), the
expected purification value as well as the Shariah sustainability indicator
of each asset.
• Output Data
The output consists mainly of:
1. The Set of Compliant Assets

Index providers are mainly interested in a list of Shariah-compliant
assets based on the selected Shariah strategy. Then, index providers
can provide their customers, asset management firms, with this list.
2. Optimal Portfolio Mix
Portfolio managers who use SPMDSS to construct their portfolios are
mostly interested in the nominal volume or shares to be invested in
each asset.
6.2.3 Model / Method Component

The model component of the Shariah Portfolio Management DSS is the core en-
gine of the system and consists of following main modules:
Compliance Checker
83
Based on the detailed financial information stored in the data component of SP-
MDSS and the guidelines and strategies selected the checker module is used to
check whether the current portfolio is Shariah compliant. The compliance level of
an asset may change either because the relative weights of the assets within the
portfolio changed due to price changes or through the availability of new financial
information (balance sheet and income statement). If the checker identifies the
portfolio as being non-compliant, the portfolio manager has to reoptimize the
portfolio using the newly available information.
Modelbase
The Modelbase consists of two components: a set of portfolio model building
blocks or constructs and solvers. The portfolio model building blocks are used
by the model constructor to assemble a problem-specific portfolio optimization
model. The model building blocks include:
• Objectives
The user can select either to solve a Mean-Variance model or an Index
Tracking model. In the case of Index Tracking models portfolio managers
may choose to consider transaction costs.
• Constraints
Portfolio Managers are provided with a set of constraint types represent-
ing guideline types as shown in chapter 2. Examples of these constraints
are cardinality constraints, min-buy-in constraints as well as minimum and
maximum investment constraints per asset, sector or country. Any selected
constraint can be flexibly parameterized by the portfolio manager.
• Shariah Paradigms and Strategies

The different Shariah strategies and paradigms developed within this re-
search can be selected by the portfolio manager so that the portfolios con-
structed comply with his / her specific school of thought.
The second major component of the Modelbase contains the mathematical meth-
ods which are required to solve the specified model. Based on the complexity of
the constructed model an adequate mathematical method is to be used to solve
84
the model either optimal or approximate.
Model Construction Module

Model construction and creation is one of the major functionalities of a model
management system within a DSS. Through the model construction module port-
folio managers are able to flexibly and easily customize a specific portfolio opti-
mization model by choosing from the set of portfolio model building blocks stored
in the Modelbase those portfolio constructs matching their requirements.
Database Interface Module

Since SPMDSS is developed using strict data-model independence, a database
interface module has been developed within the model management system to
retrieve problem-specific and actual data from the data component of the system
so that the mathematical model constructed is initiated with the appropriate
data.
Model Execution Module

This module consists of an execution routine and a modeling language. The ex-
ecution routine decodes the model constructs selected and data and sets up a
complete model using a modeling language (here AMPL). Then the appropriate
mathematical solver is identified and the model is passed to the modeling lan-
guage environment and to an appropriate solver for execution. The results of
the solver are then passed to the database and to the dialog component of the
SPMDSS.
6.2.4 Dialog Component

To achieve end-user acceptance for the system the dialog component is designed
such that the user can access all relevant system functionalities in an easy and
user-friendly manner. The major SPMDSS functionalities which end-users can
access through the dialog / user interface component include:
• Data Manipulation
Besides operations through which data can be retrieved, edited and dis-
85
played portfolio managers are able to calculate portfolio measures (see for
instance Figure 6.4) and Shariah ratios through simple dialog forms.
Figure 6.4: Return Calculation in SPMDSS
• Model Manipulation
The different model components and functionalities can be accessed through
the dialog component easily. Portfolio managers are for instance able to de-
fine, add and parameterize different portfolio constraints, Shariah guidelines
and measures (see Figure 6.5) as well as alternative objective functions.
• Analysis of Results
To evaluate and analyze the generated portfolios SPMDSS provides portfo-
lio managers with summarized table outputs, graphical representations of
the results as well as predefined reports (see Figure 6.6).
86
Figure 6.5: Return Calculation in SPMDSS
Calculation: 30.06.2007
Optimization Results: Portfolio Details

Portfolio 1 2 3 4 5 6 7 8 9 10 11 Initial.PF.
Exp. Return 6.42% 9.49% 12.56% 15.63% 18.70% 21.77% 24.84% 27.91% 30.98% 34.05% 37.12% 10.61%
Std.Dev. 5.16% 5.27% 5.60% 6.14% 6.95% 7.89% 9.02% 10.43% 12.24% 15.07% 22.81% 17.80%
Variance 0.27% 0.28% 0.31% 0.38% 0.48% 0.62% 0.81% 1.09% 1.50% 2.27% 5.20% 3.17%
Num.Assets 24 25 22 21 21 19 18 16 14 14 10 7
Asset Exp.Return Std.Dev. Asset-Weight Norm.

BARD, (C.R.) INC. 22.4731% 16.4877% 0.00% 2.00% 8.23% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 6.69% 0.00% 6.99%
JOHNSON CONTROLS 17.9664% 18.3107% 0.00% 3.99% 7.48% 9.65% 10.00% 10.00% 10.00% 10.00% 3.47% 0.00% 0.00% 5.87%
SIGMA-ALDRICH CORP 14.9451% 15.7441% 6.27% 8.49% 9.95% 9.81% 8.00% 8.10% 4.89% 2.00% 0.00% 0.00% 0.00% 5.23%
EXPRESS SCRIPTS INC 27.4242% 28.7667% 2.07% 2.80% 3.85% 4.97% 5.99% 6.37% 7.49% 8.97% 9.15% 5.23% 0.00% 5.17%
COVENTRY HEALTH CARE 32.2776% 28.1156% 0.00% 0.00% 0.00% 2.51% 4.95% 7.22% 9.83% 10.00% 10.00% 10.00% 0.00% 4.96%
COACH INC 37.2691% 27.2392% 0.00% 0.00% 0.00% Efficient
0.00% 2.00%Frontier
3.35% 6.79% 10.00% 10.00% 10.00% 10.00% 4.74%
MEDCO HEALTH SOL 26.0062% 25.9472% 0.00% 2.00% 2.80% 3.55% 5.07% 6.23% 7.33% 7.91% 10.00% 7.21% 0.00% 4.74%
TYCO ELECTRONICS -1.7245% 3.6528% 10.00% 10.00% 10.00% 10.00% 9.49% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 4.50%
OCCIDENTAL PETROLEUM 28.2711% 40.00% 0.00%
21.0337% 0.00% 0.00% 0.00% 5.72% 8.45% 10.00% 10.00% 10.00% 4.90% 0.00% 4.46%
SEARS HOLDINGS CORP 32.9382% 41.5430% 0.00% 0.00% 0.00% 2.00% 2.24% 3.05% 4.29% 5.62% 7.54% 9.69% 10.00% 4.04%
PUBLIC STORAGE, INC 13.3773% 35.00% 5.25%
20.6446% 6.09% 5.89% 6.02% 6.06% 6.63% 4.97% 3.11% 0.00% 0.00% 0.00% 4.00%
HOSPIRA, INC 6.8164% 19.0472% 10.00% 9.63% 9.26% 6.78% 3.58% 2.75% 0.00% 0.00% 0.00% 0.00% 0.00% 3.82%
XTO ENERGY, INC. 38.6322% 30.00% 0.00%
27.7553% 0.00% 0.00% 0.00% 0.00% 0.00% 2.88% 8.87% 10.00% 10.00% 10.00% 3.80%
Expected Return
ECOLAB INC 13.9846% 15.3454% 0.00% 2.00% 4.00% 5.23% 6.93% 8.46% 7.99% 2.31% 0.00% 0.00% 0.00% 3.36%
AETNA INC 32.3913% 25.00% 0.00%
29.6780% 0.00% 0.00% 0.00% 2.00% 2.00% 2.00% 2.99% 5.86% 6.73% 10.00% 2.87%
CUMMINS INC. 34.1786% 34.7911% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 2.00% 4.21% 7.68% 7.13% 10.00% 2.82%
APACHE CORPORATION 23.9998%
20.00% 2.30%
24.3456% 5.02% 4.31% 5.60% 3.47% 3.81% 2.84% 0.00% 0.00% 0.00% 0.00% 2.49%
PATTERSON CO INC 11.4656% 23.1817% 4.73% 5.20% 6.22% 4.02% 2.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 2.02%
15.00%
TEREX CORPORATION 41.9935% 40.4056% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 2.11% 10.00% 10.00% 2.01%
ZIMMER HOLDINGS INC 16.2325% 22.0376% 2.04% 2.80% 2.39% 2.35% 3.01% 3.69% 2.26% 2.00% 0.00% 0.00% 0.00% 1.87%
10.00%
NATL OILWELL VARCO 36.1084% 34.7550% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 2.00% 6.09% 10.00% 1.64%
QUESTAR CORPORATION 25.9984% 22.2421% 0.00% 0.00% 2.16% 2.80% 2.78% 2.44% 2.17% 2.00% 0.00% 0.00% 0.00% 1.30%
5.00%
MEMC ELECTRONIC 49.6688% 71.7382% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 4.33% 10.00% 1.30%
FREEPORT-MCMORAN COP 33.9836% 38.7177%
0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 2.18% 2.00% 10.00% 1.29%
JOHNSON & JOHNSON 2.2752% 13.9658% 8.17% 5.97% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 1.29%
UNITED PARCEL SVCS 4.5940% 15.6108% 0.00%
6.83% 3.83% 5.00%
2.92% 0.00%10.00% 0.00% 15.00%
0.00% 0.00% 20.00%0.00%
0.00% 25.00% 0.00%
0.00% 1.23%
SYMANTEC CORP 11.7135% 33.6116% 2.00% 2.00% 2.43% 2.00%Standard
2.00% Deviation
2.00% 0.00% 0.00% 0.00% 0.00% 0.00% 1.13%
UNITEDHEALTH GROUP 17.0702% 18.7629% 2.00% 3.68% 3.54% 3.17% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 1.13%
WM. WRIGLEY JR. CO 6.7878% 14.2534% 6.54% 3.44% 2.00% 0.00%
Efficient0.00%
Frontier 0.00% Initial
0.00%
portfolio 0.00% 0.00% 0.00% 0.00% 1.09%
CONAGRA FOODS INC 0 7012%
0.7012% 18 9868%
18.9868% 7 35%
7.35% 4 53%
4.53% 0 00%
0.00% 0 00%
0.00% 0 00%
0.00% 0 00%
0.00% 0 00%
0.00% 0 00%
0.00% 0 00%
0.00% 0 00%
0.00% 0 00%
0.00% 1 08%
1.08%
MERCK & CO INC -1.1917% 26.5220% 2.00% 2.53% 2.57% 3.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.92%
ALLEGHENY TECHNOLOGS 34.0814% 66.5485% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 10.00% 0.91%
STARBUCKS CORP 14.3362% 25.7991% 0.00% 0.00% 0.00% 2.00% 2.00% 2.77% 2.27% 0.00% 0.00% 0.00% 0.00% 0.82%
Figure 6.6: Example Report of SPMDSS
87
6.3 Examples of Specific SPMDSS

Based on the concepts reviewed and developed within this research as well as
previous project experiences (Derigs & Nickel, 2004c) different portfolio manage-
ment requirements can be customized into a Specific DSS using the SPMDSS
Generator. Due to the flexibility of the SPMDSS Generator fund managers can
easily configure their specific DSS. To show the capabilities of the SPMDSS Gen-
erator three examples of specific DSS for different users are described (see Figure
6.7).
SPMDSS I: SPMDSS II: SPMDSS III:

Ͳ Screening System Ͳ Active Portfolio Mgmt Ͳ Passive Portfolio Mgmt
1. Asset Compliance Ͳ Internal Guidelines Ͳ Transaction Costs
2. All Shariah Schools Ͳ Legal Guidelines Ͳ Internal Guidelines
3. All Shariah Strategies Ͳ Shariah Requirements Ͳ Legal Guidelines
1. Asset Compliance
p Ͳ Shariah Requirements
q
2. Schools: DJ, S&P, MSCI 1. Portfolio Compliance S ifi SPMDSS
SpecificSPMDSS
3. Ijmaa Strategy 2. InͲHouse Shariah Rules
4. Purification 3. Purification
5. Shariah Sustainability
SPMDSSGenerator
DSSTools
Figure 6.7: Examples of Specific DSS using SPMDSS
6.3.1 SPMDSS I - A Screening System

Shariah service providers and conventional index providers who provide Shariah
screening services provide fund managers with a list of assets which based on
88
the specified Shariah guidelines are compliant and can therefore be considered
for investment. Through using the SPMDSS Generator a specific screening sys-
tem (Specific DSS) can be configured and used by either the Shariah service
providers or the fund managers directly so that they can interactively screen
the asset universe using the Shariah guidelines. This specific screening system
(which is named ShariahIntelligence) differs from existing screening systems used
by Shariah services providers in
• The ability to screen for multiple Shariah schools simultaneously using the
new strategies developed in section 4.1 (see Figure 6.8).
• The possibility to flexibly define new Shariah guidelines
• The interpretation and reasoning explanation for asset compliance / non-

compliance (see Figure 6.9)
The specific SPMDSS ShariahIntelligence is used within the empirical analysis

done in section 7.1.
6.3.2 SPMDSS II - Active Portfolio Management

A classical portfolio optimization problem is the construction of the efficient fron-
tier using the Markowitz Mean-Variance model as described in section 2.2.3. Fund
managers can then based on their risk / return preferences select one of the effi-
cient portfolios for investment. The specific SPMDSS II enables fund managers
to construct the efficient frontier considering all the conventional portfolio man-
agement aspects such as transaction costs, legal as well as internal guidelines.
More over it supports:
• Shariah guidelines such as those defined by Dow Jones, Standard and Poor’s
and MSCI
• Shariah strategies like the Ijmaa strategy etc. (see section 4.1.1)
• The newly developed portfolio paradigm (see Figure 6.10)
89
Figure 6.8: Selection of Shariah Schools and Strategies
• Purification-adjusted returns (see section 4.2)
• Shariah sustainability (see section 4.3)
This specific SPMDSS II called ”Shariah Optimizer” was used to perform the
empirical analysis in sections 7.2 and 7.3.
90
Figure 6.9: Example of Shariah Compliance Reasoning
6.3.3 SPMDSS III - Passive Portfolio Management
Recently a new class of Islamic investment products, the so-called Islamic Ex-
change Traded Funds (ETFs), has been introduced to the market . ETFs are
financial instruments which expose investors to market risk only. Such funds are
index trackers which track a specific index (such as the S&P500 or Dax30).
SPMDSS III for passive management of Islamic ETFs extends a conventional
index tracking model and enables the user to
• Customize the set of Shariah guidelines
• Consider purification-adjusted returns
• Apply the new Shariah-compliance paradigm
91
Optimization Parameters
Optimization Model Markowitz Model
Compliance Level Portfolio Level
Consider Purification YES
Min. Number of Assets 0
Max. Number of Assets 40
Shariah Assets Consensus / Ijmaa
Rules to consider:
S&P Shariah Rules YES
DJ Shariah Rules YES
FTSE Shariah Rules NO
MSCI Shariah Rules YES
HSBC Shariah Rules NO
Amiri Shariah Rules NO
User-defined Rules NO
Number of Steps 10
Transaction Costs NO
Save Solutions YES
Figure 6.10: Configuration of SPMDSS Optimizer
These three examples show how the SPMDSS Generator can be used to implement
different Specific SPMDSS which support different decision problems faced by
fund managers or Shariah index providers.
92
Part III
Empirical Analysis
93
Chapter 7
Empirical Analysis
7.1 Analysis I: Shariah Compliance Compara-

tive Analysis
1
In the following analysis the quantitative financial screens used by the differ-
ent Islamic funds and index providers are compared. Through this comparative
analysis the impact of using different Shariah screening bundles for the definition
of the asset universe is identified and interpreted. The objective of this analysis
is to identify whether the use of different screening bundles has an impact on the
inclusion or exclusion of a single asset and on the overall size of the compliant
asset universe.
7.1.1 Basics and Assumptions

Since the analysis targets to identify the impact of using different Shariah guide-
lines on a representative basis a professional reference asset universe, the Standard
and Poor’s 500 index is used. Since the S&P 500 index constituents change over
time, a static snapshot with the constituents of 17th of September 2007 has been
selected. Due to the fact that detailed financial statements are only available on
an annual basis, the screening process and the analysis is based on the five an-
nual financial statements published by each of the companies included in the S&P
1
This section has been partially published in Derigs & Marzban (2008b)
95
7. EMPIRICAL ANALYSIS
500 asset universe from January 2003 until April 2007. The Thomson database
retrieved through the software system MarketIQ1 has been used as data-source.
Yet, to perform the analysis adequately, financial data from other publicly avail-
able data providers had to be added to and merged with the data provided by
MarketIQ to overcome the problem of missing data elements. Additionally, a
number of data cleansing operations, conditional calculations as well as auto-
mated web queries needed to be performed to reach a satisfactory and usable
data quality. The reader should be aware that the obtained results are based
on the specific data used and are therefore subject to precision errors and devia-
tions from the calculations and results obtained by providers using different data
sources. But, since all Shariah screens are calculated using the same data set,
the results are consistent, and, also precision errors should not have a significant
effect on the analysis.
Since relevant differences among screening guidelines are more with respect to the
quantitative financial screens rather than the qualitative sector screens, a unified
sector screen has been used for all considered funds and indexes to measure the
impact of using different financial screens exclusively. An additional assumption
of minor importance is that the business activity or industry to which a company
belongs stays the same over time instead of being possibly modified through merg-
ers or acquisitions, for instance.
A sample of the Islamic indexes and funds listed in appendix A has been selected
to be included in the comparative analysis. The Islamic indexes and funds con-
sidered are Dow Jones, Standard and Poor’s, FTSE, MSCI, HSBC and Amiri
Capital. The reasons for selecting this sample are:
• This subset includes the most prominent indexes and funds in the industry
• It includes representative providers using total assets as well as market

capitalization as divisors.
1
The same data source, MarketIQ, is used by professional Islamic index and fund providers
such as Amiri Capital and FTSE. The data used in this analysis was provided for research
purposes by Afkar Consulting and Amiri Capital.
96
7.1 Analysis I: Shariah Compliance Comparative Analysis
• All the indexes and funds selected have at least one Shariah scholar super-
vising in common. This allows analyzing additional aspects concerning the
source of jurisdiction.
7.1.2 Sector Compliance

There are mainly three different industry classification codes used across the
industry for Shariah screening. Standard and Poors and MSCI perform screening
based on GICS (Global Industry Classification Standard) a standard which was
jointly developed by both. Dow Jones and FTSE also use a self-developed coding
system ICB (Industry Classification Benchmark) that is very similar to the GICS
coding system. A different sector screening approach is used for instance by
Amiri Capital, which uses the Standard Industry Classification (SIC) codes. The
advantage of using SIC rather than GICS or ICB is that a company can be
assigned multiple SIC codes based on the different industries or businesses it is
operating in. In the case of GICS and ICB, each company is assigned a single
code based on its major business activity. Therefore using GICS or ICB codes
would not screen out for instance an automotive company which is at the same
time involved to a high extent in financial services. Alternatively, based on SIC
codes such a company is screened out more easily since one of its codes indicates a
non-compliant activity. The sector screening has been performed based on GICS.
In Table 7.1 the non-compliant1 industries / sub-industries are listed.
Thus in the analysis every constituent of the S&P 500 asset universe which is
assigned one of the GICS codes stated in Table 7.1 has been excluded from any
further Shariah-compliant investment consideration.
Table 7.2 illustrates the outcome of the sector screening phase with the exclusion
of 113 companies out of 500, which is about 23 percent of the S&P 500 asset
universe, grouped by sectors. Thus, considering a fund that uses only sector
screens such as the Allianz Islamic fund in Egypt, all 387 out of 500 companies
passing the above screen would be eligible for investment.
1
The GICS codes used are based on the sector exclusion rules of MSCI Shariah Indexes
(MSCI, 2007). From the diversified financial companies all are excluded except Residential and
Office Real Estate Investment Fund and Real Estate Management and Development companies
97
GICS Code Industry / Sub-Industry

20101010 Aerospace and Defense
25301010 Casinos and Gaming
25301020 Hotels, Resorts and Cruise Lines
25301040 Restaurants
25401020 Broadcasting and Cable TV
25401030 Movies and Entertainment
30201010 Brewers
30201020 Distillers and Vintners
30203010 Tobacco
4010xxxx Banks
4020xxxx Diversified Financials
4030xxxx Insurance
Table 7.1: Unified Exclusion Codes
Unified Sector Screens

S&P 500
Sectors Halal Haram Constituents
Consumer Discretionary 71 17 88
Consumer Staples 32 7 39
Energy 32 32
Financials 14 78 92
Health Care 53 53
Industrials 42 11 53
Information Technology 75 75
Materials 28 28
Telecommunication Services 9 9
Utilities 31 31
S&P 500 Constituents 387 113 500
Table 7.2: Sector Screening Result
7.1.3 Financial Compliance
In the following sections, the impact of using different financial screening bundles
on the size of the Shariah asset universe and the level of classification differences
among Islamic funds and indexes is identified and interpreted. Therefore, after
reducing the S&P 500 asset universe using the unified GICS sector screens, the
individual financial screens used by the different funds and indexes are applied
and compared to each other.
98
7.1.3.1 Size of the Asset Universe
Table 7.3 gives an overview on the size of the asset universe after applying the
individual financial screens over the period of five years.
S&P 500 Asset Universe Halal Companies

2007 2006 2005 2004 2003
S&P 271 274 265 231 217
DJIM 266 268 258 224 210
MSCI 247 250 237 223 214
Amiri 246 247 235 221 211
FTSE 241 244 231 217 209
HSBC 232 231 226 212 190
Table 7.3: Financial Screening - Asset Universe
It can be seen that using the guidelines of Standard and Poor’s provides a rel-
atively larger asset universe as applying the guidelines of HSBC, for instance.
Another remarkable aspect is that S&P and Dow Jones, the two providers who
use market capitalization as divisor, have a larger number of halal companies in
their asset universe compared to the rest of the providers who all use total assets
as divisors. On the other hand, as shown in appendix A (see Table A.1), this
greater liberalism is compensated since S&P and Dow Jones are more conser-
vative with respect to sector screens where companies with any involvement in
haram activities are excluded compared to other providers that consider only the
core business activity for exclusion. The reason why differences in the number of
companies classified as being halal exists, using for instance the financial guide-
lines of HSBC Amanah and MSCI, can be explained as follows: MSCI uses two
separate ratios to bound for each asset i at time period t the sum of accounts re-
ceivables ARi (t), cash and short-term investments CSIi (t) relative to total assets
T Ai (t), i.e. the formulas used are:
CSIi (t) ARi (t)

c= ≤ 33.33% and a= ≤ 70.00%
T Ai (t) T Ai (t)
99
On the other hand HSBC uses a single ratio for the two denominator elements of
the MSCI ratio, i.e. the formula used is:
ARi (t) + CSIi (t)

c+a= ≤ 50.00%
T Ai (t)
Figure 7.1 illustrates that based on the MSCI guidelines the number of companies
passing the financial screen may be significantly larger.
c
0.8
0.7
0.6
0.5 MSCI 1
MSCI 2
04
0.4
HSBC
0.3
0.2
01
0.1
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 a
Figure 7.1: Screening Impact on Asset Universe
7.1.3.2 Different Classifications among Islamic indexes and funds
More consequential and relevant for asset selection, portfolio management and
optimization is to compare the different Shariah-compliant asset universes, that
are defined as a consequence of using the individual Shariah guidelines. Table 7.4
shows how the set of the remaining 387 candidates which passed the qualitative
sector screening are further classified. In the year 2007 for instance, using the
guidelines of the sample funds and indexes resulted in a joint agreement on 197
(about 50 percent) companies as being halal and 79 companies (about 20 percent)
100
as being haram. The companies on which the funds and index providers agreed
upon as being halal can be regarded as labeled ”green” and the ones on which
the providers agreed on as being haram ”red”. The remaining ”gray” companies
are those where the funds and index providers differ in their classification and
this category contains 109 companies representing a substantial fraction of about
28 percent of the considered universe. The existence of such a large number
of companies categorized as being gray is highly problematic and confusing for
Islamic investors. Fund managers that follow more moderate Shariah guidelines
have a much bigger asset universe to select from compared to managers who have
to follow stricter guidelines such as the ones defined by the Shariah board of
HSBC Amanah.
Table 7.5 gives a pair wise comparison of the difference in classification among
S&P 500
S&P Status DJIM Status MSCI Status Amiri Status FTSE Status HSBC Status 2007 2006 2005 2004 2003
Halal 197 186 187 161 148
Halal
Halal Haram 6 13 5 7 7
Halal Haram Haram 3 4 3 4 3
Halal Halal Haram 2 1 1 2
Halal Haram 1 1 1 1 1
Haram
Haram Halal 8 12 9 9 6
Haram
Haram 51 50 52 41 43
Halal Halal 5 6 6 7 7
Haram Haram 1
Halal Halal Halal 22 27 22 33 29
Halal
Haram Haram 11 10 10 8 16
Haram Haram 2 1 1 1 1
Haram Halal 2 2
Haram Haram
Haram 79 74 84 107 117
N/A 2 1 3 5 7
Total 387 387 387 387 387
Table 7.4: Funds / Indexes Discrepancies
the different funds giving the percentage of assets which are defined halal by
one provider and defined at the same time as haram by another provider and
vice versa. One major reason for the existence of variations is related to the
divisor used to calculate the financial screening ratios. S&P and Dow Jones use
average market capitalization as divisor and both use almost similar ratios and
101
thresholds levels. Thus, it is logically consistent that the differences between S&P
and Dow Jones are almost negligible with 1.3 percent only. On the other hand
comparing Dow Jones or S&P to the rest of the providers who use total assets as
divisor, a different level of variation of about 25 percent is noticed. Again, among
the providers using total assets as divisor the variation rate is negligible except
for HSBC Amanah where a higher variation between 6.5 and 8 percent can be
observed. This is due to the more conservative financial ratios used by HSBC.
In a final analysis the reasoning behind the differences among the halal asset
S&P DJIM MSCI Amiri FTSE HSBC

S&P 1.30% 24.40% 24.60% 24.90% 21.60%
DJIM 25.70% 26.00% 26.20% 22.90%
MSCI 0.00% 1.60% 8.00%
Amiri 1.30% 7.80%
FTSE 6.50%
Table 7.5: Variation in classification among Funds / Indexes
universes defined by the different Islamic funds and index providers is investigated
and may be due to the subjective opinion of specific schools or scholars. Therefore
a combination of two providers and a set of six Shariah scholars with four of the
six scholars serving on both boards is considered. The two providers were selected
such that one of them represents providers using market capitalization as divisor
whereas the other represents providers that use total assets as ratios divisor (the
names of the Shariah scholars and as well as the sample funds / indexes are kept
anonymous). Table 7.6 illustrates this sample.
This joint supervision by four scholars should logically imply that either no
or only neglectable differences exist. Yet, as can be observed in Table 7.7, this is
not the case.
This specific comparison shows again that the provider using market capitaliza-
tion has a slightly larger asset universe of assets which are halal although almost
the same Shariah board is involved. Thus this indicates that the alternative
to choose market capitalization over total assets is systematically offering larger
102
Supervision Sample Provider1 Provider2

Provider using Market Cap
r Provider using Total Assets
Shariah Scholar 1 X X
Shariah Scholar 5 X
Shariah Scholar 6 X
Table 7.6: Shariah Scholars across Funds / Indexes
S&P500Universe–2007 TotalAssetsRepresentative
MarketCapRepresentative Halal Haram Total
Halal 205 61 266
Haram 27 92 119
Total 232 153 385
Table 7.7: Classification Market Cap vs. Total Assets Representatives
freedom. Another aspect which is more striking is the outcome that this is not
achieved by just shifting haram assets to halal, but that also 27 assets which are
halal under market capitalization become haram when calculating total assets.
In total the same Shariah scholars defined on average approximately one out of
five companies as halal for one product and as haram for the other product.
7.1.4 Conclusion of Analysis I

This analysis demonstrates the impact of using different Shariah guidelines on
the definition of a halal asset universe and the analysis provides a deeper un-
derstanding of the rationale behind the different existing, most-frequently used
Shariah screening guidelines in the industry. The analysis has clearly shown that
the use of different guidelines generally results in different classifications of com-
panies into halal and haram among the considered funds and indexes. From the
authors’ point of view, such an inconsistency can contribute to insecurity and
distrust of Islamic investors into financial products like funds and thereby hin-
ders the further development of the Islamic equity area and the attraction of
larger investments. The expertise of Shariah scholars is an essential and crucial
103
element in structuring Islamic financial products and also making conventional

financial products accessible to Islamic investors. However, this research has re-
vealed that different classifications by the same scholars occur across funds and
indexes. Certainly, the Shariah scholars are not doing the operational work in
terms of financial ratio calculations themselves and therefore they are not explic-
itly defining a specific company once as halal and at the same time as haram for
another provider. Yet, the results show that the mathematical formalism may
not be able to fully account for the subtle and subjective interpretation of the
Islamic sources and that the effect of bundles of such formal constraints may be
too complex to be anticipated on every possible asset universe. Therefore, the
development of a unified and standardized screening framework which takes into
account the different existing Shariah guidelines and allows a controlled and un-
derstandable classification will certainly enrich the credibility and consistency of
Islamic equity products.
7.2 Analysis II: Shariah Compliance in Active

Portfolio Management
1
In the following empirical analysis results concerning the impact of the different
compliance strategies on expected portfolio return, risk and compliance consis-
tency are reported. The main purpose of this analysis is to make the poten-
tials of the new strategies transparent, i.e. to show that the Shariah compliance
strategies which have been developed and proposed in section 4.1 perform better
than portfolios following one of the basic Shariah strategies. The analysis has
been executed using the Shariah Portfolio Management Decision Support Sys-
tems (SPMDSS) described in section 6.2, through which the selection of different
compliance strategies, data preparation, model parameterizations, model manip-
ulation and model solving as well as graphical representation of results can be
performed easily through a user friendly spreadsheet interface.
1
This section has been partially published in Derigs & Marzban (2008c) and Derigs &
Marzban (2008a)
104
7.2 Analysis II: Shariah Compliance in Active Portfolio Management
7.2.1 Data and Portfolio Optimization Model
The analysis is based on the assets included in the Standard & Poor’s 500
(S&P500) index on the 17th of September 2007, which will be from now on re-
ferred to as the asset universe. To measure the Shariah-compliance of the assets
included in the asset universe, the detailed financial figures for the financial year
2006 of the companies issuing the respective assets, as published in their annual
financial statements, have been retrieved using the software system MarketIQ.
Additionally, the monthly total returns (annualized) and market capitalization
values of the considered assets were retrieved from Bloomberg. The following set
of basic Shariah strategies S = { S&P, DJIM, FTSE, MSCI, HSBC, ANON }
has been considered. Based on the type of financial ratios used these strategies
can be categorized into two groups: the set of market-capitalization (MC) based
strategies S M C = { S&P, DJIM } and the set of total assets (T A) based strategies
S T A = { FTSE, MSCI, HSBC, ANON }.
Reflecting the portfolio management strategy (active or passive) different portfo-
lio optimization models with different objective functions have to be formulated
and used. Within a passive management strategy so called index tracking models
(Coleman et al. (2006); Derigs & Nickel (2003);Derigs & Nickel (2004a)) are com-
mon where the objective is to approximate a benchmark index as close as possible.
For this study an active portfolio management is assumed and the implementation
and comparison is based on the Markowitz Mean-Variance approach (Markowitz,
1952) constructing the efficient frontier and the set of efficient portfolios from
which the user can then choose an appropriate portfolio according to his risk
profile. Here a portfolio is efficient if it has minimal risk among all portfolios of
the same return (or vice versa). In a practical situation the efficient frontier can
only be approximated and due to the possibly large number of efficient solutions
only a representative subset of efficient portfolios should be constructed and pre-
sented to the investor to reduce complexity. This approach is implemented as
follows: For every model instance first the possible return spread is calculated
by constructing the two extreme portfolios which are efficient: the portfolio with
maximal (expected) return and the portfolio with minimal (expected) risk. Then
the efficient frontier is approximated by constructing for ten equidistant return
105
values μ∗ between these extreme values the associated portfolios of minimal risk.
Portfolio Problem Extensions and Parameters

Standard Model Used: Min{σ (x)| ni=1 xi = 1, μ(x) ≥ μ∗ , xi ≥ 0 ∀i ∈ I}
2
Floor & Ceiling Requirement: No Short-Sellings are allowed and maxi-

mum weight of a single asset may not exceed 10%
li ≤ xi ≤ ui ∀i ∈ I, with li = 0 and ui = 0.1
Sector Exclusion: The assets assigned to one of the following sector codes
are non-complaint:
GICS Code Industry / Sub-Industry

20101010 Aerospace and Defense
25301010 Casinos and Gaming
25301020 Hotels, Resorts and Cruise
Lines
25301040 Restaurants
25401020 Broadcasting and Cable TV
25401030 Movies and Entertainment
30201010 Brewers
30201020 Distillers and Vintners
30203010 Tobacco
4010XXXX Banks
4020XXXX Diversified Financials
4030XXXX Insurance
Maximum Cardinality: The number of assets included in a portfolio is
limited
n to 40 assets. This can be modeled as follows:
i=1 i ≤ CardMax
v
xi ≤ vi ∀i ∈ I
vi ∈ {0, 1} ∀i ∈ I
with CardMax=40
Table 7.8: Model and Parameter Settings
To show that the models are practical, i.e. can be solved within a practical en-
vironment two constraints have been included which represent aspects which on
top of Shariah compliance have to be considered in real investment situations:
a constraint limiting the weight of an asset to at most 10 percent which can be
interpreted as an example for a legal guideline (Derigs & Nickel, 2003) and a
106
constraint limiting the number of assets to be included in the portfolio to at most

40 assets which is a common internal guideline reducing the complexity of man-
agement (Jobst et al., 2001). Also, in a preprocessing step the asset universe is
reduced by applying unified Shariah sector guidelines. The complete model and
used parameters are summarized in Table 7.8. Now the results of the analysis for
the different strategies and paradigms are reported.
7.2.2 Performance of Basic Shariah Strategies

First, the portfolio model was run with the guidelines/constraints from the six
basic strategies. The resulting efficient frontiers are depicted in Figure 7.2. As a
reference the conventional non-Shariah model was also run i.e. without any fur-
ther reduction of the asset universe. In section 7.1.3 of this research it is shown
that the variations with respect to Shariah compliance among basic strategies
belonging to the same class, S M C or S T A , are almost negligible. This explains
why in Figure 7.2 the efficient frontiers for the different strategies within one class
are almost identical. Due to the fact that the basic strategies s ∈ S M C result in
a larger asset universe than the strategies s ∈ S T A (see Table 7.3) all the efficient
frontiers of the basic strategies s ∈ S M C are above the efficient frontiers of the
basic strategies s ∈ S T A , i.e. with the first class of strategies higher return at
lower risk can be obtained. Of course, the frontiers of all basic Shariah strate-
gies are below the frontier from the related conventional model without Shariah
compliance guidelines. It is worth noting that strategies s ∈ S M C perform only
slightly worse with respect to return. Yet, to realize the maximal possible return
much higher risk has to be taken.
A closer look at the set of efficient portfolios reveals that the difference in per-
formance is not only attributable to the larger asset universe but stems from
the fact that the constituents included in the different asset universes and con-
sequently the assets selected for investment portfolios differ highly among the
efficient portfolios of different strategies. This is reflected in Table 7.9. Here
the assets of the efficient portfolios are clustered into six representative sectors.
Then, for DJIM as representative for a MC-based strategy and MSCI as rep-
resentative for a T A-based strategy the proportion of investment which is not
107
Return
45.00%
40 00%
40.00%
35.00%
30.00% Conventional
S&P
25.00% DJIM
FTSE
20.00% HSBC
MSCI & AMIRI
15.00%
10.00%
5.00%
0.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% Risk
Figure 7.2: Performance of Basic Shariah Strategies
compliant with respect to the other strategy is calculated and the amount is allo-
cated to the respective clusters. The last line (sum of weights) of the upper part
of Table 7.9 shows that overall a significant fraction of the optimal investments
under the MC-strategy DJIM are into assets which are not compliant under the
T A-strategy MSCI whereas the last line of the lower part shows that the reverse
inconsistency is much less. This means that assets which contribute positively to
the portfolio performance for DJIM are non-compliant under the MSCI strategy.
Considering the individual figures it can be noted that for instance DJIM re-
sults for almost all return levels in efficient portfolios with a high proportion of
wealth invested in assets belonging to the Information Technology, Health Care
and Consumer Staples sectors which are not compliant under the T A-strategy
MSCI.
To further analyze this phenomenon the percentage of companies whose market
capitalization is significantly larger or smaller to total assets is calculated for
each sector. As you can see from Figure 7.3, most of the companies belonging to
sectors such as Information Technology (85 percent), Health Care (79 percent)
108
Table 7.9: Weights of assets aggregated by sector compliant under DJIM and not
under MSCI and vice versa
and Consumer Staples (72 percent) have a market capitalization value which is
larger than their total assets value. Contrary, companies belonging to the utili-
ties (94 percent) and telecommunication (89 percent) sectors have a total assets
value larger than their respective market capitalization value. One of the main
reasons for this property is that in general the value of intangible assets such as
intellectual properties, patents and projects under development is not accounted
for in the balance sheet of the respective companies and thus total assets are
undervalued. An information technology company such as Microsoft for instance
is not capital intensive since most of the assets are in intangible form and cur-
rently valued on the market four times the total assets value. The same also
applies to companies in the health sector whose in-house developed intellectual
property and projects in the pipeline do not appear on the balance sheet. Thus,
for such companies market capitalization is usually significantly larger than total
assets and if two Shariah guidelines differ in terms of the divisor only, which is
almost the case for DJIM and MSCI (see Appendix A), then systematically the
use of TA-based guidelines results in an exclusion of companies from intellectual
property sensitive sectors from the asset universe which means the exclusion of
assets with good return and risk profiles. This exactly could be observed in this
analysis where assets of good performance were excluded from the asset universe
by TA-based strategies resulting in an overall under performance compared to
the MC-based strategies.
109
Utilities 6% 94%
Telecom 11% 89%
Materials 57% 43%
InformationTechnology 85% 15%
Industrials 57% 43%

MCLarger
HealthCare 79% 21%
TALarger
Financials 38% 62%
Energy 63% 38%
ConsumerStaples 72% 28%
ConsumerDiscretionary 63% 37%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Figure 7.3: Sector-based Comparison Market Capitalization vs. Total Assets
These sector-specific findings motivate to apply modified screening guidelines

in which the type of divisor of the financial ratios is decided upon based on the
company’s sector. Thus, this research claims that a more realistic evaluation
would be achieved if the financial ratios for companies from Information Technol-
ogy, Health Care and Consumer Staples are based on their market capitalization
value whereas for companies from the Utility and Telecommunication sector their
total assets value are used.
In Figure 7.4 the impact of this modified screening approach compared to the
common approaches is shown which are based on either total assets or market
capitalization. As can be seen, the usually total assets based strategy MSCI shows
a much better risk/return profile since a number of companies from the formerly
excluded sectors are now eligible and contribute positively to the portfolio per-
formance. Such an effect does not show up for the usually market capitalization
based strategy DJIM, since the efficient portfolios contain already all favorable
companies. In fact, under the modified strategy the performance difference be-
tween MSCI and DJIM diminishes.
110
Return
45.00%
40 00%
40.00%
35.00%
30.00%
DJIMStandard
J Sta da d
25.00% MSCIStandard
MSCINew
20.00% DJIMNew
15.00%
10.00%
5.00%
0.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% Risk
Figure 7.4: Effect of using sector-based MC/TA divisor on DJIM and MSCI
7.2.3 Performance of New Asset-based Shariah Compli-

ance Strategies
First, the degree of inconsistency between the new strategies and the base strate-
gies is analyzed i.e. the difference between the asset universes analogously to the
analysis shown in Table 7.10 with the only difference that the inconsistency is
partitioned into type I error (classifying an asset compliant by a new strategy
and non-compliant by a basic strategy) and type II error (classifying an asset
non-compliant by a new strategy and compliant by a basic strategy). As can be
seen in Table 7.10 the Ijmaa strategy achieves lowest type I error since no asset
is included in its asset universe which is considered to be non-compliant by any
basic strategy and the majority strategy has a type I error which is lower than
the inconsistencies among the basic strategies. With respect to type II error, the
liberal strategy shows no inconsistencies and the majority strategy is more or less
consistent with the TA-strategies.
Figure 7.5 reveals that these different levels of Shariah compliance of the new
strategies are reflected in performance, i.e. return and risk profile as expressed
by the efficient frontier. Less conservative strategies such as the liberal and Best
111
Type I Error: compliant by new strategy and non compliant

r by basic strategy
Best of Remains the same as in Table 7.5
Ijmaa 197 0% 0% 0% 0% 0% 0%
Majority 253 8.57% 9.87% 2.08% 2.34% 3.12% 5.45%
Liberal 306 9.09% 10.39% 15.32% 15.58% 16.88% 19.22%
Type II Error: non compliant

r by new strategy and compliant by basic strategy
Best of Remains the same as in Table 7.5
Ijmaa 197 19.22% 17.92% 12.98% 12.72% 11.43% 9.09%
Majority 253 13.25% 13.25% 0.52% 0.52% 0.00% 0.00%
Liberal 306 0% 0% 0% 0% 0% 0%
Table 7.10: Inconsistency in classification of new strategies vs. basic strategies
of strategy perform very similar and their frontiers are close to the conventional
portfolio model and they clearly dominate the portfolios constructed using the Ij-
maa or the majority strategy. As expected, the most conservative Ijmaa strategy
performs worst, which is a logical result of the small asset universe (197 assets).
Return
45.00%
40.00%
35 00%
35.00%
30.00%
Conventional
Liberal
25.00%
Best of
Bestof
Majority
20.00%
Ijmaa
15.00%
10.00%
5.00%
0 00%
0.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% Risk
Figure 7.5: Performance of Proposed Strategies Asset-based
112
7.2.4 Performance of Portfolio-based Shariah Compliance

Strategies
When analyzing the effect of the new paradigm i.e. considering compliance as an
attribute of the portfolio rather than the single assets it can be noted that for
every new strategy the portfolios constructed under the portfolio-based compli-
ance paradigm outperform their asset compliance counterparts (see Figure 7.6).
Yet, there is a significant difference: while the asset-based Ijmaa and Majority
strategies are clearly dominated by their portfolio-based counterpart, it can be
observed that such outperformance for the Best of and the liberal strategy occur
only on the extreme ends of the spread i.e. for low risk and high return levels.
A. Best of Strategy
A.Bestof B. Ijmaa Strategy
B.IjmaaStrategy
45.00% 45.00%
40.00% 40.00%
35.00% 35.00%
30 00%
30.00% 30 00%
30.00%
25.00% 25.00%
20.00% 20.00%
15.00% 15.00%
10 00%
10.00% 10 00%
10.00%
5.00% 5.00%
0.00% 0.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00%
C.LiberalStrategy D.Majority Strategy

45.00% 45.00%
40.00% 40.00%
35.00% 35.00%
30.00% 30.00%
25.00% 25.00%
20.00% 20.00%
15 00%
15.00% 15 00%
15.00%
10.00% 10.00%
5.00% 5.00%
0.00% 0.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00%
Figure 7.6: Asset versus Portfolio-based Compliance Strategy
The added-value of the portfolio-based compliance paradigm compared to basic

strategies currently used by Islamic funds and index providers can be identified
113
in Figure 7.7. The portfolios of the portfolio-based compliance strategies out-

perform the basic TA-based strategy MSCI significantly whereas the MC-based
strategy DJIM is outperformed slightly.
Another effect could be observed which has not been expected at all. Applying
Return
45.00%
40 00%
40.00%
35.00%
30.00% Conventional
LiberalPortfolioͲbased
25.00% BestofPortfolioͲbased
MajorityPortfolioͲbased
20.00% IjmaaPortfolioͲbased
DJIMAssetͲbased
15.00%
MSCIAssetͲbased
10.00%
5.00%
0.00%
0 00%
0.00% 5 00%
5.00% 10 00%
10.00% 15 00%
15.00% 20 00%
20.00% 25 00%
25.00% 30 00%
30.00% Risk
Figure 7.7: Portfolio-based versus Basic Asset-based Compliance Strategies
the new portfolio-based compliance paradigm the significant differences in perfor-

mance between the two classes of basic Shariah strategies, s ∈ S M C and strategies
s ∈ S T A , diminish (see Figure 7.7). This means that under the new paradigm
the use of market-capitalization does not lead to better performance anymore
i.e. the total assets based strategies which suffered from eliminating more assets
from the universe are now comparable. Also, all frontiers constructed under the
new portfolio-based compliance paradigm are much closer to the frontier for the
conventional portfolio model. Thus the new paradigm offers investors the oppor-
tunity to achieve nearly the same risk-return options as conventional funds but
being Shariah compliant.
114
7.2.5 Conclusion of Analysis II
Within this analysis the problem of Shariah-compliant portfolio construction has

been considered. The analysis revealed that on the same asset universe current
basic Shariah-compliance strategies result in much lower portfolio performance
than portfolios without considering Shariah compliance. To overcome these short
comings a number of new concepts for defining Shariah compliance at different
levels have been developed including a new paradigm which considers Shariah
compliance as an attribute of the portfolio constructed rather than measuring
compliance on an asset level as is done in all current approaches. All concepts have
been formalized such that they can be incorporated in every conventional port-
folio optimization model by simply introducing appropriate sets of constraints.
The empirical analysis has clearly shown that if fund managers stick to the cur-
rent Shariah strategies then they are better off employing market-capitalization
based ratios which outperform strategies which use total assets based ratios. This
research proposed new concepts for defining Shariah compliance leading to strate-
gies by which portfolios can be constructed that achieve better portfolio perfor-
mance than current Shariah strategies. Within this research also a new paradigm
which measures compliance on a portfolio level rather than individually for ev-
ery asset has been proposed and justified. The analysis shows that applying
this paradigm results in portfolios which perform much better than their asset-
based counterparts in terms of return and risk. Another significant effect of the
portfolio-based compliance strategies is that not only the performance differences
between market capitalization based and total asset based compliance strategies
are almost eliminated but even more important Shariah compliant portfolios can
reach the performance of conventional portfolios on the same asset universe. Con-
sidering compliance as an attribute of the portfolio forces compliance control to
take place during portfolio optimization instead of a preprocessing phase as can
be done with the current strategies. This requires a shift from the purely ex-
tensional description of compliance in terms of specifying the asset universe to
an intentional description of compliance in form of checkable guidelines which
can be incorporated into the portfolio optimization model. Besides the necessary
provision of such guidelines by the Shariah scholars the availability of tools for
115
modeling and solving the Shariah portfolio optimization problem is an important

prerequisite, though not mandatory for applying the new paradigm in practice.
Such a supporting system has been developed in this work. Certainly and most
importantly, the eligibility of the new portfolio-based compliance paradigm has
to be analyzed from a Shariah perspective by experienced Shariah scholars whose
opinion and judgment decides on the practical acceptance.
7.3 Analysis III: Purification and Shariah Sus-

tainability
7.3.1 Impact of Purification on Portfolio Performance

Within this analysis the impact of considering purification ex-ante rather than
as conventionally done ex-post (after investment decisions have been taken) is
investigated and evaluated.
To consider purification ex-ante expected purification and net purified return is
calculated using the formulas introduced in section 4.2.
Expected purification is calculated from the historical purification values deduced
from historical financial statements and is given by:
1 NP II(i, t)
t
ρ(i) = ∀i ∈ I
t τ =1 T R(i, t)
The net purified return using the value increase approach is consequently given
by: ⎧ ⎫
⎪
⎨ ⎪
⎬
μ̂(i) = μ(i) − max μ(i) · ρ(i),
0 ∀i ∈ I
⎩ if μ(i)<0⎪
⎪ ⎭
if μ(i)≥0
Based on these calculations the Mean-Variance model used in the previous anal-
ysis is modified to consider purification losses ex-ante through substituting μ(i)
by μ̂(i) in the models.
To evaluate the impact of considering ex-ante purification two Mean-Variance
116
7.3 Analysis III: Purification and Shariah Sustainability
models are solved using the asset-based Shariah guidelines of the Dow Jones Is-
lamic Index. The first model is the one used in Analysis II, i.e. returns used
are not netted from purification. The second model differs from the first model
only that net purified returns are used instead. After solving the two models the
actual occurring purification values are deducted from the return to measure the
impact of considering purification within optimization.
Returns
Portfolio No Purification Ex-Post Purification Ex-Ante Purification Active Return
1 7.3939% 7.3040% 7.3458% 0.0419%
2 11.5741% 11.4020% 11.4075% 0.0055%
3 15.7543% 15.4572% 15.4660% 0.0088%
4 19.9345% 19.5148% 19.5226% 0.0078%
5 24.1147% 23.5905% 23.6023% 0.0118%
6 28.2949% 27.6706% 27.6904% 0.0198%
7 32.4750% 31.8050% 31.8219% 0.0169%
8 36.6552% 35.9370% 35.9683% 0.0313%
9 40.8354% 40.1330% 40.1654% 0.0324%
10 45.0156% 44.4765% 44.4967% 0.0201%
11 49.1958% 48.7273% 48.7273% 0.0000%
Average 0.0179%
Table 7.11: Ex-Post versus Ex-Ante Purification
The results for the 11 efficient portfolio generated are summarized in Table 7.11.
In 7.11 the difference between ex-ante and ex-post return is called active return.
Considering for example portfolio number 8 we note that ex-ante purification
would result in a portfolio yielding a return which is 3 basis points higher than
the portfolio which is optimal under ex-post purification. Overall the ex-ante
purification model produced portfolios which on average have a higher net return
of 1.8 basis points.
7.3.2 Empirical Analysis of Shariah Sustainability

Shariah Sustainability, which is a new measure defined in section 4.3 is used to
identify the Shariah compliance of an asset over time. Shariah sustainability
measures the historical compliance of an asset over time and a value of one indi-
cates that the asset has always been Shariah compliant whereas a value of zero
indicates that the asset has never been compliant.
117
200
180
160
140
120
100
80 Frequency
60
40
20
0
= 0 < 0.2 < 0.4 < 0.6 < 0.8 <1 =1
Figure 7.8: Shariah Sustainability of Assets
Applying the formula introduced in section 4.3 to the subset of sector-compliant

assets of the S&P 500 asset universe we obtain the results shown in Figure 7.8.
It can be noted that about 50 percent of the assets remain sustainable over
time (sustainability = 1) and that about 20 percent of the asset have always been
non-compliant (sustainability = 0). The remaining 30 percent of assets show a
changing compliance status and therefore may have a negative impact on portfo-
lio performance since investors would be obliged to liquidate an investment which
turns from compliant to non-compliant. The portfolio performance is negatively
influenced by transaction costs and the fact that the liquidation may be enforced
at a time of falling prices. Another positive effect of using the Shariah sustain-
ability measure is that there might be investors who want to invest their capital
only in assets whose company always operate in a Shariah-compliant manner and
consequently only assets with a Shariah sustainability value equal to one are to
be included in the portfolio. In Table 7.12 the Shariah sustainability values are
shown by sector. For instance 48 out of 53 companies ( about 90 percent) be-
longing to the health sector have a Shariah sustainability value larger than 80
percent whereas almost all utility companies (97 percent) have a Shariah sus-
tainability value less than 20 percent. This means that historically most health
companies operated compliant and almost all utility companies non-compliant.
118
7.3 Analysis III: Purification and Shariah Sustainability
Sustainability = 0 < 0.2 < 0.4 < 0.6 < 0.8 <1 =1 Total
Sectors
Consumer Discretionary 10 4 3 4 8 6 36 71
Consumer Staples 6 5 1 2 18 32
Energy 4 1 6 7 2 12 32
Financials 9 3 1 1 14
Health Care 2 1 1 1 6 42 53
Industrials 9 2 4 1 2 4 20 42
Information Technology 2 3 1 5 6 8 50 75
Materials 6 2 2 2 4 2 10 28
Telecommunication Service 3 1 2 1 2 9
Utilities 29 1 1 31
Total 80 14 22 21 33 28 189 387
Table 7.12: Shariah Sustainability of Assets by Sector
This analysis reveals that based on the Shariah guidelines used (DJIM) and the
historical sustainability measure utility companies may be excluded completely
from consideration. But, if we consider the impact of using market capitalization
and total assets as divisor as analyzed in section 7.2, these results are attributable
to the fact that the divisor of DJIM, which is market capitalization, undervalues
the worth of these companies and therefore results in higher conservatism and
the exclusion of companies belonging to the utility sector.
Nevertheless based on the Shariah guidelines used the figures indicate for some
sectors, such as health and utility, a clear tendency of compliance over time.
7.3.3 Conclusion of Analysis III

Concerning the consideration of expected purification losses during portfolio op-
timization, the analysis has revealed that better portfolio performance can be
achieved compared to ex-post purification practices. Based on the data used the
surplus return compared to ex-post purification is rather small. Yet, we believe
that purification is important to be considered since depending on the portfolio
constituents selected the surplus return might be much larger if the portfolio con-
stituents have much higher fraction of non-permissible income which needs to be
purified.
The calculation of the Shariah sustainability measure revealed that a large frac-
tion of companies (about 30 percent) change their compliance status over time.
119
The negative impact of this dynamic compliance status on transaction costs and
portfolio performance is obvious but needs to be further analyzed empirically.
120
Chapter 8
Conclusion
8.1 Summary
Within this research the current status of Shariah-compliant portfolio manage-

ment has been analyzed and evaluated. The analysis reveals that the lack of
standardization found in Islamic equity management practices results in high in-
consistencies and therefore a number of new strategies, paradigms and measures
has been developed and introduced.
Based on these findings consistent Shariah-compliance procedures were developed

and formalized and have been used within the developed Shariah Portfolio Man-
agement Decision Support System (SPMDSS). Through using the SPMDSS port-
folio managers are able to customize, manipulate and analyze advanced Shariah
portfolio optimization models and execute them using the available optimization
methods in an interactive, flexible and easy manner.
As shown in chapter 7 the SPMDSS Generator was used successfully to gen-

erate the result shown.
121
8. CONCLUSION
8.2 Validating the Hypotheses
Based on the empirical analysis made we are now able to validate the hypotheses
formulated at the beginning of this research work.
8.2.1 Hypothesis H1
H1:
Shariah-compliance procedures currently used across the industry are if compared
to each other highly inconsistent resulting in different compliant asset universe
sizes and different constituents within the compliant asset universes.
Validation:
The empirical analysis performed in section 7.1 revealed that current practices
are highly inconsistent and that discrepancies of about 25 percent can be noted
(see Table 7.4).
8.2.2 Hypothesis H2
H2:
The development of new paradigms and strategies for Shariah-compliance check-
ing if considered within portfolio optimization yield better portfolio results and
/ or less inconsistencies compared to Shariah procedures currently used.
Validation:
The new strategies and paradigms developed yield either better portfolio perfor-
mance or result in reduced inconsistencies. This is empirically clarified in section
7.2. The newly introduced liberal strategy and the portfolio compliance paradigm
result both in the generation of portfolios with better portfolio performance (see
Figures 7.5 and 7.7). On the other hand currently existing Shariah inconsistencies
are completely eliminated using the Ijmaa strategy 7.10.
122
8.2 Validating the Hypotheses
8.2.3 Hypothesis H3
H3:
The consideration of existing and newly developed Shariah measures within port-
folio optimization results in better portfolio performance compared to an opti-
mization done without these measures.
Validation:
In the third empirical analysis (see section 7.3) we have shown that through
using net purified returns higher returns at same risk level are generated com-
pared to classical ex-post purification practices. Additionally, the newly intro-
duced Shariah sustainability measure revealed that the compliance status of assets
change over time and through considering this measure during portfolio construc-
tion we expect reduced transaction costs and thus better portfolio performance.
8.2.4 Hypothesis H4
H4:
The development of a Decision Support System with advanced model manage-
ment capabilities and clear data model independence simplifies the task of port-
folio managers to analyze and execute different strategies.
Validation:
Unfortunately we were not able to validate this hypotheses empirically since the
developed system is not yet used by professional Shariah service providers. But
based on criticism on the existing systems on the market and the feedback we
have received from practitioners who have seen the developed system we believe
that the SPMDSS will simplify the work of and support portfolio managers in
managing Shariah-compliant portfolios tremendously.
123
8. CONCLUSION
8.3 Future Research

The current research status with respect to Islamic Finance is still underdevel-
oped and therefore a lot of new and innovative contributions can be made.
Based on the work done in this research the impact of using the Shariah sustain-
ability measure on portfolio performance still needs to be further investigated.
This can only be done if adequate and accurate historical financial statements
data is available for the asset universe to be analyzed.
Based on the feedback we have received from practitioners and the potentials
of the market it might be useful to further develop the SPMDSS prototype to a
professional system usable by Shariah-compliant service providers.
But the major and most interesting task is to approach experienced Shariah
scholars to increase their awareness about the negative impact of current Shariah
procedures and to convince them of the ideas, strategies and paradigms developed
within this research.
124
Appendix A
Survey of Shariah Guidelines
To illustrate how widely diversified the Shariah screens are among the differ-
ent Islamic funds and indexes, with respect to qualitative screens and quantita-
tive screens the different guidelines used by the main Shariah funds and index
providers are shortly reviewed in the following paragraphs.
Consider an asset universe I = {1, ..., n} of n assets which through applying

qualitative screens has been reduced to a sector-compliant asset universe I =

{1, ..., m}. Additionally Pi (t) is the price of the asset i ∈ I at time t ∈ Tday . To
be able to define and evaluate the financial screen ratios a number of financial
measures has to be given.

From the current balance sheets we extract for each asset i ∈ I and t ∈ Tday :
• ARi (t): Accounts receivables of asset i at time t
• Ci (t): Cash and cash equivalents of asset i at time t
• SIi (t): Short-term investments of asset i at time t
• LIi (t): Long-term investments of asset i at time t
• CSIi (t): Cash, equivalents and short-term investments of asset i at time t
125
A. SURVEY OF SHARIAH GUIDELINES
• T Ai (t): Total assets of asset i at time t
• T Di (t): Total debt of asset i at time t
• T CSi (t): Total common shares outstanding of asset i at time t
Additionally, consider the following information from the current income state-
ment:
• T Ri (t): Total revenue of asset i at time t
• NOIi (t): Net operating income of asset i at time t
• T Ii (t): Total interest income or expense of asset i at time t
• NIi (t): Net income of asset i at time t
• NP Ii (t): Non-permissible income other than interest of asset i at time t
• NP IIi (t): Non-permissible income including interest of asset i at time t
Using these parameters, the following key indicators can be derived:
• Market capitalization of asset i at time t

MCi (t) = T CSi (t) · Pi (t)
• Average market capitalization for asset i over the last trading day for each
of the previous 12 months where t ∈ Tprev12month and Tprev12month ⊂ Tday :

MCi (t) = 1/12 t∈Tprev12month MCi (t)
A.1 Dow Jones Islamic Index Group

The DJ Index Group1 is one of the most referred Islamic indexes. The DJ Shariah
Board has defined a set of qualitative and quantitative screens.
1
see Dow Jones (2007)
126
A.2 Financial Times Islamic Index Series
Qualitative Screens
The Dow Jones Shariah Board has defined a company as non-Shariah-compliant if
the company is involved in any activities related to alcohol, tobacco, pork-related
products, conventional financial services, weapons and defense and entertainment
such as hotels, casinos, cinema, pornography and music. Thus, DJIM excludes
any company involved in such a business instead of other interpretations differ-
entiating between core business and minor business income.
Quantitative Screens
In terms of quantitative screening the DJ Shariah board decided to use average
market capitalization as divisor for the ratios as from their perspective it mea-
sures the value of a company more realistically compared to total assets. The
following financial guidelines have to be satisfied to ensure Shariah-compliance:
1. Total debt to trailing 12-month market capitalization
T Di (t)
≤ 33%
MCi (t)
2. Cash and short-term investments to trailing 12-month market capitalization
CSIi (t)
≤ 33%
MCi (t)
3. Account receivables to trailing 12-month market capitalization
ARi (t)
≤ 33%
MCi (t)
A.2 Financial Times Islamic Index Series

FTSE1 has outsourced the Shariah-compliance screening process to Yasaar Lim-
ited, an independent Shariah solution provider which is supervised by an ap-
pointed Shariah board.
1
see FTSE (2007)
127
Qualitative Screens
The FTSE qualitative criteria exclude companies whose core business is related to
conventional finance (such as non-Islamic banking, finance and insurance), alco-
hol, pork-related products, entertainment (including casinos, gambling, cinema,
music, pornography and hotels), tobacco and weapons and defense. The FTSE
criteria are less restrictive than the DJ Islamic Index criteria since assets are
excluded only if their core business is non-Shariah-compliant rather than elim-
inating companies involved in any non-Shariah activity even if this activity is
generating a negligible return.
For quantitative screening the FTSE and Yasaar Limited Islamic Index team use
total assets rather than average market capitalization as divisor for the finan-
cial ratios to measure the worth of the company. Only companies passing the
following financial screens are included in the FTSE Islamic Index:
1. Total debt to total assets

T Di (t)
≤ 33%
T Ai (t)
2. Cash and short term investments to total assets
CSIi (t)
≤ 33%
T Ai (t)
3. Sum of account receivables and cash to total assets
ARi (t) + CSIi (t)

≤ 50%
T Ai (t)
4. Non-compliant income other than interest to total revenue
NP Ii (t)
≤ 5%
T Ri (t)
128
A.3 Standard and Poor’s Islamic Group
5. Total interest income to total revenue
NP IIi (t)
≤ 5%
T Ri (t)
A.3 Standard and Poor’s Islamic Group

Similar to FTSE, Standard and Poor’s1 has outsourced screening to a Shariah
Solution provider (Ratings Intelligence Partners) to define the Shariah rules to
be used for defining the S&P Shariah Index constituents.
Qualitative Screens
Any core business activities related to pork, alcohol, gambling, financial services,
advertising and media (except newspapers and sub-industries are analyzed indi-
vidually), pornography, tobacco and trading of gold and silver as cash on deferred
basis are treated as being non-permissible. Here slight differences between the
S&P Shariah rules for qualitative screening and the others can be noted. For
instance weapons and defense was not included in the list of non-permissible in-
vestments. Of course this is an arguable topic since the production of weapons is
normally not haram but some Islamic scholars agreed to classify it as non-ethical
since these weapons could be used to harm innocent people.
The quantitative screening rules of S&P are very similar to the guidelines used by
the Dow Jones Islamic Index differing only in the use of an additional ratio that
measures the maximum non-permissible income and in a different threshold level
for the account receivables level. The Shariah-compliance of companies from a
financial perspective is measured as follows:
1. Total debt to trailing 12-month market capitalization
T Di (t)
≤ 33%
MCi (t)
1
see Standard and Poor’s (2007)
129
2. Cash and short-term investments to trailing 12-month market capitalization
CSIi (t)
≤ 33%
MCi (t)
3. Account receivables to trailing 12-month market capitalization
ARi (t)
≤ 49%
MCi (t)
4. Non-compliant income other than interest to total revenue
NP Ii (t)
≤ 5%
T Ri (t)
A.4 Morgan Stanley Capital International Is-
lamic Index Series

The MSCI Islamic Index Series1 is one of the most recent Islamic indexes launched
in April 2007. MSCI introduced some innovative ideas in the index calculations
especially with respect to dividend purified index values.
Qualitative Screens
Any company whose core business activities or more than 5% of their total rev-
enue is generated from alcohol, tobacco, port-related products, financial services,
defence and weapons, gambling and casinos, music, hotels, television, cinema or
adult entertainment is considered as non-compliant. The published MSCI Index
Methodology Sheet has an advantage that it defines the non-permissible activities
in detail.
The quantitative screening of MSCI is very similar to the guidelines used by the
competitive index providers and are as follows:
1
see Morgan Stanley Capital International (2007)
130
A.5 Dubai Islamic Bank
T Di (t)
≤ 33.33%
T Ai (t)
2. Cash and short term investments to total assets
CSIi (t)
≤ 33.33%
T Ai (t)
ARi (t) + CSIi (t)

≤ 70%
T Ai (t)
A.5 Dubai Islamic Bank

The Dubai Islamic Bank1 defined a set of qualitative and quantitative guidelines
to be followed by their internal asset management to ensure Shariah-compliance.
Qualitative Screens
Any company whose core business activities or business objectives contradict
with Shariah is excluded from consideration. Unfortunately the type of businesses
which are considered by their Shariah boards as haram is not explicitly mentioned.
The quantitative screening guidelines of the Dubai Islamic Bank differ from the
conventional guidelines used by other Shariah boards. The DIB Shariah board
first solved the problem of choosing to use total assets or market capitalization
as divisor by applying both measures for ratio calculation. Thus, companies have
to pass both total asset based ratios and market capitalization ratios. On the
other hand DIB uses current market capitalization rather than using the trailing
market capitalization as done by the other screening providers. The following
ratios are used by DIB for Shariah screening:
1
see Nisar (2007)
131
1. Total debt to total assets and to market capitalization
T Di (t)
≤ 30%
T Ai (t)
T Di (t)
≤ 30%
MCi (t)
2. Interest-bearing investments to total assets and to market capitalization
SIi (t) + LIi (t)

≤ 30%
T Ai (t)
SIi (t) + LIi (t)

≤ 30%
MCi (t)
3. Sum of account receivables, cash and investment to total assets and to

market capitalization
CIi (t) + ARi (t) + SIi (t) + LIi (t)

≤ 30%
T Ai (t)
CIi (t) + ARi (t) + SIi (t) + LIi (t)

≤ 30%
MCi (t)
4. Non-compliant income from interest and others to total revenue
NP IIi (t)
≤ 5%
T Ri (t)
A.6 HSBC Amanah Fund

The HSBC Amanah1 is one of the most popular Islamic finance institutions and
offers a palette of funds managed under Shariah principles.
1
see HSBC Amanah (2007)
132
A.7 Meezan Islamic Fund
Qualitative Screens
Companies with primary business activities in biotechnology (genetic and foetus
experimentation), finance, tobacco, arms, entertainment and media, gambling,
pork or alcohol are excluded. Interesting is that their Shariah board is the only
one which disallows investments in companies involved in genetic and fetus ex-
perimentation.
The quantitative screening guidelines of the HSBC Amanah funds for Shariah-
compliant companies are as follows:

T Di (t)
≤ 30%
T Ai (t)
ARi (t) + CSIi (t)

≤ 50%
T Ai (t)
3. Non-compliant income from interest to total revenue
T Ii (t)
≤ 5%
T Ri (t)
A.7 Meezan Islamic Fund

The Meezan Islamic Fund1 is based in Pakistan and invests in different Shariah-
compliant products such as sukuks and Shariah-screened equity.
Qualitative Screens
It is not allowed to invest in companies with a core business related to conven-
tional banking, insurance, leasing, mudaraba, alcohol, tobacco, pornography and
other activities which are clearly non-permissible from a Shariah perspective.
1
see Usmani (2002)
133
The quantitative screening guidelines of the Meezan Islamic fund are somehow
unique compared to the other Shariah screening providers and contain the fol-
lowing ratios:

T Di (t)
≤ 40%
T Ai (t)
ARi (t) + CSIi (t)

≤ 80%
T Ai (t)
3. Investments to total assets
SIi (t) + LIi (t)

≤ 33%
T Ai (t)
4. Non-compliant income from interest to total revenue
T Ii(t)
≤ 5%
T Ri (t)
5. Net liquid assets to share price
CAi (t) − CLi (t)

≤ Pi (t)
T CSi(t)
A.8 Amiri Capital Islamic Fund

Amiri Capital1 is managing an innovative Shariah-compliant long short equity
fund, where short selling is run under an Islamic wa’ad contract as approved by
their Shariah board. Another innovative approach of Amiri Capital (so-called
”positive screening”) is that companies excluded by quantitative and qualitative
1
see Asaria (2007)
134
A.8 Amiri Capital Islamic Fund
screens are analyzed in more detail so that a subjective opinion is made about
considering it as Shariah-compliant.
Qualitative Screens
The qualitative screens of Amiri Capital do not differ from others such as Stan-
dard and Poor’s since they exclude companies that have as primary business a
non-permissible activity.
The quantitative screening guidelines of the Amiri Capital Islamic fund contain
the following ratios:

T Di (t)
≤ 33%
T Ai (t)
ARi (t) + CSIi (t)

≤ 70%
T Ai (t)
3. Interest-bearing investments to total assets
SIi (t) + LIi (t)

≤ 33%
T Ai (t)
4. Non-compliant income from interest or others to total revenue
NP IIi (t)
≤ 5%
T Ri (t)
If the company does not pass this screen, the company is considered for positive
screening so that on a set of alternative criteria a decision is taken whether the
company is to be considered compliant or not.
135
A.9 Azzad Asset Management Islamic Fund

Azzad Asset Management1 is managing a number of ethical funds and they have
developed an internal screening system for sector and financial screening purposes
to define which companies are permissible for investment.
Qualitative Screens
The qualitative screens of Azzad do not differ highly from other Islamic screening
norms, except that they exclude companies highly involved in meat production.
So this extends the prohibition to be involved in pork-related business activities
and the reason behind this is that meat is from the point of view of their Shariah
board not prepared in a halal way in general.
The quantitative screening guidelines of the Azzad Islamic funds contain the
following ratios:
1. Total debt to to market capitalization
T Di (t)
≤ 33%
MCi (t)
2. Sum of account receivables and cash to to market capitalization
ARi (t)
≤ 45%
MCi (t)
A.10 Malaysian Securities and Exchange Com-
mission
A completely different screening approach is the one used by the Malaysian Se-
curities and Exchange Commission (SEC)2 . Due to the fact that Malaysia is an
Islamic country, the screening process is done central by the Shariah Advisory
1
see Azzad Asset Management (2007)
2
see Nisar (2007)
136
A.10 Malaysian Securities and Exchange Commission
Board of the SEC which encompasses all securities registered. The first distinc-
tion to the other Shariah providers is that only sector screens and non-permissible
income screens are used, i.e. debt and liquidity screens are not considered. Sim-
ilar to the other providers, companies whose core business is not compliant with
Shariah are excluded from the compliant asset universe. The compliance of those
remaining companies which are involved in both compliant and non-compliant
business activities and practices is based on public interest, i.e. their economic
and social relevance for the country. Here three screening levels are applied:
• Clearly Prohibited Activities

The proportion of non-compliant income from clearly non-compliant activ-
ities such as alcohol or pork has to be less than five percent of the total
revenue.
• Unavoidable Activities
Since almost all companies have bank accounts and short-term investments
generating interest income which is generally non-compliant the SEC con-
siders it as a non-avoidable element which exists in all companies and there-
fore a higher threshold level (ten percent) is used to measure compliance.
• Public Interest
For companies of public interest the limit of non-permissible income is raised
to 25 percent of the total income
The differences between Shariah index and fund providers (except the Malaysian
SEC) concerning qualitative and quantitative compliance requirements are sum-
marized in Table A.1 and Table A.2 respectively.
137
DJIM FTSE S&P MSCI HSBC Amiri DIB* Azzad Meezan
Alcoholic Beverages ჳ x ჳ x x x x ჳ x
Biotechnology (Genetic &

x
Foetus)
Broadcasting & Entertainment ჳ x ჳ x x x x ჳ x
Conventional financial services ჳ x ჳ x x x x ჳ x
Gambling ჳ x ჳ x x x x ჳ x
Hotels ჳ x ჳ x x x ჳ
Insurance ჳ x ჳ x x x x ჳ x
Meat Production ჳ
Media Agencies**
ჳ ჳ x ჳ x
Pork-related products ჳ x ჳ x x x x ჳ x
Restaurants & Bars ჳ x ჳ x x x x ჳ x
Tobacco ჳ x ჳ x x x x ჳ x
Trading of Gold & Silver ‫ڛ‬
Weapons & Defence ‫ڛ‬ x x x x x ‫ڛ‬

x core business ‫ ڛ‬any involvement
* The sector screens of DIB is defined based on the best of our knowledge
** except newspapers
Table A.1: Summary on Qualitative (Sector) Screens
138
A.10 Malaysian Securities and Exchange Commission
Eligibility if DJIM FTSE S&P MSCI HSBC Amiri DIB Azzad Meezan
Liquidity Ratios
‫ܴܣ‬௜ ൅ ‫ܫܵܥ‬௜
ܶ‫ܣ‬௜ 50% 80%
‫ܴܣ‬௜ ൅ ‫ܥ‬௜
ܶ‫ܣ‬௜ 50% 70%
‫ܴܣ‬௜
ܶ‫ܣ‬௜ 70%
‫ܴܣ‬௜
തതതതത
‫ܥܯ‬ప 33% 49% 45%
‫ܣܥ‬௜ െ ‫ܮܥ‬௜ ܲ௜

ܶ‫ܵܥ‬௜
Interest Ratios
ܶ‫ܫ‬௜
ܴܶ௜ 5% 5% 5%
‫ܫܵܥ‬௜
തതതതത
‫ܥܯ‬ప 33% 33%
‫ܫܵܥ‬௜
ܶ‫ܣ‬௜ 33% 33.33% 33%
ܵ‫ܫ‬௜ ൅ ‫ܫܮ‬௜
ܶ‫ܣ‬௜ 30% 33%
ܵ‫ܫ‬௜ ൅ ‫ܫܮ‬௜
തതതതത
‫ܥܯ‬ప 30%
‫ܥ‬௜ ൅ ‫ܴܣ‬௜ ൅ ܵ‫ܫ‬௜ ൅ ‫ܫܮ‬௜
ܶ‫ܣ‬௜ 30%
‫ܥ‬௜ ൅ ‫ܴܣ‬௜ ൅ ܵ‫ܫ‬௜ ൅ ‫ܫܮ‬௜

തതതതത
‫ܥܯ‬ప 30%
Debt Ratios
ܶ‫ܦ‬௜
ܶ‫ܣ‬௜ 33% 33.33% 30% 33% 30% 40%
ܶ‫ܦ‬௜
തതതതത
‫ܥܯ‬ప 33% 33% 30% 33%
Non-Permissible Ratio
ܰܲ‫ܫ‬௜
ܴܶ௜ 5% 5% 5%
ܰܲ‫ܫܫ‬௜
ܴܶ௜ 5% 5%
Table A.2: Summary on Quantitative (Financial) Screens
139
140
Appendix B
Glossary of Shariah Terms
Fatwa / Fatwas
A legal opinion or pronouncement made by a Shariah scholar on a specific issue.
Fiqh / Fiqhy
Fiqh is the science of Islamic jurisprudence or Islamic law.
Gharar
Arabic word for excessive uncertainty and speculative risk
Ghish
Arabic word for deception
Hadith
The narrative records of the sayings and actions of the prophet Mohamed Peace
Be Upon Him
Halal
Any matters permitted by the Shariah
Hanafi
141
B. GLOSSARY OF SHARIAH TERMS
One of the Islamic schools of jurisprudence mainly followed by Muslims in Central

Asia
Hanbali
One of the Islamic schools of jurisprudence dominated in the Arabian Peninsula
Haram
Any matters prohibited by the Shariah such as the consumption of alcohol and
pork
Ibadat
The relationship between mankind and God
Ihtikar
Monopolistic activities
Ijmaa
Consensus of all the leading Shariah scholars on a certain Shariah matter at a
certain time.
Ijtihad
The endeavor of a qualified jurist to use the Quran and Hadith to derive or for-
mulate a rule or law on a matter not explicitly mentioned
Kasra
Arabic word for majority
Khamra
Arabic word for Alcohol
Maysir
Gambling and game of chance
142
Muamalat
Arabic word for dealing with mankind and it encompasses activities between man
kinds in term of social, economic and political activities. Such economic activities
include banking and financial activities in which Muslims are involved.
Mudaraba
An form of partnership where one party provides the funds (Rab-ul-maal) while
the other provides the expertise and management. The latter is referred to as
the Mudarib. Any profits occurred are shared between the two parties on a pre-
agreed basis, while loss is borne by the capital providers.
Mudarib
The party managing the capital
Quimar
Arabic word for gambling.
Quran
Text of God delivered to humankind the prophet Mohamed Peace Be Upon Him.
Rab-ul-maal
The party providing the capital
Riba
An excess or increase, interest. Technically it means an increase over principle in
a loan transaction
Shariah
Islamic canon law derived mainly from the Quran and the Hadith
Shariah Scholars
Experienced Islamic jurists who are able to issue a fatwa. Within this research
work Shariah scholars are acquainted with both Shariah and Financial issues.
143
B. GLOSSARY OF SHARIAH TERMS
Sukuk
Shariah-compliant bonds which are not interest-based
Wakala
An agency contract in which one person appoints someone else (the wakeel) to
manage his capital for instance for a certain fee
Wa’ad
Arabic word for promise and used for contractual agreements
Wakeel
Person managing the fund of the provider on an agent basis
Zakat
The religious obligation of Muslims to donate 2.5% of certain kind of wealth an-
nually.
144
List of Figures
1.1 Growth of Islamic Mutual Funds . . . . . . . . . . . . . . . . . . 2
4.1 Asset Universes based on diverse Asset Compliance Strategies . . 53

4.2 Structure of Shariah-Compliant Funds . . . . . . . . . . . . . . . 55
4.3 Shariah-Compliance Options . . . . . . . . . . . . . . . . . . . . . 57
4.4 Shariah Sustainability of an Asset over Time . . . . . . . . . . . . 61
4.5 Islamic Equity Management Process . . . . . . . . . . . . . . . . . 63
5.1 Comparison of SLP approximation and exact MIQP solution for

constructing an efficient frontier . . . . . . . . . . . . . . . . . . . 76
6.1 DSS Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

6.2 Classical DSS Architecture . . . . . . . . . . . . . . . . . . . . . . 79
6.3 SPMDSS Architecture . . . . . . . . . . . . . . . . . . . . . . . . 82
6.4 Return Calculation in SPMDSS . . . . . . . . . . . . . . . . . . . 86
6.5 Return Calculation in SPMDSS . . . . . . . . . . . . . . . . . . . 87
6.6 Example Report of SPMDSS . . . . . . . . . . . . . . . . . . . . . 87
6.7 Examples of Specific DSS using SPMDSS . . . . . . . . . . . . . . 88
6.8 Selection of Shariah Schools and Strategies . . . . . . . . . . . . . 90
6.9 Example of Shariah Compliance Reasoning . . . . . . . . . . . . 91
6.10 Configuration of SPMDSS Optimizer . . . . . . . . . . . . . . . . 92
7.1 Screening Impact on Asset Universe . . . . . . . . . . . . . . . . . 100

7.2 Performance of Basic Shariah Strategies . . . . . . . . . . . . . . 108
7.3 Sector-based Comparison Market Capitalization vs. Total Assets . 110
145
LIST OF FIGURES
7.4 Effect of using sector-based MC/TA divisor on DJIM and MSCI . 111
7.5 Performance of Proposed Strategies Asset-based . . . . . . . . . . 112
7.6 Asset versus Portfolio-based Compliance Strategy . . . . . . . . . 113
7.7 Portfolio-based versus Basic Asset-based Compliance Strategies . 114
7.8 Shariah Sustainability of Assets . . . . . . . . . . . . . . . . . . . 118
146
List of Tables
3.1 Example Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
7.1 Unified Exclusion Codes . . . . . . . . . . . . . . . . . . . . . . . 98

7.2 Sector Screening Result . . . . . . . . . . . . . . . . . . . . . . . . 98
7.3 Financial Screening - Asset Universe . . . . . . . . . . . . . . . . 99
7.4 Funds / Indexes Discrepancies . . . . . . . . . . . . . . . . . . . . 101
7.5 Variation in classification among Funds / Indexes . . . . . . . . . 102
7.6 Shariah Scholars across Funds / Indexes . . . . . . . . . . . . . . 103
7.7 Classification Market Cap vs. Total Assets Representatives . . . 103
7.8 Model and Parameter Settings . . . . . . . . . . . . . . . . . . . . 106
7.9 Weights of assets aggregated by sector compliant under DJIM and
not under MSCI and vice versa . . . . . . . . . . . . . . . . . . . 109
7.10 Inconsistency in classification of new strategies vs. basic strategies 112
7.11 Ex-Post versus Ex-Ante Purification . . . . . . . . . . . . . . . . 117
7.12 Shariah Sustainability of Assets by Sector . . . . . . . . . . . . . 119
A.1 Summary on Qualitative (Sector) Screens . . . . . . . . . . . . . . 138

A.2 Summary on Quantitative (Financial) Screens . . . . . . . . . . . 139
147
LIST OF TABLES
148
References
Asaria, M.I. (2007). Shariah Screens of Amiri Capital - Personal

Communication.
Auckenthaler, C. (1994). Theorie und Praxis des modernen

Portfolio-Managements. Paul Haupt, Bern / Stuttgart / Wien.
Azzad Asset Management (2007). Social and Financial Screens of Azzad

Asset Management, available at http://azzad.net/new/ethical screens.aspx.
Beasley, J., Meade, N. & Chang, T. (1999). Index Tracking. Working

Paper, The Management School, Imperial College, London.
Beasley, J., Meade, N. & Chang, T. (2003). An evolutionary heuristic for

the index tracking problem. European Journal of Operational Research, 148,
621–643.
Bhowmik, R. (2008). Building Design Optimization Using Sequential Linear

Programming. Journal of Computers, 3, 58–64.
Brosh, I. (1981). Optimal cargo allocation on board a plane: a sequential linear

programming approach. European Journal of Operational Research, 8, 40–46.
Chalermkraivuth, K., Bollapragada, S., Clark, M., Deaton, J.,

Kiaer, L., Murzdek, J., Neeves, W., Scholz, B. & Toledano, D.
(2005). GE Asset Management, Genworth Financial, and GE Insurance Use a
Sequential Linear Programming Algorithm to Optimize Portfolios. Interfaces,
35, 370–380.
149
REFERENCES
Coleman, T., Henninger, J. & Li, Y. (2006). Minimizing Tracking Error

While Restricting the Number of Assets. Journal of Risk , 8, 33–56.
Delorenzo, Y. (2000). Shariah Supervision of Islamic Mutual Funds. In Pro-

ceedings of the Fourth Harvard University Forum on Islamic Finance, Harvard
University - Cambridge, Massachusetts.
Derigs, U. & Alparslan, E. (2007). PMDSS.net An Internet-based DSS gen-

erator for end-user portfolio optimization. Working Paper, WINFORS, Univer-
sity of Cologne.
Derigs, U. & Marzban, S. (2008a). Inequalities of Screening. Islamic Banking

and Finance, 18, 11–13.
Derigs, U. & Marzban, S. (2008b). Review and Analysis of Current

Shariah-Compliant Equity Screening Practices. To appear in: International
Journal of Islamic and Middle Eastern Finance and Management.
Derigs, U. & Marzban, S. (2008c). New Strategies and a New Paradigm for
Shariah-Compliant Portfolio Optimization. Submitted to: Journal of Banking
and Finance (under revision).
Derigs, U. & Nickel, N. (2003). Meta-Heuristic based Decision Support for

Portfolio Optimization with a Case Study on Tracking Error Minimization in
Passive Portfolio Management. OR Spectrum (Special Issue on Risk Manage-
ment), 25, 345–378.
Derigs, U. & Nickel, N. (2004a). On a Local-Search Heuristic for a Class

of Tracking Error Minimization Problem in Portfolio Management. Annals of
Operations Research, 131, 45–77.
Derigs, U. & Nickel, N. (2004b). Some remarks on the complexity of mod-

eling and solving real-world portfolio optimization problems. Working Paper,
WINFORS, University of Cologne.
Derigs, U. & Nickel, N. (2004c). PM-DSS: Ein Portfoliomanagementsystem

fr Analyse, Simulation und Optimierung. Working Paper, WINFORS, Univer-
sity of Cologne.
150
REFERENCES
Derigs, U., Alparslan, E. & Marzban, S. (2007). Spreadsheet-based

Portfolio Management System for a German Bank. CCDSS Project Report.
Dong, J., Du, H., Wang, S., Chen, K. & Deng, X. (2004). A framework
of Web-based Decision Support Systems for portfolio selection with OLAP and
PVM. Decision Support Systems, 37, 367–376.
Dow Jones (2007). Dow Jones Islamic Market Indexes, available at

http://www.djindexes.com/mdsidx/downloads/brochure info/Islamic broch.pdf.
Elgari, M. (2000). Purification of Islamic Equity Funds: Methodology and

Shari’ah Foundation. In Proceedings of the Fourth Harvard University Forum
on Islamic Finance, Harvard University - Cambridge, Massachusetts.
Fama, E. (1991). Efficient Capital Markets II. Journal of Finance, 26, 1575–
1617.
Franks, E.C. (1992). Targeting excess-of-benchmark returns. Journal of Port-

folio Management, 18, 6–12.
FTSE (2007). FTSE Shariah Global Equity Index Series, available at

http://www.ftse.com/Indices/FTSE Shariah Global Equity Index Series.
Gaivoronski, A.A. & Pflug, G. (2000). Value at Risk in Portfolio

Optimization: Properties and Computational Approach. Working Paper 00/2,
Norwegian University of Science Technology.
Gerrity, T. (1971). The Design of Man-Machine Decision Systems. Sloan Man-

agement Review , 12, 59–75.
Gilli, M. & Kellezi, E. (2001). Threshold Accepting for Index Tracking.

Working Paper, Department of Econometrics and FAME, University of
Geneva.
Guertler, M. & Mendi, M. (2001). The Markowitz Mean-Variance Model:

A Technical Perspective. White Paper, Department of Mathematical Science,
Brunel University.
151
REFERENCES
HSBC Amanah (2007). Sector and Financial Screens of HSBC Amanah, avail-
able at http://www.hsbcamanah.com.
Iqbal, Z. & Mirakhor, A. (2007). An Introduction to Islamic Finance -

Theory and Practice. John Wiley & Sons, Singapore.
Jobst, N., Horniman, M., Lucas, C. & Mitra, G. (2001). Computational

aspects of alternative portfolio selection models in the presence of discrete asset
choice constraints. Quantitative Finance, 1, 489–501.
Kellerer, H., Mansini, R. & Speranza, M.G. (2000). Selecting Portfolios

with Fixed Costs and Minimum Transaction Lots. Annals of Operations Re-
search, 99, 287–304.
Ketell, B. (2008). Why are derivatives haram under Shariah law? Islamic
Banking & Finance, 6, 23–25.
Khatkhatay, M. & Nisar, S. (2006). Shari’a-Compliant Equity Investments:

An Assessment of Current Screening Norms. In Proceedings of the Seventh Har-
vard University Forum on Islamic Finance, Harvard University - Cambridge,
Massachusetts.
Larsen, G. & Resnick, B. (1998). Empirical Insights on Indexing. Journal of

Portfolio Management, 25, 51–60.
Lobo, M.S., Fazel, M. & Boyd, S. (2007). Portfolio Optimization with Linear
and Fixed Transaction Costs. Annals of Operations Research ( Special Issue on
Financial Optimization), 152, 376–394.
Markowitz, H. (1952). Portfolio Selection. Journal of Finance, 7, 77–91.
Mitchell, J. & Braun, S. (2002). Rebalancing an Investment Portfolio in the

Presence of Transaction Costs. Unpublished Paper under NSF Grant number
CCR-9901822 .
Morgan Stanley Capital International (2007).

Msci Islamic Index Series Methodology, available at
http://www.msci.com/gimi/islamic/MSCI May07 IslamicMethod.pdf.
152
REFERENCES
Nickel, N. (2005). Portfoliooptimierung im Fondsmanagement von

Kapitalanlagegesellschaften: Konzeption, Entwurf und Implementierung
eines Decision Support Systems. Ph.D. thesis, Information Systems and
Operations Research Department, University of Cologne.
Nisar, S. (2007). Islamic Norms for Stock Screening, al Huda Islamic Banking
and Finance Magazine available at http://www.alhudacibe.com/.
Norman, T. (2004). Islamic Investment Funds. In S. Jaffer, Islamic Asset Man-

agement: Forming the Future for Sharia’a-Compliant Investment Strategies,
Euromoney Books - London, UK.
Obaidullah, M. (2002). Islamic Risk Management: Towards Greater Ethics

and Efficiency. International Journal of Islamic Financial Services, 3, 1–18.
Obaidullah, M. (2005). Islamic Financial Services. Scientific Publishing Cen-

ter, King Abdul Aziz University, Jeddah, Saudi Arabia.
Poddig, T., Brinkmann, U. & Seiler, K. (2003). Portfoliomanagement:

Konzepte und Strategien - Theorie und praxisorientierte Anwendungen mit
Excel. Uhlenbruch Verlag, Bad Soden.
Power, D. (2002). Decision Support Systems: Concepts and Resources for

Managers. Quorum Books, West Port, USA.
Rockafellar, R. & Uryasev (2000). Optimization of Conditional

Value-at-Risk. Journal of Risk , 2, 21–41.
Rudd, A. (1980). Optimal Selection of Passive Portfolios. Financial Manage-

ment, 9, 57–66.
Sharpe, W. (1991). The Arithmetic of Active Management. The Financial An-

alysts’ Journal , 47, 7–9.
Sprague, R. (1980). A Framework for the Development of Decision Support

Systems. MIS Quarterly, 4, 1–26.
153
REFERENCES
Sprague, R.H. & Watson, H.J. (1995). Decision Support for Management.
Prentice Hall, Upper Saddle River, New Jersey.
Standard and Poor’s (2007). S&P Shariah Indices, available at

http://www2.standardandpoors.com/spf/pdf/index/Shariah Methodology.pdf.
Usmani, M. (2002). Meezan Bank’s Guide to Islamic Banking. Darul Ishaat,

Karachi, Pakistan.
Vayanos, P. & Wackerbeck, P. (2008). Islamic Banking - How do

Islamic Banks compete in an increasingly competitive environment. Memo.
Booz & Company, Germany.
Wilson, R. (2004). Screening criteria for Islamic Equity Funds. In S. Jaffer,

Islamic Asset Management: Forming the Future for Sharia’a-Compliant In-
vestment Strategies, 35–45, Euromoney Books - London, UK.
154
Curriculum Vitae
Personal Data
Name: Shehab El-Din Marzban
Address: 32, Mahrousa Street
Mohandseen - Cairo, Egypt
Birth Date: 9 September 1977
Birth Place: Goettingen - Germany
Education
1983 - 1989 Different Primary Schools in Goettingen
1989 - 1996 Deutsche Evangelische Oberschule in Cairo
Degree: Allgemeine Hochschulreife
1996 - 2000 Cairo University - Faculty of Computers and Information
Degree: Bachelor of Science
2000 - 2003 Cairo University - Faculty of Computers and Information
Degree: Master of Science
Jan 2004 - Postgraduate Studies (PhD) at the Information Systems
and Operations Research Department, University of Cologne
Employment
2000 -2003 Research and Teaching Assistant - Cairo University
2004 -2008 Research and Teaching Assistant - University of Cologne
2006 -2008 TEMPUS Project Coordinator - University of Cologne
View publication stats

Marzban Thesis

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Marzban Thesis

Uploaded by

Copyright:

Available Formats

See discussions, stats, and author profiles for this publication at: https://www.researchgate.

Shariah-compliant Portfolio Management: Processes, Methodologies, and

Chapter · January 2011

The user has requested enhancement of the downloaded file.

Shehab Marzban, MSc.

I Fundamentals of Portfolio Management and Shariah 9

3 Shariah Issues in Portfolio Management 25

II New Concepts for Shariah-Compliance and Devel-

4 New Strategies and Paradigms for Shariah Portfolio Manage-

4.2 Strategies for Shariah Puriﬁcation . . . . . . . . . . . . . . . . . . 58

5 Shariah Portfolio Optimization Model 67

6 Shariah Portfolio Management DSS 77

III Empirical Analysis 93

A Survey of Shariah Guidelines 125

B Glossary of Shariah Terms 141

1.1 Islamic Finance and Equity Management

guidelines or screens to be used to distinguish between the set of halal (Shariah-

Figure 1.1: Growth of Islamic Mutual Funds

1.2 Motivation and Hypotheses

Analysis of current industry-driven Shariah procedures

Development of research-driven Shariah procedures

Extension of practical portfolio models by Shariah requirements

Development of a DSS prototype for dynamic and customized Port-

Empirical Analysis of Developed Concepts

formed to quantify the impact of non-standardization on Shariah consistency and

• Hypothesis H1: Shariah-compliance procedures currently used across the

• Hypothesis H2: The development of new paradigms and strategies for

• Hypothesis H3: The consideration of existing and newly developed Shariah

• Hypothesis H4: The development of a Decision Support System with ad-

1.3 Structure of the Thesis

• Part I: Fundamentals of Portfolio Management and Shariah

• Part II: New Concepts for Shariah-Compliance and the Development of

• Part III: Empirical Analysis

Part I: Fundamentals of Portfolio Management and Shariah

Part II: New Concepts for Shariah-Compliance and the Development

and paradigms are mathematically formulated so that the Shariah requirements

Part III: Empirical Analysis

2.1 Introduction to Portfolio Management

The classical portfolio management process extended by Shariah requirements

Based on investors’ preference diﬀerent portfolio management strategies can be

2.1.1 Portfolio Management Strategies

2.1.1.1 Active Portfolio Management Strategy

Portfolio managers using active portfolio management strategies do not believe

2.1.1.2 Passive Portfolio Management Strategy

2.1.1.3 Active versus Passive Portfolio Management

2.2 Portfolio Optimization Modeling

2.2.1 Portfolio Representation

y = (y1 , ..., yn ) (2.1)

Alternatively, a more frequently used portfolio representation form is to represent

x = (x1 , ..., xn ) (2.2)

Since xi is the proportional budget invested in each asset i ∈ I, xi ∈ [0, 1] holds

2.2.2 Measuring Portfolio Return and Risk

The function σ 2 (x) is a quadratic (nonlinear) function which adds complexity to

2.2.3 Classical Portfolio Models

2.2.3.1 Markowitz Mean-Variance Model

2.2.3.2 Index Tracking Model

Under a passive portfolio management strategy such as index tracking, a portfolio

T E = (x − x)T C(x − x) (2.11)

2.2.4 Portfolio Model Extensions

A major criticism of classical Mean-Variance portfolio optimization models is that

Budget and Cash Constraint

in article 8a of the KAGG that a maximum level of 10 percent can be invested

It is worth mentioning that index tracking models with cardinality restrictions