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Contents lists available at ScienceDirect

**Journal of Banking & Finance
**

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

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

Ulrich Derigs*, Shehab Marzban

University of Cologne, Department of Information Systems and Operations Research, Pohligstrasse 1, Cologne, Germany

a r t i c l e

i n f o

a b s t r a c t

In this paper we analyze the effects of different strategies to construct Shariah compatible ﬁnancial portfolios. The difference between conventional and current Shariah portfolio management is the application of sector screens and ﬁnancial screens by which the asset universe is reduced. Yet, here different schools of scholars deﬁne different screening rules leading to signiﬁcant differences with respect to compliance, but also with respect to performance. After analyzing this discrepancy we propose several new strategies to apply the inconsistent rule systems and a new paradigm for deﬁning Shariah-compliance. Under this new paradigm compliance is attributed to the portfolio and not to the individual assets of the universe. We report results of an empirical study analyzing the potentials of these strategies and of the paradigm. We can show that under the proposed concepts Shariah-compliant portfolios can be realized which have return and risk proﬁles comparable to the conventional non-constrained portfolios. Ó 2008 Elsevier B.V. All rights reserved.

Article history: Received 24 April 2008 Accepted 21 December 2008 Available online 1 January 2009 JEL classiﬁcation: C61 G11 G15 Keywords: Shariah guidelines Islamic funds Portfolio models Empirical analysis

1. Introduction The increasing capital value of the Muslim population and the demand of these investors to invest their capital in ﬁnancial products that do not conﬂict with the Shariah triggered the development of Shariah-compliant investment products such as Islamic equity funds. Due to the fact that Shariah prohibits the involvement in interest-based assets such as conventional bonds, speculative investments such as derivatives and speciﬁc prohibited industries such as the armaments industry (Wilson, 2004), speciﬁc guidelines need to be introduced as additional constraints into (optimization) models for constructing Shariah-compliant portfolios. These guidelines stem from the main Shariah sources Quran, Hadith and Ijtihad. The Quran is the primary source of Islam including the words of God as delivered to the prophet Mohammed whereas the Hadith consists 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. Since there is no higher institution responsible for religious opinions to be followed by all Muslims, experienced Shariah scholars (DeLorenzo, 2000) interpret these sources and specify so

* Corresponding author. Tel.: +49 221 4705328; fax: +49 221 4705329. E-mail addresses: ulrich.derigs@uni-koeln.de (U. Derigs), smarzban@ idealratings.com (S. Marzban). 0378-4266/$ - see front matter Ó 2008 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankﬁn.2008.12.011

called Shariah-compliance strategies to be followed within asset selection. Here a compliance strategy is simply a set of computable or executable rules by which non-compliant assets are identiﬁed. Derigs and Marzban (2008) have shown that different opinions and inconsistencies exist among the Shariah scholars and their compliance strategies. These can mainly be attributed to the different Shariah perceptions of the scholars and to the ‘‘complexity of transforming the historical and verbal Shariah sources into quantiﬁable and formal guidelines to be used within a modern guideline evaluation and portfolio management system” (Derigs and Marzban, 2008). The area of Shariah Finance is a speciﬁc instance of a broader appearance, the so called socially responsible investments (SRI) which have been discussed in the ﬁnance literature only recently (Renneboog et al., 2008; Galema et al., 2008). In this paper we introduce several new approaches to motivate and initiate a discussion on developing concepts for deﬁning different levels of compliance and standardization of interpretation. In Section 2 we ﬁrst describe a set of new strategies for Shariah-compliant asset selection. While so far all strategies consider compliance as an attribute of single assets, we then propose to consider compliance as an attribute of the portfolio leading to what could be called a new ‘‘paradigm” in Shariah portfolio theory and practice. This new paradigm can be combined with the different Shariah-compliance strategies and offers several new compliance options. In Section 3 the proposed strategies and the new paradigm are formalized leading to a set of different portfolio optimization models which are all practical in the sense that they are comput-

the inconsistencies between these strategies as all inconsistencies among expert opinion call for what can be called compromises or view integration. As reference asset universe we have chosen the Standard and Poor’s 500 index constituents of the 17th of September 2007. 2. Thus.1. the Morgan Stanley Capital International Islamic Index Series (MSCI). The following four strategies to combine the expertise suggest themselves and are more or less self explanatory.60% 22. While S&P and DJIM use average market capitalization as divisor for their ﬁnancial ratios the other Shariah strategies use total assets as divisor. These basic strategies were based on the guidelines deﬁned by the Shariah boards of the Standard and Poor’s Islamic Index Group (S&P). 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. sector guidelines are conservative prescriptions through which companies operating in non Shariah-compliant business activities are excluded. ‘‘Best of” strategy The basic Shariah strategies are deﬁned by different Shariah boards.e. yet.30% 24. i. The alternative strategies and the new paradigm proposed in this paper are justiﬁed and formulated based on Shariah practices and reasoning. 1. Shariah-compliance strategies are based on two types or sets of guidelines: sector guidelines and ﬁnancial guidelines (Nisar and Khatkhatay. 1 gives an overview of the sizes of the asset universes after applying these basic Shariah strategies individually as well as the variation in classiﬁcation. Fig. 2. New Shariah-compliance strategies Conventionally Islamic investment trusts use a speciﬁc Shariahcompliance strategy to deﬁne a compliant asset universe.50% DJIM MSCI ANON FTSE HSBC Fig. 1 these basic compliance strategies if compared to each other are characterized by high inconsistencies in the size of asset universe as well as in the constituents considered to be compliant. The practicability and effectiveness is demonstrated in the paper. Such a ‘‘basic” Shariah-compliance strategy is either deﬁned by an inhouse 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 asset is classiﬁed as non-compliant and as with the sector guidelines has to be excluded from further investment consideration. If the company that issued the asset is involved in ﬁnancial practices exceeding the respective threshold. Generally. casinos or even partially as for instance many hotels due to their income from bars and clubs. To study the diversity of Shariah strategies Derigs and Marzban (2008) have analyzed the impact of six different Shariah strategies on a unique reference asset universe. For that purpose Shariah scholars deﬁne threshold levels for speciﬁc indicators/ﬁnancial ratios through which the degree of compliance is measured. the Financial Times Islamic Index Series (FTSE). the ‘‘Best of” strategy selects from the pool of basic compliance strategies the one which results in the best portfolio Compliant Asset S&P Universe Size S&P DJIM MSCI ANON FTSE HSBC 271 266 247 246 241 232 1. The effect of the proposed strategies and paradigms on compliance consistency and on portfolio performance (return and risk) will then be empirically investigated and interpreted in Section 4.60% 26. 2. the decision regarding their Shariah-compliance and practical use needs to be checked and decided upon by Shariah scholars. the Dow Jones Islamic Index Group (DJIM). Muslims are not allowed to invest in assets from businesses earning primarily from such activities such as alcohol producers. Derigs. As we have seen in Fig. New Shariah-compliance approaches Generally. the use of such guidelines is a relaxation of the conservative Shariah rules and a tribute paid to the complexity and the generally non-islamic nature of the current capital markets.00% 0. 2006). return obtained from portfolios constructed under these relaxations has to be cleansed through post-investment puriﬁcation practices (Elgari. Now. a process in which the proportion of non-compliant income is identiﬁed and donated. One reason for these variations can be attributed to the type and semantic of the ﬁnancial ratios used within the Shariah guidelines.00% 7.90% 8. one strategy considers the asset to be compliant and the other considers it as non-compliant).40% 25.e.70% 24. Now. Shariah clearly deﬁnes activities in which Muslims may not be involved in such as the consumption of alcohol and pork and activities related to gambling. we propose and describe in the next section four new Shariah-compliance strategies which establish a system of different levels of compliance and on the other hand contribute to a standardization and integration of different basic strategies.1. S.80% 6. the HSBC Amanah Fund (HSBC) and an anonymous Isla- mic Fund (ANON). Motivated by these ﬁndings on inconsistencies in current compliance strategies. Asset universes and variation in classiﬁcation among basic compliance strategies. with each of these boards claiming that their strategy and the deﬁned guidelines ensure Shariah-compliant asset selection. Consequently. Variation or what we will refer to as ‘‘compliance inconsistency” is measured by the percentage of assets which are differently classiﬁed between two compliance strategies (i.20% 1.90% 26. 2000). .U.30% 21. In order to claim Shariah-compliance. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 1167 able.1.30% 24.60% 1. Financial guidelines on the other hand are used to analyze how deeply companies are involved in ﬁnancial practices not compliant with Shariah.

Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 performance in terms of some objective function based on return and risk.e. 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.2. which are ﬁnancially independent of the institutions that establish them. 3. but it is deduced by logical reasoning from current compliance strategies. Majority/Kasra strategy The majority (in Arabic Kasra) strategy is motivated by the Islamic juristic principle which states that ‘‘the majority deserves to be treated as the whole thing”. Secondly. it can be combined with any basic strategy from an Islamic index. ‘‘Funds are investment vehicles.4. according to the guideline. Accordingly. Thus. a fund takes the form of an independent company. then analogously an investment in a fund which invests in different companies. Now.3. since not all companies report the revenue generated by each SIC classiﬁcation business segment it is almost impossible to identify the amount of non-permissible revenue generated without further research and analysis. The Shariah foundation of this compliance strategy can be attributed to the Ijmaa principle. 2. but. within a portfolio-based compliance strategy no asset is excluded from the asset universe per se. the control of the entire portfolio through the ﬁnancial ratios may put limitations on the proportional wealth to be invested in certain assets implicitly. . But. else the asset is deemed non-compliant and has to be eliminated from the asset universe. Thus. Under the Ijmaa strategy. These combinations vary from very conservative to rather liberal.1168 U.” Therefore. no investment should be allowed in assets from companies whose primary activities are not compliant with Shariah. Modeling Shariah-compliance In this section we outline how Shariah-compliance can be modeled within the framework of portfolio optimization. S. We will justify this point of view and illustrate it by an example. 2004). Of course. . Thus the conventional sector guidelines. 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. 2. should be applied beforehand. 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. On the other hand. a hotel. Derigs. it is considered to be compliant for investment. for example. If an asset satisﬁes the respective guidelines it is considered compliant. this guideline is used to restrict the investment to only those hotels with a non-compliant income less than the threshold. Consider. This results in a large variety of new options for compliance speciﬁcation. 2. Therefore 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 indication is made to the revenue generated by non-compliant activities such as the sales of alcohol and revenue from casinos and night clubs. 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. A new paradigm for Shariah-compliance The compliance strategies described above consider compliance as an attribute of the single assets. then a critical Shariah guideline is the following: Income from the casinos. The new portfolio compliance paradigm can be used in conjunction with any asset compliance strategy as for instance those described in Section 2.. an asset universe I = {1. i. this paradigm should be applied only to speciﬁc products and after some preprocessing: First. 2. n} from . then. . 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. i. night clubs and alcoholic beverages has to be less than 5% of the total revenue generated by the hotel. bars. The following proposal leads to a new paradigm which if accepted by current Shariah scholars will revolutionize Islamic equity management. This problem can be solved using a different industry classiﬁcation standard which is the standard classiﬁcation system (SIC) through which each company is assigned multiple SIC codes based on the different industries or businesses it is operating in.1.1. such as a limited liability company (Norman. Using such a classiﬁcation standard makes it impossible to identify the different compliant and non-compliant business segments companies operate in. 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. liberal or majority compliance strategy. Obviously. which is the unanimous consensus of all major qualiﬁed Shariah scholars on a certain Shariah issue at a given time. the best of.1. asset compliance is deﬁned through considering all basic Shariah strategies and their respective guidelines simultaneously within the portfolio optimization model. a hotel can be considered as a company operating in three business lines which are: accommodation and Shariah-compliant hotel services.1. an asset is compliant under this strategy if and only if the majority of the basic Shariah strategies consider this asset to be compliant. Ijmaa. The liberal compliance strategy results in a larger asset universe and therefore higher returns and lower risks can be expected under this strategy. We consider the standard situation. the sale of alcohol and casinos and night clubs. through which those assets are excluded from the asset universe. in which investors act as shareholders. Since the core business of the hotel is considered compliant. If a hotel has an overall non-compliant income from the second and third business lines which is less than 5% of the accumulated revenue generated by the three business lines together. 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. 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. Using the same argumentation. Most Shariah providers use an industry classiﬁcation standard such as the global industry classiﬁcation benchmark (GICS) or the industry classiﬁcation benchmark (ICB) through which companies are assigned to a single business segment based on the core business activity they operate in. respectively.e. Also. or. The new paradigm might be considered as too liberal or even non-Islamic. 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 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).2.

the ratio is above the respective threshold.. . which is realistic since short-sellings are generally not allowed under Shariah. 3. i¼1 For the following we also 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. 8g 2 Gs ð14Þ r i ðgÞ TðgÞ ð7Þ The model is very similar to the model for a basic strategy with the only difference that the constraints for all Shariah strategies s 2 S are added to the model. Formally. Thus we have to control a set of constraints of the following type ri ðgÞ Á zi TðgÞ 8i 2 I. The objective function is reﬂecting the investment strategy as well as the return/risk tradeoff and could stem for instance from the mean-variance model (Markowitz.e. cash and short-term investments CSIi and total assets TAi ﬁgures as published in the ﬁnancial statements of the company issuing the asset ieI is given by Now we introduce the new strategies: Best of Shariah strategy In the ‘‘best of” Shariah strategy we have to solve the model for each s 2 S independently and the optimal portfolio with respect to this strategy is the one generated by the model yielding the best portfolio performance. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 1169 which a portfolio can be constructed and we assume that the total wealth has to be invested and short-sellings are not allowed.U. 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 Shariahcompliance of a portfolio can be operationally obtained by a prepro- . Then every portfolio can be represented by a share vector x = (x1.1. 2008). i. Thus we assume that before or without regarding Shariah-compliance we have the following conventional portfolio optimization model: cessing phase in which the asset universe for a conventional portfolio optimization model is speciﬁed. xi > 0. a ﬁnancial guideline can be modeled by a set of logical constraints of the following type xi ¼ 0 if ri ðgÞ > TðgÞ 8i 2 I ð8Þ Now (8) can be transformed into a set of mathematical inequalities as follows: For each asset i 2 I we deﬁne a binary variable zi with zi ¼ 1 if i is complaint 0 otherwise ð9Þ and we introduce the constraints xi zi 8i 2 I TðgÞ 8 i 2 I ð10Þ ð11Þ ri ðgÞ Á zi Min f ðxÞ Subject to x fulfils constraints in C n X i¼1 ð1Þ ð2Þ ð3Þ ð4Þ Constraints (10) ensure that for every asset i 2 I xi > 0 only if zi ¼ 1 ð12Þ xi ¼ 1 xi ! 0 8i 2 l Since constraints (11) ensure that zi is 0 if the guideline (7) is not fulﬁlled i. S. is possible only if the guideline is fulﬁlled. the so called threshold value.. asset compliance is deﬁned through considering all basic Shariah strategies s 2 S and their respective guidelines g 2 G simultaneously within the portfolio optimization problem. then a speciﬁc basic Shariah-compliance strategy s 2 S is formulated using a speciﬁc subset Gs & G and the associated portfolio optimization problem is given by Irrespective whether compliance is measured as an attribute of the single assets or the whole portfolio. sector guidelines have to be fulﬁlled i. they have to be applied to exclude assets of those companies operating in Shariah non-compliant business activities from the asset universe. xi ¼ 0 8i 2 INC ð5Þ 8 g 2 Gs ð13Þ Note that these exclusion constraints need not to be included into the portfolio optimization model. 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 INC & I can be speciﬁed easily and the sector guidelines can be modeled by exclusion constraints Min f ðxÞ subject to ð2Þ—ð4Þ.e. Liberal strategy The liberal compliance strategy reduces the asset universe by those assets which are jointly deﬁned non-compliant by all basic Obviously. 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. xn) where x1 e [0. and to compare the value with a maximum permissible value T(g). Derigs.. 1952. investment in asset i 2 I.. Such a strategy can be formulated within the model by replacing (13) by: ARi þ CSIi TA 0:5 ð6Þ This guideline ensures that the liquid assets of the company as proportion of total assets are less than or equal 50% and stems from the Shariah rule that income should be mainly gained from illiquid assets and therefore the majority of assets have to be of illiquid form. legal guidelines for instance. 8s 2 S. Consensus/Ijmaa Shariah strategy Within the Ijmaa strategy.e. In the following we show how these techniques can be used to model the different compliance strategies introduced in Section 2. Obviously. Dentcheva and Ruszczynski. An alternative. yet inefﬁcient way to model compliance with respect to a guideline is to formalize conditions (7) as set of mathematical inequalities which are introduced as constraints into the portfolio model.1] represents the weight or fractional P wealth invested in each asset ieI and n x1 ¼ 1 holds. if the model is instantiated with I :¼ I n INC : An example for a prominent ﬁnancial guideline using the accounts receivables ARi. given a ﬁnancial guideline g 2 G we have to calculate a ﬁnancial ratio ri(g) for each asset i 2 I which measures the level of involvement in a non-compliant ﬁnancial activity. ð10Þ and r i ðgÞ Á zi ! TðgÞ 8 i 2 I. 2006) or index tracking concepts (Corielli and Marcellino. The speciﬁc type of objective function and constraint set C is irrelevant for the following discussion and thus we keep these components on an abstract level to reduce complexity and focus on the essential aspects.

Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 Shariah strategies considered. Modeling portfolio compliance strategies A portfolio x fulﬁlls a speciﬁc guideline g if the sum of the ratio values over all assets i 2 I weighted by their share values xi is less than the threshold. Consensus/Ijmaa Shariah strategy To deﬁne Shariah-compliance under the Ijmaa strategy. Thus. 4. Additionally. i. ð25Þ and by introducing the following set of constraints: r i ðgÞ Á zi ðsÞ ! TðgÞ 8i 2 I. were retrieved using the software system MarketIQ. s0 say. 8g 2 G s ð28Þ with M a sufﬁciently large number. DJIM} and the set of total assets (TA) based for the associated portfolios of minimal risk strategies STA = {FTSE. as published in their annual ﬁnancial statements. s say. DJIM. X jSj Á zi 8i 2 I zi ðsÞ ! 2 s2S 8g 2 Gs ð19Þ ð20Þ The constraints (10) and (20) ensure that if X s2S zps ! jSj 2 ð29Þ x0 > 0 for an asset i 2 I then i zi ðsÞ ¼ 1 for the majority of s 2 S. HSBC. s Majority/Kasra strategy This strategy can be modeled using the binary variables zi for i 2 I and zi(s) for i 2 I and s 2 S which have been introduced before as follows: Constraints (26) are nonlinear and with respect to solvability of the optimization model should be linearized as follows: X i2I r i ðgÞ Á xi ð1 À zpðsÞÞ Á M þ TðgÞ 8s 2 S. For our study we have assumed an active portfolio management and we have implemented and based our comparison on the Markowitz mean-variance approach (Markowitz. S.e. risk and compliance consistency. X zi ðsÞ 8i 2 I xi s2S 8s 2 S. Here a portfolio is efﬁcient if it has minimal risk X i2I ri ðgÞ Á xi TðgÞ ð22Þ Now a portfolio x is compliant with respect to a strategy s 2 S if x fulﬁls all guidelines g 2 Gs . The analysis is based on the assets included in the Standard & Poor’s 500 (S&P500) index on the 17th of September 2007.e. FTSE. 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. i. the monthly total returns (annualized) and market capitalization values of the considered assets were retrieved from Bloomberg. i0 is compliant for the majority of strategies. which will be from now on referred to as the asset universe. Derigs. MSCI. ANON}. we have to replace (23) by: X i2I ri ðgÞ Á xi TðgÞ 8s 2 S. To measure the Shariah-compliance of the assets included in the asset universe. we can show that the Shariah-compliance strategies which we have developed and proposed in Section 2 perform better than portfolios following one of the basic Shariah strategies.e. the detailed ﬁnancial ﬁgures for the ﬁnancial year 2006 of the companies issuing the respective assets. ANON}. The identiﬁcation of these assets and their exclusion from the solution domain is accomplished through introducing a binary variable Liberal strategy To model the liberal compliance strategy we introduce the binary variables zi ðsÞ ¼ 1 if i is complaint w:r:t: s 2 S 0 otherwise ð15Þ zpðsÞ ¼ 1 if the portfolio x is compliant for s 2 S 0 otherwise ! r i ðgÞ Á xi TðgÞ 8s 2 S. 8g 2 G s ð24Þ . MSCI. Now due to (27) at least for one s 2 S. then all constraints of type (13) are fulﬁlled for g 2 G0 . we obtain zp(s0) = 1 and thus (28) and/or (26) hold for at least one s 2 S. Implementation – empirical results In the following empirical analysis we report results concerning the impact of the different compliance strategies on expected portfolio return.2. We have considered the following set of basic Shariah strategies S = {S&P. for a basic strategy s and the set of guidelines Gs we obtain the following portfolio optimization model: Min f ðxÞ subject to ð2Þ—ð4Þ and X i2I r i ðgÞ Á xi TðgÞ 8g 2 Gs ð23Þ The portfolio-based compliance strategies can now be modeled as follows: Best of Shariah strategy Again for the ‘‘best of” strategy the optimal portfolio is the one generated by the basic strategy s yielding the best portfolio performance.1170 U. The main purpose of this analysis is to make the potentials of the new strategies transparent. 8g 2 Gs and we replace (23) by: ð16Þ ð17Þ zpðsÞ Á X s2S X i2I 8g 2 Gs and ð26Þ ð27Þ The constraints (17) ensure that zpðsÞ ! 1 xi > 0 only if zi ðsÞ ¼ 1 for at least one s 2 S 8i 2 I 0 ð18Þ and thus if xi > 0 for at least one s 2 S. Based on the type of ﬁnancial ratios used these strategies can be categorized into two groups: the set of market capitalization (MC) based strategies SMC = {S&P. HSBC. 3. 0 ð21Þ which ensures that at least the majority of basic strategies s 2 S consider the portfolio as being compliant. Majority/Kasra strategy To model the majority strategy we replace in the model for the liberal strategy (27) by r i ðgÞ Á zi ðsÞ TðgÞ 8i 2 I. 8s 2 S. i.

78% 41. with the ﬁrst class of strategies we can obtain higher return at lower risk.00% 36.95% 3.56% 2. Now we report the results of our analysis for the different strategies and paradigms. Performance of basic Shariah strategies.e.95% P-5 14. to realize the maximal possible return much higher risk has to be taken.51% 9.1. As a reference we have also run the conventional model i.00% P-7 18.60% 13.U.50% 21.57% 0.00% 5. 2001).39% 53.00% 10.00% 0.04% P-5 12. . 2.48% 21. 3.77% 3.78% 10.79% Optimal Weights of Assets per Sector compliant under TA and not compliant under a MC Strategy Sectors / Sample Portfolios Utilities Consumer Discretionary Health Care Materials Sum of Weights P-1 13.e.03% 3.07% 3.31% 10.16% 21. Then we approximate the efﬁcient frontier by constructing the portfolio of minimal risk for ten equidistant return values between these extreme values. Also. SMC or STA.91% 14. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 1171 among all portfolios of the same return (or vice versa).94% 2. without any further reduction of the asset universe. i.80% P-11 24.00% 10. 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 presented to the investor to reduce complexity.40% 14.94% 8.32% 10. i.69% P-4 12. 2 the efﬁcient frontiers for the different strategies within one class are almost identical.22% 10. Optimal Weights of Assets per Sector compliant under MC and not compliant under a TA Strategy Sectors / Sample Portfolios Information Technology Health Care Consumer Staples Consumer Discretionary Materials Energy Sum of Weights P-1 0. 2003) and a 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 management (Jobst et al.18% P-9 21. We have implemented this approach as follows: For every model instance we ﬁrst calculate the possible return spread by constructing the two extreme portfolios which are efﬁcient: the portfolio with maximal (expected) return and the portfolio with minimal (expected) risk.85% 0. It is worth noting that strategies s 2 SMC perform only slightly worse with respect to return.00% 10.00% 70. in a preprocessing step we have reduced the asset universe by applying uniﬁed Shariah sector guidelines.32% 28. can be solved within a practical environment we have included two constraints 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% which can be interpreted as an example for a legal guideline (Derigs and Nickel.06% 52.62% 8.e.51% 49. we have run the portfolio model with the guidelines/constraints from the six basic strategies. S. are almost negligible.00% Fig..26% 3.88% 7.31% 13. 1) all the efﬁcient frontiers of the basic strategies s 2 SMC are above the efﬁcient frontiers of the basic strategies s 2 STA .59% 5. A closer look at the set of efﬁcient portfolios reveals that the difference in performance is not only attributable to the larger asset universe but stems from the fact that the constituents included Fig.01% P-11 40. the frontiers of all basic Shariah strategies are below the frontier for the conventional model without Shariah-compliance guidelines.42% 8. To show that the models are practical.00% P-9 9.05% 17. Of course. This explains why in Fig. Due to the fact that the basic strategies s 2 SMC result in a larger asset universe than the strategies s 2 STA (see Fig. Performance of basic Shariah-compliance strategies First.48% P-4 9. 2. Yet. The resulting efﬁcient frontiers are depicted in Fig.94% 12. Derigs.28% P-7 18. 4. In Section 2 we have already shown that the variations with respect to Shariah-compliance among basic strategies belonging to the same class. Weights of assets aggregated by sector compliant under DJIM and not under MSCI and vice versa.

The last line (sum of weights) of the upper part of Fig. S. . health care and consumer staples sectors which are not compliant under the TA-strategy MSCI. Fig. Derigs. then system- Fig. Sector-based comparison market capitalization vs. 3. This is reﬂected in Fig. One of the main reasons for this property is that in general the value of intangible assets such as intellectual properties. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 in the different asset universes and consequently the assets selected for investment portfolios differ highly among the efﬁcient portfolios of different strategies. Thus. companies belonging to the utilities (94%) and telecommunication (89%) sectors have a total assets value larger than their respective market capitalization value. total assets. Contrary. As you can see from Fig. This means that assets which contribute positively to the portfolio performance for DJIM are non-compliant under the MSCI strategy. Then. for DJIM as representative for a MC-based strategy and MSCI as representative for a TA-based strategy we have calculated the proportion of investment which is not compliant with respect to the other strategy and we have allocated the amount to the respective clusters. MC–TA mixed strategy. 5. most of the companies belonging to sectors such as information technology (85%). 4. If we consider the individual ﬁgures we can note that for instance DJIM results for almost all return levels in efﬁcient portfolios with a high proportion of wealth invested in assets belonging to the information technology. 3 shows that overall a signiﬁcant fraction of the optimal investments under the MC-strategy DJIM are into assets which are not compliant under the TA-strategy MSCI whereas the last line of the lower part shows that the reverse inconsistency is much less. 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. 4. for such companies market capitalization is usually signiﬁcantly larger than total assets and if two Shariah guidelines differ in terms of the divisor only. An information technology company such as Microsoft for instance is not capital intensive since most of the assets are in intangible form and currently valued on the market four times the total assets value. Here we have clustered the assets of the efﬁcient portfolios into six representative sectors. To further analyze this phenomenon we calculated for each sector the percentage of companies whose market capitalization is signiﬁcantly larger or smaller than total assets. which is almost the case for DJIM and MSCI.1172 U. patents and projects under development is not accounted for in the balance sheet of the respective companies and thus total assets are undervalued. health care (79%) and consumer staples (72%) have a market capitalization value which is larger than their total assets value.

7 reveals that these different levels of Shariah-compliance of the new strategies are reﬂected in performance. Inconsistency in classiﬁcation of new strategies vs. 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 underperformance compared to the MC-based strategies. the liberal strategy shows no inconsistencies and the majority strategy is more or less consistent with the TA-strategies. Such an effect does not show up for the usually market capitalization based strategy DJIM. the return and risk proﬁle as expressed by the efﬁcient frontier.e.e. basic strategies. i. Thus. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 1173 atically 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. 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. the difference between the asset universes analogously to the analysis shown in Fig. since the efﬁcient portfolios contain already all favorable companies. under the modiﬁed strategy the performance difference between MSCI and DJIM diminishes. 1 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). we believe that a more realistic evaluation would be achieved if the ﬁnancial ratios for companies from information technology. Derigs. Less conser- Fig. . health care and consumer staples are based on their market capitalization value whereas for companies from the utility and telecommunication sector their total assets values are used. 4. As can be seen. Performance of proposed strategies – Asset-based. we analyze the degree of inconsistency between the new strategies and the base strategies i. S. Performance of the new asset-based Shariah-compliance strategies First. With respect to type II error.U. 6 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. 7. Fig.2. As can be seen in Fig. the usually total assets based strategy MSCI now 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 performance. In fact. In Fig. 6. Fig. 5 we show the impact of this modiﬁed screening approach compared to the common approaches which are based on either total assets or market capitalization.

As expected. 8. .1174 U. the most conservative Ijmaa strategy performs worst. Portfolio-based versus basic asset-based compliance strategies. Fig. Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 vative strategies such as the liberal and ‘‘best of” strategy perform very similar and their frontiers are close to the conservative portfolio model and they clearly dominate the portfolios constructed using the Ijmaa or the majority strategy. Derigs. Fig. which is a logical result of the small asset universe (197 assets). 9. S. Asset versus portfolio-based compliance strategy.

The added-value of the portfolio-based compliance paradigm compared to the basic strategies currently used by Islamic funds and index providers can be identiﬁed in Fig. Yet.e. we can observe such an outperformance for the ‘‘best of” and the liberal strategy only on the extreme ends of the spread i. Our empirical analysis has clearly shown that if fund managers stick to the current Shariah strategies then they are better off employing market capitalization based ratios which outperform strategies which use total assets based ratios.e. 10). Marzban / Journal of Banking & Finance 33 (2009) 1166–1176 1175 Fig. Applying the new portfolio-based compliance paradigm the signiﬁcant differences in performance between the two classes of basic Shariah strategies. for low risk and high return levels. We have proposed new concepts for deﬁning Shariah-compliance leading to strategies by which portfolios can be constructed that achieve better portfolio performance than current Shariah strategies. The portfolios of the portfolio-based compliance strategies outperform the basic TA-based strategy MSCI signiﬁcantly whereas the MC-based strategy DJIM is outperformed slightly. all frontiers constructed under the new portfolio-based compliance paradigm are much closer to the frontier for the conventional portfolio model. Another effect could be observed which has not been expected at all. Conclusion Within this paper we have considered the problem of Shariahcompliant portfolio construction. the total assets based strategies which suffered from eliminating more assets from the universe are now comparable.U. Thus the new paradigm offers investors the opportunity to achieve nearly the same risk-return options as conventional funds but being Shariah-compliant. Also. Derigs. 9. 4. 5. Besides the necessary provision of such guidelines by the Shariah scholars the availability of modeling tools for setting up the Shariah-compliant portfolio optimization model is an important prerequisite. Considering 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.e. Certainly and most importantly. All concepts have been formalized such that they can be incorporated in every conventional portfolio optimization model by simply introducing appropriate sets of constraints. Performance of the portfolio-based compliance strategies When analyzing the effect of the new paradigm i. We also have proposed and justiﬁed a new paradigm which measures compliance on a portfolio level rather than individually for each asset. Our analysis shows that applying this paradigm results in portfolios which perform much better than their asset-based counterparts in terms of return and risk. S. To overcome these short comings a number of new concepts for deﬁning Shariah-compliance at different levels have been devel- oped 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. there is a signiﬁcant difference: while the asset-based Ijmaa and Majority strategies are clearly dominated by their portfolio-based counterpart. 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. though not mandatory for applying the new paradigm in practice. 8). Basic strategies – Portfolio-based compliance. This means that under the new paradigm the use of market capitalization does not lead to better performance anymore i. considering compliance as an attribute of the portfolio rather than the single assets we can see that for every new strategy the portfolios constructed under the portfolio-based compliance paradigm outperform their asset compliance counterparts (see Fig. s 2 SMC and strategies s 2 STA . 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. This requires a shift from the purely extensional 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. 10. Such a supporting system has been developed by the authors. diminish (see Fig. . 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.3.

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by Asad Khan

A review of UK FTSE 100 climate strategy and a framework for more in-depth analysis in the context of a post-2012 climate regime

by Tyndall Centre for Climate Change Research

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