Asset pricing factors in Islamic equity returns

• Published date: 01 June 2021
• Author: Md Safiullah,Abul Shamsuddin
• Date: 01 June 2021
• DOI: http://doi.org/10.1111/irfi.12290

ORIGINAL ARTICLE

Asset pricing factors in Islamic equity returns

Md Safiullah

1

| Abul Shamsuddin

2

1

Department of Economics and Finance, La

Trobe Business School, La Trobe University,

Bundoora, Victoria, Australia

2

Newcastle Business School, The University

of Newcastle, Newcastle, New South Wales,

Australia

Correspondence

Abul Shamsuddin, Newcastle Business School,

The University of Newcastle, Newcastle, New

South Wales 2300, Australia.

Email: abul.shamsuddin@newcastle.edu.au

Abstract

Previous studies have compared risk–return characteristics

of Islamic equity indices with their conventional counter-

parts, which may produce spurious results because a con-

ventional equity index includes both Islamic and non-Islamic

constituents. Hence, this study compares Islamic equity

portfolios with their non-Islamic counterparts. We find that

aggregate Islamic equity portfolios generally outperform

non-Islamic equity portfolios after controlling for the five

asset pricing factors—market, size, value, profitability, and

investment (Fama and French, 2015). The average cost of

equity is 2.77 percentage points lower for Islamic firms

compared to non-Islamic firms. The findings hold for the

various segments of the global equity market, and remain

robust when the interest rate-augmented and the liquidity

factor-augmented versions of the Fama–French five-factor

model are employed. The GRS test results suggest these

asset pricing models may not be adequate for pricing both

Islamic and non-Islamic equities.

KEYWORDS

asset pricing, interest rate risk, Islamic equities

JEL CLASSIFICATION

G10; G12

1|INTRODUCTION

Asset pricing literature has proliferated following the introduction of the Fama–French three-factor model

(Fama & French, 1993), which explains the variation in expected excess return on a security using the market,

size, and value factors. The momentum factor was later added to the model by Carhart (1997); however, in a

Received: 21 September 2017 Revised: 4 August 2019 Accepted: 26 October 2019

DOI: 10.1111/irfi.12290

© 2019 International Review of Finance Ltd. 2019

International Review of Finance. 2021;21:523–554. wileyonlinelibrary.com/journal/irfi 523

recent article, Fama and French (2015) omitted this factor and introduced two additional pricing factors: profit-

ability and investment. They defined the former as the difference in returns between robust-profitability stocks

and weak-profitability stocks, while the latter is the difference between the returns on low-investment stocks

(firms that invest conservatively) and high-investment stocks (firms that invest aggressively). Fama and French

(2015) argued that the five-factor model better explains returns than their three-factor model, because the profit-

ability and investment factors convey information about expected returns. They later show that the five-factor

model can better explain several anomalies in returns (Fama & French, 2016, 2017). Hou, Xue, and Zhang (2015)

come to a similar conclusion, using a model that includes all but the value factor from the Fama–French five-

factor model.

The Shariah screening process omits firms with more than a threshold level of financial leverage and engaging in

economic activities that are not consistent with Islamic principles. Subsequently, the Shariah screening process may

expose Islamic equities to different sources of risk than their non-Islamic counterparts.

1

For this reason, Islamic equi-

ties can be viewed as a separate asset class. However, the use of mainstream asset pricing models in pricing Islamic

equities is in its infancy. We aim to expand on the literature in the context of the global Islamic equity portfolios that

are developed by Dow Jones.

First, previous studies have predominantly used the capital asset-pricing model (e.g., Akhtar & Jahromi, 2017;

Ashraf, 2016; Hayat & Kraeussl, 2011; Ho, Rahman, Yusuf, & Zamzamin, 2014; Sensoy, 2016) or its interest rate-

augmented version (Shamsuddin, 2014) to examine the risk exposure of Islamic equity portfolios. With reference to

the multi-factor asset pricing models, Walkshäusl and Lobe (2012), Mohammad and Ashraf (2015), and Nainggolan,

How, and Verhoeven (2016) use Carhart's (1997) four-factor model, while Ashraf, Felixson, Khawaja, and Hussain

(2017) use Carhart's (1997) model augmented by the leverage and investment variables. Unlike our predecessors, we

use the Fama–French five-factor model as the base asset-pricing model to estimate the exposure of an Islamic equity

portfolio to the factors of size, value, growth, profitability, and investment. No previous study has examined the

empirical validity of the mainstream asset-pricing models for pricing Islamic equities. We fill this gap in the literature

by employing the GRS test (Gibbons, Ross, & Shanken, 1989) of the joint null hypothesis where the risk-adjusted

return is zero across a range of sectoral or aggregate Islamic equity portfolios. This test is applied to the Fama–

French five-factor model, its interest rate-augmented version, its liquidity-augmented version, and its restricted ver-

sion where the value factor is omitted (Hou et al., 2015). This analysis evaluates the applicability of the mainstream

asset pricing models in pricing Islamic equities.

Second, previous research on Islamic equity markets generally compared risk–return characteristics of Islamicequity

indices with those of the corresponding conventional equity indices that include both Islamic and non-Islamic constitu-

ents (seeAshraf, 2016; Ho et al., 2014;Mohammad & Ashraf,2015). An exception tothis is Akhtar and Jahromi's(2017)

study on the mean–variance efficiency of Malaysian Islamic and non-Islamic stocks.

2

Any observed difference in risk–

return characteristics between an Islamic equity portfolio and its conventional counterpart reflects the joint effects of

the Shariahscreening processand market share of Islamicequities in the conventional portfolio. Unlikeprevious studies,

we test thedifference in risk-adjusted returnsand factor betas between Islamicand non-Islamic equityportfolios.

Third, the asset pricing models are extensively employed to estimate the cost of equity capital in the mainstream

finance literature (Fama & French, 1997; Griffin, 2002; Pratt & Grabowski, 2014). Firms complying with Islamic principles

have little or no financial leverage and their core businesses are restricted to activities that conform to Islamic practices.

Thus, Islamic firms are underrepresented in some sectors

3

and they are expected to differ from non-Islamic firms in terms

of the capital structure, dividend and investment policies. All of these characteristics can affect the cost of capital within

an asset pricing model through their effects on factor betas.

4

Consequently, there are a priori reasons for the different

cost of equity between Islamic and non-Islamic firms. We empirically verify this proposition using alternative asset pricing

models.

This article proceeds as follows: Section 2 presents the literature review and research motivation, Section 3

describes the properties of Islamic and non-Islamic equity returns, and Section 4 provides asset pricing tests and the

main results. This is followed by a robustness check and conclusion, respectively, in Sections 5 and 6.

524 SAFIULLAH AND SHAMSUDDIN

2|LITERATURE REVIEW AND RESEARCH MOTIVATION

2.1 |Principles of Islamic finance and Shariah screening of equities

Islamic finance refers to activities pertaining to the investing, financing and distributing of profits to shareholders,

which are undertaken in accordance with Shariah principles (Islamic law). These principles impose the prohibitions of

interest (riba),

5

excessive risk-taking (gharar), and business activities that Islam deems will harm the well-being of

individuals and society (Iqbal & Mirakhor, 2011; Naughton & Naughton, 2000).

In a market economy, the interest rate is considered to be compensation from lendersto borrowers for postpon-

ing consumption and the inflation-induced erosion of the value of money. Islam prohibits such a compensation pay-

ment because it considers money to be a pure medium of exchange, not an asset for generating positive cash flows.

Intertemporal trading of money is viewed as a mechanism for earning a return assuming little or no risk, usually

involving exploitation of the weak by the strong (Ahmed, 1989; El-Gamal, 2001). In Islam generally, fixed-income

securities are not viewed as permissible financial instruments because they involve trading more future money for

less present money without transferring ownership of assets. As a substitute of interest-based financing, Islam pre-

scribes a profit-and-loss sharing (PLS) arrangement between suppliers and users of funds (Bashir, 1983).

Islamic law also prohibits financial transactions that involve excessive risk-taking (gharar) because they yield

highly risky payoffs, and are often based on optimism backed by wishful thinking rather than economic fundamen-

tals. It is difficult for economic agents to estimate the value of state-dependent payoffs, where states are highly risky

or ambiguous with unknown probabilities. Excessive risk-taking often involves a zero-sum game, resulting in exploi-

tation of one party's wealth by another party (El-Gamal, 2006; Iqbal & Llewellyn, 2002). Also prohibited in Islam are

the financing, manufacturing, distribution and consumption of the following goods and services: alcoholic beverages,

gambling or gambling activities, pork products, adult entertainment, interest-based financial services, tobacco, intoxi-

cating drugs and defense products (Siddiqui, 2007).

Investment in Islamic equities was first facilitated by the Dow Jones in the mid-1990s by developing Islamic

equity indices (Dow Jones, 2016). The Shariah supervisory board (SSB) of Dow Jones uses a two-stage equity

screening process to ensure that Islamic finance principles are maintained. The screening process is summarized in

Table A1 in the appendix.

The Dow Jones SSB uses qualitative screening at the first stage to exclude companies whose main businesses

are in any of the following sectors: alcohol, pork-related products, conventional financial services (interest-based

banking, conventional insurance, etc.), entertainment services (hotels, casinos/gambling, cinema, pornography, music,

etc.), tobacco, and defense products. In the second stage, in an effort to comply with the prohibition of riba (interest

income) or other impure income, the Dow Jones SSB includes businesses in an Islamic index that comply with the

requirements. Specifically, each of the following three financial ratios are less than 33%: (a) the ratio of total debt to

trailing 24-month average market capitalization; (b) the ratio of the sum of cash and interest-bearing securities to

trailing 24-month average market capitalization; and (c) the ratio of accounts receivables to trailing 24-month aver-

age market capitalization (Dow Jones, 2016). Firms whose core business activities comply with Islamic principles

may be allowed to generate less than 5% of their total revenues from non-permissible activities. This provision rec-

ognizes that in the normal course of business, an Islamic firm must be linked with other economic agents regardless

of their religious denomination.

2.2 |Risk–return characteristics of Islamic equities

Risk–return characteristics of Islamic equities may differ from their conventional counterparts due to the application

of religious screening discussed above. In the Islamic finance literature, a number of studies compared risk–return

characteristics of Islamic and conventional stock portfolios using the market model. Hussein (2004) found that the

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