Combining momentum, value, and quality for the Islamic equity portfolio: Multi-style rotation strategies using augmented Black Litterman factor model

Abstract

This study constructs active Islamic portfolios using a multi-style rotation strategy, derived from the three prominent styles, namely, momentum, value, and quality investing. We use the stocks that are consistently listed in the U.S. Dow Jones Islamic index for a sample period from 1996 to 2012. We also include two macroeconomic mimicking portfolios to capture the premiums of industrial production growth and inflation innovation, accommodating the economic regime shifts. Based on the information coefficients, we find the six-month momentum and the fractal measure as momentum factors; the enterprise yield (gross profit/TEV) and the book to market ratio as valuation factors; the gross profit to total assets, the return on capital, and the scaled total accruals as quality factors. We further construct active portfolios using the augmented Black Litterman (ABL) factor model to avoid the factor alignment problem, with the factor views predicted using Markov Switching VAR, MIDAS, and Bayesian Model Averaging. The out-of-sample performance of our portfolios can produce information ratios of 0.7-0.8 over the composite indices, and information ratios of 0.42-0.48 over the style indices, with the annualized alphas of 10-11%. Even when we put the constrained tracking error of 1% over the benchmark, our portfolios still produce information ratios of 0.9-1.2 before transaction costs, and 0.6-0.8 after transaction costs. We provide intuitive explanations for each premium changing over time, and suggest the promising strategy for Islamic equity investors to outperform the market.

Do Islamic stock indices perform better than conventional counterparts? An empirical investigation of sectoral efficiency

“…On an interesting note, the comparison between Islamic and conventional counterparts shows that generally, the efficiency ranking seems to follow a similar trend with few differences (Table 3). One difference which stands out and has been explored in the works of Milly and Sultan (2012), Al‐Khazali et al (2014), Jawadi et al (2014), Ho et al (2014), Rizvi et al (2015) and Dewandaru et al (2015) regarding the merits of Islamic stocks being more grounded in the real sector and attract fundaments based investors is evident in our longer term efficiency. Although the ranking of sectoral efficiency may be similar to their conventional counterparts, the Islamic sectoral indices generally tend to exhibit a higher efficiency regime across the last decade.…”

“…The MFDFA is proficient in measuring the efficiency as it allows us to sequentially rank the individual efficiency of market. MF‐DFA has recently become popular in the financial literature with Rizvi, Dewandaru, Bacha, and Masih (2014), Dutta, Ghosh, and Samanta (2014), Horta, Lagao, and Martins (2014), Batten, Kinateder, and Wagner (2014), Arshad and Rizvi (2015), Dewandaru, Masih, Bacha, and Masih (2015), Arshad, Rizvi, Ghani, and Duasa (2016), all focusing on the fractal nature of financial markets to investigate their behaviour under new light. Furthermore, it can determine the extent of the inefficiency.…”

Issues in Islamic banking and finance: Islamic banks, Shari’ah-compliant investment and sukuk

“…This finding suggests that investors stand to benefit by allocating their financial resources to Islamic stocks. Dewandaru et al (2015) elaborate further on the potential of Islamic equity investors to outperform the market. In their paper, they construct active Islamic portfolios using multi-style rotation strategy on the basis of momentum, value and quality investment strategies and apply Black-Litterman factor model for the analysis.…”

Is momentum trading profitable from Shari'ah compliant stocks?

“…This particular evidence may carry significant implication for Asian markets as several studies have reported that Asian markets are particularly more efficient during economic boom when compared to busts (Arshad & Rizvi, 2015; Arshad, Rizvi, Gairuzazmi, & Duasa, 2016). Momentum has recently been investigated by Dewandaru, Masih, Bacha, and Masih (in press‐a) and Dewandaru, Masih, Bacha, and Masih (in press‐b). They largely argued that using MF‐DFA strategy can produce 6.12% excess momentum return.…”