Macro-financial regimes and performance of Shariah-compliant equity portfolios

Abstract

This study proposes the Markov Regime Driven Style allocation (MRDS) strategy for Shariah-compliant portfolio construction, a forward-looking methodology that merges economic forecasting with Shariah-compliant investment principles. By using Shariahcompliant equities from the S&P 500 universe over the period 1986-2016, we find that a Shariah-compliant investor can achieve stable performance by dynamically allocating across investment styles determined from the macro-financial information, as compared with various single style strategies. The MRDS improves both the level and stability of relative performance. This strategy also successfully mitigates risk by reducing volatility, value-at-risk, and portfolio drawdowns. Ó 2019 Elsevier B.V. All rights reserved. ''Investment strategies will also wax and wane, performing well in certain environments and performing poorly in other environments." [Andrew Lo, 2004.] The two-fund separation theorem of Tobin (1958) prescribes that mean-variance efficient investors allocate their portfolio to a risk-free asset and risky assets with the aim to maximize their expected returns at a given level of risk. While the result has been seminal in modern finance theory, it is of little relevance for the Shariah-compliant equity investor due to business and finance-related restrictions. A Shariah-compliant investor may not invest in the shares of those companies engaged in the production of goods and services related to alcohol, tobacco, gambling, adult entertainment, weapons, swine, media and broadcasting, borrowing and/or lending based on Usury (interest), or game of chance (excess speculation). The restrictions on investments reduce the investable universe of equities for Islamic investors (Arslan-Ayaydin et al., 2018; Ashraf, 2016). Implementing those restrictions involves screening stocks from an investment universe and then selecting an asset allocation strategy. Ashraf and Khawaja (2016) structured Shariah-compliant equity portfolios using a market-capitalization approach and found that Shariah screening reduces the investable universe to almost half with minimal difference in performance as compared with unscreened portfolios. As an alternative, Boudt et al. (2017) investigated the use of so-called

How resilient are Islamic financial markets during the COVID-19 pandemic?

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Sector Portfolio Performance Comparison between Islamic and Conventional Stock Markets

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Performance-sharing optimization by risk-constrained equity investors

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