Halal Money Matters

Episode 19: Can Islamic Investing Outperform?

Dr. Dawood Ashraf joins the show to discuss his research into the question of if and when the Islamic model of investing can outperform traditional investing.

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Halal Money Matters Podcast

Episode 19 – Can Islamic Investing Outperform?

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CHRISTOPHER PATTON: The thoughts and opinions expressed on Halal Money Matters do not necessarily reflect the views of Saturna Capital, Amana Mutual Funds, or their affiliates.

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CHRISTOPHER PATTON: Welcome to Halal Money Matters, presented by Saturna Capital. I’m Christopher Patton.

MONEM SALAM: And I’m Monem Salam.

CHRISTOPHER PATTON: Today’s episode is really seeking to answer a question and I want to know your take on this question before we jump in with our guest. And that is... does the Islamic model of investing outperform what we would call traditional finance?

MONEM SALAM: Yeah, you know, so we get this question a lot. You know, whenever we are out. Typically, people aren’t really... industry practitioners are not asking the question: they’re making a statement.

CHRISTOPHER PATTON: So, there is a strong belief, then.

MONEM SALAM: There’s a strong belief that’s out there.


MONEM SALAM: And so, it’s like, “Okay let’s dig into this a little further. Is there really something there?” Is really the idea. And so, you know, from a retail investment perspective, you know, yeah, they are happy, and they are proud of the fact that they would be outperforming but for them, it’s like... “As long as we’re not underperforming really badly,” then they should be fine with the Islamic principles. But I really like this episode because it kind of drills down into, “Okay, let’s talk about this outperformance. What does that really mean?”

CHRISTOPHER PATTON: Perhaps not surprisingly, this might be a harder question to answer. It may not be just a yes or no answer, shockingly. 


CHRISTOPHER PATTON: To help us dig into this question, we’re going to speak to Dr. Dawood Ashraf. He’s a Senior Research Economist at the Islamic Research and Training Institute. He has a PhD in Banking & Finance from the University of Wales.

MONEM SALAM: Yeah, and he’s really spent most of his professional life researching this exact topic that we’re going to be talking about today, so I’m really excited.

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MONEM SALAM: So, thank you, Dr. Ashraf, for joining us on this topic. You know, does Islamic investing really outperform? I think this is a question that comes up over and over again. As Muslims, we’re very, very proud of the fact that the answer, for us at least, is always yes. So, I think this is a good topic for us to discuss and really—from your research—which, Hamdullah, you’ve been able to do quite a bit of in this area, maybe you’ll be able to come up with an answer which is more succinct and maybe even truthful. What do you think, Chris?

CHRISTOPHER PATTON: Yeah, I’m curious, is the answer yes? We’ve settled on that? Sounds like we’ve answered the question. [laughter]

DAWOOD ASHRAF: Eh... The answer is yes and no as well. It depends on the time period that you’re looking at. Given my background, when I started... first, so I had that feeling that the Shariah screening helps investors to gain better returns for two major reasons. One is the absence of sin stocks from the portfolio and second is the lower leverage. So, having lower leverage means that when the market is going really, really down and financial stocks are beating up quite a bit, at that point in time the portfolio will act like... hedging against this whole situation. And with that view in my mind, I started my research on Islamic equity investing. And the initial results... I took the first one on the Saudi market as the Saudi market was the biggest market, still is the biggest market for the mutual fund investing. So, I looked, and I find that there are mutual funds that are performing better than their benchmark and there are other ones that are not performing better than the benchmark which simply tells me that there are some good managers and there are some bad managers.

MONEM SALAM: It makes more sense, I guess, to do it like a regular index to a Shariah index rather than an index to a manager, right? Because it does play into, you know, how good the manager is or if they’re on a good run and maybe he won’t perform three or four years later.

DAWOOD ASHRAF: Exactly, that’s what my thought was, immediately, once I finished that paper. Once I finished that research, I had the feeling that it’s maybe the manager. It’s not the Shariah screening standard or anything. So, the second piece that I worked on was basically looking at this specific question. And then, at that point in time, I thought maybe, like, if I pick a mutual fund and try to understand the performance difference, I may not be able to get the right answer. So, I worked with a colleague from Prince Mohammad University, and we looked into the performance of indices. And then, at that point in time, ideas were made more clear. Is it the performance all time or is it the performance during a downturn of the market and so on and so forth? So, this piece of research... what we did is, we used indices. So, this is now what we are trying. We are trying to compare apple with apple. So, the benchmark is an index, and the Shariah compliant equity investment is an index as well. So, we took out the manager. We took out the market timing. And then, as I mentioned to you, the idea was to look at whether this performance is, in general, every time we get it or is it specific to specific time periods. So, in that piece of research, what we found was that there is no evidence that the Islamic equity investment outperforms the conventional investments all of the time. However, we found that, at times, and especially during the times that the market is experiencing an extreme downfall. So, it’s not the downfall that we see, say, for example, after every three, four, five, weeks, we see the market is going down a few hundred points and then it recovers back. I’m talking about the market going down around twenty to twenty-five... more than 10%. And then, in those times, we see that the performance of the Islamic equity investments are better than the conventional investments. So, we look at the basic model of using the capitalist pricing to understand... what is the source of that performance deviation, if there is any? We consistently have observed that the downfall of the Shariah compliant investment vehicles are far less than the downfall of the general market. It was significant in terms of being a researcher. So, it was statistically significant. These are the things that are important. So, when we talk about the equity investments, there are several other things that we need to look at. And I must say that the performance difference could come from within the Shariah screening criteria. So, say for example, the major Shariah screening criteria that has come from these contemporary Shariah scholars are the Dow Jones Shariah screen criteria back in ’98-’99. These criteria used the quantitative screening by using the market value of equity. While there are other screening criteria that use the book value of equity as the basis for determining the leverage and all of the ratios for compliance status. So, if you look at these different standards then maybe there is a difference between the performance based on the Shariah screening standard. And what we found, time and again, is... first, let me put this how it was different. So, when you’re using the market value of equity as the denominator for the Shariah screenings, so what happens is when the market is going up, more quickly, those equities that are gaining value... they’re gaining in price, become Shariah compliant. And when the market is going down, those equities that are losing values quickly will be Shariah incompliant sooner. So, this way, the market mechanism can help. One side it could exacerbate. On the other side, it could be helpful in terms that it would help the fund manager to quickly make the decision to get out of the position. But at the same time, the manager is working with the portfolio which is kind of following the momentum strategy.

MONEM SALAM: That’s a really good point that you mentioned because conventional wisdom, or at least in the Islamic investing community is that, you know, during a bull market, when the markets are going up, the highly leveraged companies actually tend to outperform because they have the leverage. And then in the down market, the reason why Islamic investing outperforms is because those are the companies we never own and thus those are the ones that are falling the worst because they have debt, and they can’t pay their debts. That type of thing. Are you saying that might not be the case and it’s more about the fact that these momentum shifts that happen?

DAWOOD ASHRAF: See, the thing is... how an equity would be Shariah compliant is based on the denominator.

MONEM SALAM: Just for our listeners, the majority of the Shariah screens have a debt, total debt, to either market capitalization which is the denominator, or total assets, which is the denominator. And most of them have it between less than 30% to 33%. Just wanted to clarify.

DAWOOD ASHRAF: Exactly. So, what happens with this one is say, for example, if an equity is Shariah incompliant because of the debt leverage ratio, if the price of that equity stars rising, and it gets to the threshold level where it comes under 33%, so now in that case, if the price goes up so the Shariah compliant equity holder will benefit—if it buys it at a 33% point—will get benefit from the rise in price. So, he will get the whole benefit of the rise in price as soon as the equity touches the threshold point. Now, on the other side, as soon as the price of that equity started going down... so, it will become quickly Shariah incompliant as it breaks the ceiling of 33% or 30% whatever the number that the fund manager is following. And then, certainly, this could become incompliant, and it has to go out of the portfolio. So, this means that on both sides... on the upside, the fund manager can benefit from the rising price, and on the downside, it can protect itself as soon as it touches the floor. So, given the situation, personally, I believe that it will be beneficial to the equity holder but my concern most probably is on the Shariah compliance side. Are we getting into a speculative portfolio which basically follows a trend in the market? So, that needs to be addressed. That is one of the concerns when we are using the market value of equity. But on the other side when we are using the book value of equity, the adjustment in the market is too slow. Most of the time is it after almost one year. So, in one year time, the fund manager can hold on but during this time, whatever has happened to the stock in the market, the stock will remain in the portfolio. So, again, one or the other way there are issues that can raise in one or the other standards. So, the next piece of my research that I looked at was whether there was a difference in performance based on the Shariah screening standard. So, this happened in 2016 and I had the data until 2014. So, given that period of time, we did find that the book value of equity being a more stable approach of Shariah screening was kind of more favorable to the Shariah compliant equity investors. However, when we did the same analysis in 2021, during the covid and after covid... during this time there was an extreme shortfall in March of 2020 and thereafter the recovery. And what we found was that the market value of equity in fact helped the Shariah compliant investors to gain better returns than the book value of equity investors.

MONEM SALAM: So, that’s more like... more short-term in nature. From 2014 to 2016, and then now.


MONEM SALAM: But we always are, you know, talking to our shareholders about long-term investing. You know, five-year, 10-year, 15-year. Most people, when they do invest, they are trying to build wealth, right? Not make money.


MONEM SALAM: So, what happens in that situation?

DAWOOD ASHRAF: See, in that... like, the first piece of research, as I mentioned in 2014, it was 2008 to... about six years on the horizon. But this one that I’m talking now about, this covid period, is only two years. And that is something that I believe that there is a need, maybe, standardization. As you started talking, you try to explain how these two different standards work.


DAWOOD ASHRAF: So, for any ordinary investor, it is always difficult to decide which is better and why do you have several standards? So, I think it may be a responsibility of the scholars’ community as we’re from the investment side, that we should try to reach to a point that is kind of uniform and try to get to a point which is more acceptable to everybody and then it would be very helpful for the investor as it will reduce confusion about which Shariah standard is a good one and which is not as good as the other one.

MONEM SALAM: And that purely has to be done based on Shariah and not based on what outperforms, one or the other. Right? Obviously.

DAWOOD ASHRAF: For sure not. For sure not. That’s why, like, when I say that we need to think very clearly, it is important for the transparency for the investors as well. An investor who is coming with faith in mind does not have to make decisions which way to go. It has to be transparent, straightforward, and should not be different kinds of scenarios.

MONEM SALAM: I think the scholars have done a good job. What I have found is that really, even in finance, there’s a disagreement on how you value a company. You know, whether it’s on assets, whether it’s on market value, enterprise value, those types of things. So, they’re coming at it from a Shariah perspective but even in finance there’s a difference of opinion as to how you do that. That shows up in the Shariah criteria as well, also. So now, going back to this area, has there been any research done, for example... so the Dow Jones Index came out roughly around 1997 or so and that was, you know, during the kind of right in the middle of the Dot Com kind of increase and then there was a crash and other things have happened. But have you done any analysis of, let’s supposing the Dow Jones All World, for example, and the Dow Jones Islamic Index over that longer period of time? That twenty, twenty-five years or so?

DAWOOD ASHRAF: No, I did not do that. That’s a good idea. I think I should look at it now.

MONEM SALAM: We might have you on another podcast to talk about that one, then.


MONEM SALAM: Hamdullah.

DAWOOD ASHRAF: What we have done recently, and for that we used a little bit of a trick to construct our own portfolios, is we took from CRSP, the data since 1976 to, if I’m not wrong, 2017. And then, based on the constituent S&P 500, we created Shariah compliant indices right from the beginning. Our business screening criteria was not very good. Like, we just used an ad hoc approach where we took out all of the financial institutions. Then we applied the... just the leverage ratios and all of those ratios. What we found... that’s interesting, I think if there is a difference in performance it would not be as much because of our ad hoc approach to the business screening. We find that the Islamic equity investments, in fact, has performed, over the longer period, better than the conventional one. But what’s interesting is that is we use a smart beta strategy... Say, for example, if we are using a lower-risk investment strategy, basically a low-volatility investment strategy, we found that the price of Islamic equity investments was far better than the performance of market capitalizing-based S&P 500. So, the same time period, the only difference is that the weighting that we have applied is not based on the market capitalization, it is based on the riskiness of the stocks. So, the higher the volatility of the stock, the lower the weight in the portfolio. And then, amazingly, the results were amazing. If I’m recalling properly, I think over the period of 25 years on an annual basis our return was like 1.5% or 2% higher than the return of the S&P 500. I’m talking about, on average, annually.

MONEM SALAM: That’s a pretty good number.

DAWOOD ASHRAF: That’s a pretty good return. Pretty good number.


DAWOOD ASHRAF: So, that is something that we all need to look at. That market capitalization is not the only approach to construct portfolios. There are other ways maybe more suitable for Islamic equity investments. Especially the fundamental weighting technique could be really helpful for the Islamic equity investors because the companies that are really good in doing their business usually are less leveraged, more dividend-paying, so this was the total return for those companies which are having higher fundamental value would be more beneficial to the investors. Especially when, as you mentioned earlier, that the investment is long-term. So, given the long-term horizon, it would be good for the Islamic equity investors to look at portfolios which are constructed not purely based on market capitalization. Rather, there are other ways to do that. In finance we call them smart betas. But you can call it some other name as well.

MONEM SALAM: So just as a recap. For example, then, from that perspective, if you look at low volatility portfolios, there is a statistical difference and maybe the Islamic ones do outperform, but generally speaking on an index-to-index comparison, over a longer period of time as you mentioned, there was statistically no differences, but for periods of time in the middle, let’s say when there were crises or market correction, there was some sort of opportunity for Islamic investors to outperform in the funds that they have. Is that pretty much a good summary?

DAWOOD ASHRAF: Oh yes. What we need to look at whenever we talk about Islamic equity investments, as Monem has mentioned about the low volatility, is it’s just not the low volatility in the portfolio. You took out sin stocks as well. So, you are more comfortable investing in the companies that you are basically not only getting the return but also you are performing your social duty as well where you are investing in those stocks that are more useful to society.

MONEM SALAM: For me, there are two lessons, right? One is that if you can stick to your beliefs and be able to just as good as the market on an index level then why not, right? Because you will feel more comfortable with it, you’ll be able to sleep better at night, and maybe also you’ll be in a better place in the afterlife as well. Right? So, that’s one aspect of it. But the second part of it, then, it speaks to then, you know, another way to put it would be then, the active management is what could drive the portfolio to do better than an index. And so, you know, active management on the Islamic side would probably then, lead to possibly outperformance over just putting it into an index.

DAWOOD ASHRAF: Yes, and the other thing is if you are comparing the performance of an Islamic fund manager, I always say that you cannot compare the performance of an Islamic fund manager with the performance of the S&P 500. It has to be S&P 500 Shariah so that you are comparing apple with apple. You are not paying your manager for something that you could achieve without hiring a manager. So, if you’re hiring an active manager, it has to be pure performance and then alpha which is produced by the manager, not by the strategy of the investment.

MONEM SALAM: Yeah, that’s a good point.

CHRISTOPHER PATTON: Have you done any research into sukuk and how that compares? What would you be comparing it to? That kind of relationship?

DAWOOD ASHRAF: With the sukuk, you cannot compare the performance of sukuk with that of a bond. The reason is both are debt instruments. They don’t compare with each other in the sense that the fund managers are competing for funds in the case of the Islamic equity investments and the conventional investment. So, what you see there is you try to compare the price, whether somebody... a company, which is issuing a sukuk, do they have high cost of funding as compared with issuing a bond? In those cases... and then, like, the issue with a debt issuance within that... the rating of the institution, the rating of the project, so it is a bit difficult to compare in a meaningful way. So, I never had that opportunity. I tried it a couple of times on an index-to-index level basis. I was not feeling comfortable that the findings I was getting were really from the index performance. Was it because of the economic environment that we are in? So, that’s why I decided to stay away from that. One good thing that I see in the sukuk market, especially in the past... let’s put it five years, and especially the last couple of years, is that the sovereigns are more active in the market, especially from the GCC on one side. And secondly is that the kind of issues that are coming from green sukuk, performance based sukuk, all of these things are really interesting and that basically tells us that the Islamic finance industry is growing and it’s maturing and is able to offer instruments at least which are comparable to what the conventional side is offering.

MONEM SALAM: Thank you for the research that you have done and will continue to do. I think that goes a long way for everybody to have a better understanding of it because the more we know, the better decisions we can make, right? That’s kind of the idea.

DAWOOD ASHRAF: It’s a good thing that you guys are working on, helping investors to understand what they are investing in and Shariah screening standards and the performance of Islamic equity investments is an important area and I believe that this conversation will help your audience to better understand the drivers of performance of Islamic equity investments.

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