Doing well while doing good: The case of Islamic and sustainability equity investing

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Doing well while doing good: The case of Islamic and sustainability equity investing Wajahat Azmi a,*, Adam Ng a,b, Ginanjar Dewandaru a, Ruslan Nagayev c b

a International Centre for Education in Islamic Finance (INCEIF), Kuala Lumpur, Malaysia Oxford Centre for Islamic Studies and Global Economic Governance Programme, University of Oxford, UK c Istanbul Sabahattin Zaim University, Turkey

Received 15 August 2018; revised 23 January 2019; accepted 1 February 2019 Available online ▪ ▪ ▪

Abstract The objective of this paper is to investigate the notion of “doing well while doing good” through examining the performance of Islamic, sustainability, and Islamic sustainability equity indices and comparing against the global equity market benchmark. Specifically, we address three key issues that are of concern to most investors: (i) how different are the global portfolio's efficient frontiers that comprise the four types of equities?; (ii) what are the driving factors behind these index performance differences?; and (iii) do the performance and volatilities of these four indices vary across time-periods and regimes? Overall, our findings reveal that investors do not have to pay a price for being Islamic or sustainable while investing. In fact, combining Islamic and sustainability investing strategies are more rewarding, particularly during the economic boom, bullish equity markets and subprime crisis periods. Policy implications are provided. _ Copyright © 2019, Borsa Istanbul Anonim S¸irketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NCND license (http://creativecommons.org/licenses/by-nc-nd/4.0/). Keywords: Islamic equity; Sustainability investing; Wavelet analysis; Efficient frontier; Bayesian model averaging; Markov switching

1. Introduction Sustainable, responsible and impact investing (SRI) (also known as sustainable investing/socially responsible investing and ethical investing) has witnessed significant growth and acceptance in the global financial industry, particularly in the last decade.1 It has been hailed as one of the significant developments in the financial industry (Bauer, Koedijk, & Otten, 2005). Global SRI assets rose 61 percent, from $13.3 trillion at the outset of 2012 to $21.4 trillion in 2014. As a result, the assets employing sustainable investing strategies have risen from 21.5 percent to 30.2 percent of professionally managed assets (GSIA, 2015). At the same time, Islamic finance has * Corresponding author. E-mail address: [email protected] (W. Azmi). _ Peer review under responsibility of Borsa Istanbul Anonim S¸irketi. 1 The terms socially responsible investment, sustainable investment, and ethical investment are used interchangeably in the paper.

also progressed on a double-digit growth trajectory, with an increase from $200 billion in 2003 to $1.8 trillion by the end of 2013 (Kammer et al., 2015). However, the growth has slowed to a single digit in last few years (Dar 2017). Within the Islamic asset allocation universe, equity funds represent one-third of Islamic funds worldwide. Islamic equity indexes have proven to be valuable to Islamic fund managers, who have been benefiting from the standardized screening methodologies and growing number of Shari'ah-compliant securities, as well as to those investors searching for portfolio diversification and ethical investment opportunities (IFSB, 2015). SRI is a broad term that encompasses any investment strategy that fulfills the investors' financial objectives along with their concerns about the environmental, social, and governance (ESG) issues (Mu~noz, Vargas, & Marco, 2014). In essence, SRIs have dual objectives: to generate financial returns and nonfinancial utility (ESG benefits). Along these lines, Islamic investing can be categorized as a subset of

https://doi.org/10.1016/j.bir.2019.02.002 _ 2214-8450/Copyright © 2019, Borsa Istanbul Anonim S¸irketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/). _ Please cite this article as: Azmi, W et al., Doing well while doing good: The case of Islamic and sustainability equity investing, Borsa Istanbul Review, https:// doi.org/10.1016/j.bir.2019.02.002

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socially responsible investing. However, the main difference between the two is the guiding principles that dictate the screening criteria. The screening criteria of Islamic investing are based on religious guidance, whereas socially responsible investing relies solely on what society or a group of people perceive as ethical, sustainable, and promoting good governance. Because both these types of investments are guided by different principles, at times, an investment can be considered to be ethical, but it may not be Islamic. Islamic investing norms screen out businesses engaged in immoral activities such as production of weapons and gambling (on the basis of qualitative criteria) and firms that exceed a certain level of leverage and interest-bearing investments (on the basis of) quantitative criteria. Large non-compliant firms are generally excluded from the pool of investable assets. This restricts the Shari'ah-compliant investable universe and increases the volatility of the portfolio because of its underdiversification, preponderance of smaller firms, and sector concentration (Hussein & Omran, 2005).2 Yet some studies have shown that levered firms also tend to have lower current returns but volatile stocks (Black, 1976; Christie, 1982). On the positive side, the low leverage and asset-backed nature of Islamic equities imply that the real and financial sectors are closely linked, limiting exposure to volatility spillovers (Majdoub & Mansour, 2014). In short, the viability of Islamic equity as a diversifier to conventional equity has been scrutinized in the literature, with a range of findings.3 Considering the significance of the investment universe and its implications for asset allocation, this study explores whether there is a cost attached to investing in a sustainable/ ethical manner from the Islamic and/or sustainability perspectives. This question has been examined before. Opponents argue that such an investment strategy will always deliver inferior risk-adjusted performance because it suffers from underdiversification and suboptimal mean-variance in the portfolio (Markowitz, 1991). However, a growing body of literature is yielding mixed results (Belghitar, Clark, & Deshmukh, 2014). Most of these papers argue that these investment strategies are on par with the performance of their conventional counterparts.4

2 As of March 2015, the Dow Jones Islamic Market World Index has only 2590 components, compared to the global universe of 7257 components in the Dow Jones Global Index. Islamic equity indexes are typically focused on growth and small-cap equities, while conventional indexes are oriented toward value and mid-cap equities (Girard & Hassan, 2008). The effect of the concentration on small firms and certain sectors on performance is debatable. Hussein and Omran (2005) argue that basic materials, consumer cyclicals, industrials, telecommunication industries, and small firms are the driving forces in the positive abnormal returns of Islamic index. 3 In the mainstream conventional financial market, studies on global stock return co-movements and time-varying world market integration have been conducted by Bekaert and Harvey (1995), Bekaert, Hodrick, and Zhang (2009), and Baele, Bekaert, and Inghelbrecht (2010), among others. 4 The number of Islamic asset classes has increased over the years as investors have become more religiously conscious. This implies that the meanvariance would not be substantially affected. Also, in the early days of Islamic investment, these asset classes formed a very small portion of the overall universe, contributing to higher screening costs.

This study revisits the debate on the notion of “doing well while doing good” by examining the performance of two investment strategies: sustainable investing and Islamic investing. Specifically, it compares the performance of sustainable equity, Islamic equity, and Islamic sustainable equity (as the mixture of two approaches) to the global equity market benchmark. The samples of this study are derived from four major indexes offered by Dow Jones: the Dow Jones Islamic Market World Index (DJ Islamic), the Dow Jones Sustainability World Index (DJ Sustainability) and the Dow Jones Islamic Market Sustainability Index (DJIS), with the Dow Jones Global Index (DJ Global) serving as a market benchmark. This paper extend the literature in several ways. First, we examine the risk-adjusted returns and efficient frontiers of both the Islamic and sustainability indices not only at the level of individual equity asset class but also at the portfolio level of “mixed” global asset classes. Second, we examine the factors driving these indices in the form of factor premium (market, size, value and momentum) within the factor model. In that case, we apply Bayesian model averaging in order to estimate the factor contribution within the appropriate model. Third, we examine the performance during different economic conditions across different regimes, corresponding to investors' preference for both strategic and dynamic asset allocations. The regime changes are determined based on Markov switching analysis. These regimes include the subprime crisis, the Dotcom crisis, economic expansion, equity bullish and bearish period, high default and low default premium, as well as high term premium and low term premium. Fourth, since most of the previous studies have analyzed these indices at the portfolio level and the volatility aspects of these indices are largely ignored, we examine the volatility dynamic of these indices by using multivariate generalized autoregressive conditional heteroskedasticity (MGARCH) analysis. Finally, to accommodate the needs of investors with respect to their varying investment horizons, we assess the co-movements among the indices across multiple timescales (4, 8 to 512 and 1024 days) using Wavelet analysis. This method of analysis would enable us to identify diversification opportunities across different horizons of investment, if any, between the indices. Precisely, besides investigating the performance, this paper address several unexplored issues: a) how different are the global portfolio's efficient frontiers that comprise the four types of equities?; b) what are the driving factors behind these index performance differences?; and c) do the performance and volatilities of these four indices vary across time-periods and regimes? To answer such questions, we use novel methodologies such as wavelet coherence, MGARCH, Bayesian model averaging, Markov switching and efficient frontier analyses. We report three new findings. First, the most efficient frontier is that of DJ Islamic portfolio, except during the Dotcom crisis. This is in sharp contrast to the traditional portfolio

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theory which argues that the screened portfolios suffer from diversification issues. Second, the main driver of DJ Islamic is value and size investing followed by momentum investing.5 This suggests that DJ Islamic comprises of small-value stocks which possess the two best qualities: size and value. These results are similar across DJIS and the DJ Sustainability. On the other hand, value and momentum are more important in case of DJ Global. Third, there is a high degree of co-movements of the 4 indices across multiple timescale (4, 8 to 512 and 1024 days) over 1996e2014. These findings indicate minimal diversification opportunities for those who wish to invest in these indices. The lack of diversification is evident in not only short run but long run as well. These results are not in line with the extant literature. For instance, Saiti et al., (2016) report no contagion between Islamic and conventional index whereas Najeeb, Bacha, and Masih (2015) argue that the co-movement is contingent on the time-scale. In the next section, we briefly discuss the literature followed by the description of data and methodology in section 3. We elaborate our findings in section 4 and conclude in section 5. 2. Literature review 2.1. Comparative studies in performance The literature on ethical and Islamic investing can be broadly classified into three strands. The first claims that these portfolios are bound to underperform a conventional benchmark/portfolio (see Abdullah, Hassan, & Mohamad, 2007 and Mansor & Bhatti, 2011 for Islamic indexes). For instance, Abdullah et al. (2007), using a range of performance measuresdsuch as the Adjusted Sharpe Index, Treynor Index, Adjusted Jensen Index, Modigliani Measures, and the Information Ratiodcompare the performance of 14 Islamic and 51 conventional Malaysian unit trusts from January 1992 through December 2001. Their findings suggest that Islamic funds generated lower returns than conventional funds. Mansor and Bhatti (2011) report similar findings. However, these indexes suffer from higher moments of the return distribution.6 Similar results on a sample of 116 French SRIs are reported by Capelle-Blancard and Monjon (2014), who document the underperformance of these funds over 2004e07. The second strand of studies, which forms the majority of the literature, argues in favor of outperformance.7 Hussein and Omran (2005) examine the performance of the Dow Jones Islamic Index against its conventional counterpart. Using monthly samples from 1995 to 2003, they report superior returns on the Islamic index. Similarly, using the sample from 5 To make our results clearer, we present the evidence of factor premiums in Fig. 2. 6 These performance measures rely on the first two moments only (mean and standard deviation) only and ignores other moments (skewness and kurtosis). 7 For Islamic indexes, see Hussein and Omran (2005) and Islam and Habib (2014). For SRI indexes, seeCollison et al. (2008).

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India and Malaysia, Islam and Habib (2014) compare the performance of Islamic index with its counterpart. Their findings reveal that the Islamic index in both countries managed to outperform their conventional peers. For the case of SRIs, Collison, Cobb, Power, and Stevenson (2008), using the sample of FTSE4Good indexes from 1996 to 2005, conclude that these indexes outperformed the conventional benchmarks. The third strand of literature finds that the difference in performance is negligible.8 Focusing on Islamic indexes, BinMahfouz and Kabir Hassan (2013) examine the comparative performance of the family of Dow Jones indexesdincluding the Dow Jones Islamic Index, the Dow Jones Islamic Sustainability Index, the Dow Jones Sustainability Index, and the Dow Jones World Indexdagainst the MSCI (Morgan Stanley Capital International) Index and suggest that there is no significant performance difference between the screened and the unscreened indexes based on the Sharpe ratio, as well as single and multi-factor models.9 Focusing on SRIs, Sauer (1997) and Statman (2000) compare the performance of the Domini Social Index to the S&P 500, using the conventional performance measures such as the Sharpe ratio and the capital asset pricing model (CAPM). Both studies find no performance difference between the SRIs and their conventional peers. Similarly, Statman (2006) reports that other prominent indexes such as Calvert's Social Index, Citizen's Index, and Dow Jones Sustainability US Index do not exhibit any significant difference. More recently, Ortas, Moneva, and Salvador (2014), using SRIs from Europe, report no significant performance difference between the SRIs and their conventional peers. Their sample consists of Dow Jones Sustainability Stoxx and EuroStoxx indexes. The findings on underperformance of ethical/Islamic assets are broadly due to three factors. First, as mentioned, such portfolios suffer from the lack of instruments for diversification. As a result, it is argued, the mean-variance portfolio will always be suboptimal (Markowitz, 1991). The second reason that has been put forth is that these portfolios are subset of the larger universe and hence will always underperform. Underperformance could also be due to the investment restrictions in certain prohibited lines of business. For instance, portfolios would not be able to benefit from profitable opportunity that is in direct or indirect contradiction to ethical and/or Islamic principles (Nainggolan, How, & Verhoeven, 2015). Finally, these investments strategies also suffer from extra costs in the 8

For Islamic indexes, see Girard and Hassan (2008); Hassan, Antoniou, and Paudyal (2005); BinMahfouz and Kabir Hassan (2013); Ho et al. (2014). For SRIs, see Sauer (1997); Statman (2000, 2006); Schr€oder (2007);Ortas et al. (2014). 9 Ho et al. (2014) examined 12 conventional and Islamic indexes from eight different countries. Based on the Sharpe ratio, Treynor index, and other performance measures, they argue that the performance of Islamic indexes is very much dependent on the time period. For instance, the comparative performance of these indexes during the dot-com crisis is mixed. While Islamic indexes managed to do better than their conventional counterparts during the global financial crisis, both indexes generated negative returns.

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form of screenings by Shari‘ah Advisory Councils (Islamic investments) and the Ethical Advisory Boards (socially responsible investments). As for the findings on outperformance of ethical/Islamic assets, the literature claims that these stocks reduce the potential conflict between stakeholders and the managers that may arise due to corporate fraud and/or environmental disasters. These reduced conflicts may result in higher net present values (Heal, 2005). However, these benefits can be reaped only in the long term (Renneboog, Ter Host, and Zhang 2008). On the other hand, Allen, Carletti, and Marquez (2007) find that firms that design policies so as to take care not only of shareholders but also all stakeholders yield more value for investors through increased financial performance. Advocates that support the “no performance difference” notion argue that markets are efficient and hence any value proposition, whether in form of religious and or ethical values, will not be able to affect stock prices. In other words, stock prices already reflect the premium or discount of these firms (Bebchuk, Cohen, & Wang, 2013)dalthough some also argue that these indexes provide safer haven during the crisis period.10 2.2. Factor premiums and regime changes As discussed, this study investigates the contributing factors to both sustainable and Islamic equities to assess the differences in factor exposures. Analyzing the contributing factors is important given the strand of literature documenting the superiority of factor-based asset allocation relative to asset-classesebased asset allocation (Bender et al. 2010, 2013; Clarke, de Silva, & Murdock, 2005; Page & Taborsky, 2011). This study also investigates the performance across different regimes. Many empirical studies show that the returns of various asset classes interact in complicated ways with different macroeconomic regimes, along with a very different distribution of asset returns (Ang & Bekaert, 2002; Calvet & Fisher, 2005; Detemple, Garcia, & Rindisbacher, 2003; Honda, 2003; Lettau, Ludvigsson, & Wachter, 2005). As a result, and with the expansion of new market data, the shape of the classical mean-variance frontier (MVF) and the location of the efficient portfolios have changed drastically (Sch€ottle & Werner, 2006). The more efficient and desirable risk-reward combinations of the state-dependent frontier can be achieved only by systematically adjusting allocations as the economy switches back and forth between different states (Clarke & de Silva, 1998). In particular, studies have examined how the presence of regimes in means, variances, and correlations of asset returns can be translated into explicit dynamics of the Markowitz mean-variance frontier (Guidolin & Timmermann, 2005a; 2005b; 2006a; 2006b; 2006c, 2007). To the best of our knowledge, there is no prior study that has investigated the performance of either sustainable or Islamic equities within the mixture of the global asset classes

10 For Islamic indexes, see Al-Khazali et al. (2014) and Ho et al. (2014). For SRI indexes, seeNofsinger and Varma (2014).

portfolio, nor is there any prior study that has assessed the performance, taking into account regime changes, multihorizon investments, and factor premium exposures. This study attempts to fill the gap by examining the performance of sustainable equities and Islamic equities incorporated within the global asset classes portfolio, along with their performance across regimes as well as their factor premium exposures. 3. Data and methodology11 3.1. Background on the Dow Jones Sustainability World Index and the Dow Jones Islamic Market Sustainability Index Among the first global equity indexes was the Dow Jones Sustainability World Index (DJ Sustainability), launched in 1999 in the move toward integrating sustainability into the capital market. There are currently 12 broad market, 10 bluechip, 3 specialty/screened, and 8 diversified sustainability indexes that track the financial performance of leading sustainability-driven companies worldwide. The first global Islamic sustainability index, the Dow Jones Islamic Market Sustainability Index (DJIS), was launched in 2006. Both DJ Sustainability and DJIS are concentrated in leading SRI markets, such as the United States, the United Kingdom, and Switzerland. DJIS has higher average market capitalization ($41.5 billion) despite having a smaller universe of constituent equities (106 components) relative to other indexes. Technology and health care are the dominant sectors in DJIS, representing 28.97 percent and 20.56 percent of the sector allocation, respectively, as at January 2015. By contrast, the financial sector is featured prominently in both the Dow Jones Global Index and the Dow Jones Sustainability World Index. 3.2. Performance of sustainable and Islamic equities within the global asset classes portfolio The first part of this study measures the performance of sustainable and Islamic equities, including their relative performance against the global equity benchmark. The study analyzes the performance of a particular index within the portfolio of global asset classes. In other words, it assesses the performance of a particular global portfolio that include sustainability equities, and compares it to the performance of another global portfolio that include Islamic equities, or the global equities benchmark. This study examines the various aspects of four Dow Jones indexes: the Dow Jones Global Index (DJ Global) (as the

11 The choice of Dow Jones Index is a natural one for several reasons. First, it is the only index to have Islamic index, Islamic sustainable index, Sustainable Index and conventional index. As all the data comes from a single index provider, the comparison becomes easier as there is a uniformity in not only the selection of stocks but also the screening of stocks. It has the longest available data of Sustainable index, Islamic index, and Islamic sustainable index. The length of data increases the reliability of results. Last, but not the least, most of the papers on Islamic index have used the Dow Jones data.

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_ W. Azmi et al. / Borsa Istanbul Review xxx (xxxx) xxx Table 1 Global asset classes and proxies. Asset classes

Proxies

Riskless asset Emerging markets equity Global bond Global REITs Global private equity Global hedge fund Commodity Gold

Citigroup 3-month T-bill Dow Jones Emerging Total Stock Market Index JPM Global Aggregate Bond Index S&P Global REITs LPX Private Equity Index HFRX Composite Index S&P GSCI Commodity Index S&P GSCI Gold Spot Index

Note: GSCI ¼ Goldman Sachs Commodity Index; REIT ¼ real estate investment trusts.

market benchmark), the Dow Jones Islamic Market World Index (DJ Islamic), the Dow Jones Sustainability World Index (DJ Sustainability), and the Dow Jones Islamic Market Sustainability Index (DJIS). For the global portfolio, the analysis includes the global asset classes that are used in the standard global asset allocation framework (see Table 1). The dataset spans from 1998 to 2013. Data are collected from Datastream and Bloomberg. 3.3. Performance at different regimes: Markov switching analysis Firstly, we examine the performance of sustainable and Islamic equities within the global portfolio across different regimes using the Markov switching method.12 To identify the macroeconomic regimes, the analysis uses expansion and recession periods as defined by the National Bureau of Economic Research (NBER) dating panel. The study examines the ranking of returns of each asset class across different regimes. It specifically analyzes the performance across much broader types of regimes, concentrating on factor premiums. The rationale is that the factor-based allocation concentrates on factors that carry risk premiums as multiple distinct sources of returns. A number of distinct premiums across multiple asset classes may include the equity premium, term structure premium, default premium, exchange rate premium, funding premium, and so on (Pastor and Stambaugh 2003; Lustig, Roussanov, & Verdelhan, 2011; Asl & Etula, 2012; Adrian, Etula, and Muir 2012). Because each factor premium varies at different points in time (Arshanapalli, Coggin, and Doukas 1998; Oertmann, 1999; Ahmed, Lockwood, and Nanda 2002; Amenc, Malaise, Martellini, & Sfeir, 2003), the analysis uses the switching model with two regimes, where investors may reallocate their assets when the available factor premium

12 In a layman terms, this model is designed to endogenously capture regime shifts based on the data. In other words, it allows the data to endogenously define different regimes. Moreover, Markov switching modelling can identify more than two regimes based on the data. This modelling is powerful and useful as it captures regime change based on data and reduces the error where the regime is imposed exogenously by the researchers which may be wrong in most of the cases, except for US or other developed countries where the identification of regime shifts are more sophisticated and hence reliable.

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exhibits a high or low return (for further discussions, see the Supplementary Material, available online). 3.4. Sector and factor exposures: Bayesian model averaging (BMA) Next, to measure the exposures of sustainability and Islamic equities to both sector premiums (which represents idiosyncratic risks) and factor premiums (which represents systematic risks) and to select the significant variables from among the large possible candidate regressors, the Bayesian model averaging (BMA) approach is used13 (for details, see the Supplementary Material, available online). 3.5. Diversification benefits in different investment horizons: Wavelet analysis Further, to identify the degree of diversification benefits from either sustainable or Islamic equities, taking into account the presence of multiple horizons in investmentdwhich is of particular interest to dynamic investorsdthe analysis uses Wavelet Coherence analysis (see the Supplementary Material, available online). 3.6. Dynamic volatility: multivariate GARCH model and dynamic conditional correlations (DCC) Finally, to understand how correlations and volatility change over time and when they are strong or weak is a persuasive motivation for the use of the MGARCH-DCC models,14 particularly in the financial markets. The DCC (dynamic conditional correlation) modeling allows the analysis to pinpoint changes (both when and how do they occur) in the interdependence between time-series variables (for more information, please see the Supplementary Material, available online). 4. Empirical findings and analysis 4.1. Risk-return profile of global asset allocation portfolio and efficient frontier Table 2 reports the risk-return profile of global asset allocation portfolio (tangency portfolio), which includes the DJ Global, DJ Islamic, DJIS, and DJ Sustainability 13 Given competing theories and the nature of the empirical evidence, one is always uncertain about the correct model. The BMA approach has the advantage of using many more regressors than the traditional model selection approach. As an alternative to selecting a single model, model averaging considers and estimates all the possible candidate models, with a weighted average as the estimate of the effect of interest. 14 The MGARCH models are used to estimate the DCC for a financial time series. The models' obvious advantage is that it captures the time-varying correlations. However, the main merit of DCC in relation to other timevarying estimating methods is that it accounts for changes in both the mean and variances of the time. In other words, DCC allows for changes in both the first moment (mean) and the second moment (variance).

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Indexes, for each of the global portfolios. The analysis determines the regimes that allows the study to perform the spanning tests of the long-term mean variance, as well as the state-dependent mean variance. From the start of the observations in 1998, two main recession periods (from the NBER dating panel) are observed: March 2001 to November 2001 (the dot-com crisis); and December 2007 to June 2009 (the global financial crisis, GFC). These are referred to as bearish periods. Periods other than the bearish ones are categorized as the bullish period. Table 2 has two panels: panel an examines overall and bullish periods, and panel b examines bearish periods. The findings for overall period, based on the risk and return of the tangency portfolio, reveal that the DJ Islamic Index has the highest Sharpe ratio, followed by the DJ Global, DJIS, and the DJ Sustainability Indexes. In other words, DJ Islamic is a better alternative compared to the four indexes included in the global portfolio of asset classes. These results are in line with Hussein and Omran (2005) and Islam and Habib (2014). More precisely, Islamic equities feature a lower level of leverage, corresponding to the low leverage effects and volatility feedback hypothesis, particularly during market downturns. The low leverage of DJ Islamic can offer greater diversification benefits, with higher returns, given that it is not constrained by sustainability screening criteria. DJ Sustainability provides the maximum average return during the bullish period, implying the strong linkage between financial performance and ESG materiality. In the case of the first bearish period (the dot-com crisis), DJ Islamic is the worst performer, whereas DJ Global and the DJ Sustainability provided the best returns of all the indexes. These results are not surprising. As we shall see later, the technology sector is one of the main driving factors of the performance of the DJ Islamic Index. Since the technology sector was hit badly during the dot-com crisis, DJ Islamic performance during the crisis was correspondingly poor. However, during the global financial crisis, the Dow Jones Islamic Market Sustainability Index (DJIS) and the Dow Jones Islamic Market World Index (DJ Islamic) managed to perform

better as compared to DJ Global and DJ Sustainability. This superior performance can be traced to the fact that both these indexes screen out banks and the other financial institutions, which were badly affected by the crisis. Furthermore, these indexes managed do better because their screening criteria exclude the highly leveraged stocks that formed the majority of the financially unhealthy firms in that period. These results are in line with those who argue that the Islamic indexes are expected to perform better during the economic recession because the constituent stocks of these indexes manage to meet their liabilities due to their lower debt. Similar results were reported by some other recent studies (Al-Khazali, Lean, & Samet, 2014; Ho, Rahman, Yusuf, & Zamzamin, 2014). The analysis further constructs efficient frontiers of these indexes during different time periods (see Fig. 1). The efficient frontier portfolio of DJIS is close to that of DJ Global over 1998e2013 and during periods of economic expansion. While it had a less efficient frontier during the dot-com crisis because of high concentration in technology sector, its frontier was more efficient during the global financial crisis because of lower financial leverage. On the other hand, the portfolio construction of DJ Islamic turns out to be the most efficient across all the periods except for the dot-com crisis period. The efficient frontiers of DJIS and DJ Islamic suggest that these indexes do not suffer from lack of diversification. These results sharply contradict the theoretical literature on the meanvariance portfolio. In other words, the efficient frontiers suggest that the underperformance of these indexes may not be due to lack of diversification. 4.2. Drivers of performance differences: sector and factor premiums To examine the main performance drivers of the indexes, they are further broken down at the sector level. The estimation, based on the Bayesian model averaging of 70 sector premiums, reveals that the basic materials, recreational products, personal products, and technology sectors are significant drivers of the performance of the DJIS (see Table S1, available

Table 2 Risk and return of global asset allocation portfolio. a. All periods and a bullish period Portfolio with mixed asset classes

All periods Monthly average return (%)

Monthly standard deviation

Monthly average return (%)

Monthly standard deviation

DJ DJ DJ DJ

0.2975 0.3024 0.2945 0.2854

2.21 2.16 2.21 2.31

0.717 0.704 0.718 0.737

2.27 2.14 2.26 2.44

Global Islamic Islamic Sustainability Sustainability

Portfolio with mixed asset classes

DJ DJ DJ DJ

Global Islamic Islamic Sustainability Sustainability

Bullish period

b. Bearish periods Dot-com crisis

Global financial crisis

Monthly average return (%)

Monthly standard deviation

Monthly average return (%)

Monthly standard deviation

0.068 0.185 0.152 0.092

1.58 1.69 1.68 1.67

0.024 0.125 0.129 0.005

3.87 3.78 3.83 3.90

Note: Full sample ¼ 1998e2015; the dot-com crisis ¼ March 2001eNovember 2001; the global financial crisis ¼ December 2007eJune 2009. Periods other than the bearish ones are categorized as the bullish period. DJ ¼ Dow Jones. _ Please cite this article as: Azmi, W et al., Doing well while doing good: The case of Islamic and sustainability equity investing, Borsa Istanbul Review, https:// doi.org/10.1016/j.bir.2019.02.002

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Fig. 1. Efficient frontiers.

online). Excluding basic materials, these sectors resemble the drivers of DJ Sustainability, which also includes full-line insurance and banks. On the other hand, industrials, technology, oil & gas, and commercial vehicles drive the performance of DJ Islamic, whereas Industrials, Technology, Health care and Specialty Retailer are the major drivers of DJ Global. The performance of DJ Sustainability during the global financial crisis is not surprising given that full-line insurance and banks, which together are the main drivers of this index during the bullish period, were badly hit by the crisis. The analysis further examines how certain premiums can influence the performance of the four indexes. The literature suggests that there are two main strategies to achieve superior returns. The first strand argues for asset-based allocation (Brown, Garlappi, & Tiu, 2010), while the second advocates for factor-based allocation (Dewandaru, Masih, Bacha, & Masih, 2015). Recent literature documents the superiority of factorbased asset allocation because some factors have been able to earn long-term risk premiums, and these premiums reflect the exposure to systematic risk (Bender et al., 2013). A number of distinct premiums across multiple asset classes may include the equity premium, term structure premium, default premium, exchange rate premium, funding premium, and so on. There are three main different styles of factor-based allocations: size investing (Annaert, Van Holle, Crombez, & Spinel, 2002; Van Dijk, 2011); value investing; and momentum investing (Asness, Moskowitz, & Pedersen, 2013; Cakici, Fabozzi, & Tan, 2013; Yeh & Hsu, 2011). The strategy based on the size

follows the principle that stocks with low market capitalization provide superior returns as compared to firms with high market capitalization. Value strategies exploit the principle of investing in underpriced stocks. Underpriced stocks are identified based on a certain measure, such as dividend yield, price-to-book ratio, and/or price-to-earnings ratio. The momentum style of investing is based on the premise that past winning stocks are expected to outperform in the future. Fig. 2 examines these four types of premiums for the four indexes. The results suggest that the market premium is a very important explanatory variable: it affects the performance of all the indexes with a 100 percent posterior inclusion probability. In addition to the market premium, the performance of DJ Islamic is driven mainly by value and size premiums, followed by the momentum premium. This implies that DJ Islamic consists of small and value stocks, which possess the two best qualities (size and value) for which a premium is given to offset the associated risk. Similar patterns are observed across DJIS and the DJ Sustainability. However, value and momentum are more important in the case of DJ Global. Overall, the results are in line with the large empirical € literature that suggests that size (Aksu & Onder, 2003; Bagella, Becchetti, & Carpentieri, 2000); value (Fama & French, 1992, 1996; Petkovaa and Zhang 2005); and momentum factors (Jegadeesh and Titman 1993; 2001) are among the most important determinants of performance. The result that DJ Islamic, DJIS, and DJ Sustainability consist of small stocks is in line with the empirical literature

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Fig. 2. Factor premiums.

on Shari'ah-compliant investments (Hassan & Girard, 2011; Hussein, 2004) and SRIs (Humphrey & Lee, 2011). The results for DJ Islamic and DJIS are not surprising because most large capitalized firms would be screened out, given that these firms are likely to be more leveraged and also to receive income from prohibited sources, as they are often well diversified (Hoepner, Rammal, & Rezec, 2011). The presence of value stocks in DJ Islamic and DJIS is evident from the presence of value sectors like industrial and basic industries, which are also one of the main drivers of their performance (see Table S1, available online). 4.3. Performance across different economic conditions As mentioned, this study assesses the return ranking among various asset classes in much broader types of regimes, which is of interest to investors who use dynamic strategies across multiple regimes. A strand of literature underscores the importance of factor premium regimes. The probability and timing of these factor regimes are estimated with Markov switching analysis. The equity premium is computed as the return of the S&P 500 composite index minus the three-month US T-bill rate. The term structure premium is calculated as the yield on 20-year US Treasuries minus the three-month US Treasuries yield. The high-yield spread is computed as the return on the Barclays Capital US Corporate High-Yield index minus the US Corporate AAA index return. A higher highyield spread indicates a lower default premium, and vice versa. The results of estimation on factor premium in different regimes reveals the following. The bearish equity premium has a negative average return and high volatility, while the bullish premium has a positive return and low volatility. The bearish regime covers the periods of August 1998 to December 1998; December 1999 to February 2003; December 2007 to August 2009; March 2010 to October 2010; and August 2011 to November 2011. The findings for the bearish regime are understandable, as these periods can be linked to a few major events, such as the Russian default in August 1998; the dot-com bubble burst in 1999e2001; Enron's collapse in 2002; the global financial crisis in 2007e2009; and the euro crisis in 2010. The bearish regime of high-yield spread covers the periods of August 1998 to November 1998; September 2000 to November 2001; May 2002 to April 2003; June 2007 to October 2009; March 2010 to July 2010; and August 2011 to January 2012. Again, these periods can be related to a few

crises, which are similar to the findings in the equity premium. This can be discerned from the fact that a lower high-yield spread indicates a higher default premium in the market (Clarke et al., 2005). Finally, the term premium is an inflation premium, which depends on the sector (such as the sensitivity of the technology sector to inflation). The low term premium regime covers the periods of January 1998 to October 1998; February 2000 to February 2001; and November 2005 to August 2007. This is a regime when an average of yield difference between long-term and short-term treasuries is lower relative to that in another regime. For example, the pattern for the period of 2005e2007 is understandable because the yields at longer maturities stayed at surprisingly low rates despite of the rise in short-term interest rates stemming from a series of policy tightenings by the Federal Reserve begun in 2004. The analysis compares the returns of these indexes with other asset classes during different regimes. Using Markov switching analysis, the results in Fig. 3 imply that the DJ Islamic and the DJIS are ranked 6 and 9 among 11 asset classes during the full sample period. Not surprisingly, these indexes are ranked lowest in the dot-com crisis, as is evident from Table 2, panel b. During the global financial crisis, these two indexes did not do too badly as compared to other asset classes, as they are ranked 6 and 7. The results from the equity bullish premium and the low default premium seem to be most promising, as they are among the top asset classes in these regimes. Overall, Islamic and Islamic sustainability equity investing offered competitive risk-return profiles particularly during economic expansions, equity bullish periods, and the global financial crisis. This supports the principle that it is possible to do well while doing good. 4.4. Dynamic conditional correlations and volatility Fig. 4 examines the dynamic conditional correlations and the volatility aspects of these indexes derived using MGARCH-DCC. The conditional correlation suggests that all the indexes were strongly correlated throughout the sample period, except for the period of mid-2006. 4.5. Degree of diversification across multiple time scales Finally, the Wavelet Coherence suggest (see Fig. S1, available online) that there is a high degree of co-movement of

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Fig. 3. Equity returns under different regimes.

Fig. 4. Conditional correlations.

the four indexes across multiple time scales (4 days, 8e512 days, and 1024 days) over 1996e, 2014. The results correspond to some recent studies on Islamic and conventional index coherency, but not others. For instance, Saiti, Bacha, and Masih (2016) did not find any significant contagion among the conventional and Islamic indexes. On the other hand, Najeeb et al. (2015) argue that the correlation among the indexes depends on the time horizon. Overall, this study's results indicate that these indexes provide minimal diversification opportunities, not only in the short term but also in the long term. 5. Conclusion Because dynamic investing strategies are gaining prominence, it is important to evaluate established equity indexes in terms of their performance and volatility (during different time periods), the drivers of their performance in terms of industry

as well as factor premiums, dynamic correlation and coherence across different time horizons. To achieve this objective, this study made use of the DJ Islamic, DJ Sustainability, and DJIS Indexes. For comparison and benchmark purposes, it used the DJ Global Index. The results can be summarized as follows. First, DJIS has a higher Sharpe ratio than DJ Sustainability (full sample) at the portfolio level and ranks second during periods of economic expansion. Even during the global financial crisis, its performance was comparable to other indexes. Second, the DJIS efficient frontier portfolio is close to the DJ Global efficient frontier portfolio over the full sample and during economic expansions. Although DJIS had a less efficient frontier during the dot-com crisis, its frontier was more efficient during the global financial crisis. Third, the basic materials, recreational products, personal products, and technology sectors are significant drivers of the performance of DJIS. Fourth, the performance of DJIS is also driven mainly by market, value, and

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size premiums. Fifth, compared to other global asset classes, DJIS performed relatively well during periods of economic expansion (with an average monthly return of 1.02 percent) and the global financial crisis (with an average monthly return of 1.60 percent), but was adversely affected by the dot-com crisis. DJIS also performed better than other non-equity asset classes during the equity bullish period (with an average monthly return of 1.11 percent) and had positive returns during low default and high term premium regimes. Sixth, there is high degree of co-movement of the four indexes across multiple time scales (4 days, 8e512 days, and 1024 days) over the entire sample period. Finally, all four indexes exhibit similar volatility patterns over the whole period of study. This study demonstrates that Islamic sustainability equity investing has offered competitive risk-return profiles, particularly during economic expansions, equity bullish periods, and the global financial crisis. Its frontier is also efficient as compared to other indexes and its volatility is similar to that of other indexes. The findings support the notion that it is possible to do well while doing good. These findings can be instrumental in strengthening the universality and acceptability of Islamic finance. 6. Policy implications Given the sustainability trends and empirical evidence provided in this study, the Islamic finance industry should proactively participate in mainstream sustainability investing. There are significant market opportunities for Islamic finance industry. The socially responsible investment (SRI) market offers access to over $33 trillion in assets (having grown 486 percent since 1995) and facilitates the scale required to improve the efficiency of Islamic funds. Pension funds that integrate environmental, social, and governance (ESG) issues into their investments and $36 billion in pension assets from Gulf Cooperation Council (GCC) countries can be potentially channeled to the Islamic asset management industry. There are also opportunities to integrate the global Hal al real sector with sustainability investing. The extension of the Dow Jones Sustainability Indexes and the development of customized domestic Islamic sustainability indexes in major Islamic finance jurisdictions are expected to broaden market opportunities. Islamic financial institutions should consider adopting globally recognized principles such as the United Nations Principles for Responsible Investment (UN PRI)15 and corporate sustainability reporting, and participate in United Nations Environment Programme (UNEP) Financial Initiative.16 Given that sustainable investment performance would also depend on unique strategies to outperform market benchmarks, Islamic financial institutions should strengthen their investment strategies and capacity in 15

See https://www.unpri.org/about/the-six-principles. The UNEP Finance Initiative is a global partnership between the United Nations Environment Programme and the financial sector. Over 200 institutions, including banks, insurers, and investors, work with UNEP to bring about systemic change in finance to support a sustainable world. See http:// web.unep.org/greeneconomy/what-we-do/unep-finance-initiative. 16

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sustainable investing. Industry bodies can also encourage clauses on responsible investment to be included in Islamic fund management contracts. Policy and regulatory initiatives to facilitate this drive include:  Promoting transparency and disclosure from institutional investors, fund managers, and companies on integrating environmental, social, and governance (ESG) issues into their investments;  Providing fiscal incentives to improve profitability of sustainable businesses;  Conducting investment performance reviews over longer time horizons;  Extending the United Nations Principles for Responsible Investment to include distinctive Islamic principles. Specifically for portfolio managers, the results have several implications. The option of Islamic and Islamic sustainability stocks provide them additional opportunity to diverse their portfolio without sacrificing on the financial grounds. Moreover, these options also provide them a set of safer haven during economic downturn. However, the findings has to be interpreted with respect to other considerations. More specifically, the results highlight that the links and co-movements of indices are contingent on the time horizon, regime and risk/ return profiles and targets. Conflict of interest None.

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