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Should Islamic investors consider SRI criteria in their investment strategies?
Finance Research Letters xxx (2015) xxx–xxx
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Should Islamic investors consider SRI criteria in their investment strategies? Elias Erragraguy, Christophe Revelli ⇑ University of Toulon-Var, Kedge Business School, Domaine de Luminy, BP921, 13288 Marseille Cedex 09, France
a r t i c l e
i n f o
Article history: Received 9 February 2015 Accepted 13 July 2015 Available online xxxx JEL classification: G11 M14 A13 G15 Keywords: Socially responsible investing (SRI) Islamic investing Environmental Social and governance (ESG) scores Corporate social responsibility (CSR) Portfolio management
a b s t r a c t Can environmental, social and governance (ESG) performance be a criterion for Islamic investment policies? The development of socially responsible investments (SRI) challenges the conservative approach of Islamic investments toward promoting corporate social responsibility. This study therefore tests the potential of integrating positive ESG screening with Islamic portfolios using KLD social ratings, to determine the financial price that shariah compliance and social responsibility entail. Our results reveal no adverse effects on returns due to the application of Islamic and ESG screening; substantially higher performance results from the inclusion of good governance criteria in the post-subprime crisis period. Ó 2015 Elsevier Inc. All rights reserved.
1. Introduction In the past 20 years, socially responsible investing (SRI) has increasingly attracted the interest of individual and private investors, as well as academics. Unlike conventional investments, SRIs entail a set of screening methods that exclude or include stocks on the basis of environmental, social and corporate governance (ESG) criteria, often with the engagement of local communities and active shareholders who encourage relevant corporate strategies (Renneboog et al., 2008). More recently, ⇑ Corresponding author. E-mail addresses: [email protected] (E. Erragraguy), [email protected] (C. Revelli). http://dx.doi.org/10.1016/j.frl.2015.07.003 1544-6123/Ó 2015 Elsevier Inc. All rights reserved.
Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003
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E. Erragraguy, C. Revelli / Finance Research Letters xxx (2015) xxx–xxx
another form of ethical investment, Islamic investment, focuses the interest of academics and practitioners. An Islamic investment policy instead conforms with the shariah guidelines and principles that govern all aspects of human activity, including portfolio allocations, trading practices and dividend distributions (Girard and Hassan, 2008). From a scientific standpoint, most research in the last decade on SRI focused on performance, seeking to understand whether this type of investment has financial costs beyond those associated with conventional investments. Several empirical studies have attempted to demonstrate a causal link between the effect of introducing non-financial criteria in the investment process and the financial performance of SRI funds or SRI indices. Recently, a meta-analysis proposed by Revelli and Viviani (2015) concluded that the consideration of corporate social responsibility in stock market portfolios is neither a weakness nor a strength compared with conventional investments and that the heterogeneous results in prior studies largely reflect the SRI dimensions under study. In this perspective, Barnett and Salomon (2006) demonstrate that SRI fund performance increases with intensified screening. Capelle-Blancard and Monjon (2014) note that greater strategy distinction is associated with better financial performance, as well as that positive screenings promoting best ESG practices are less harmful than negative screenings that exclude entire sectors. From another side, the resilience of the Islamic financial market to the subprime crisis triggered substantial research interest. Previous findings suggest that sector screening imposed by Islamic funds should not hinder performance (Wilson, 2001). Similarly, Hayat and Kraeussl (2011) report no statistically significant differences between the risk-adjusted performance of Islamic mutual equity funds or indexes and their conventional benchmarks. Hussein and Omran (2005) further suggest that Islamic indices may provide better returns than conventional indices in times of financial distress. For example, the exclusion of high-profile firms such as Enron and WorldCom, due to their excessive indebtedness, enabled the Dow Jones Islamic Market Index (DJIMI) to outperform its conventional counterparts after both firms collapsed in, respectively, 2001 and 2002. Significant international studies also confirm the better performance observed during the subprime crisis by Islamic developed market indices (Walkshaeusl and Lobe, 2012) and funds (Hoepner et al., 2011). Walkshaeusl and Lobe (2012) note that the performance difference is largely attributable to the exclusion of financial stocks from shariah-screened portfolios, but however, they predict that such superior performance should not persist over time. Merdad et al. (2010) accordingly highlight the underperformance of Islamic funds during buoyant periods. This insight suggests a means to investigate how the greater performance recorded by Islamic investments during times of financial distress might be sustained during stable periods. Islamic finance and SRI share clear similarities in their objectives and claims (e.g., promoting social welfare through ethics). Williams and Zinkin (2010) highlight the compatibility of Islamic ethics and classic business ethics as fundamental sources of current SRI practices. However, this study also suggests that a strategy that focuses only on excluding ‘‘sinful’’ activities is insufficient to comply with all ethical and social guidelines prescribed by Islamic sources, such that the integration of ESG indicators in the Islamic investment process may be necessary. A survey among Islamic finance practitioners shows that 98.8% of respondents believe that promoting social responsibility in financial transactions would reconcile Islamic financial institutions with their ethical origin (Sairally, 2007), leading the author to conclude that Islamic investment could ‘‘learn from the more proactive engagement practices of SRI funds whereby they encourage companies to be more responsive to society’s expectations’’ while still preserving their financial performance. Many justifications in previous works support mixing Islamic and SRI strategies. Forte and Miglietta (2007) show that Islamic investment and SRI have different characteristics in terms of asset allocations, econometric profiles and sector exposure. Despite empirical evidence that both Islamic and SRI funds are more oriented toward growth and small-cap stocks (Walkshaeusl and Lobe, 2012), in very developed SRI markets, SRI funds are more oriented toward large caps (Bauer et al., 2005). Therefore, from a financial point of view, integrating SRI filters into an Islamic portfolio, or vice versa, might provide complementary investment classes for both types of investors. It also could produce diversification benefits for fund managers, by reducing the non-systematic risk that stems from differences in Islamic and SRI portfolio profiles. Finally, incorporating positive ESG screening in Islamic investments might mitigate exposures to environmental and ecological risks that Islamic investments suffer, due to their traditional orientation toward industrial and fossil energy sectors (Forte and Miglietta, 2007). Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003
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Despite such calls for reconciliation, no serious attempts have been made to combine these two ethical investing styles into a single investment process appear in prior research (Hayat, 2013). To fill this gap, we examine the effect of combining positive ESG criteria (the companies that are most virtuous in terms of their ESG scores) with an Islamic investment process. That is, we apply various ESG screenings to an Islamic stock universe to determine if socially responsible Islamic portfolios differ in their performance and investment styles. Noting the differences in sector exposure between SRI and Islamic investments, we also test the robustness of the results using an industry-adjusted measurement model. Our results show that integrating ESG screenings into Islamic portfolios does not impair performance, and generate higher performance for the good governance and diversity criteria. From a practical perspective, merging two forms of ethical screening practices offers new diversification perspectives for investors from both realms who seek to include new asset classes in their portfolios. By demonstrating proving the financial merit of SRI, our research also supports arguments for transparency and social accountability guidelines applied to Islamic financial regulatory institutions.1 In the next section, we present our methodological study settings. After we report the results and test their robustness, we discuss the main findings and implications through the conclusion. 2. Data and methods Our data set combines ESG ratings and financial data of the constituents of the MSCI U.S. Islamic index, since its inception in 2007, which forms our shariah-compliant stock universe.2 Of the 270 firms listed in the MSCI U.S. Islamic index in 2007, we retained 238 that received ESG ratings from KLD. Several authors pointed out the inconsistency of using aggregated measures of ESG performance (Brammer et al., 2006; Barnett and Salomon, 2011). Therefore, aggregate measures of ESG performance may confound opposing relationships between specific subcomponents of ESG performance and returns (Galema et al., 2008). Consequently, we avoided relying on a single composite ESG score and instead used disaggregated measures for each subcomponent. Therefore, our portfolio composition relies on a simple, passive, value-weighted methodology that controls for manager stock selection skills and enables measures of the effects linked exclusively to ESG strategic allocations. We isolate each of the seven ESG domains based on positive criteria (community, governance, diversity, employee relations, environment, human rights and product) and separate out the two screening dimensions (positive strength/negative concerns) proposed by KLD. Next, we classify the scores according to three rankings: 0, 1 or greater than 1. For each ESG subcomponent, depending on the type of dimension, 0 indicates either ‘‘no engagement’’ or ‘‘no implication in controversies’’; 1 indicates ‘‘partial engagement’’ or ‘‘partial controversies’’; and a score greater than 1 indicates ‘‘significant engagement’’ or ‘‘significant controversies.’’ The final panel consists of 34 portfolios.3 These portfolios are non-mutually exclusive. To verify the relevance of our disaggregated ESG performance approach, we constructed a subset of 5 portfolios using an aggregate scoring approach for comparative purpose. Table 1 contains the descriptive statistics for the 39 portfolios in our panel, grouped according to their level of ESG engagement and level of implication in ESG controversies. It thus provides the descriptive statistics of monthly returns from January 2008 to December 2011. To assess the effect of ESG screening on portfolio performance, we conducted two analyses. First, we used the four-factor model proposed by Carhart (1997). Formally, we measured performance with the following equation:
Rði; tÞ RFðtÞ ¼ ai þ bi½RMðtÞ RFðtÞ þ siSMBðtÞ þ hiHMLðtÞ þ miMOMðtÞ þ eði; tÞ;
ð1:1Þ
where R(i,t) is the return on portfolio i; RM(t) is the return in month t on a value-weighted market proxy; RF(t) is the return in month t of a one-month Treasury bill extracted from Kenneth French’s 1
Such as AAOIFI or IFSB. The methodology MSCI uses to screen shariah-compliant stocks is available at. 3 Our panel is shorter than the expected 42 portfolios because for some ESG domains we found no scores above 1. 2
Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003
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E. Erragraguy, C. Revelli / Finance Research Letters xxx (2015) xxx–xxx
Table 1 Descriptive Statistics for Islamic SRI Portfolios. Mean
Std. dev.
Sharpe ratio
Minimum
Maximum
Pr (Skew)
Pr (Kurtosis)
Panel A: Not engaged in ESG strengths (strengths = 0) Community 1.11 22 0.05 Governance 0.31 23.35 0.01 Diversity 1.99 26.22 0.08 Employee 2.67 20.59 0.13 Environment 2.68 21.16 0.13 Human Rights 0.34 17.76 0.02 Product 0.67 18.95 0.04
16.47 18.95 19.48 19.29 18.46 15.06 15.25
17.58 17.07 18.11 13.95 15.48 11.04 13.68
0.32 0.17 0.19 0.04 0.10 0.08 0.19
0.17 0.19 0.54 0.05 0.09 0.26 0.27
Panel B: Not involved in ESG concerns (concerns = 0) Community 1.12 18.74 0.06 Governance 2.54 23.91 0.10 Diversity 3.53 18.99 0.18 Employee 0.55 17.78 0.03 Environment 0.94 18.88 0.05 Human Rights 0.43 18.19 0.02 Product 0.67 21.88 0.03
15.58 21.33 17.45 15.28 17.70 14.63 18.91
12.02 15.52 10.00 10.91 10.58 11.74 14.56
0.10 0.04 0.02 0.16 0.03 0.12 0.07
0.27 0.10 0.12 0.29 0.09 0.32 0.22
Panel C: Engaged in ESG strengths (strengths = 1) Community 1.60 16.29 0.10 Governance 3.08 15.24 0.20 Diversity 1.87 25.55 0.07 Employee 0.06 22.10 0.00 Environment 3.54 19.9 0.18 Human Rights 8.92 35.44 0.26 Product 6.01 17.43 0.34
14.17 12.88 25.80 17.96 14.30 57.45 15.22
9.25 8.12 18.58 13.62 16.01 12.48 10.56
0.05 0.03 0.01 0.14 0.40 0.00 0.04
0.21 0.20 0.01 0.38 0.16 0.00 0.14
Panel D: Involved in ESG concerns (concerns = 1) Community 2.64 17.92 0.15 Governance 2.64 18.91 0.14 Diversity 0.65 17.54 0.04 Employee 0.68 19.36 0.03 Environment 2.11 18.60 0.11 Human Rights 2.59 18.55 0.14 Product 1.56 15.38 0.1
14.94 15.99 11.16 15.38 16.40 15.97 12.16
8.89 10.37 14.13 13.78 11.21 10.76 8.31
0.06 0.07 0.52 0.15 0.04 0.08 0.14
0.45 0.37 0.31 0.29 0.20 0.33 0.52
Panel E: Significantly engaged in ESG strengths (strengths > 1) Diversity 3.34 15.39 0.21 Employee 0.76 17.46 0.04 Environment 2.72 16.68 0.16
11.86 12.27 13.35
8.66 14.56 10.69
0.10 0.55 0.21
0.53 0.17 0.35
Panel F: Significantly involved in ESG concerns (concerns > 1) Governance 4.37 16.19 0.26 Employee 0.94 17.31 0.05 Environment 0.43 18.10 0.02
12.60 15.08 13.24
8.39 9.06 12.33
0.09 0.06 0.32
0.45 0.26 0.63
Portfolios based on aggregated scoring Worst ESG score 2.07 26.42 Bad ESG score 0.43 20.35 Mid ESG score 0.26 20.34 Good ESG score 1.81 19.07 Best ESG score 2.56 15.57
20.77 13.88 17.08 15.45 13.62
20.20 13.56 14.35 9.43 8.15
0.29 0.36 0.11 0.08 0.05
0.14 0.96 0.18 0.39 0.24
Group 1: Non-engaged portfolios
Group 2: Partially engaged portfolios
Group 3: Significantly engaged portfolios
0.08 0.02 0.01 0.09 0.16
Notes: The mean returns, standard deviations and Sharpe ratios (mean excess return to the standard deviation of the returns) are all annual measures. The last two columns provide skewness and kurtosis data. Group 3 does not contain all seven domains, because for some domains, no firms were significantly engaged in ESG issues or significantly involved in ESG controversies. In the lower part of the table, the benchmark was a set of five portfolios constructed on the basis of aggregated scores. The sample period was January 2008–December 2011.
Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003
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E. Erragraguy, C. Revelli / Finance Research Letters xxx (2015) xxx–xxx Table 2 Performance of Islamic SRI Portfolios (Four-Factor Model). HML
t-Stat
MOM
t-Stat
Rm-Rf
t-Stat
Adj. R2
Panel A: Not engaged in ESG strengths (strengths = 0) Community 0.96 0.36 0.15 1.30 Governance 2.02 0.68 0.30*** 3.44 Diversity 0.12 0.02 0.40** 1.69 Employee 0.00 0.01 0.41*** 2.73 Environment 0.96 0.33 0.29*** 4.05 Human Rights 1.21 0.69 0.03 0.89 Product 0.36 0.18 0.04 0.74
0.06 0.08 0.09 0.13 0.11 0.05 0.02
0.55 0.68 0.59 1.05 1.09 0.87 0.24
0.01 0.06 0.01 0.06 0.05 0.00 0.03
0.27 2.42 0.24 1.33 2.70 0.44 2.30
1.17*** 1.23*** 1.32*** 1.04*** 1.12*** 0.99*** 1.06***
15.00 19.70 13.30 16.80 18.70 11.70 32.40
0.93 0.94 0.86 0.92 0.94 0.98 0.95
Panel B: Not involved in ESG concerns (concerns = 0) Community 1.07 0.51 0.41*** Governance 0.36 0.10 0.35*** Diversity 3.29 1.25 0.13 Employee 0.48 0.18 0.17 Environment 1.31 0.59 0.37*** Human rights 1.19 0.88 0.21*** Product 1.09 0.40 0.04
0.02 0.07 0.05 0.04 0.01 0.08 0.08
0.27 0.62 0.63 0.56 0.13 1.32 0.90
0.03 0.08 0.02 0.05 0.08** 0.03 0.03
0.68 1.80 0.79 0.94 3.16 1.15 0.87
0.92*** 1.22*** 1.00*** 0.91*** 0.93*** 0.94*** 1.18***
30.90 14.30 17.00 20.80 16.80 40.00 24.00
0.92 0.91 0.92 0.89 0.94 0.96 0.94
0.01 0.13 0.25* 0.01 0.07 0.53 0.14
0.31 1.86 1.72 0.06 0.64 0.86 1.31
0.01 0.05 0.04 0.03 0.06 0.06 0.09*
0.45 1.83 1.02 1.01 2.13 0.73 1.48
0.89*** 0.84*** 1.34*** 1.16*** 1.12*** 1.07*** 0.78***
30.20 24.90 12.50 19.40 15.40 10.80 9.61
0.94 0.93 0.90 0.90 0.88 0.21 0.80
1.47 2.12 0.51 1.94 0.86 0.25 1.10
0.04 0.01 0.09** 0.02 0.01 0.04 0.01
1.55 0.20 2.75 0.92 0.60 1.81 0.42
1.03*** 0.94*** 0.95*** 1.05*** 1.00*** 1.07*** 0.84***
23.80 20.60 12.30 26.70 31.70 38.40 22.90
0.94 0.92 0.90 0.97 0.94 0.93 0.92
2.15 0.40 2.09
0.03 0.03 0.02
0.87 1.68 0.46
0.82*** 0.96*** 0.87***
25.20 11.50 19.70
0.91 0.92 0.93
0.81 0.50 0.85
0.05 0.01 0.05
2.22 0.43 3.42
0.90*** 0.98*** 1.04***
20.50 20.10 28.20
0.88 0.91 0.94
1.75 0.23 0.00 3.33 1.19
0.00 0.08 0.02 0.03 0.08
0.04 1.66 0.82 0.98 1.21
1.41*** 1.14*** 1.13*** 0.96*** 0.67***
15.40 20.10 20.80 19.90 8.38
0.86 0.86 0.93 0.91 0.75
a
t-Stat
SMB
t-Stat
Group 1: Non-engaged portfolios
3.30 2.04 0.88 1.31 4.75 4.08 0.64
Group 2: Partially engaged portfolios Panel C: Engaged in ESG strengths (strengths = 1) Community 1.94 1.14 0.05 Governance 4.91** 2.54 0.10 Diversity 4.24 1.22 0.38** Employee 0.48 0.16 0.22* Environment 1.79 0.53 0.15 Human rights 11.04 0.61 0.19 Product 5.03 1.68 0.19
0.44 1.00 2.60 1.27 1.18 0.75 1.36
Panel D: Involved in ESG concerns (concerns = 1) Community 6.04** 1.99 0.33 Governance 1.81 0.63 0.27*** Diversity 0.12 0.04 0.06 Employee 1.57 0.84 0.02 Environment 2.43 1.01 0.06 Human rights 5.54** 1.61 0.30*** Product 2.67 1.15 0.06
4.96 2.16 0.52 0.38 0.75 4.75 1.16
0.11 0.15* 0.04 0.15*** 0.06 0.02 0.07
Group 3: Significantly engaged portfolios Panel E: Significantly Diversity Employee Environment
engaged in ESG strengths (strengths > 1) 2.06 0.01 0.09 0.14* 4.41* 1.57 0.54 0.00 0.01 0.04 3.29 1.83 0.04 0.55 0.16**
Panel F: Significantly Governance Employee Environment
involved in ESG concerns (concerns > 1) 7.06** 1.98 0.24** 1.49 0.07 2.43 0.90 0.14 1.64 0.03 3.04 1.10 0.23*** 4.14 0.06
Portfolios based on aggregated scoring Worst ESG score 3.43 0.77 Bad ESG score 3.66 0.77 Mid ESG score 1.33 0.63 Good ESG score 2.43 1.13 Best ESG score 1.21 0.43
0.24 0.31** 0.04 0.06 0.23
1.26 2.79 0.34 0.52 1.60
0.28* 0.03 0.00 0.24*** 0.10
Notes: This table shows the R-square values, coefficients and their respective t-statistics and p-values, for each regression. Portfolios are grouped into three categories. All alphas are annual measures. The t-statistics came from Newey–West heteroskedasticity and autocorrelation-consistent standard errors. The sample period was January 2008–December 2011. * 10% significance. ** 5% significance. *** 1% significance.
Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003
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E. Erragraguy, C. Revelli / Finance Research Letters xxx (2015) xxx–xxx
Table 3 Relative performance of Islamic SRI differenced portfolios (four-factor model).
a Panel A: ESG engagement Community 0.96 Governance 7.06* Diversity 4.24 Employee 0.48 Environment 2.73 Human rights 12.11 Product 4.66
t-Stat
SMB
t-Stat
HML
t-Stat
MOM
t-Stat
Rm-Rf
t-Stat
Adj. R2
0.30 1.86 1.32 0.12 0.57 0.62 1.01
0.11 0.39*** 0.02 0.19 0.43*** 0.22 0.23
0.60 2.77 0.16 1.63 2.79 0.77 1.23
0.05 0.22* 0.16 0.14 0.04 0.58 0.13
0.43 1.34 1.50 1.20 0.27 0.86 0.81
0.01 0.11 0.03 0.09** 0.11** 0.06 0.12
0.12 2.23 0.69 1.49 3.06 0.70 1.66
0.28*** 0.39*** 0.02 0.12** 0.00 0.08 0.28***
2.62 4.16 0.19 2.03 0.01 0.75 2.51
0.30 0.53 0.04 0.10 0.24 0.07 0.15
0.74*** 0.08 0.07 0.15 0.31** 0.51*** 0.11
5.04 0.54 0.38 1.03 3.15 4.71 0.90
0.09 0.23* 0.01 0.19* 0.06 0.06 0.00
1.09 1.85 0.06 1.98 0.49 0.57 0.03
0.07 0.07 0.11** 0.07 0.07 0.07 0.04
1.04 1.08 2.17 1.33 2.33 1.50 0.65
0.10 0.28*** 0.05 0.14** 0.07 0.13* 0.33***
1.72 3.50 0.34 1.93 1.46 2.57 3.99
0.39 0.29 0.07 0.13 0.10 0.29 0.37
Panel B: ESG concerns disengagement Community 6.74* 1.76 Governance 1.43 0.36 Diversity 3.17 0.60 Employee 2.02 0.76 Environment 3.66 1.17 Human rights 6.40* 1.75 Product 1.55 0.39
Notes: This table shows the results of the multifactor regressions conducted on difference portfolios expressed by the following equation: R(i,t,p) R(i,t,n) = ai + bi[RM(t) RF(t)] + siSMB(t) + hiHML(t) + miMOM(t) + e(i,t). The table shows the R-square value, coefficients and their respective t-statistics and p-values, for each regression. All alphas are annual measures. The t-statistics derive from the Newey–West heteroskedasticity and autocorrelation-consistent standard errors. The sample period was January 2008–December 2011. * 10% significance. ** 5% significance. *** 1% significance.
data library4; SMB(t) is the difference in monthly returns between small and large-cap portfolios; HML(t) is the difference in returns between value and growth portfolios; and MOM(t) is the monthly return on a portfolio long on past one-year winners and short on past one-year losers. In addition, we measure the return’s difference between SRI portfolios and their non-socially responsible counterparts (Derwall et al., 2005; Galema et al., 2008). To construct these ‘‘differenced’’ portfolios, we first subtracted the returns of portfolios engaged in ESG strengths from those of portfolios not engaged in ESG strengths, then the returns of portfolios involved in ESG concerns from those of portfolios not involved in ESG controversies. The corresponding equation is as follows:
Rði; t; pÞ Rði; t; nÞ ¼ ai þ bi½RMðtÞ RFðtÞ þ siSMBðtÞ þ hiHMLðtÞ þ miMOMðtÞ þ eði; tÞ;
ð1:2Þ 5
where R(i,t,p) represents the returns on socially responsible portfolios (panels C + E and panel B, ) and R(i,t,n) is the return on their accompanying non-socially responsible portfolios. The independent variables are similar to those in Eq. (1.1), except that ai is the differential excess performance between SRI and non-SRI portfolios. 3. Results 3.1. Four-factor performance analysis Table 2 reports the results of the four-factor regressions estimating Islamic SRI and non-SRI portfolios’ performance. The estimates of the four factors show significant differences across panels, and we find significant alpha values for five portfolios (of 39). The portfolio composed of companies with partial engagement in governance outperformed its peer Islamic index (i.e., MSCI U.S. Islamic) over the observation period (a = 4.91%, p < .05). Among ESG concerns, we observed that two portfolios, representing firms with partial involvement in community relationships and human rights controversies, outperformed their peer indexes (a = 6.04% and a = 5.54%, respectively; p < .05). The results thus indicate a positive effect of ESG strengths exclusively for the governance domain, as well as positive effects of ESG concerns in the community and human rights domains. 4 5
Available at. We merged the partially and significantly engaged portfolios into a single set of engaged portfolios.
Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003
Industry-adjusted a t-Stat
SMB
t-Stat
HML
t-Stat
MOM
t-Stat
Rm-Rf
t-Stat
IP1
t-Stat
IP2
t-Stat
IP3
t-Stat
Adj. R2
ESG baseline portfolios Group 2: Partially engaged portfolios Panel C: Engaged in ESG strengths (strengths = 1) 2.47 0.10 Governance 4.91**
0.13*
1.86
0.04***
2.81
0.85***
33.30
0.11 0.03
1.55 0.34
0.05** 0.04***
2.18 2.56
1.01*** 1.05***
25.20 0.20** 2.40 0.02 28.20 0.21** 2.53 0.35*
Panel E: Significantly engaged in ESG strengths (strengths > 1) 2.06 0.02 0.25 Diversity 4.41**
0.13**
2.15
0.02
1.11
0.84***
29.80
0.12
0.97
Panel F: Significantly involved in ESG concerns (concerns > 1) Governance 6.98** 1.99 0.24** 1.84
0.07
0.80
0.04*
1.82
0.90***
22.60 0.20
1.57
0.21
1.31
0.10***
4.25 0.35*** 4.38
1.56
Panel D: Involved in ESG concerns (concerns = 1) Community 6.04* 1.96 0.33*** 5.12 Human Rights 5.54* 1.75 0.29*** 4.66
0.00
0.04
0.30**
2.01 0.45*** 3.25 0.94 0.10 1.83
0.11 0.09
0.62 0.94 0.50 0.93
Group 3: Significantly engaged portfolios 0.41***
2.67 0.50*** 2.75 0.94
0.18
0.70 0.38
1.47 0.89
Difference portfolios Panel A: ESG strengths engagement Governance 7.06**
1.94 0.41*** 3.80
Panel B: ESG concerns disengagement Community 6.74 1.61 Human Rights 6.40* 1.89
0.74*** 0.50***
5.65 0.10 4.81 0.05
1.18 0.08* 0.53 0.08**
1.67 0.08 2.48 0.09
1.25 1.66
0.22
0.90
0.74***
2.60 0.57**
2.47 0.51
0.22 0.29**
1.54 2.51
0.19 0.53**
0.60 0.69** 2.00 0.40**
2.39 0.62 2.05 0.28
Notes: The equation used for industry adjustment derives from the classic four-factor model. Additional industry factors are represented by the IP variable. The equation is modified as follows: R(it) RF(t) = ai + bi[RM(t) RF(t)] + siSMB(t) + hiHML(t) + miMOM(t) + hiIP1 3(t) + e(t). To form our industry dummies, we performed a principal components analysis of the portion of Fama and French’s (1993) excess industry-sorted portfolio returns that could not be explained by the four-factor model (i.e., model intercept and residual series). We only used seven industry-sorted portfolios (consumer, manufacturing, energy, high-tech, telecommunications, shops, utilities and others) due to the limited number of sectors in our shariahcompliant universe. Then we retained the first three components, which captured most remaining industry return variations, and added them to the four-factor model. The t-statistics (in italics) derive from the Newey–West heteroskedasticity and autocorrelation-consistent standard errors. The sample period was January 2008–December 2011. * 10% significance. ** 5% significance. *** 1% significance.
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Table 4 Performance of industry-adjusted islamic SRI portfolios (seven-factor model).
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Beyond the effect linked to each ESG domain, we find a tangible effect related to ESG scoring intensity. For portfolios with firms that are significantly engaged in ESG strengths or significantly involved in ESG concerns (Panels E and F), we observe noticeable differences compared with the partially engaged and partially involved portfolios (Panels C and D). The portfolio of firms with significant engagement in diversity outperformed its peer index (a = 4.41%, p < .1), as did the portfolio of firms with significant involvement in governance concerns, surprisingly (a = 7.06, p < .05). These significant alphas for the portfolios partially engaged in governance strengths and significantly involved in governance concerns seem contradictory. However, examining the indicators considered by KLD for this domain, we find that good governance is measured by firms’ declared support for ESG public policies and the quality of their social reporting,6 whereas the measure of bad governance includes the severity of disputes in relation to executive compensation and misconduct such as bribery, tax evasion, insider trading or accounting irregularities. The paradox and positive alpha reported for portfolios partially involved in community and human rights concerns thus suggest that firms with good financial performance may intentionally seek to conceal their ESG concerns with a proactive CSR communication strategy, that is, engage in ‘‘greenwashing’’. The last rows of Table 2 contain the results of the four-factor regressions for the five portfolios, ranked according to firm aggregate ESG performance. None of the reported alpha estimates were significant, confirming Sharfman’s (1996) argument about the potentially opposing effects across ESG domains. The differenced portfolio treatment helps reduce the dimensionality of our panel, in addition to indicating variations in factor exposure. We thus estimated the relative performance of ESG strengths engagement and ESG concerns disengagement; from our perspective, both strategies are socially responsible. That is, we measure the relative performance of the ESG strengths portfolios compared with their zero-ESG strengths counterparts, then measure the relative performance of the zero-ESG concerns portfolios in relation to their ESG concerns counterparts. As we show in Table 3, the return difference between the governance strengths – no governance strengths portfolios is significantly positive (7.06%, p < .1). However, the results report negative return differences between no community concerns and community concerns portfolios, as well as between no human rights concerns and human rights concerns portfolios (6.74% and 6.40%, respectively; p < .1). An inclusion strategy favouring governance strengths thus should enhance portfolio performance, but an exclusion strategy intended to disengage from community and human rights controversies likely impairs portfolio performance. Our results confirm previous findings that the presence of socially irresponsible firms in a portfolio enhances its performance (Dravenstott and Chieffe, 2011). 3.2. Industry-adjusted seven-factor model Kurtz and Di Bartolomeo (2011) provide evidence that sector exposure substantially drives SRI portfolio returns. Accordingly, we investigated whether the portfolio loadings changed, after controlling for industry effects. That is, we constructed a factor model composed of the four investment style regressors and three industry factors orthogonal to the primary factor. The resultant model took the following form:
RðitÞ RFðtÞ ¼ ai þ bi½RMðtÞ RFðtÞ þ siSMBðtÞ þ hiHMLðtÞ þ miMOMðtÞ þ piIP1 3ðtÞ þ eðitÞ;
ð1:3Þ
where IP1 3(t) represents three factors (principal components) that capture industry effects. The results of this industry-adjusted regression provide robust, unbiased estimates (Table 4). The loadings recorded for the industry-adjustment variables cannot be interpreted with respect to specific industry exposure but rather provide evidence of industry effects, according to the significant alphas obtained in the regressions performed on the eight portfolios in the original four-factor model. The regression estimates confirm the robustness of our original results, with a slight change in the significance level for the alpha estimates linked to community controversies disengagement. Moreover, from an investment style perspective, the results in Table 4 show that a governance strengths engagement strategy tilts Islamic investments toward big stocks and that a community and human right concerns disengagement strategy intensifies the original small-cap effects produced by Islamic screenings. These results match previous findings that large firms are more likely to have both positive and negative ESG ratings (Dravenstott and Chieffe, 2011).
4. Conclusion In this study, we measure the financial impact of combining Islamic investment practices with positive SRI practices (i.e., integrating the portfolios of the best ESG companies). Our observations point to the presence of varying, confounding effects resulting from the different ESG selection criteria. The results from the four-factor model regressions, confirmed by the industry-adjusted seven-factor model, provide conclusive evidence about the better performance of Islamic portfolios that exhibit partial good governance and significant diversity strengths, compared with their traditional Islamic peers during 2007–2011. This study provides empirical evidence that incorporating ESG criteria into an Islamic investment process does not impair portfolio performance, as well as partial support for a good governance premium (Derwall et al., 2005; Galema et al., 2008). From a practical perspective, 6
The quality assessment of the reports relies on their compliance with the Global Reporting Initiative.
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this pioneering study offers Islamic investors a means to consider the potential financial benefits of positive ESG screening and more specifically good governance, as supported by Shleifer and Vishny (1997). Furthermore, from a market efficiency perspective, Islamic screening favors smaller companies that are less liquid than companies with higher market capitalization, so the adoption of ESG standards by these firms should increase transparency, mitigate information asymmetry and improve stock market liquidity and quality (Chung et al., 2010). References Barnett, M.L., Salomon, R.M., 2006. Beyond dichotomy: the curvilinear relationship between social responsibility and financial performance. Strategic Management Journal 27 (11), 1101–1122. Barnett, M.L., Salomon, R.M., 2011. Does it pay to be really good? Addressing the shape of the relationship between social and financial performance. Strategic Management Journal 33 (11), 1304–1320. Bauer, R., Koedijk, K., Otten, R., 2005. International evidence on ethical mutual fund performance and investment style. Journal of Banking & Finance 29 (7), 1751–1767. Brammer, S., Brooks, C., Pavelin, S., 2006. Corporate social performance and stock returns: UK evidence from disaggregate measures. Financial Management 35 (3), 97–116. Capelle-Blancard, G., Monjon, S., 2014. The performance of socially responsible funds: does the screening process matter? Eur. Financial Manage. 20 (3), 494–520. Carhart, M.M., 1997. On persistence in mutual fund performance. J. Finance 52 (1), 57–82. Chung, K.H., Elder, J., Kim, J.C., 2010. Corporate governance and liquidity. J. Financial Quant. Anal. 45 (2), 265–291. Derwall, J., Guenster, N., Bauer, R., Koedijk, K., 2005. The eco-efficiency premium puzzle. Financial Anal. J. 61 (2), 51–63. Dravenstott, J., Chieffe, N., 2011. ‘‘Corporate social responsibility: should I invest for it or against it? J. Invest. 20 (3), 108–117. Fama, E.F., French, K.R., 1993. Common risk factors in stock and bond returns. J. Financ. Econ. 33, 3–56. Forte, G., Miglietta, F., 2007. ‘‘Islamic Mutual Funds as a Faith-based Funds in a Socially Responsible Context’’, Working paper, Bocconi University, Milan. Galema, R., Plantinga, A., Scholtens, B., 2008. The stocks at stake: return and risk in socially responsible investment. Journal of Banking & Finance 32 (12), 2646–2654. Girard, E., Hassan, M.K., 2008. Is there a cost to faith-based investing? Evidence from FTSE Islamic indices. J. Invest. 17 (4), 112– 121. Hayat, R., Kraeussl, R., 2011. Risk and return characteristics of Islamic equity funds. Emerg. Markets Rev. 12 (2), 189–203. Hayat, U., 2013. ‘‘Islamic Finance and Socially Responsible Investing’’. CFA Institute Magazine 8. Hoepner, A.G.F., Rammal, H.G., Rezec, M., 2011. Islamic mutual funds’ financial performance and international investment style: evidence from 20 countries. Eur. J. Finance 17 (9–10), 829–850. Hussein, K., Omran, M., 2005. Ethical investment revisited: evidence from Dow Jones Islamic indexes. J. Invest. 14 (3), 105–124. Kurtz, L., Di Bartolomeo, D., 2011. The long-term performance of a social investment universe. J. Invest. 20 (3), 95–102. Merdad, H., Hassan, M.K., Alhenawi, Y., 2010. Islamic versus conventional mutual funds performance in Saudi Arabia: a case study. J. King Abdulaziz Univ.: Islamic Econ. 23 (2). Renneboog, L., Ter-Horst, J., Zhang, C., 2008. Socially responsible investments: institutional aspects, performance and investor behavior. Journal of Banking & Finance 32, 1723–1742. Revelli, C., Viviani, J.L., 2015. Financial performance of socially responsible investments (SRI): what have we learned? A metaanalysis. Business Ethics: Eur. Rev. 24 (2), 158–185. Sairally, S., 2007. Evaluating the ‘social responsibility’ of Islamic finance. Learning from the experiences of socially responsible investment funds’’, Advances in Islamic Economics and Finance. In: Proceedings of the 6th international conference on islamic economics and finance, pp. 279–320. Sharfman, M., 1996. The construct validity of the Kinder, Lydenberg & Domini social performance ratings data. Journal of Business Ethics 15 (3), 287–296. Shleifer, A., Vishny, R.W., 1997. A survey of corporate governance. J. Finance 52 (2), 737–783. Walkshaeusl, C., Lobe, S., 2012. Islamic investing. Rev. Financial Econ. 21 (2), 53–62. Williams, G., Zinkin, J., 2010. Islam and CSR: a study of the compatibility between the tenets of Islam and the UN global compact. Journal of Business Ethics 91 (4), 519–533. Wilson, R., 2001. ‘‘The Economics of Mutual Funds: An Islamic Approach’’, working Paper, University of Durham.
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Should Islamic investors consider SRI criteria in their investment strategies? Elias Erragraguy, Christophe Revelli ⇑ University of Toulon-Var, Kedge Business School, Domaine de Luminy, BP921, 13288 Marseille Cedex 09, France
a r t i c l e
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Article history: Received 9 February 2015 Accepted 13 July 2015 Available online xxxx JEL classification: G11 M14 A13 G15 Keywords: Socially responsible investing (SRI) Islamic investing Environmental Social and governance (ESG) scores Corporate social responsibility (CSR) Portfolio management
a b s t r a c t Can environmental, social and governance (ESG) performance be a criterion for Islamic investment policies? The development of socially responsible investments (SRI) challenges the conservative approach of Islamic investments toward promoting corporate social responsibility. This study therefore tests the potential of integrating positive ESG screening with Islamic portfolios using KLD social ratings, to determine the financial price that shariah compliance and social responsibility entail. Our results reveal no adverse effects on returns due to the application of Islamic and ESG screening; substantially higher performance results from the inclusion of good governance criteria in the post-subprime crisis period. Ó 2015 Elsevier Inc. All rights reserved.
1. Introduction In the past 20 years, socially responsible investing (SRI) has increasingly attracted the interest of individual and private investors, as well as academics. Unlike conventional investments, SRIs entail a set of screening methods that exclude or include stocks on the basis of environmental, social and corporate governance (ESG) criteria, often with the engagement of local communities and active shareholders who encourage relevant corporate strategies (Renneboog et al., 2008). More recently, ⇑ Corresponding author. E-mail addresses: [email protected] (E. Erragraguy), [email protected] (C. Revelli). http://dx.doi.org/10.1016/j.frl.2015.07.003 1544-6123/Ó 2015 Elsevier Inc. All rights reserved.
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another form of ethical investment, Islamic investment, focuses the interest of academics and practitioners. An Islamic investment policy instead conforms with the shariah guidelines and principles that govern all aspects of human activity, including portfolio allocations, trading practices and dividend distributions (Girard and Hassan, 2008). From a scientific standpoint, most research in the last decade on SRI focused on performance, seeking to understand whether this type of investment has financial costs beyond those associated with conventional investments. Several empirical studies have attempted to demonstrate a causal link between the effect of introducing non-financial criteria in the investment process and the financial performance of SRI funds or SRI indices. Recently, a meta-analysis proposed by Revelli and Viviani (2015) concluded that the consideration of corporate social responsibility in stock market portfolios is neither a weakness nor a strength compared with conventional investments and that the heterogeneous results in prior studies largely reflect the SRI dimensions under study. In this perspective, Barnett and Salomon (2006) demonstrate that SRI fund performance increases with intensified screening. Capelle-Blancard and Monjon (2014) note that greater strategy distinction is associated with better financial performance, as well as that positive screenings promoting best ESG practices are less harmful than negative screenings that exclude entire sectors. From another side, the resilience of the Islamic financial market to the subprime crisis triggered substantial research interest. Previous findings suggest that sector screening imposed by Islamic funds should not hinder performance (Wilson, 2001). Similarly, Hayat and Kraeussl (2011) report no statistically significant differences between the risk-adjusted performance of Islamic mutual equity funds or indexes and their conventional benchmarks. Hussein and Omran (2005) further suggest that Islamic indices may provide better returns than conventional indices in times of financial distress. For example, the exclusion of high-profile firms such as Enron and WorldCom, due to their excessive indebtedness, enabled the Dow Jones Islamic Market Index (DJIMI) to outperform its conventional counterparts after both firms collapsed in, respectively, 2001 and 2002. Significant international studies also confirm the better performance observed during the subprime crisis by Islamic developed market indices (Walkshaeusl and Lobe, 2012) and funds (Hoepner et al., 2011). Walkshaeusl and Lobe (2012) note that the performance difference is largely attributable to the exclusion of financial stocks from shariah-screened portfolios, but however, they predict that such superior performance should not persist over time. Merdad et al. (2010) accordingly highlight the underperformance of Islamic funds during buoyant periods. This insight suggests a means to investigate how the greater performance recorded by Islamic investments during times of financial distress might be sustained during stable periods. Islamic finance and SRI share clear similarities in their objectives and claims (e.g., promoting social welfare through ethics). Williams and Zinkin (2010) highlight the compatibility of Islamic ethics and classic business ethics as fundamental sources of current SRI practices. However, this study also suggests that a strategy that focuses only on excluding ‘‘sinful’’ activities is insufficient to comply with all ethical and social guidelines prescribed by Islamic sources, such that the integration of ESG indicators in the Islamic investment process may be necessary. A survey among Islamic finance practitioners shows that 98.8% of respondents believe that promoting social responsibility in financial transactions would reconcile Islamic financial institutions with their ethical origin (Sairally, 2007), leading the author to conclude that Islamic investment could ‘‘learn from the more proactive engagement practices of SRI funds whereby they encourage companies to be more responsive to society’s expectations’’ while still preserving their financial performance. Many justifications in previous works support mixing Islamic and SRI strategies. Forte and Miglietta (2007) show that Islamic investment and SRI have different characteristics in terms of asset allocations, econometric profiles and sector exposure. Despite empirical evidence that both Islamic and SRI funds are more oriented toward growth and small-cap stocks (Walkshaeusl and Lobe, 2012), in very developed SRI markets, SRI funds are more oriented toward large caps (Bauer et al., 2005). Therefore, from a financial point of view, integrating SRI filters into an Islamic portfolio, or vice versa, might provide complementary investment classes for both types of investors. It also could produce diversification benefits for fund managers, by reducing the non-systematic risk that stems from differences in Islamic and SRI portfolio profiles. Finally, incorporating positive ESG screening in Islamic investments might mitigate exposures to environmental and ecological risks that Islamic investments suffer, due to their traditional orientation toward industrial and fossil energy sectors (Forte and Miglietta, 2007). Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003
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Despite such calls for reconciliation, no serious attempts have been made to combine these two ethical investing styles into a single investment process appear in prior research (Hayat, 2013). To fill this gap, we examine the effect of combining positive ESG criteria (the companies that are most virtuous in terms of their ESG scores) with an Islamic investment process. That is, we apply various ESG screenings to an Islamic stock universe to determine if socially responsible Islamic portfolios differ in their performance and investment styles. Noting the differences in sector exposure between SRI and Islamic investments, we also test the robustness of the results using an industry-adjusted measurement model. Our results show that integrating ESG screenings into Islamic portfolios does not impair performance, and generate higher performance for the good governance and diversity criteria. From a practical perspective, merging two forms of ethical screening practices offers new diversification perspectives for investors from both realms who seek to include new asset classes in their portfolios. By demonstrating proving the financial merit of SRI, our research also supports arguments for transparency and social accountability guidelines applied to Islamic financial regulatory institutions.1 In the next section, we present our methodological study settings. After we report the results and test their robustness, we discuss the main findings and implications through the conclusion. 2. Data and methods Our data set combines ESG ratings and financial data of the constituents of the MSCI U.S. Islamic index, since its inception in 2007, which forms our shariah-compliant stock universe.2 Of the 270 firms listed in the MSCI U.S. Islamic index in 2007, we retained 238 that received ESG ratings from KLD. Several authors pointed out the inconsistency of using aggregated measures of ESG performance (Brammer et al., 2006; Barnett and Salomon, 2011). Therefore, aggregate measures of ESG performance may confound opposing relationships between specific subcomponents of ESG performance and returns (Galema et al., 2008). Consequently, we avoided relying on a single composite ESG score and instead used disaggregated measures for each subcomponent. Therefore, our portfolio composition relies on a simple, passive, value-weighted methodology that controls for manager stock selection skills and enables measures of the effects linked exclusively to ESG strategic allocations. We isolate each of the seven ESG domains based on positive criteria (community, governance, diversity, employee relations, environment, human rights and product) and separate out the two screening dimensions (positive strength/negative concerns) proposed by KLD. Next, we classify the scores according to three rankings: 0, 1 or greater than 1. For each ESG subcomponent, depending on the type of dimension, 0 indicates either ‘‘no engagement’’ or ‘‘no implication in controversies’’; 1 indicates ‘‘partial engagement’’ or ‘‘partial controversies’’; and a score greater than 1 indicates ‘‘significant engagement’’ or ‘‘significant controversies.’’ The final panel consists of 34 portfolios.3 These portfolios are non-mutually exclusive. To verify the relevance of our disaggregated ESG performance approach, we constructed a subset of 5 portfolios using an aggregate scoring approach for comparative purpose. Table 1 contains the descriptive statistics for the 39 portfolios in our panel, grouped according to their level of ESG engagement and level of implication in ESG controversies. It thus provides the descriptive statistics of monthly returns from January 2008 to December 2011. To assess the effect of ESG screening on portfolio performance, we conducted two analyses. First, we used the four-factor model proposed by Carhart (1997). Formally, we measured performance with the following equation:
Rði; tÞ RFðtÞ ¼ ai þ bi½RMðtÞ RFðtÞ þ siSMBðtÞ þ hiHMLðtÞ þ miMOMðtÞ þ eði; tÞ;
ð1:1Þ
where R(i,t) is the return on portfolio i; RM(t) is the return in month t on a value-weighted market proxy; RF(t) is the return in month t of a one-month Treasury bill extracted from Kenneth French’s 1
Such as AAOIFI or IFSB. The methodology MSCI uses to screen shariah-compliant stocks is available at
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Table 1 Descriptive Statistics for Islamic SRI Portfolios. Mean
Std. dev.
Sharpe ratio
Minimum
Maximum
Pr (Skew)
Pr (Kurtosis)
Panel A: Not engaged in ESG strengths (strengths = 0) Community 1.11 22 0.05 Governance 0.31 23.35 0.01 Diversity 1.99 26.22 0.08 Employee 2.67 20.59 0.13 Environment 2.68 21.16 0.13 Human Rights 0.34 17.76 0.02 Product 0.67 18.95 0.04
16.47 18.95 19.48 19.29 18.46 15.06 15.25
17.58 17.07 18.11 13.95 15.48 11.04 13.68
0.32 0.17 0.19 0.04 0.10 0.08 0.19
0.17 0.19 0.54 0.05 0.09 0.26 0.27
Panel B: Not involved in ESG concerns (concerns = 0) Community 1.12 18.74 0.06 Governance 2.54 23.91 0.10 Diversity 3.53 18.99 0.18 Employee 0.55 17.78 0.03 Environment 0.94 18.88 0.05 Human Rights 0.43 18.19 0.02 Product 0.67 21.88 0.03
15.58 21.33 17.45 15.28 17.70 14.63 18.91
12.02 15.52 10.00 10.91 10.58 11.74 14.56
0.10 0.04 0.02 0.16 0.03 0.12 0.07
0.27 0.10 0.12 0.29 0.09 0.32 0.22
Panel C: Engaged in ESG strengths (strengths = 1) Community 1.60 16.29 0.10 Governance 3.08 15.24 0.20 Diversity 1.87 25.55 0.07 Employee 0.06 22.10 0.00 Environment 3.54 19.9 0.18 Human Rights 8.92 35.44 0.26 Product 6.01 17.43 0.34
14.17 12.88 25.80 17.96 14.30 57.45 15.22
9.25 8.12 18.58 13.62 16.01 12.48 10.56
0.05 0.03 0.01 0.14 0.40 0.00 0.04
0.21 0.20 0.01 0.38 0.16 0.00 0.14
Panel D: Involved in ESG concerns (concerns = 1) Community 2.64 17.92 0.15 Governance 2.64 18.91 0.14 Diversity 0.65 17.54 0.04 Employee 0.68 19.36 0.03 Environment 2.11 18.60 0.11 Human Rights 2.59 18.55 0.14 Product 1.56 15.38 0.1
14.94 15.99 11.16 15.38 16.40 15.97 12.16
8.89 10.37 14.13 13.78 11.21 10.76 8.31
0.06 0.07 0.52 0.15 0.04 0.08 0.14
0.45 0.37 0.31 0.29 0.20 0.33 0.52
Panel E: Significantly engaged in ESG strengths (strengths > 1) Diversity 3.34 15.39 0.21 Employee 0.76 17.46 0.04 Environment 2.72 16.68 0.16
11.86 12.27 13.35
8.66 14.56 10.69
0.10 0.55 0.21
0.53 0.17 0.35
Panel F: Significantly involved in ESG concerns (concerns > 1) Governance 4.37 16.19 0.26 Employee 0.94 17.31 0.05 Environment 0.43 18.10 0.02
12.60 15.08 13.24
8.39 9.06 12.33
0.09 0.06 0.32
0.45 0.26 0.63
Portfolios based on aggregated scoring Worst ESG score 2.07 26.42 Bad ESG score 0.43 20.35 Mid ESG score 0.26 20.34 Good ESG score 1.81 19.07 Best ESG score 2.56 15.57
20.77 13.88 17.08 15.45 13.62
20.20 13.56 14.35 9.43 8.15
0.29 0.36 0.11 0.08 0.05
0.14 0.96 0.18 0.39 0.24
Group 1: Non-engaged portfolios
Group 2: Partially engaged portfolios
Group 3: Significantly engaged portfolios
0.08 0.02 0.01 0.09 0.16
Notes: The mean returns, standard deviations and Sharpe ratios (mean excess return to the standard deviation of the returns) are all annual measures. The last two columns provide skewness and kurtosis data. Group 3 does not contain all seven domains, because for some domains, no firms were significantly engaged in ESG issues or significantly involved in ESG controversies. In the lower part of the table, the benchmark was a set of five portfolios constructed on the basis of aggregated scores. The sample period was January 2008–December 2011.
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E. Erragraguy, C. Revelli / Finance Research Letters xxx (2015) xxx–xxx Table 2 Performance of Islamic SRI Portfolios (Four-Factor Model). HML
t-Stat
MOM
t-Stat
Rm-Rf
t-Stat
Adj. R2
Panel A: Not engaged in ESG strengths (strengths = 0) Community 0.96 0.36 0.15 1.30 Governance 2.02 0.68 0.30*** 3.44 Diversity 0.12 0.02 0.40** 1.69 Employee 0.00 0.01 0.41*** 2.73 Environment 0.96 0.33 0.29*** 4.05 Human Rights 1.21 0.69 0.03 0.89 Product 0.36 0.18 0.04 0.74
0.06 0.08 0.09 0.13 0.11 0.05 0.02
0.55 0.68 0.59 1.05 1.09 0.87 0.24
0.01 0.06 0.01 0.06 0.05 0.00 0.03
0.27 2.42 0.24 1.33 2.70 0.44 2.30
1.17*** 1.23*** 1.32*** 1.04*** 1.12*** 0.99*** 1.06***
15.00 19.70 13.30 16.80 18.70 11.70 32.40
0.93 0.94 0.86 0.92 0.94 0.98 0.95
Panel B: Not involved in ESG concerns (concerns = 0) Community 1.07 0.51 0.41*** Governance 0.36 0.10 0.35*** Diversity 3.29 1.25 0.13 Employee 0.48 0.18 0.17 Environment 1.31 0.59 0.37*** Human rights 1.19 0.88 0.21*** Product 1.09 0.40 0.04
0.02 0.07 0.05 0.04 0.01 0.08 0.08
0.27 0.62 0.63 0.56 0.13 1.32 0.90
0.03 0.08 0.02 0.05 0.08** 0.03 0.03
0.68 1.80 0.79 0.94 3.16 1.15 0.87
0.92*** 1.22*** 1.00*** 0.91*** 0.93*** 0.94*** 1.18***
30.90 14.30 17.00 20.80 16.80 40.00 24.00
0.92 0.91 0.92 0.89 0.94 0.96 0.94
0.01 0.13 0.25* 0.01 0.07 0.53 0.14
0.31 1.86 1.72 0.06 0.64 0.86 1.31
0.01 0.05 0.04 0.03 0.06 0.06 0.09*
0.45 1.83 1.02 1.01 2.13 0.73 1.48
0.89*** 0.84*** 1.34*** 1.16*** 1.12*** 1.07*** 0.78***
30.20 24.90 12.50 19.40 15.40 10.80 9.61
0.94 0.93 0.90 0.90 0.88 0.21 0.80
1.47 2.12 0.51 1.94 0.86 0.25 1.10
0.04 0.01 0.09** 0.02 0.01 0.04 0.01
1.55 0.20 2.75 0.92 0.60 1.81 0.42
1.03*** 0.94*** 0.95*** 1.05*** 1.00*** 1.07*** 0.84***
23.80 20.60 12.30 26.70 31.70 38.40 22.90
0.94 0.92 0.90 0.97 0.94 0.93 0.92
2.15 0.40 2.09
0.03 0.03 0.02
0.87 1.68 0.46
0.82*** 0.96*** 0.87***
25.20 11.50 19.70
0.91 0.92 0.93
0.81 0.50 0.85
0.05 0.01 0.05
2.22 0.43 3.42
0.90*** 0.98*** 1.04***
20.50 20.10 28.20
0.88 0.91 0.94
1.75 0.23 0.00 3.33 1.19
0.00 0.08 0.02 0.03 0.08
0.04 1.66 0.82 0.98 1.21
1.41*** 1.14*** 1.13*** 0.96*** 0.67***
15.40 20.10 20.80 19.90 8.38
0.86 0.86 0.93 0.91 0.75
a
t-Stat
SMB
t-Stat
Group 1: Non-engaged portfolios
3.30 2.04 0.88 1.31 4.75 4.08 0.64
Group 2: Partially engaged portfolios Panel C: Engaged in ESG strengths (strengths = 1) Community 1.94 1.14 0.05 Governance 4.91** 2.54 0.10 Diversity 4.24 1.22 0.38** Employee 0.48 0.16 0.22* Environment 1.79 0.53 0.15 Human rights 11.04 0.61 0.19 Product 5.03 1.68 0.19
0.44 1.00 2.60 1.27 1.18 0.75 1.36
Panel D: Involved in ESG concerns (concerns = 1) Community 6.04** 1.99 0.33 Governance 1.81 0.63 0.27*** Diversity 0.12 0.04 0.06 Employee 1.57 0.84 0.02 Environment 2.43 1.01 0.06 Human rights 5.54** 1.61 0.30*** Product 2.67 1.15 0.06
4.96 2.16 0.52 0.38 0.75 4.75 1.16
0.11 0.15* 0.04 0.15*** 0.06 0.02 0.07
Group 3: Significantly engaged portfolios Panel E: Significantly Diversity Employee Environment
engaged in ESG strengths (strengths > 1) 2.06 0.01 0.09 0.14* 4.41* 1.57 0.54 0.00 0.01 0.04 3.29 1.83 0.04 0.55 0.16**
Panel F: Significantly Governance Employee Environment
involved in ESG concerns (concerns > 1) 7.06** 1.98 0.24** 1.49 0.07 2.43 0.90 0.14 1.64 0.03 3.04 1.10 0.23*** 4.14 0.06
Portfolios based on aggregated scoring Worst ESG score 3.43 0.77 Bad ESG score 3.66 0.77 Mid ESG score 1.33 0.63 Good ESG score 2.43 1.13 Best ESG score 1.21 0.43
0.24 0.31** 0.04 0.06 0.23
1.26 2.79 0.34 0.52 1.60
0.28* 0.03 0.00 0.24*** 0.10
Notes: This table shows the R-square values, coefficients and their respective t-statistics and p-values, for each regression. Portfolios are grouped into three categories. All alphas are annual measures. The t-statistics came from Newey–West heteroskedasticity and autocorrelation-consistent standard errors. The sample period was January 2008–December 2011. * 10% significance. ** 5% significance. *** 1% significance.
Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003
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Table 3 Relative performance of Islamic SRI differenced portfolios (four-factor model).
a Panel A: ESG engagement Community 0.96 Governance 7.06* Diversity 4.24 Employee 0.48 Environment 2.73 Human rights 12.11 Product 4.66
t-Stat
SMB
t-Stat
HML
t-Stat
MOM
t-Stat
Rm-Rf
t-Stat
Adj. R2
0.30 1.86 1.32 0.12 0.57 0.62 1.01
0.11 0.39*** 0.02 0.19 0.43*** 0.22 0.23
0.60 2.77 0.16 1.63 2.79 0.77 1.23
0.05 0.22* 0.16 0.14 0.04 0.58 0.13
0.43 1.34 1.50 1.20 0.27 0.86 0.81
0.01 0.11 0.03 0.09** 0.11** 0.06 0.12
0.12 2.23 0.69 1.49 3.06 0.70 1.66
0.28*** 0.39*** 0.02 0.12** 0.00 0.08 0.28***
2.62 4.16 0.19 2.03 0.01 0.75 2.51
0.30 0.53 0.04 0.10 0.24 0.07 0.15
0.74*** 0.08 0.07 0.15 0.31** 0.51*** 0.11
5.04 0.54 0.38 1.03 3.15 4.71 0.90
0.09 0.23* 0.01 0.19* 0.06 0.06 0.00
1.09 1.85 0.06 1.98 0.49 0.57 0.03
0.07 0.07 0.11** 0.07 0.07 0.07 0.04
1.04 1.08 2.17 1.33 2.33 1.50 0.65
0.10 0.28*** 0.05 0.14** 0.07 0.13* 0.33***
1.72 3.50 0.34 1.93 1.46 2.57 3.99
0.39 0.29 0.07 0.13 0.10 0.29 0.37
Panel B: ESG concerns disengagement Community 6.74* 1.76 Governance 1.43 0.36 Diversity 3.17 0.60 Employee 2.02 0.76 Environment 3.66 1.17 Human rights 6.40* 1.75 Product 1.55 0.39
Notes: This table shows the results of the multifactor regressions conducted on difference portfolios expressed by the following equation: R(i,t,p) R(i,t,n) = ai + bi[RM(t) RF(t)] + siSMB(t) + hiHML(t) + miMOM(t) + e(i,t). The table shows the R-square value, coefficients and their respective t-statistics and p-values, for each regression. All alphas are annual measures. The t-statistics derive from the Newey–West heteroskedasticity and autocorrelation-consistent standard errors. The sample period was January 2008–December 2011. * 10% significance. ** 5% significance. *** 1% significance.
data library4; SMB(t) is the difference in monthly returns between small and large-cap portfolios; HML(t) is the difference in returns between value and growth portfolios; and MOM(t) is the monthly return on a portfolio long on past one-year winners and short on past one-year losers. In addition, we measure the return’s difference between SRI portfolios and their non-socially responsible counterparts (Derwall et al., 2005; Galema et al., 2008). To construct these ‘‘differenced’’ portfolios, we first subtracted the returns of portfolios engaged in ESG strengths from those of portfolios not engaged in ESG strengths, then the returns of portfolios involved in ESG concerns from those of portfolios not involved in ESG controversies. The corresponding equation is as follows:
Rði; t; pÞ Rði; t; nÞ ¼ ai þ bi½RMðtÞ RFðtÞ þ siSMBðtÞ þ hiHMLðtÞ þ miMOMðtÞ þ eði; tÞ;
ð1:2Þ 5
where R(i,t,p) represents the returns on socially responsible portfolios (panels C + E and panel B, ) and R(i,t,n) is the return on their accompanying non-socially responsible portfolios. The independent variables are similar to those in Eq. (1.1), except that ai is the differential excess performance between SRI and non-SRI portfolios. 3. Results 3.1. Four-factor performance analysis Table 2 reports the results of the four-factor regressions estimating Islamic SRI and non-SRI portfolios’ performance. The estimates of the four factors show significant differences across panels, and we find significant alpha values for five portfolios (of 39). The portfolio composed of companies with partial engagement in governance outperformed its peer Islamic index (i.e., MSCI U.S. Islamic) over the observation period (a = 4.91%, p < .05). Among ESG concerns, we observed that two portfolios, representing firms with partial involvement in community relationships and human rights controversies, outperformed their peer indexes (a = 6.04% and a = 5.54%, respectively; p < .05). The results thus indicate a positive effect of ESG strengths exclusively for the governance domain, as well as positive effects of ESG concerns in the community and human rights domains. 4 5
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Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003
Industry-adjusted a t-Stat
SMB
t-Stat
HML
t-Stat
MOM
t-Stat
Rm-Rf
t-Stat
IP1
t-Stat
IP2
t-Stat
IP3
t-Stat
Adj. R2
ESG baseline portfolios Group 2: Partially engaged portfolios Panel C: Engaged in ESG strengths (strengths = 1) 2.47 0.10 Governance 4.91**
0.13*
1.86
0.04***
2.81
0.85***
33.30
0.11 0.03
1.55 0.34
0.05** 0.04***
2.18 2.56
1.01*** 1.05***
25.20 0.20** 2.40 0.02 28.20 0.21** 2.53 0.35*
Panel E: Significantly engaged in ESG strengths (strengths > 1) 2.06 0.02 0.25 Diversity 4.41**
0.13**
2.15
0.02
1.11
0.84***
29.80
0.12
0.97
Panel F: Significantly involved in ESG concerns (concerns > 1) Governance 6.98** 1.99 0.24** 1.84
0.07
0.80
0.04*
1.82
0.90***
22.60 0.20
1.57
0.21
1.31
0.10***
4.25 0.35*** 4.38
1.56
Panel D: Involved in ESG concerns (concerns = 1) Community 6.04* 1.96 0.33*** 5.12 Human Rights 5.54* 1.75 0.29*** 4.66
0.00
0.04
0.30**
2.01 0.45*** 3.25 0.94 0.10 1.83
0.11 0.09
0.62 0.94 0.50 0.93
Group 3: Significantly engaged portfolios 0.41***
2.67 0.50*** 2.75 0.94
0.18
0.70 0.38
1.47 0.89
Difference portfolios Panel A: ESG strengths engagement Governance 7.06**
1.94 0.41*** 3.80
Panel B: ESG concerns disengagement Community 6.74 1.61 Human Rights 6.40* 1.89
0.74*** 0.50***
5.65 0.10 4.81 0.05
1.18 0.08* 0.53 0.08**
1.67 0.08 2.48 0.09
1.25 1.66
0.22
0.90
0.74***
2.60 0.57**
2.47 0.51
0.22 0.29**
1.54 2.51
0.19 0.53**
0.60 0.69** 2.00 0.40**
2.39 0.62 2.05 0.28
Notes: The equation used for industry adjustment derives from the classic four-factor model. Additional industry factors are represented by the IP variable. The equation is modified as follows: R(it) RF(t) = ai + bi[RM(t) RF(t)] + siSMB(t) + hiHML(t) + miMOM(t) + hiIP1 3(t) + e(t). To form our industry dummies, we performed a principal components analysis of the portion of Fama and French’s (1993) excess industry-sorted portfolio returns that could not be explained by the four-factor model (i.e., model intercept and residual series). We only used seven industry-sorted portfolios (consumer, manufacturing, energy, high-tech, telecommunications, shops, utilities and others) due to the limited number of sectors in our shariahcompliant universe. Then we retained the first three components, which captured most remaining industry return variations, and added them to the four-factor model. The t-statistics (in italics) derive from the Newey–West heteroskedasticity and autocorrelation-consistent standard errors. The sample period was January 2008–December 2011. * 10% significance. ** 5% significance. *** 1% significance.
E. Erragraguy, C. Revelli / Finance Research Letters xxx (2015) xxx–xxx 7
Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003
Table 4 Performance of industry-adjusted islamic SRI portfolios (seven-factor model).
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E. Erragraguy, C. Revelli / Finance Research Letters xxx (2015) xxx–xxx
Beyond the effect linked to each ESG domain, we find a tangible effect related to ESG scoring intensity. For portfolios with firms that are significantly engaged in ESG strengths or significantly involved in ESG concerns (Panels E and F), we observe noticeable differences compared with the partially engaged and partially involved portfolios (Panels C and D). The portfolio of firms with significant engagement in diversity outperformed its peer index (a = 4.41%, p < .1), as did the portfolio of firms with significant involvement in governance concerns, surprisingly (a = 7.06, p < .05). These significant alphas for the portfolios partially engaged in governance strengths and significantly involved in governance concerns seem contradictory. However, examining the indicators considered by KLD for this domain, we find that good governance is measured by firms’ declared support for ESG public policies and the quality of their social reporting,6 whereas the measure of bad governance includes the severity of disputes in relation to executive compensation and misconduct such as bribery, tax evasion, insider trading or accounting irregularities. The paradox and positive alpha reported for portfolios partially involved in community and human rights concerns thus suggest that firms with good financial performance may intentionally seek to conceal their ESG concerns with a proactive CSR communication strategy, that is, engage in ‘‘greenwashing’’. The last rows of Table 2 contain the results of the four-factor regressions for the five portfolios, ranked according to firm aggregate ESG performance. None of the reported alpha estimates were significant, confirming Sharfman’s (1996) argument about the potentially opposing effects across ESG domains. The differenced portfolio treatment helps reduce the dimensionality of our panel, in addition to indicating variations in factor exposure. We thus estimated the relative performance of ESG strengths engagement and ESG concerns disengagement; from our perspective, both strategies are socially responsible. That is, we measure the relative performance of the ESG strengths portfolios compared with their zero-ESG strengths counterparts, then measure the relative performance of the zero-ESG concerns portfolios in relation to their ESG concerns counterparts. As we show in Table 3, the return difference between the governance strengths – no governance strengths portfolios is significantly positive (7.06%, p < .1). However, the results report negative return differences between no community concerns and community concerns portfolios, as well as between no human rights concerns and human rights concerns portfolios (6.74% and 6.40%, respectively; p < .1). An inclusion strategy favouring governance strengths thus should enhance portfolio performance, but an exclusion strategy intended to disengage from community and human rights controversies likely impairs portfolio performance. Our results confirm previous findings that the presence of socially irresponsible firms in a portfolio enhances its performance (Dravenstott and Chieffe, 2011). 3.2. Industry-adjusted seven-factor model Kurtz and Di Bartolomeo (2011) provide evidence that sector exposure substantially drives SRI portfolio returns. Accordingly, we investigated whether the portfolio loadings changed, after controlling for industry effects. That is, we constructed a factor model composed of the four investment style regressors and three industry factors orthogonal to the primary factor. The resultant model took the following form:
RðitÞ RFðtÞ ¼ ai þ bi½RMðtÞ RFðtÞ þ siSMBðtÞ þ hiHMLðtÞ þ miMOMðtÞ þ piIP1 3ðtÞ þ eðitÞ;
ð1:3Þ
where IP1 3(t) represents three factors (principal components) that capture industry effects. The results of this industry-adjusted regression provide robust, unbiased estimates (Table 4). The loadings recorded for the industry-adjustment variables cannot be interpreted with respect to specific industry exposure but rather provide evidence of industry effects, according to the significant alphas obtained in the regressions performed on the eight portfolios in the original four-factor model. The regression estimates confirm the robustness of our original results, with a slight change in the significance level for the alpha estimates linked to community controversies disengagement. Moreover, from an investment style perspective, the results in Table 4 show that a governance strengths engagement strategy tilts Islamic investments toward big stocks and that a community and human right concerns disengagement strategy intensifies the original small-cap effects produced by Islamic screenings. These results match previous findings that large firms are more likely to have both positive and negative ESG ratings (Dravenstott and Chieffe, 2011).
4. Conclusion In this study, we measure the financial impact of combining Islamic investment practices with positive SRI practices (i.e., integrating the portfolios of the best ESG companies). Our observations point to the presence of varying, confounding effects resulting from the different ESG selection criteria. The results from the four-factor model regressions, confirmed by the industry-adjusted seven-factor model, provide conclusive evidence about the better performance of Islamic portfolios that exhibit partial good governance and significant diversity strengths, compared with their traditional Islamic peers during 2007–2011. This study provides empirical evidence that incorporating ESG criteria into an Islamic investment process does not impair portfolio performance, as well as partial support for a good governance premium (Derwall et al., 2005; Galema et al., 2008). From a practical perspective, 6
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Please cite this article in press as: Erragraguy, E., Revelli, C. Should Islamic investors consider SRI criteria in their investment strategies? Finance Research Letters (2015), http://dx.doi.org/10.1016/j.frl.2015.07.003