Accepted Manuscript

Title: Does the Degree of Shari’ah Compliance Affect the

Volatility?: Evidence from the MENA Region

Authors: Neveen Ahmed, Omar Farooq

PII: S0275-5319(17)30178-2
DOI: http://dx.doi.org/doi:10.1016/j.ribaf.2017.07.143
Reference: RIBAF 833

To appear in: Research in International Business and Finance

Received date: 14-1-2017

Accepted date: 6-7-2017

Please cite this article as: Ahmed, Neveen, Farooq, Omar, Does the Degree of Shari’ah
Compliance Affect the Volatility?: Evidence from the MENA Region.Research in
International Business and Finance http://dx.doi.org/10.1016/j.ribaf.2017.07.143

This is a PDF file of an unedited manuscript that has been accepted for publication.
As a service to our customers we are providing this early version of the manuscript.
The manuscript will undergo copyediting, typesetting, and review of the resulting proof
before it is published in its final form. Please note that during the production process
errors may be discovered which could affect the content, and all legal disclaimers that
apply to the journal pertain.
Does the Degree of Shari’ah Compliance Affect the Volatility? : Evidence from the MENA
Region

Neveen Ahmed

The American University in Cairo

Omar Farooq
ADA University

Highlights
 We analyze the difference in returns and volatility behavior of Shari’ah versus
conventional portfolios.
 We pursue a novel approach of distinguishing between different degrees of
Shari’ah compliance.
 Our results show asymmetric impact of volatility behavior among the three
portfolios in pre versus post financial crisis.
 The persistence in the long-run component deceases after the financial crisis in
the most Shari’ah compliant portfolio.

Abstract
Growing interest in Shari’ah compliant indices evolves with the surge in Islamic financial asset
value over the past decades, and the need to understand how these indices perform in comparison
with conventional ones. We focus our analysis on the MENA region and answer the following
questions; Does the degree of Shari’ah compliance affect volatility? Does volatility behavior of
Shari’ah-compliant portfolio different than volatility behavior of non-Shari’ah-compliant
portfolio?. We cover the period between 2003-2013, we decompose our sample into pre and post
financial crisis, and we pursue a novel approach of distinguishing between different degrees of
Shari’ah compliance. We analyze the difference in returns and volatility behavior of Shari’ah
versus conventional portfolios. We use Component-GARCH to analyze difference in volatility
behavior between Shari’ah and conventional portfolios. Our results show asymmetric impact of
volatility behavior among the three portfolios in pre versus post financial crisis. In additional,
volatility behavior alters as we compare the complete sample against pre and post financial crisis.
The most compliant portfolio shows a reduction in the effect of short-run on long-run volatility.
In addition, our result shows that the persistence in the long-run component deceases after the
financial crisis in the most Shari’ah compliant portfolio.

Key word: Shari’ah Index, Stock Volatility, CGARCH, MENA Region

JEL classification: G0 , G15

1. Introduction

Islamic financial asset increased from US $ 200 billion in 2003 to US $1.8 trillion at the end of
2013 (IMF, 2015). During the first half of the last decade there has been a 30% increase in the
Shari’ah Complaint asset, (Robinson, 2007). Nonetheless there is limited published empirical
literature on the performance of Islamic versus conventional investment. The question whether
Shari’ah complaint firm posses higher or lower volatility than non Shari’ah firms is still a
debatable issue. Answering this question is of a direct use to fund managers; identification of the
volatility and return performance of Shari’ah versus non Shari’ah indices have substantial
influence on fund managers’ portfolio composition.

The Shari’ah classification relies on two steps; first to eliminate firms engaged in certain activity
like alcohol, and conventional financial services, and the second step is based on three financial
ratios. These ratios are Debt Ratio, Cash Ratio, and Receivables Ratio. For a firm to be
categorized as Shari’ah compliant each of these three ratios has to be below 33%. Our analysis
focuses on these three ratios where we try to analyze how they influence the performance and
volatility of Shari’ah versus non Shari’ah index. In order to achieve this we introduce a novel
approach of adding a further distinguisher between Shari’ah compliant firms according to their
level of the financial ratios which in turn determine their degree of compliance. Then we examine
the differences in returns and volatiles of these portfolios as opposed to conventional market
index.

Previous literature tried to examine the performance of Shari’ah versus non-Shari’ah firms.
Nevertheless, we implement a novel approach of forming portfolios based on the degree of
compliance which is based on the level of these three ratios. One of these ratios is debt to equity
ratio; it has a significant impact on stock returns for both Shari’ah compliant and conventional
stocks. The debt to equity ratio represents a firm financial structure and a high debt to equity ratio
indicates that the company uses debt financing assertively. Firms that use debt as their main
source of capital and are able to raise capital at the cheapest rate are more able to engage in more
value enhancing projects than firms that do not use debt as their primary capital source. However,
increasing debt ratio also increases the risk of the business so the final effect on firm’s
performance and volatility is ambiguous. The second ratio is related to account receivable;

2
account receivables affects the firms’ ability to develop long-term relationship with their clients
and develop their business networks. High intensity of account receivables could indicate that
buyers having secured credit from firms are expected to purchase more from these firms. The
third financial ratio is related to amount of cash available in the firm; low amount of cash and
interest bearing securities; means the firms are unable to fund large capital expenditures and are
unable to fund more projects. However, Bukit and Iskandar (2009) document that earnings
manipulation is higher among firms with surplus cash. Thus, the impact of these financial ratios
that characterize Shari’ah compliant firm is a debatable subject and hence the performance of
Shari’ah versus conventional stocks is a debatable subject that needs more empirical studies.

Mixed results are found in the literature on the performance of Shari’ah versus non-Shari’ah
indexes. Literature examining the Shariah versus non-Shariah firms includes for example Romli
et al. (2012), Miniaoui (2014), Setiawan & Oktariza (2013), Farooq & Alahkam (2016).
Albaity and Ahmad (2008) found that Kuala Lumpur Shari’ah s Index had lower volatility than
that of Kuala Lumpur composite index but with lower return during the period of 1999-2005. In
the long-run they didn’t find a significant return difference. Albaity and Ahmad (2011) studied
the return difference between Malaysian Stock Exchange using panel data of 300 firms from the
period of 2000 to 2006, and found no significant difference. Same results were found by
Natarajan and Dharani (2012) covering Indian Market. Chiadmi and Ghaiti (2012) studied the
volatility difference between S&P Shari’ah index and S&P 500. They found that S&P Shari’ah
index are less volatile in the long-run, and it shows less risk in crises times.

Romli et al. (2012) examined the volatility of Islamic stock market in Malaysia during the world
economic recession in 2007 to 2009. Their results show that an Islamic stock market index to
have a higher volatility than conventional indices which makes the return rate of Shari’ah indices
becomes unstable. These results contradicts with the results concluded by Miniaoui (2014) which
showed no difference in volatility between Shari’ah compliant and non Shari’ah compliant in
Gulf countries during economic crisis as both types of firms showed high level of volatility.
Miniaoui (2014) study also identified both stocks to have similar return and similar risk.
Comparable results were obtained by Setiawan & Oktariza (2013).

Thus there is no conclusive results in the literature about the performance of Shari’ah companies
versus non-Shari’ah ones. Our paper investigates the differences of volatility between Shari’ah
and non-Shari’ah firms. In addition we pursue a new approach of distinguishing between different

3
degrees of compliance within the Shari’ah compliant firms. Having three degrees of compliance
allows us not only to study the volatility differences between Shari’ah and Non Shari’ah indexes.
But also we study the impact of the degree of compliance on Volatility. In this paper we answer
the following questions; does the degree of Shari’ah compliance affect volatility? Does volatility
behavior of Shari’ah-compliant portfolio different than volatility behavior of non-Shari’ah-
compliant portfolio?

The paper is organized as follows; section two provides analysis of the literature and hypothesis
development. Section three presents data description, section four discusses model and
methodology. Section five analyses results, finally, section 6 concludes.

2. Literature Review and Hypothesis Development

Literature on the performance of Shari’ah compliant firms versus conventional firms d has no
conclusive results. The results vary within countries and within time period examined. Hakim &
Rashidian (2004) used Down Jones Islamic (DJI) Index as proxy for Shari’ah compliant firms and
the Down Jones World (DJW) Index as a proxy for the world stock market as non Shari’ah
compliant counterpart. Additionally, the DJI was compared to the Down Jones Sustainability
World Index (DJS) which is a socially responsible index or “Green Index” with an environmental
awareness and avoid the stock of any company engaged in gambling and alcohol. Hence, it is the
closest alternative to the DJI to allow for direct comparison and evaluation of the cost of
complying with the Shari’ah restrictions. The study showed that both DJI and DJS had a higher
return than DJW using Treynor’s ratio. Additionally, the Islamic Indexes showed a similar risk to
worldwide non Shari’ah compliant market. Hence, the limited diversification of the Islamic
indices did not impose higher risk to its business. Possible reasons are that the Shari’ah
regulations can be less strict in some firms as Shari’ah are generally subject to broad
interpretation and the potential for error can be significant. However, the DJI underperformed the
socially responsible DJS as it showed both lower return and higher volatility. Possible
explanation is that the analysis showed that the Islamic Indices have double the risk of the Green
Indices.

Similar results were obtained by Krishna & Fu (2012) investigating the Australian Stock
exchange (ASX) for the period of 2001-2013. The study found that the Shari’ah compliant firms

4
outperformed the non Shari’ah compliant firms and had higher returns using Sharpe Ratio.
However, the Shari’ah compliant firms showed a higher risk than its counterpart. The study
examined the effect of debt to equity ratio which was found to have statistically significant
negative relationship with the returns of both Shari’ah and conventional firms. Additionally,
return on equity had the strongest positive relationship with return for both firms.

Romli et al. (2012) have examined the Islamic stock market in Malaysia during the world
economic recession in 2007 to 2009 in terms of volatility. Results shown that the Islamic stock
market index to have a higher volatility than conventional indices which makes the return rate of
Shari’ah indices becomes unstable. These results contradicts with the results concluded by
Miniaoui (2014) which showed no difference in volatility between Shari’ah compliant and non
Shari’ah compliant in Gulf countries during economic crisis as both types of firms showed high
level of volatility. Miniaoui (2014) study also identified both stocks to have similar return and
similar risk. Comparable results were obtained by Setiawan & Oktariza (2013) as they showed no
difference in risk, volatility and returns. The study compared the Shari’ah stock market and
conventional stock market in the Indonesian Stock Exchange during the period of 2009 to 2011.
Additionally, the risk-adjusted return measured by Sharpe Ratio and Jensen’s Alpha of both
Shari’ah and conventional stocks performed in a similar manner. However, the conventional
stocks had higher Treynor ratio which suggests that that conventional stocks has a significant
lower systematic risk than Shari’ah stocks portfolio.

Richardson et al. (2002) document that firms that do not have debt obligations are less inclined to
misrepresent their earnings. Press and Weintrop (1990) and Sweeney (1994) document that firms
with high leverage are more likely to misreport earnings to avoid debt covenant default.
Marquardt and Wiedman (2004) show that increase in account receivables results in earnings
manipulation. Caylor (2009) argues that high level of account receivables provide flexibility to
management to manipulate accounting statements. Bukit and Iskandar (2009) document that
earnings manipulation is higher among firms with surplus cash. Gul (2001) and Chung et al.
(2005) argue that firms with high surplus cash face significant agency problems. Managers of
these firms act opportunistically for personal gains and tend to get involved in un-profitable
projects, over investments, and misuse funds.
We argue that better information environment associated with Shari’ah compliant characteristics
may reduce volatility of Shari’ah-compliant firms relative to non-Shari’ah-compliant firms. The
greater is the degree of compliance, the lower is the volatility.

5
Thus we build our first Hypothesis:
H01: Shari’ah compliant firms are less volatile than Conventional firms.

The impact of several financial ratios of both Shari’ah and conventional stocks were examined
recently; see for example Krishna & Fu (2012), Setiawan & Oktariza (2013) , and Farooq &
Alahkam (2016). Setiawan & Oktariza (2013) showed no difference in risk, volatility and returns.
The study compared the Shari’ah stock market and conventional stock market in the Indonesian
Stock Exchange during the period of 2009 to 2011. Additionally, the risk-adjusted return
measured by Sharpe Ratio and Jensen’s Alpha of both Shari’ah and conventional stocks
performed in a similar manner. However, the conventional stocks had higher Treynor ratio which
suggests that that conventional stocks has a significant lower systematic risk than Shari’ah stocks
portfolio. Additionally, the researchers examined whether there is a significant relationship
between stock returns and several financial ratios of both Shari’ah and conventional stocks. The
six financial ratios examined were Debt to Equity Ratio, Earnings per Share Ratio, Price Earnings
Ratio, Net Profit Margin, Return on Equity, Price to Book Value and Random Error. For Shari’ah
stocks, all variables except Net Profit Margin have a significant relationship with stock returns
while for conventional stocks, all variables except Net Profit Margin and Price to Book Value
have a significant relationship with the stock returns.

Debt to Equity Ratio had a significant positive relationship with stock returns for both Shari’ah
compliant and conventional stocks. The debt to equity ratio represents a firm financial structure
and a high debt to equity ratio indicates that the company uses debt financing assertively. The
authors argue that the fund can be used to support long term growth for the firm so it can earn
more. Thus, high debt to equity ratio correlates with the increase of stock returns and vice versa.
However, empirical findings by Myers (1993) , Fama and French (1998), Shyam-Sunder and
Myers (1999) indicate that most profitable firms borrow least, therefore there exist a negative
relationship between profitability and leverage.

Additionally, the return on equity showed the most significant relationship with stocks returns of
both Shari’ah and conventional stocks. This was also indicted by Krishna & Fu (2012). A higher
return on equity shows that the company can earn higher returns on shareholder’s equity and high
return on equity also indicates high efficiency in spending money invested by shareholder to earn
profit growth. The profit growth then reflects the increase of stock returns.

6
Farooq & Alahkam (2016) compared the performance of non-financial Shari’ah compliant firms
and non-financial non-Shari’ah compliant firms in the MENA during the period between 2005
and 2009. The performance was assessed based on the firms return and results showed that the
Shari’ah compliant firms underperformed the non-Shari’ah compliant firms and had lower
returns. Additionally, they compared the results between common law and civil law countries and
found that the Shari’ah compliant firms still underperformed its counterpart firms. The authors
argue that low returns resulted from the characteristics of the Shari’ah compliant firms which are
low leverage, cash and liquidity ratios. Non-Shari’ah compliant firms use debt as their main
source of capital and are able to raise capital at the cheapest rate and be able to engage in more
value enhancing projects than firms that do not use debt as their primary capital source.
Additionally, the low amount of account receivables hinders the firms’ ability to develop long-
term relationship with their clients and develop their business networks. High intensity of account
receivables could indicate that buyers having secured credit from firms are expected to purchase
more from these firms. Another limitation of Shari’ah compliant firms is low amount of cash and
interest bearing securities; hence the firms are unable to fund large capital expenditures and are
unable to fund more projects.

However, the results also show that difference between the performance of Shari’ah compliant
firms and the performance of non-Shari’ah compliant firms disappears completely during the
crisis period. A possible explanation is that the Shari’ah compliant firms have such financial
characteristics that make them more resilient to the crisis. For instance, low leverage and low
account receivables are associated with lower risk of bankruptcy and lower risk of non-payment
by clients, respectively. Both of these risks become significantly important during the crisis
period.

Shahar (2015) compared the impact of firm’s leverage and debt on the performance of Shari’ah
compliant firms listed companies and the non-Shari’ah compliant. The study used data of
Shari’ah and non-Shari’ah compliant listed Malaysian companies in the construction business in
the period from 2008 until 2012. The results from the analysis showed that the debt ratio does not
have an impact on Shari’ah compliant firms’ performance namely Return on Asset (ROA) and
Return on Equity (ROE). This contradicts with Farooq & Alahkam (2016) who argued that the
Shari’ah compliant firms underperform due its low debt ratio. However, short-term debt and
long-term debt does give an impact to Shari’ah compliant firm’s performance based on Market
to- book value (MTBV) with negative relationship. The results were different for the non-

7
Shari’ah compliant firms which showed that long term debt and total had significant relationship
towards Return on Equity. Possible explanation is the study focused on the construction
companies which are asset intensive companies and doesn’t depend on short-term debt for
boosting their company’s performance.

Shafaai & Masih (2013) used Cost of Equity to refer to the expected minimum return as
compensation for the capital invested by the common stockholders of a firm. The study aimed to
examine the determinants of cost of equity by analyzing firm-specific risk factors in Shari’ah
compliant firms based in Malaysia. The study investigated the effect of several firm factors in
different business sectors e.g. trading/Services, technology, construction and industrial products.
The debt to equity ratio, earnings per share, total asset turnover ratio, firm size and stock liquidity
were found to have significant relationship with the cost of equity. The relationship for stock
liquidity was inconsistent with what was found in previous literature. Hence, this study showed
that firms with higher liquidity have higher cost of equity. A possible explanation for this
inconsistency could be due to a moderate collinear relationship between stock liquidity and firm
size, as larger firms tend to have higher liquidity. The study also showed that the relationship
between cost of equity and firm size is an important determinant for most for most sectors.

However, debt to equity ratio was important determinant in only two sectors; construction sector
and trading/Services sector. The debt to equity has a negative relationship with the cost of equity;
hence the debt in a firm seems to be views favorably by investors, probably as an indication of
higher future growth. This result is in line with Krishna & Fu (2012) who found a negative
association between return and debt to equity ratio in Shari’ah compliant and non Shari’ah
compliant firms.
Thus we build our second Hypothesis:
H02: The degree of compliance affects volatility behavior of Shari’ah versus conventional indexes.

3. Data

We use DATASTREAM data base for seven MENA countries: Morocco, Egypt, Saudi Arabia,
United Arab Emirates, Jordan, Kuwait, and Bahrain, for the period January 2003 – December
2013. We have a total of 2863 observations; we decompose our sample into pre-crisis and post-
crisis. Pre-Crisis: January 2003 to September 2007; Post-crisis: April 2009 to December 2013.

8
We rely on 2003 Dow Jones categorization for Shari’ah compliant based on two steps. The first
step is to eliminate firms that generate its revenues from activities prohibited by Islam, such as
alcohol and conventional financial services. The second step is to categorize firms within Shari'ah
compliant sectors according to their compliance with respect to three financial ratios: Debt Ratio,
Cash Ratio, and Receivables Ratio. Debt Ratio is defined as total debt divided by trailing 12-
month average market capitalization. Cash Ratio is defined as the sum of a firm's cash and
interest-bearing securities divided by trailing 12-month average market capitalization.
Receivables Ratio is defined as accounts receivables divided by trailing 12-month average market
capitalization.

For a firm to be categorized as Shari’ah compliant each of these three ratios has to be below 33%.
We added a further distinguisher between Shari’ah compliant firms according to their level of the
financial ratio that determine their degree of compliance. We define degree of Compliance =
(Debt Ratio + Cash Ratio + Receivables Ratio) / 3. The less these ratios, the more compliant to
Shari’ah is the firm. Thus, Portfolios with degree of compliance less than 0.11 are classified as
portfolios with the highest compliance. Portfolios with degree of compliance between 0.22 and
0.33 are classified as portfolios with the lowest compliance. We analyze three dollar-denominated
portfolios; Market Portfolio, Portfolio with the Highest Shari'ah Compliance, Portfolio with the
Lowest Shari'ah Compliance. Descriptive statistics of the three portfolios is presented in table 1.

INSERT TABLE 1

Our three portfolios are; the RVEW1 representing portfolio of firms that are most Shari’ah
compliant, RVEW3 is portfolio with least Shari’ah compliance, while RVEM is market portfolio.
RVEW1 portfolio has the highest mean return and outperforms RVEW3 and the market portfolio.
The maximum return by RVEW1 is 12.5% versus 5.8% for market portfolio. Figure 1 shows
portfolio returns of the three portfolios from 2003-2013; it is shown that over time the portfolio
with highest degree of compliance outperform other two portfolios. We find that market portfolio
outperform the least compliant portfolio. Thus, the degree of compliance seems to impact the
performance of Shari’ah versus conventional portfolios.

INSERT FIGURE 1

9
4. Model and Methodology

We model the volatility behavior of Shari’ah and conventional portfolios using Component
GARCH (C-GARCH) of Engle and Lee (1999). The C-GARCH has an advantage of better
accounting for long-run volatility dependencies. We use Maximum Likelihood to estimate our
model.
4.1 Modeling Conditional Mean
𝑟𝑡𝑒 = 𝛽 𝜎𝑡2 + 𝜀𝑡 (1)
Where rte is excess return, t2 is Conditional variance, which is modeled using C-GARCH. This
return specification assumes dependence of returns on the volatility. In this specification, 

measures the price of risk. The innovation to the return equation t ~ N (0, t2) is normally

distributed with t2 being the corresponding conditional covariance.

4.2 Modeling Volatility
Having specified the conditional mean we model volatility. Out of the various GARCH models
used in the literature we employ component GARCH (C-GARCH). C-GARCH allow us to
distinguish between short-run and long-run volatility behavior of the three portfolios; the most,
the least Shari’ah compliant and the market portfolio.
2 2
𝜎𝑡2 = 𝑞𝑡 + (𝛾1 + 𝛾2 𝐼𝑡−1 ( 𝜀𝑡−1 − 𝑞𝑡−1 )) + 𝛾3 (𝜎𝑡−1 − 𝑞𝑡−1 ) (2)
1 𝑖𝑓 𝜀𝑡 < 0
𝐼𝑡−1 = { }
0 𝑂𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒
𝜎𝑡2 is the conditional variance, it is composed of two components; a short-run variance
component and a long-run variance component that capture the long-run dependency. The short-
2
run component of the conditional variance is captured by(𝛾1 + 𝛾2 𝐼𝑡−1 ( 𝜀𝑡−1 − 𝑞𝑡−1 )). The term

1 captures news effect. While the term 2, captures bad news effect or the leverage effect, bad
news is when𝜀𝑡 < 0. The term 3 measures the effect of short-run volatility on long-run volatility.
The long-run variance component; qt is modeled below.
Long Run Variance component:
2 2
𝑞𝑡 = 𝛾0 + 𝜌 (𝑞𝑡−1 − 𝛾0 ) + 𝛼 (𝜀𝑡−1 − 𝜎𝑡−1 ) (3)
𝑞𝑡 is the long-run component of the conditional variance. Where 0 < 𝜌 < 1, is the persistence
parameter, the closer 𝜌 to 1 the higher the persistence, i.e the longer is the effect of previous
2 2
shocks on the current volatility. The term 𝜀𝑡−1 − 𝜎𝑡−1 measures the excess effect of news.

5. Empirical Results

10
5.1 Conditional Mean Results
Table 2 shows the results of mean equation. Our results show that for the total sample;
Beta; the coefficient that captures the effect of volatility on returns has a significant impact on
market portfolio and portfolio of the least Shari’ah compliant firms and does not affect the
portfolio of the most Shari’ah compliant firms. The impact of volatility on the three portfolios
become prominent after the crisis, we find a significant value for the Beta after the crisis for the
three portfolios. This implies that financial crisis increases the vulnerability of the stocks in
general to market shocks, whether these stocks are Shari’ah or convention firms.

INSERT TABLE 2

5.2 Volatility Results

In this section we analyze the estimated volatility of the three portfolios across sub-periods and
total sample. Figure 2 presents the volatility behavior among the three portfolios; the most
Shari’ah compliant, the least Shari’ah compliant and the market portfolio. We find that portfolios
with highest degree of Shari’ah compliance show lower volatility compared with the two other
portfolios, this is consistent with the result of Albaity and Ahmad (2008) and contradict with
Hakim & Rashidian (2004 ) . The difference in volatility behavior between the most and least
Shari’ah complaint firms becomes more significant in pre-crisis period as opposed to post-crisis
period; which is consistent with our results above.

INSERT FIGURE 2

The estimated of CGARCH is presented in Table 3.1-3.3. Total sample, pre-crisis, and post-crisis
results are presented in Table 3.1, 3.2, and 3.3 respectively. The persistence in volatility is
captured by the coefficient (ρ). The results suggest that there is persistence in volatility among the
three portfolios; they are significant in all samples. This indicates a persistence effect of previous
shocks on volatility regardless of the type of the portfolio. However, examining the size of ρ
shows that the persistence of the most Shari’ah compliant portfolio decreases in the post-crisis
period as compared with the pre-crisis period, while the persistence of the two other portfolios
increases after the crisis. This is consistent with the result of Farooq and Alahkam which suggest
that the financial characteristics of Shari’ah make them more resilient to crisis. Moreover, it is
consistent with the study by Chiadmi and Ghaiti (2012) which found that S&P Shari’ah index are
less volatile in the long-run and it shows less risk in crisis times. In addition it affirms our

11
hypothesis of asymmetric effect of the financial crisis on portfolio volatility based on their degree
of compliance.

News effect is captured by 1 . The results indicate no difference in the three portfolios with
respect of the effect of news on volatility. However, bad news or the leverage effect varies across
portfolios and across samples. We find that leverage shows no significant effect in total sample
for the three portfolios. However, it becomes significant in the pre crisis sample for the most
compliant portfolio and in the post crisis sample for both the least compliant and market
portfolios. This result indicates that the most compliant portfolio is not affected by bad news post
crisis, which again support our previous conclusion of the potential usage of the most compliant
portfolio in hedging. Moreover, the value of the coefficient in most compliant portfolio (0.147) is
less than the market portfolio (0.164), which indicates less reaction to negative shock.

The effect of short-run (SR) volatility on long-run (LR) volatility is captured by 3 . Our results
show that 3 is significant for the pre-crisis and post-crisis samples across the three portfolios,
however a difference in the direction of this effect exists. We find a positive effect of the SR
volatility on the LR volatility in the most compliant portfolio both in the total sample and pre-
crisis sample, however this effect becomes negative in the post crisis sample. This means that the
SR volatility decreases volatility in the most compliant portfolio, while the opposite is true for the
least compliant firm. The SR volatility has a positive effect on LR effect for the market portfolio,
which means that SR volatility increases LR volatility both in the pre-crisis and post crisis. Our
results is consistent with

INSERT TABLE 3.1-3.3

6. Conclusion

We examine the performance of Shari’ah index versus conventional index. We cover the period
2003-2013; we decompose our sample into pre-crisis and post-crisis. In addition, based on the
three financial ratios that define the Shari’ah firms we construct two portfolios; the most Shari’ah
complaint, the least Shari’ah compliant and compared them to the marker portfolio. Decomposing
our sample into pre and post crisis together with our approach of distinguishing between firms
within the Shari’ah compliant firms assist in better understanding the contradictory empirical
results in the literature. We find that the degree of compliance affect the results. We find that the

12
Shari’ah compliant portfolio outperform the conventional one. However, both Shari’ah and
conventional indices show increasing vulnerability to the market after the financial crisis.

We analyze the volatility of the three portfolios using CGARCH. This GARCH specification
allows us to decompose the conditional variance into short-run and long-run components .The
persistence parameter in the long run component indicates that there is high persistence in the
three portfolios. However, decomposing our sample into pre-crisis and post-crisis, we show more
persistence in the least and market portfolio when compared with the most Shari’ah compliant
portfolios after the crisis. Bad news or the leverage effect varies across portfolios and across
samples. We find that leverage shows no significant effect in total sample for the three portfolios.
However, it becomes significant in the pre crisis sample for the most compliant portfolio and in
the post crisis sample for both the least compliant and market portfolios.

Finally, we find a positive effect of the SR volatility on the LR volatility in the most compliant
portfolio both in the total sample and pre-crisis sample; however this effect becomes negative in
the post crisis sample. Thus there is a reduction of short-run volatility on long-run volatility for
the most compliant portfolio after the crisis.

13
References

1. Albaity, M., & Ahmad, R. (2008). Performance of Syariah and composite indices:
Evidence from Bursa Malaysia. Asian Academy of Management Journal of Accounting
and Finance, 4(1), 23-43.
2. Bukit, R. B., & Iskandar, T. M. (2009). Surplus free cash flow, earnings management and
audit committee. International Journal of Economics and Management, 3(1), 204-223.
3. Caylor, M. L. (2010). Strategic revenue recognition to achieve earnings
`benchmarks. Journal of Accounting and Public Policy, 29(1), 82-95.
4. Chiadmi, M. M. S., & Ghaiti, F. (2012). Modeling volatility stock market using the
ARCH and GARCH models: Comparative study between an Islamic and a conventional
index (SP Sharia VS SP 500). International Research Journal of Finance and Economics,
91, 138-146.
5. Chung, R., Firth, M., & Kim, J. B. (2005). Earnings management, surplus free cash flow,
and external monitoring. Journal of business research, 58(6), 766-776.
6. Fama E, French K (1998). Taxes, Financing Decisions, and Firm Value. Journal of
Finance 53(3):819–843.
7. Farinelli, S., & Tibiletti, L. (2008). Sharpe thinking in asset ranking with one-sided
measures. European Journal of Operational Research, 185(3), 1542-1547.
8. Farooq, O., & Alahkam, A. (2016). Performance of shariah-compliant firms and non-
shariah-compliant firms in the MENA region: Which is better?.Journal of Islamic
Accounting and Business Research, 7(4).
9. Gul, F. A. (2001). Free cash flow, debt-monitoring and managers' LIFO/FIFO policy
choice. Journal of Corporate Finance, 7(4), 475-492.
10. Hakim, S., & Rashidian, M. (2004, December). How Costly is Investors' Compliance
with Sharia. Economic Research Forum.
11. IMF. (2015). The IMF and Islamic finance. Retrieved from
http://www.imf.org/external/themes/islamicfinance/
12. KR, K. R., & Fu, M. (2014). Does Shariah Compliant Stocks Perform Better than the
Conventional Stocks? A Comparative Study Stocks Listed on the Australian Stock
Exchange. Asian Journal of Finance & Accounting, 6(2), 155-170.
13. Marquardt, C. A., & Wiedman, C. I. (2004). How are earnings managed? An examination
of specific accruals. Contemporary Accounting Research, 21(2), 461-491.
14. Miniaoui, H., Sayani, H., & Chaibi, A. (2014). The Impact of Financial Crisis on Islamic
and Conventional Indices of the GCC Countries, No. 401. Department of Research, Ipag
Business School.
15. Myers SC (1993). Still Searching for Optimal Capital Structure. Journal of Applied
Corporate Finance 39:4–14.
16. Natarajan, P., & Dharani, M. (2012). Shariah Compliant Stocks in India-A Viable and
Ethical Investment Vehicle. Arabian Journal of Business and Management Review
(AJBMR), 1(6), 50-62.
17. Press, E. G., & Weintrop, J. B. (1990). Accounting-based constraints in public and
private debt agreements: Their association with leverage and impact on accounting
choice. Journal of accounting and economics, 12(1), 65-95.

14
18. Richardson, S. A., Sloan, R. G., Soliman, M. T., & Tuna, A. (2001). Information in
Accruals about the Quality of Earnings. Information in Accruals About the Quality of
Earnings (July 2001).
19. Robinson, K. (2007). Islamic finance is seeing spectacular growth. Times Reader, 2(5).
20. Romli, N., Mohamad, A. A. S., & Yusof, M. F. M. (2012). Volatility analysis of FTSE
Bursa Malaysia: Study of the problems of Islamic stock market speculation in the period
2007 to 2010. African Journal of Business Management, 6(29), 8490.
21. Setiawan, C., & Oktariza, H. (2013). Syariah and conventional stocks performance of
public companies listed on Indonesia Stock Exchange.Journal of Accounting, Finance
and Economics, 3(1), 51-64.
22. Shafaai, S., & Masih, M. (2013). Determinants of cost of equity: The case of Shariah-
compliant Malaysian firms. MPRA Paper No. 62364.
23. Shahar, W. S. S. B., & Shahar, W. S. S. B. (2015). Impact of Firm Leverage to
Performance: Evidence from Shariah and Non-Shariah Compliant Companies in
Malaysia.
24. Shyam-Sunder L, Myers SC (1999) .Testing the Static Trade-off against Pecking Order
Models of Capital Structure”. J Financial Economics 51:219–244.
25. Sweeney, A. P. (1994). Debt-covenant violations and managers' accounting responses.
Journal of accounting and Economics, 17(3), 281-308.

15
Figure 1: Portfolio Return 2003-3013
900

800

700

600

500

400

300

200

100

0
03 04 05 06 07 08 09 10 11 12 13

RVW1 RVW3 RVWM

This graph represents the return on equally value weighted portfolios.

RVW1: return on equally value weighted portfolio of most Shari’ah compliant firms
RVW3: return on equally value weighted portfolio with least Shari’ah compliance,
RVM :return on equally value weighted market portfolio.

16
Figure 2: Total volatility for the three portfolios
.0035

.0030

.0025

.0020

.0015

.0010

.0005

.0000
03 04 05 06 07 08 09 10 11 12 13

VARP1 VARP3 VARPM

This graph represents the volatility of equally value weighted portfolios.

VARP1: volatility of most Shari’ah compliant portfolio
VARP3: volatility of the least Shari’ah compliance portfolio,
VARP3: volatility of market portfolio.

17
Table 1: Descriptive Statistics

Most compliant Least Compliant Market

Mean 0.0004 0.0001 0.0002
Median 0.0001 0.0002 0.0007
Maximum 0.1254 0.1802 0.0585
Minimum -0.068 -0.1890 -0.0637
Std. Dev. 0.0120 0.0161 0.0083
Skewness 1.0360 -0.6869 -0.7441
Kurtosis 16.2491 23.32166 11.0371
Jarque-Bera 21452.37 49489.00 7969.777
Probability 0.000000 0.000000 0.000000
Observations 2863 2863 2863
This table presents summary statistics for the three examined portfolios, the most Shari’ah compliant portfolio, the least Shari’ah
complaint portfolio and the market portfolio.

Table 2: Effect of Risk on Returns

 Most compliant Least Compliant Market

Total Sample 1.602 0.251*** 5.175***

Pre Crisis 2.066 -0.333 11.282***
Post Crisis 2.382*** 8.553** 8.847***
 Refers to the price of risk in the conditional mean equation for the three portfolios; the most Shari’ah complaint, least Shari’ah complaint and
market portfolio. 𝑟𝑡𝑒 = 𝛽 𝜎𝑡2 + 𝜀𝑡
* Significance at 10%
** Significance at 5%
*** Significance at 1%

18
 Table 3.1: The estimated C-GARCH model - Total Sample

Most Compliant Least Compliant Market

 0.992*** 0.998*** 0.100***

1 0.210*** 0.037* 0.232***
2 -0.002 0.011 -0.075
3 0.554*** -0.870*** -0.042
1 is news effect, 2 is leverage effect , and 3 is the effect of short-run volatility in the long run volatility in the CGARCH

𝜎𝑡2 = 𝑞𝑡 + (𝛾1 + 𝛾2 𝐼𝑡−1 ( 𝜀𝑡−1

2 2
− 𝑞𝑡−1 )) + 𝛾3 (𝜎𝑡−1 − 𝑞𝑡−1 )
1 𝑖𝑓 𝜀𝑡 < 0
𝐼𝑡−1 = { }
0 𝑂𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒
 is the persistence parameter in the long run variance component
2 2
𝑞𝑡 = 𝛾0 + 𝜌 (𝑞𝑡−1 − 𝛾0 ) + 𝛼 (𝜀𝑡−1 − 𝜎𝑡−1 )
* Significance at 10%
** Significance at 5%
*** Significance at 1%

Table 3.2: The estimated C-GARCH model - Pre Crisis Period

Most Compliant Least Compliant Market
 0.983*** 0.986*** 0.985***

1 0.013 0.076* 0.133**

2 0.148*** -0.033 0.052
3 0.609*** -0.800 *** 0.440**
1 is news effect, 2 is leverage effect , and 3 is the effect of short-run volatility in the long run volatility in the CGARCH

𝜎𝑡2 = 𝑞𝑡 + (𝛾1 + 𝛾2 𝐼𝑡−1 ( 𝜀𝑡−1

2 2
− 𝑞𝑡−1 )) + 𝛾3 (𝜎𝑡−1 − 𝑞𝑡−1 )
1 𝑖𝑓 𝜀𝑡 < 0
𝐼𝑡−1 = { }
0 𝑂𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒
 is the persistence parameter in the long run variance component
2 2
𝑞𝑡 = 𝛾0 + 𝜌 (𝑞𝑡−1 − 𝛾0 ) + 𝛼 (𝜀𝑡−1 − 𝜎𝑡−1 )
* Significance at 10%
** Significance at 5%
*** Significance at 1%

19
Table 3.3: The estimated C-GARCH model- Post Crisis Period
Most Compliant Least Compliant Market

 0.727*** 0.992*** 0.994***

1 0.094 0.230*** 0.108***

2 -0.020 -0.166** 0.164***
3 -0.608*** 0.706*** 0.741***
1 is news effect, 2 is leverage effect , and 3 is the effect of short-run volatility in the long run volatility in the CGARCH

𝜎𝑡2 = 𝑞𝑡 + (𝛾1 + 𝛾2 𝐼𝑡−1 ( 𝜀𝑡−1

2 2
− 𝑞𝑡−1 )) + 𝛾3 (𝜎𝑡−1 − 𝑞𝑡−1 )
1 𝑖𝑓 𝜀𝑡 < 0
𝐼𝑡−1 = { }
0 𝑂𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒
 is the persistence parameter in the long run variance component
2 2
𝑞𝑡 = 𝛾0 + 𝜌 (𝑞𝑡−1 − 𝛾0 ) + 𝛼 (𝜀𝑡−1 − 𝜎𝑡−1 )
* Significance at 10%
** Significance at 5%
*** Significance at 1%

20