Review of literature on Islamic Finance: How far do Islamic stock markets perform since

inception?

Shafiu Ibrahim Abdullahi

PhD candidate, Department of Economics, Bayero University Kano Nigeria

Email: shafiuibrahim@gmail.com

Abstract

This paper surveys developments in Islamic finance, particularly the Islamic stock
market, from inception to the current period. It tries to find out how Islamic stock market
has perform since inception, the direction it is heading to and whether it has changed
course from its original ethico-moral foundations. The main methods of analysis used in
conducting the study are intensive literature survey and trend analysis. The nobility of the
work is in studying the trajectory and performance of Islamic stock markets independent
of the larger Islamic finance industry. The review observes the many developments in the
Islamic finance industry since inception; some of the developments were viewed as
contributing very much to the progress made by the industry, but others as negatively
contributing. The progress been made, from an industry that manages few million Dollars
to a trillion Dollar industry, is commendable. But, the paper also concludes that Islamic
stock market is gradually changing course from its ethico-moral focus of the 1980s and
1990s. Islamic markets have been subsumed in the rush to imitate the conventional stock
markets, championed mainly by market operators and policy makers. The paper
recommends that Islamic stock market revert back to its original ethico-moral foundation
and focus, while trying to increase its overall market valuation.

Keywords: Islamic finance, Islamic indices, Shariah compliant index, Islamic economics, Equities,

Electronic copy available at: https://ssrn.com/abstract=4091504

Introduction

Empirical work on Islamic finance is of recent origin (about three and half decades long); due to
absence of relevant data and developing nature of Islamic economic and finance (Abdullahi, 2018). Even
the existing empirical works are in their infancy stage and need to be situated properly relative to
conventional finance due to the difference axiomatic foundations of the respective systems (Hasan, 2007).
But, since the turn of the 21st century the volume of empirical works on Islamic finance has raised
dramatically. The number of peer-reviewed conventional journals that accept papers in this area has been
on the increase. For the first time since its inauguration in 1988, the annual prize awarded by Islamic
research and training institute (IRTI) of Islamic development bank (IDB) for contributions to Islamic
economics and finance was awarded to an economist whose contributions were mostly in empirical
Islamic finance in 2016. This serves as a pointer to the increasing relevance of empirical research to
Islamic economics and finance. The early works on Islamic economic and finance were dominated by
adaptation of conventional economic models with moderate modifications to suit some ethical
requirement of Islam (Abdullahi, 2018). Such modifications include replacing interest with profit and loss
sharing, including Zakah alms, recognizing moderation in consumption, observing the criteria of Halal-
Haram, avoidance of Maisir (gambling) and Gharar (excessive uncertainty). The 1980s saw the
introductions of general equilibrium analysis to determine how changes occur in an economy that is
following Sharia. Examples of these works includes, Siddiqi (1983), Mirakhor and Zaidi (1988), Khan
and Mirakhor (1989), Metwally (1990), Sattar (1991). This development was in part to help Muslim
nations who want to introduce the Islamic economic system at economy wide (macroeconomic) level.
Sudan, Pakistan and Iran had attempted this strategy but its final results were mixed. But, the successes
achieved by countries such as Malaysia and some Gulf emirates with the introduction of Islamic financial
system at micro level has helped strengthen the current trend of partial analysis in Islamic economic and
finance research, thus facilitating gradual discarding of general equilibrium analysis in Islamic economics
and finance literature in favor of micro-analysis. Thus, most of today’s literature on Islamic finance
focused on partial equilibrium analysis. Such as analyzing the performance of Islamic banks, calculating
the efficacy of Sukuk bond, measuring Zakah collection or efficiency of Waqf institutions in the Muslim
world as well as measuring the performance of Islamic stock indices.

Conventional economics is unique in its championing of self-interest and greed, to the extent that
they are seen as pillars of capitalism. Emphasis on morally sound citizens has given way to egoistic
rationality and materialism. Greed was at the centre of the global stock market collapse of 2008 that
resulted in loss of trillions of Dollars of portfolio investments. Derivative is one instrument that
exemplifies greed in financial market than any other instrument. It can technically be defined as
product/instrument that is derived from another product/instrument. Thus, derivative products such as
options, swaps and futures in themselves do not have real values but borrow whatever they claim to have
from another product. Unlike conventional finance, Islamic finance looks at transaction within the limit
allowed by Islamic law. Islam did not allow the kind of derivative instruments at the heart of the past
global financial crisis of 2008. Islamic equity index was introduced in order to cure the moral bankruptcy
found in conventional stock trading. Today there are increasing numbers of Islamic stock indices that are
distributed around the four corners of the globe, following in the footsteps of Islamic banking successes.
Islamic stock indices have high exposure to real estate market, lower leverage effects due to Sharia

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screening, and concentration of smaller firms (Saiti, Bacha and Masih, 2014). But just like Islamic
banking, the amount of assets under Islamic indices management is meager when compared with its
conventional counterparts. The future development of Islamic economics and finance will have positive
effect on the portfolio diversification potentials of Islamic stock indices. So also is the economic
development and prosperity in Muslim nations around the world. Generally, stock markets around the
world have responded to increasing globalisation of trade and financial transaction by becoming more
connected. This connection has the advantage of increasing efficiency of stock markets across the world
and boosting of their capitalisation, but it also has the disadvantage of facilitating financial contagion
during crisis. Thus, the more efficient a stock market become the more interconnected with the rest of the
world it becomes. There is a likelihood of correlation between the Islamic and the conventional indices
due to the fact that the Islamic index itself is a subset of the larger conventional index traded in stock
exchanges around the world (Abdullahi, 2021).

The paper surveys the developments in Islamic finance, particularly the Islamic stock market, from its
inception to the current period. It wants to find out how Islamic stock market has perform since inception,
the direction it is heading to and whether it has changed course from its original ethico-moral foundations
of the 1980s. Hence, the main method of analysis used in conducting the study is intensive literature
survey and trend analysis. The paper concludes that Islamic stock indices have changed course from their
ethico-moral focus of the 1980s and 1990s. Its recommends that Islamic stock market revert back to that
original foundation and focus. The paper is divided into four sections: section one is introduction, two is
literature review, three offers analysis of trend and finally four deals with conclusion and
recommendations.

Review of Relevant Literature

The idea of establishing an Islamic stock exchange was in great passion among Islamic
economists during the 1970s and 1980s, but starting from 1990s with the establishment of Sharia funds
and later Sharia indices such as Islamic Dow Jones index and Islamic FTSE, the long held desire for
independent Islamic Stock Exchanges (ISE) changed in favor of Islamic Stock Indices (ISI) within the
conventional exchanges, instead of creating a whole Islamic stock market. How this helps make Islamic
stock index unique, is a matter of theoretical and empirical research. Pioneering works on Islamic stock
exchange such as that of Metwally (1984) and Tag El-Din (1985, 1996) focused on ethics of the working
of the market particularly the issue of speculation which was viewed as against Islamic norms. In an
Islamic economy, an equilibrating capital market ensure that firms meet their capital needs by means of
capital market and they invest the same capital up to the point where marginal productivity of capital
equate with user cost of capital (Sattar, 1991). Metwally (1984) foresaw the intervention of authorities in
order to regulate activities in an Islamic stock exchange. On the ethics of the system, stock trading in
Islamic framework do not allowed for Gharar (excessive uncertainty) in transaction (Tag El-Din and
Hassan, 2007). One unique feature of Islamic financial assets is their links to real assets (Asutay, 2012).
According to Siddiqi (2006) “Islamic economists advocated an asset-based system of creating money and
extending credit in which money loans will occupy a marginal role”. Thus, the financialisation that goes
together with adaptation of Western banking products by existing Islamic bank is contrary to the
axiomatic foundations of Islamic economics and finance (Choudhry 2007; Asutay, 2012). Scholars have
put the blame of recent Islamic finance tilt toward imitation of conventional finance than ideal Islamic
financial structure to, among other things, Sharia scholars who are less vast in modern economics

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fundamentals and tend to see things from codified Fiqh literature rather than the objectives Maqasid al-
shariah (Siddiqi, 2006). Islamic financial institutions have much to learn from their conventional
counterparts on the issue of accessing social and environment effects of the projects they are financing on
the larger society (Asutay, 2012). In relation to this, the literature on volatility linkage proposed that
markets that are linked together through increased trading, sharing of common sets of investors, and
movement of capitals moves together during crisis. The question here then is, does the same thing apply
to Islamic share indices? From theoretical point of view, the answer may be yes and no; but from the
empirical view point more studies may need to be undertaken to ascertain the true position. The global
financial crisis of 2008 has provided some evidences on this phenomenon (spread of contagion/herd
behaviour) as taking place. The Covid 19 pandemic has provided further opportunities to tests these
puzzles. For example, in study on the effect of COVID-19 pandemic on Islamic stock indices, Abdullahi
(2021) observed that Islamic indices followed the general market trends during the period of the crisis.
The paper observed that Islamic indices were affected by the crisis like the conventional indices.

Early pioneers in the efforts to developed Islamic economic and finance had in mind the evolution
of economic system immune to financial shocks that frequently ravaged conventional economic system at
regular intervals. For example, according to Mirakhor and Zaidi (1988), disturbances to asset positions in
an Islamic economy are absorbed more efficiently and capital inflows to the economy are less affected by
sudden and uniform shifts in the perception of the country's creditworthiness. In an Islamic economy,
unlike interest based economy, monetary authorities have no power to directly set financial rates of
return. This make Islamic economy more market base than conventional system where central banks fixed
the rate of interest (Mirakhor and Zaidi, 1988). But, Islam emphasis on linking financial transaction to
real assets and prohibition of Gharar ensure that excessive volatilities as witnesses recently in the major
global economies are prevented from happening in an Islamic economy. The prohibition of interest rate in
Islamic finance literature is theorized to minimize instability in the entire macroeconomic system, reduces
inflation, as well as channels funds to the most productive uses. Few conventional economists had also
foresaw this and warned against the destabilizing function of interest to an economy and its role in
causing business cycle (Dar and Presley, 1999). Under an Islamic economic system, absence of debt
market left the system under the systemic domination of equity financing arrangement and partnership
(Mirakhor and Zaidi, 1988). Risk sharing is thus the power house of Islamic financial system. According
to Fahim Khan (n.d.) referring to this important role of risk sharing in Islamic finance: “Risk sharing in
financial dealings is an integral part of our financial system that has a strong encouragement requiring
economic agents to accommodate financial needs of others without any economic returns and strong
discouragement for borrowing other than to meet needs”. The Islamic concept of participatory, co-
operative and coordinated enterprise under Mudaraba and Musharaka is a Shari’ah requirement with
respect to Islamic joint venture business (Choudhury, 2001). Therefore, just like other aspects of Islamic
finance, equity trading and related capital market activities are run according to the principle of profit and
loss sharing.

Other works along the line of studying Islamic stock markets include, Mirza, Rizvi,
Saba, Naqvi, and Yarovaya (2021) who analyses the risk-adjusted performance of Islamic and
conventional equity funds during COVID-19 crisis. They show that Islamic equity funds indicated
differentials in risk-adjusted performance, investment styles, and volatility timing compared to their
conventional counterparts. Their results revealed that Islamic equity funds are more resilient to COVID-
19 shock and they outperformed non-Islamic peers during the peak months of the crisis. The trend

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continues even when the spread smoothens. Abbes and Trichilli (2015) investigate dynamic integration
across large set of developed and emerging Islamic stock markets. They find presence of long-run
equilibrium relationship among Islamic stock markets of similar economic grouping. But, Islamic stock
markets from different economic grouping are partially segmented. The level of integration and causality
relations among Islamic stock markets tends to change over time, especially during periods characterized
by financial crises. They proposed that Shariah compliant stocks could offer potential diversification
benefits by considering different economic grouping such as that in developed and emerging countries.
Chiadmi and Abbahaddou (2021) studied the stability of Islamic finance through analyzing the main
stylized facts widely known in conventional financial markets which are: heteroscedasticity and financial
contagion. They show that Islamic stock indexes show significant volatility, especially in times of crisis.
They observed that despite its specific properties especially intrinsic stability, Islamic finance operates in
an interdependent global economy and in a very risky environment. Hence, they advise that the operators
of Islamic finance must strengthen preventive management of systemic risks to consolidate the stability of
system.
Hasan (2019) investigate how Islamic stock index provides better diversification benefits than
conventional index from the perspective of cointegration and volatility spillover. The study uses daily
conventional (DS30) and Islamic (DSES) indices from the Dhaka Stock Exchange over the period from
20 January 2014 to 25 June 2018. The results show that both the markets are interlinked in the short-run
and long-run. The study finds evidence of volatility clustering in both index returns which have a
tendency to last a long time. The results also reveal that both markets are more sensitive to the bad news
than with good news. They find the existence of significant volatility transmission from conventional to
Islamic stock market in Bangladesh. The study concludes that conventional and Islamic stock markets in
Bangladesh do not offer any diversification benefits to investors having both indices in their portfolios.
Antar and Alahouel (2019) analyses the opportunities of an exclusive investment in the Dow Jones
Islamic indexes; their findings show that despite the existence of a long run association between the
Islamic indexes, diversification opportunities are present. Saiti, Ma, Nagayev and Yumusak (2019)
investigate the extent to which Chinese equity investors can benefit from diversifying their portfolio into
Shariah-compliant indices. The results indicate that all Islamic Indices are less volatile than the
conventional indices; hence, good for portfolio diversification. Yahyaee, Mensi, UrRehman, Vo and
Kang (2020) study the performance of 22 Islamic and conventional Dow Jones stock market indices
during pre-crisis and post-crisis periods. They also analyze the time-frequency co-movements between
conventional and Islamic stock sectors and evaluate portfolio risk management. Results show that Islamic
equity returns dominate conventional equity returns during the full sample period. But, the pre-crisis
periods are dominated by higher conventional equity returns. During crisis and post-crisis periods, Islamic
equity returns dominate their conventional counterparts.

Erdogan, Gedikli and Çevik (2020) investigate the existence of volatility spillover effects between
foreign exchange markets and Islamic stock markets in India, Malaysia, and Turkey. They find evidence
in favor of volatility spillovers from the Islamic stock market to the foreign exchange market in Turkey.
The test results show that the presence of volatility spillover is at least one direction between exchange
rates and the Islamic stock market at specific periods. Bahloul, Mroua, Naifar, and Naifar, (2021)
investigate whether Islamic indexes, Bitcoin and gold act as hedges or safe-haven assets during the global
COVID-19 crisis. The results show that Islamic index is not a hedge or a safe haven asset for the world
conventional stock market during the crisis. Adediran, Salawudeen, and Ashraf Sabzwari, (2021) study

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the transmission of COVID-19 induced shocks to Islamic stock markets indices in the midst of the
macroeconomic environment and cross-country trade linkages. The paper shows that the pandemic
induced financial crisis engenders immediate negative impacts on the Islamic stock markets with the
biggest impacts in USA and China and the least in the markets of Middle East. Çıkıryel,
Aslan, and Özdemir, (2021), study co-movement dynamics of Islamic equity returns to explain
international portfolio diversification opportunities for investors having a heterogeneous stock holding
period. The results show that there is a high correlation between the United Kingdom Islamic stock index
return with Canadian, USA, Malaysian and Indian implying lesser diversification benefits for
investors. Rahman, Khudri, Kamran, and Butt, (2021), investigate stock markets’ response to COVID-19
crisis in Bangladesh, India, Pakistan and Sri Lanka. The study investigates the causal impact of confirmed
COVID-19 cases on stock market returns. The results suggest unidirectional causality from COVID-19 to
stock market returns; this indicates that COVID-19 has a dominant short-term influence on stock
movements.

Analysis of trend

The Islamic stock indices have come a long way, from the period when the market has acted as an
effective hedge for investors during the global financial crisis of 2008 to the present crisis caused by
global COVID-19 pandemic where a number of studies have shown that Islamic stock indices also follow
herd behaviour where Islamic indices were affected by the market just like their conventional
counterparts. Hence, there is need for scholars in this period of time to find out why Islamic stock indices
are gradually losing their uniqueness to conventional indices, even as the Islamic stock market grow and
spread around the world. As the empirical works surveyed in this paper have shown, Islamic stock indices
are increasingly emulating their conventional counterparts in term of herd mentality, risk and return
behaviour. Abdullahi (2021) has observed that the general following of herd mentality by the Islamic
stock indices during the COVID-19 crisis is because, unlike the previous 2008 crisis which was mainly
concentrated in the financial sector, the current crisis is all encompassing (comprising both real and
financial sectors). Hence, the poor performance of the Islamic indices this time around is because of the
fact that the Islamic indices are more connected to the real sector of the economy. So far, most studies
have viewed the Islamic index as a means for investors to diversify their investment portfolios, with only
few works looking at the real contributions of these indices to the real economic development of nations.
Most of today’s analysis on Islamic stock markets has focused on using modern econometrics methods
with little emphasis on Islamic ethical teachings and how it comes to bear on the behaviour of the stock
market.

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Figure 1: Historical trend in Islamic stock markets since 1980s

•Laying down of the ethical foundations of Islamic stock market

Late 1980s •The begining of a number of Islamic mutual funds and Islamic stock indices
to 1990s

•Grow of Islamic stock indices around the world

•Good performance of Islamic stock indices during the global financial crisis of
2008, as against the poor performance of conventional indices during the
2010s period.

•Islamic stock indices are gradually emulating their conventional counterparts

•Islamic indices performance was not very different from their conventional
2020s counterparts during the COVID-19 induced financial crisis.

Source: author’s analysis, 2021

Conclusion and way forward

Islamic stock indices have grown exponentially from their beginning in the 1990s to date. Islamic
indices are now found in all the major continents of the world, sometimes favorably competing with their
conventional counterparts. The total value of combined Islamic indices has grown from few million
Dollars to hundreds of Billions of Dollars. Islamic stock indices have followed their Islamic banking
cousins in growing in size and value. But, this exponential growth has not come without its challenges.
Islamic indices are increasingly imitating the conventional indices; the trend is different from its earlier
ethico-moral foundations. Both the Islamic stock markets and the Islamic banks have failed to make the
real impacts envisioned by early Islamic economists. Hence, going forward, there is need to revert back to
the earlier emphasis on Islamic ethical teachings and how that will shape Islamic stock behaviour. The
initial idea of Islamic stock market was rooted in the philosophy of finding genuine Islamic alternative to
the speculative, interest base and highly leveraged conventional stock market. This single objective is yet
to be achieved, hence the need to focus more attention on realizing it. In future any further development
of Islamic stock markets shall take care of local peculiarities and the need of the Muslim public first,
before any profit considerations. Many excellence ideas have been proposed on Islamic stock market, but
the good thing that need to be done is the implementation of these ideas as well as further strengthen and
reinforcement of their applicability. This is where Islamic finance is found wanting. According to the

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State of the Global Islamic Economy Report (2020), Islamic finance industry was estimated in 2018 to be
worth $2.5 trillion and is estimated to be around $3.5 trillion around 2024, this will further provide a good
opportunity for ensuring the continue ethical growth of the industry.

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