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A Shariah-compliant portfolio selection model

Hatem Masri1*
1
College of Business Administration, University of Bahrain, P.O. Box 32038, Sakhir, Kingdom of Bahrain
The paper aims to develop a Shariah-compliant optimization model for portfolio selection in an Islamic security
market. The security return is considered stochastic and is estimated based on the stochastic market return. The
proposed model follows Shariah principles by avoiding excessive risk and providing an ethical and socially
responsible approach for portfolio selection. We assume that the portfolio return should be maximized for a given
probability of loss and that any return below the Zakat threshold is a recourse cost. The Shariah-compliant
portfolio selection model is obtained using a goal programming approach, a chance-constrained approach and a
recourse approach. An empirical study from Bahrain Islamic Market is reported.
Journal of the Operational Research Society (2017). doi:10.1057/s41274-017-0223-6

Keywords: Shariah-compliant portfolio; multiple stochastic programming; chance-constrained approach; recourse

approach; goal programming; Islamic investment; corporate social responsibility

1. Introduction answers that question by solving the following mathematical

program:
For a long time, a socially responsible behavior in investment
was considered as an additional cost, as it excludes many n P
P n

profitable stocks, such as alcohol and tobacco (Al-Shammari Min rij xi xj

and Masri, 2016). The recent financial crisis demonstrated that
corporate social responsibility (CSR) strategy and initiatives
are vital for companies’ survival (Bouslah et al, 2016).
Socially responsible investment (SRI) helps companies to
sustain their investment and build trust with their stakeholders.
Nowadays, the number of SRI funds in North America and
Europe has increased and significant researches that analyze
the financial performance of these funds compared to their
social goals is available (Van Dijk-de Groota and Nijhof,
2015). SRI indices were elaborated to guide investors through
a socially responsible behavior such as the Dow Jones
Sustainability Index (DJSI), the FTSE4Good Index and the
Morningstar Socially Responsible Investment Index (MS-SRI)
(Ito et al, 2012). Managi et al (2012) demonstrated that, in
terms of means and volatilities, there is a strong co-movement
between the SRI indexes and conventional indices. Utz and
Wimmer (2014) claimed that there is no difference between
conventional and socially responsible funds with regard to
financial performance.
Investment in securities is usually guided by the perpetual
paradigm which aims at realizing a profitable level of return
while keeping, to the minimum, the risk of not achieving that
level of return. The Markowitz (1952) mean–variance model
*Correspondence: Hatem Masri, College of Business Administration,
University of Bahrain, P.O. Box 32038, Sakhir, Kingdom of Bahrain.
E-mail: hmasri@uob.edu.bh
i¼1 j¼1
Pn
s:t: ri xi  R
i¼1
ð1Þ
Pn
xi ¼ 1
i¼1
0  xi  ui ; i ¼ 1; . . .; n
where xi is the amount invested in the ith security, ri is the
random return of the ith security, rij the covariance coefficient
between ri and rj , R is the desired level of return of the
portfolio and ui is the upper limited value of an investment in
the ith security.
For a socially responsible investor, program (1) does not
clearly exclude unethical stocks. Ballestero et al
(2012, 2014) added an ethical objective function to Markow-
itz model (1). The resulting bi-objective program was solved
using a goal programming approach and the numerical study
on green investment, demonstrating that efficient portfolios
obtained by the Markowitz model outperform their green
portfolios in terms of expected return and risk. Bilbao-Terol
et al (2012) considered maximizing the SRI attractiveness of
the portfolio as an additional objective function. Utz et al
(2015) studied a tri-criterion portfolio selection model with a
third objective function aiming to guarantee a sustainable
investment where environmental, social and corporate gov-
ernance measures are taken into account. Authors noted
that there is no significant evidence that social responsibil-
ity issues are taken into account in the asset allocation
process
 Journal of the Operational Research Society

Among the most growing SRI funds in the world, Shariah- n P

P n
compliant investment funds have grown up to $1.6 trillion and Min rij xi xj
i¼1 j¼1
expected to exceed $2 trillion in the next few years (Bellalah, Pn
2014). The management of these funds should comply with Max ri xi
i¼1
ð2Þ
Shariah standards and principles defined by Shariah boards Pn
(Garas and Pierce, 2010). The sources of these standards and s:t: xi ¼ 1
i¼1
principles are the Qur’an, the Holy Book of Islam, the Hadith, 0  xi  ui ; i ¼ 1; . . .; n
which are the teachings and sayings of Prophet Muhammad
(PBUH), and Ijtihad, comprising scholarly legal deductions. In the conventional market, Markowitz model (2) is widely
Islamic investment is an SRI since we apply ethical screening used in the financial industry and was based on a set of
criteria in order to exclude certain industries. hypotheses. First, as securities return are random variables, the
Islamic investment is based on the following principles investor should estimate risk on the basis of variability of
(Abbes, 2012): expected returns over the holding period. Second, the investor
should make decisions based on return and risk in order to
1. Haram Income: The prohibition of investing in business is minimize the risk for any given level of return or to maximize
unlawful according to Islam. It includes the manufacturing
the returns for any given level of risk. Finally, the investor is
or marketing of forbidden products or services such as
considered as risk averse and rational in nature.
pork, alcohol, tobacco, pornography, prostitution, gam-
The use of variance in the Markowitz model was criticized
bling, company that operate on interest payments.
by many scholars as it is restricted to measure the volatility of
2. Riba: interest rate on lending is prohibited, but profit and
the portfolio returns rather than the risk of loss (Cox, 2008).
loss from business is acceptable. Markowitz (1959) proposed to substitute the variance with the
3. Maysir: speculation or unnecessary risk should be semi-variance that only considers the negative deviation from
avoided; therefore, the acceptance of high risk cannot be the expected portfolio return. Following Markowitz, many risk
justified by high returns.
measures were developed (i.e., the value at risk, the condi-
4. Gharar: excessive risk or uncertainty that might lead to
tional value at risk) to track the error representing the excess or
loss.
lack in the optimal portfolio return. In their experimental study
These principles restrict the number of securities that a over 2226 investors, Veld and Veld-Merkoulova (2008)
Muslim investor can consider and should guide Muslim concluded that market return is the most important benchmark
investors throughout the selection process of their optimal for investors and that investors perceive risk as the sensitivity
portfolio. Hence, this paper aims at discussing the impact of of the security return to the market return. Abdelaziz et al
Shariah investment principles on the portfolio selection (2007) defined the portfolio risk using the systematic risk beta
process and offers a portfolio selection model that will lead as follows:
to a Shariah-compliant portfolio.
X
n
In the next section, we summarize main models developed Opt bi xi ð3Þ
for portfolio selection and we present critiques to Markowitz i¼1
model regarding the use of variance as a risk measurement. In
Section 3, we define the main characteristics of a Shariah- The ‘‘Opt’’ in (3) indicates that the optimal portfolio beta
compliant portfolio and the impact of the Islamic investment should be equal to a predefined value. The resulting portfolio
principles on building such a portfolio. We also e report the few selection model is the following multiple objective stochastic
attempts to quantify the future return of Islamic market program:
securities and the compliance of the capital asset pricing model P
n
to Shariah principles. In Section 4, we propose a portfolio Opt bi xi
i¼1
selection optimization model that leads to a Shariah-compliant Pn
portfolio. This model quantifies the possible return based on the Max ri xi
i¼1 ð4Þ
investor probability of loss and considers other special Pn
commitments of Muslim investors such as the wealth purifi- s:t: xi ¼ 1
i¼1
cation (Zakat). In Section 5, the proposed model is tested using 0  xi  ui ; i ¼ 1; . . .; n
data from 17 securities listed in the Bahrain Islamic Index.
Several solution approaches were proposed to build a certainty
equivalent to program (4). Abdelaziz et al (2007) presented a
compromise chance-constrained approach where the optimal
2. Conventional portfolio selection models
portfolio should have a systematic risk beta equal to 1 and the gap
Uni-objective Markowitz model (1) can be extended to a of not achieving the ideal portfolio return is minimized for a
multiple objective stochastic program where the portfolio’s certain probability level. Masmoudi and Ben Abdelaziz (2012)
variance is minimized and the portfolio’s return is maximized: and Abdelaziz and Masmoudi (2014) proposed to minimize the

expected negative deviation between the optimal portfolio return
and the predefined goal. That negative deviation is considered as
a recourse cost, and the whole solution strategy was a mix
between recourse approach and stochastic goal programming
approach. Recently, Masmoudi and Ben Abdelaziz (2015)
introduced a new approach called the chance-constrained
recourse approach where the negative deviation between the
portfolio return and the goal is minimized for a set of scenarios
with a certain probability distribution. Masri (2015) presented a
solution approach for program (4) where multiple goals on the
return objective function are provided. The author utilized a
combined chance-constrained approach with the recourse
approach in dealing with each of these goals.
In this paper, we aim to present a Shariah-compliant
solution approach to portfolio selection problem. This
approach must follow the Shariah principles and should guide
the Muslim investor to a Shariah-compliant portfolio.
3. Shariah-compliant portfolio
The Accounting and Auditing Organization for Islamic
Financial Institutions (AAOIFI) is one of the main Shariah
standard-setting bodies. Banks, companies and funds may have
their own Shariah screening bodies. In this paper, we refer to
standards used with the Dow Jones Islamic Market (DJIM)
index, the first index created with compliance to Shariah
principles in Bahrain in 1999 (Omar Farooq and Hasib Reza,
2014). The securities listed in the DJIM are related to
companies having a permissible activity according to Shariah,
sector screen criteria, and it should satisfy the following
financial screening criteria (Abdul Rahman et al, 2010):
(1) The debt to equity ratio must not exceed 33%
(2) It must have an accounts receivable to total asset ratio
equal to or less than 47%
(3) Interest income must not exceed 9% of the total income.
When a company fails to validate the sector screens and
financial screens criteria, it is removed from the DJIM and
replaced by another company. We note that firms which are
included in the DJIM indices are not strictly Shariah-compliant
as we have some permissible degree of interest income for
constituent firms (Shamsuddin, 2014).
In the literature, the main difference between Shariah-
compliant portfolio and a SRI financial portfolio is the
application of financial screens by which the set of admissible
investments is reduced (Derigs and Marzban, 2009). The
primary risk for Islamic investment is the non-compliance to
Shariah principles that will lead to legal sanctions and the loss
of reputation and credibility in the market (Lahsasna, 2014).
During the recent financial crisis, Shariah-compliant portfolio
demonstrated a better performance compared to conventional
portfolios (Beck et al, 2013). This performance is somehow
attributed to the process of defining Shariah-compliant securi-
ties rather than in defining the selection procedure. The selection
Hatem Masri—A Shariah-compliant portfolio selection model
procedure usually follows conventional models without taking
into account the Muslim’s investment behavior. Tahir and
Brimble (2011) claimed that Muslim investors are risk averse
and look to maximize their wealth, which is in line with the
assumptions given by Markowitz model (1), but they need to
abide by the Islamic investment principles.
The first Islamic investment principle is about avoiding
Haram income and therefore restricts the set of permissible
securities to a predefined set, for example securities listed in
the DJIM index.
The second principle is about avoiding Riba. This principle
prohibits from investing in risk-free securities as they guar-
antee a preset level of return on investment. However, Muslim
investors are required to have a wealth purification, which is
called Zakat. The Zakat is calculated based on the wealth of
the individual and is customarily 2.5% of a Muslim’s wealth
above a minimum amount known as Nisab. Therefore, the
minimum return that Muslim’s investors would expect from an
investment should cover the Zakat.
The third principle of Islamic investment is about avoiding
unnecessary risk. Therefore, Muslim investors prefer that the
risk of their portfolios should match the risk of a benchmark.
The benchmark can be the Islamic market return.
The fourth principle is related to excessive uncertainty that
leads to losses, which is called Gharar. Gharar takes place
when inappropriate information about the level of risk is not
provided and it may result in a misleading evaluation of
returns. Therefore, maximizing the portfolio return without
limit may lead to a major or excessive Gharar.
In conventional markets, the most used model to evaluate
security returns is the capital asset pricing model (CAPM) as
follows:
ri ¼ ai þ bi RM þ ei ð5Þ
where RM is the Islamic market return, bi is the beta of the ith
security that quantifies the security’s systematic risk and that is
estimated using regression analysis, ai is the vertical intercept
of the regression between ri and RM , and ei is the regression
error (Sharpe, 1964).
Several studies criticized the use of the CAPM in predicting
the return of Shariah-compliant securities, because of the
prohibition of one of the model hypothesis on risk-free
security (Shaikh, 2010). Tomkins and Karim (1987) suggested
the adjustment of CAPM Eq. (5) by removing the vertical
intercept. However, Hasan et al (2011) demonstrated through a
study of 80 Islamic securities from 2005 to 2009 listed in
Dhaka stock exchange (DSE) that the vertical intercept was
significantly nonzero. Bhatti and Hanif (2010) argued that the
nonzero intercept is due to the inflation premium that exists in
today’s interest-free Islamic economy. Based on a recent study
on weekly data, from 2010 to 2014, on 60 Islamic securities
listed in Malaysia security market, Lee et al (2016) approved
that the CAPM is reasonable enough to be used as an indicator
of stock prices for Shariah-compliant securities.
 Journal of the Operational Research Society

In the following, we present an evaluation of the security Constraint (8) is random and should be discretized. Let us
return using CAPM Eq. (5) that should enable to propose a denote by fw1 ; . . .; wS g the possible scenarios regarding the
Shariah-compliant portfolio selection model. state of the market return RM and fp1 ; . . .; pS g the correspond-
ing probabilities. Based on CAPM Eq. (5), the return of the ith
security can be written as follows
4. Shariah-compliant portfolio selection model ri ðws Þ ¼ ai þ bi RM ðws Þ ð9Þ
The Markowitz model hypotheses do not conflict with Shariah
and random constraint (8) can be discretized as follows:
principles (Hazny et al, 2012). The problem that Muslim
investor may face when using the Markowitz model is how to X
n
fix the desirable level of return or the acceptable level of risk. ri ðws Þxi þ e ðws Þ  eþ ðws Þ ¼ Z; s ¼ 1; . . .; S
i¼1
Islamic investment principles prohibit any excessive risk that
leads to losses (Gharar), and high risk cannot be justified by where e ðws Þ and eþ ðws Þ are the negative and the positive
high returns (Maysir). In addition, Muslim investors cannot deviations when the scenario ws occurs. The expected value of
predefine the value of the return as it will be considered as the negative deviation must be considered as a recourse cost.
Riba, but they can maximize the return of their portfolio for a Then, we should deduct the expected recourse cost from the
given and known probability of loss. Therefore, we think that expected portfolio return as follows:
it is more suitable for Muslim investors to consider multiple X S
objective stochastic program (4) where the return is maxi- Max R  ps e ðws Þ ð10Þ
mized and the risk is kept optimized to the risk of a s¼1
benchmark.
To solve program (4), we propose to build a certainty To deal with the systematic risk objective function in
equivalent that complies with Shariah investment rules rather program (4), we propose to follow Aouni and La Torre (2010)
than to generate the set of efficient solutions (Abdelaziz et al, and propose a goal programming approach where we consider
1994, 1995, 1999). the Islamic Market as a benchmark; therefore, the optimal
The goal of Shariah is avoiding unlimited risk where the portfolio beta should be equal to 1:
probability of loss is higher than the probability of gain X n
bi xi þ d  dþ ¼ 1 ð11Þ
(Dchieche and Aboulaich, 2016). Let us denote by a 2 ½0; 1 i¼1
the acceptable probability of loss which is usually defined by
 þ
the investor as the probability of not achieving a portfolio where d and d are, respectively, the negative and the
return R. The return objective function can be rewritten as a positive deviations between the portfolio beta and the goal 1
chance constraint, as follows: that we need to minimize:
! Min dþ þ d ð12Þ
Xn
Pr r i xi  R  1  a ð6Þ
i¼1 By following the Shariah principles, we transformed mul-
tiple objective stochastic program (4) based on a chance-
Constraint (6) is a chance constraint resulting from applying constrained approach, a recourse approach and a goal pro-
a chance-constrained approach on the return objective function gramming approach into the following certainty equivalent:
in multiple objective stochastic program (4). For a given P S  
probability of loss, Muslim investors should select the portfolio Max R  ps e ðws Þ  k dþ þ d
that guarantees the highest possible return, and therefore, we  s¼1 
P n
should maximize the value of the portfolio return: s:t: Pr ri xi  R  1  a
i¼1
P
n
Max R ð7Þ ri ðws Þxi þ e ðws Þ  eþ ðws Þ ¼ Z; s ¼ 1; . . .; S
i¼1
Pn
In addition to the probability of loss, Muslim investors bi xi þ d  dþ ¼ 1
must deduct the Zakat rate, from their returns; therefore, any i¼1
Pn
return below the Zakat rate is considered a loss. We propose xi ¼ 1
the application of a recourse approach to the return objective i¼1
0  xi  ui ; i ¼ 1; . . .; n
function in multiple objective stochastic program (4). Let us
e ðws Þ; eþ ðws Þ  0; s ¼ 1; . . .; S
denote by e and eþ the negative and the positive deviations of d ; dþ  0
the portfolio return from the Zakat rate Z:
ð13Þ
X
n
ri xi þ e  eþ ¼ Z ð8Þ where k is the weight that aggregates between return objective
i¼1 function (10) and systematic risk objective function (12).
 Hatem Masri—A Shariah-compliant portfolio selection model

The following section presents the experimentation of probability of loss. Under the hypothesis that securities return
Shariah-compliant portfolio selection model (13) using secu- are normally distributed and defined by CAPM Eq. (5), and
rities listed in the Bahrain Islamic Index (BISI) where the following Abdelaziz et al (2007), the chance constraint can be
impact of the probability of loss on the obtained optimal rewritten as follows:
portfolio is addressed. !
Xn Xn
1
Eðri Þxi  / ð1  aÞr ri xi  R ð14Þ
i¼1 i¼1
5. Empirical example
In September 14, 2015, Bahrain Bourse launched the Bahrain where Eð:Þ refers to the mean of the random variable and
Islamic Index, which includes the following stocks of listed /1 ð:Þ represents the inverse distribution function of a
companies that comply with Shariah rules: standard normal distribution.

Name Issue name Name Issue name

ALBH Aluminum Bahrain ITHMR Ithmaar Bank

BARKA Al Baraka Banking Group KHCB Khaleeji Commercial Bank
BSRC Bahrain Ship Repairing and Engineering DPCB Delmon Poultry
BFMC Bahrain Flour Mills SALAM Al Salam Bank
BISB Bahrain Islamic Bank SEEF Seef Properties
PARK Bahrain Car Park TAKA Takaful International
EICB Esterad Investment GTFP Trafco Group
GFHB GFH Financial Group ZAIN Zain Bahrain BSCC
INOV Inovest

To illustrate proposed Shariah-compliant portfolio selection
model (13), we consider the weekly data for the above 17
securities from Bahrain stock market listed in the BISI
between September 24, 2015 and October 6, 2016. The
following table represents the beta, the alpha and the variance
in returns for the BISI components:
We assume that the investor acceptable probability of loss is
a ¼ 10% (i.e., /1 ð0:9Þ ¼ 1:282) and that the upper limit of
investment is ui ¼ 0:2.
The resulting certainty equivalent program is as follows:

Name ALBH BARKA BSRC BFMC BISB PARK EICB GFHB INOV

Beta 1.89 1.17 1.05 0.84 1.15 1.16 0.20 0.69 1.89
Alpha 1.28 2.08 2.49 1.10 1.08 1.12 0.35 1.09 1.75
VAR 27.30 23.70 12.82 26.29 31.43 19.97 15.46 42.96 6.76
Name ITHMR KHCB DPCB SALAM SEEF TAKA GTFP ZAIN

Beta 0.24 0.64 0.84 0.89 0.80 0.81 0.85 0.23

Alpha 0.66 1.32 1.03 2.33 0.88 0.78 0.95 0.84
VAR 47.16 27.79 2.07 25.47 17.36 420.02 13.78 19.78

In this empirical study, we assume that market return RM

follows a normal distribution and we consider two future states P
2  
Max R  ps e ðws Þ  k dþ þ d
of the market (S = 2), the bull market (w1 ) and the bear s¼1 n 
market (w2 ), where p = 0.6 is the probability of observing a P
n P
s:t: Eðri Þxi  /1 ð1  aÞr ri xi  R
bull market: i¼1 i¼1
Pn
 þ
ri ðw1 Þxi þ e ðw1 Þ  e ðw1 Þ ¼ Z
i¼1
Pn
w1 w2 Expected market return ri ðw2 Þxi þ e ðw2 Þ  eþ ðw2 Þ ¼ Z ð15Þ
i¼1
Pn
Market return 1.37 -1.8 -0.35 bi xi þ d  dþ ¼ 1
i¼1
Pn
xi ¼ 1
i¼1
To solve Shariah-compliant portfolio selection model (13), 0  xi  ui ; i ¼ 1; . . .; n
we need to linearize the chance constraint related to the d ; dþ ; e ðw1 Þ; eþ ðw1 Þ; e ðw2 Þ; eþ ðw2 Þ  0
 Journal of the Operational Research Society

We solved certainty equivalent program (15) using LINGO 6. Conclusion

solver 14.0 Intel Core 2 Duo 2.00 GHz and 4 GO of RAM using This paper presents, as per the best of our knowledge, the first
Windows Vista, where Lingo is a mathematical modeling Shariah-compliant portfolio selection model. The proposed
language that solves mathematical programs and the following model is obtained based on a recourse approach, a chance-
global optimal solution of (15) is obtained in less than 2 s:

Security BSRC EICB INOV DPCB SALAM GTFP Portfolio return

Optimal solution 0.2 0.16 0.2 0.2 0.2 0.04 -2.98

The optimal solution systematic risk is equal to 1, and the constrained approach and a goal programming approach to a
expected recourse cost is equal to 8%. multiple objective stochastic program. The main concern of
To evaluate the impact of the probability of loss on the this model is to provide investor with the best portfolio return
obtained optimal solution, we solved program (15) for for an acceptable level of loss. The results of the empirical
different levels of probability of loss. The results are study from securities listed in the Bahrain Islamic Index
summarized in the table below: confirm the well-known results that high tolerance to risk
results in high returns.
We assumed the normality of the distribution but other
Security Probability of the loss probability distributions as well as other types of uncertainty,
for example belief function (Masri and Abdelaziz, 2010) and
5% 10% 20% 30% 50% 60%
fuzzy sets (Abdelaziz and Masri, 2009), can be considered to
ALBH 0.04 address the proposed Shariah-compliant portfolio selection
BARKA 0.02 0.18 0.2 0.2 model.
BSRC 0.2 0.2 0.2 0.2 0.2 0.2 This paper can be extended to study large list of Shariah-
EICB 0.15 0.16
compliant securities available in the international market. We
GFHB 0.1 0.16
INOV 0.2 0.2 0.2 0.11 0.1 aim also to propose a performance analysis of the proposed
KHCB 0.2 Shariah-compliant portfolio selection model with other con-
DPCB 0.2 0.2 0.2 0.2 ventional models.
SALAM 0.05 0.2 0.2 0.2 0.2 0.2
TAKA 0.2
GTFP 0.2 0.04
ZAIN 0.18 0.11 References

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We note that the Bahrain Ship Repairing and Engineering
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Some other securities are more suitable for investors averse to
loss, for example EICB and GTFP, while other securities
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Security Probability of the loss
5% 10% 20%
Return -4.05 -2.98 -1.52 -0.44 1.57
Expected 17% 8% 4% 0 0
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Received 14 October 2016;
accepted 8 March 2017