Learn about Islamic mutual fund performance and Shariah screening
Islamic mutual funds (IMFs) continue to grow as an alternative investment vehicle for investors wishing to integrate Islamic values and secular financial objectives in their investments. The most distinctive feature of IMFs lies in screening strategies based on the application of Shariah (Islamic law).
Conventionally, this mainly involves the application of exclusionary screening, whereby fund managers screen out companies involved in certain activities, including riba (interest), gharar (uncertainty), and maysir (gambling), and prohibited products from their portfolios as prescribed by the Quran, Sunnah and related Islamic texts.
The central outcome is that the managers of IMFs, unlike those of conventional mutual funds (CMFs), necessarily access only a subset of the population of investments available. This has dramatic implications for many conventional dimensions of mutual fund behaviour, including performance, the flow of funds, and the fund selection behaviour of investors.
The purpose of this thesis is to examine three separate yet complementary dimensions of IMFs that are crucial to current and future investors, industry practitioners and regulators, and academic researchers alike. These are the performance, screening, and fund flows of IMFs in Malaysia, one of the world’s most important and rapidly growing IMF markets. Given the nature of these objectives, we focus on equity funds.
In the first part of the thesis, we discuss the general development, sources, and principles of Islamic finance. We then address the rapidly growing mutual fund sector in Malaysia and describe the nature of this market, the screening methods applied, and other key institutional, economic, and social dimensions of both the Malaysian IMF and CMF sectors. Lastly, we survey the empirical literature on mutual funds, with particular attention to screened funds of all types, including socially responsible investments (SRIs) and the existing small body of research on IMFs.
In the second empirical part of the thesis, we conduct four separate but complementary empirical analyses of IMFs and their conventional counterparts in the Malaysian market. The first analysis comprises a comparative performance analysis of IMFs and CMFs. This is an important issue given the need of investors to assess contexts, such as Malaysia, where these alternative products are jointly available. The recent global financial crisis also motivates us to investigate how these events affect IMF performance.
In our analysis, we employ eight security selection and market timing models to evaluate the performance of 147 mutual funds comprising 46 IMFs and 101 CMFs over the period 1996 to 2009. We find that during the sample period, both IMFs and CMFs generally underperformed the various market benchmarks. In addition, IMFs outperformed CMFs in market downturns but not in market upturns, with neither type of funds exhibiting substantial market timing ability.
The second empirical analysis in this thesis addresses the differences in screening methodologies in Malaysian IMFs. Given there are several differences in Shariah- screening methodologies in Malaysia, encompassing screening on the basis of product and activity only and screening also for firm leverage and other financial indicators, it is interesting and useful to investigate how these influence the performance, risk and the management expenses of IMFs.
We employ cross-sectional regression analysis of 43 Islamic equity funds from 1999 to 2009 and conclude that additional Shariah screening, termed as higher Shariah screening intensity, does not appear to affect performance via systematic risk, even though it has a pronounced negative effect on performance through unsystematic risk.
The third empirical analysis in this thesis focuses on the behaviour of IMF fund flows. This has important implications for, among other things, the future growth of IMFs in Malaysia. We specify pooled least squares and panel fixed effects regression models of 35 IMFs and 92 CMFs from 2000 to 2008 to evaluate the impact of past performance on fund flows.
We also extend the fund flow analysis to investigate the ‘smart money’ effect using three- and four-factor models of 34 IMFs and 83 CMFs during the periods 1999–2008 and 1998–2009. In relation to fund flows, we conclude that investors make decisions on subscribing to and redeeming mutual funds based on historic fund performance, with better performing funds typically attracting larger flows.
However, there is some evidence of an asymmetry in fund flows in that IMF investors are generally more sensitive to poor performing funds. We find no significant evidence of a ‘smart money’ effect, whereby fund flows predict future performance, for either IMFs or CMFs.
There are several key implications from these findings. First, one of the major concerns of investors is the consequences of the application of Shariah screening on the performance of IMFs. Based on our findings, it appears that IMF investors in Malaysia do not have to pay a significant opportunity cost (in terms of foregone returns) in integrating their religious beliefs in their investments.
Further, Shariah-screening intensity also does not appear to affect IMF performance, though this could be because of a correspondence between the Shariah compliance of the operating and financial behaviour of Malaysian firms. Finally, IMF managers cannot rely on Shariah compliance by itself to attract subscriptions from Muslim investors, as at least at the aggregate level there appears to be some degree of substitutability.
That is, the performance of IMFs is just as important as Shariah compliance in attracting investor funds, at least in Malaysia.
Of course, the thesis has a number of limitations, and these suggest areas for further research. First, as a nascent market in a developing economy, the empirical analysis necessarily relies on a comparatively small set of information over a short period. While the thesis provides many insights into a number of key aspects of IMFs and IMF investors, the results would be stronger if data on, say, assets under management, were available at a greater frequency such as quarterly or monthly rather than only annually.
Second, it would be useful to gain a greater insight into the decisions made by both Muslim and non-Muslim investors in whether to invest in a particular fund at the micro rather than the macro level and the innate balancing if any of sectarian and secular concerns in these investment decisions. This would require information on the fund flows and other characteristics of individual investors.
Finally, given the limited information available and the necessity of specifying readily available market benchmarks, it was possible to only analysis equity funds in this analysis. Our conclusions may then hold for balanced funds and other asset class funds, such as fixed interest and property, and these would likewise benefit from research in the future.
Introduction 1.1 Context of thesis
Islamic finance is one of the fastest growing segments of the global finance industry, comprising financial institutions, products and services complying with Shariah (Islamic law) (Gait and Worthington, 2008). While the practice of Islamic finance in the modern world only commenced with savings institutions in 1963 (in Egypt and Malaysia), it has now spread to many other types of financial products and services, including banking, funds management (including mutual funds), takaful (Islamic insurance) and sukuk (Islamic bonds). Islamic financial products have now proliferated across almost every aspect of contemporary financial services, with comparable products complimenting those found in the conventional finance sector.
Consequently, the number of financial institutions offering Islamic financial products and services has also increased, from just 300 in 2005 (El Qorchi, 2005) to 628 at the end of 2009 (Lee and Menon, 2010) with operations in more than 75 countries (El Qorchi, 2005). Additionally, the value of Shariah- compliant assets grew 25 percent from US$758 billion in 2007 to US$951 billion at the end of 2008 (International Financial Services London, 2010). This amount is expected to grow further reaching US$1.6 trillion by 2012 (Global Islamic Finance Report, 2012).
One of the fastest growing Islamic financial products is Islamic mutual funds (IMFs), growing strongly since at least the pronouncement by the Council of the Islamic Fiqh Academy in Jeddah in 1990 that equity investment was permissible as long as it complied with Shariah (Nathie, 2009). Since then, many asset management companies have offered IMFs alongside their existing conventional mutual funds (CMFs) and socially responsible investment (SRI) funds.
For example, the number of IMFs worldwide has risen more than threefold from 200 funds in 2003 to 680 funds in 2008, representing various types of IMFs (Eurekahedge, 2008). Concomitantly, the value of assets managed under these funds has also grown, from US$20 billion in 2003 to US$44 billion in 2008 (Ernst & Young, 2009). At present, equity funds represent the largest segment of IMFs (about 40 percent), followed by fixed income (16 percent), real estate and private equity (13 percent) with the remainder in cash or commodities or other Islamic funds (Eurekahedge, 2008).
For the most part, these funds are concentrated in several regions, including the Middle East and North Africa, the Asia Pacific, North America and Europe, with more than half currently invested in the Middle East and the Asia Pacific (International Financial Services London, 2010, p. 5).
In Malaysia, the development of IMFs is relatively more important for several reasons. First, IMFs have a prospective role as a policy tool in the ongoing development of the Malaysian capital market. Malaysia already has one of the most well-developed conventional and Islamic capital markets in South-East Asia and among Islamic countries, respectively. In fact, the Malaysian government has highlighted the importance of IMFs in its Malaysian Capital Market 2001 blueprint. According to this, the government will “….facilitate the development of a wide range of competitive products and services related to the Islamic capital market” and “…create a viable market for the effective mobilisation of Islamic funds”, one of which is IMFs (Securities Commission Malaysia, 2001).
Second, the equity market, including investment funds, is an important buffer to the significant increase in household debt in the Malaysian economy (Bank Negara Malaysia, 2011b). However, the size of mutual fund assets relative to the total financial assets of Malaysian household remains small compared to other developed and developing countries.
In 2010, total mutual fund assets (net asset value) in Malaysia were RM226.81 billion (Securities Commission Malaysia, 2012), constituting about 16 percent of the total financial assets of Malaysian households as reported in the 2010 report (Bank Negara Malaysia, 2011b). Of this, RM24.04 billion was in IMFs, and thus they account for about 1.67 percent of Malaysian household sector financial assets (Securities Commission Malaysia, 2012).
This size implies that there is potential for IMFs to grow further and become the main catalyst for the growth of the overall mutual fund industry in Malaysia (Securities Commission Malaysia, 2011a). This will not only help to support the growth of the Malaysian capital markets (including the Islamic capital market) but also the Malaysian economy as a whole.
Third, even though the asset size of IMF industry is small relative to that of the total mutual fund industry, Malaysia’s IMF is among the largest in both asset under management and number of funds launched in the world besides Saudi Arabia and Kuwait [see, for instance, Securities Commission Malaysia (2012), Eurekahedge (2008), Hoepner et al. (2011), Abderrezak (2008), and Nainggolan (2011)].
This makes Malaysia one of the major players of the IMFs globally. Finally, IMFs potentially appeal to not only the Muslim investors but also to non- Muslim investors who may regard these funds as another variant of an ethical or SRI fund. Investors who are ethically (religiously) concerned are interested to integrate ethical (Shariah) values as well as financial objectives in their investment decisions.
The distinctive feature of IMFs lies in their screening strategies with IMFs applying screening based on Shariah. However, in contrast to ethical/SRI funds, IMFs mainly apply exclusionary screening as against both positive and negative screening in SRI funds.
1.2 Motivations for thesis
Several motivations have led to this study. The first motivation is that given the size and growing importance of IMFs, including the funds and their investors, it is important to understand better the performance of IMFs. In general, IMFs exist alongside CMFs in all markets, suggesting they compete with each other in attracting subscriptions from investors. In addition, a singular focus on Muslim investors only by IMF managers limits the ability of IMFs to grow further.
Thus, the issue of performance is important, as investors will not only possibly measure the viability of IMFs given their level of compliance to Shariah, but also whether the returns that IMFs offer are comparable with those of CMFs. Additionally, IMFs fundamentally differ from CMFs in their structure, management, and administration.
According to the modern portfolio theory (MPT), relying only on a subset of investment universe (due to screening strategies), will produce a less diversified portfolio and thus this portfolio will have a higher unsystematic risk and lower risk-adjusted returns. Furthermore, additional screening cost as well as the appointment of Shariah advisors may further reduce the risk-adjusted returns of IMF portfolio. Hence, we question how the performance of IMFs differs from that of CMFs from a fund management perspective.
Our second motivation concerns the differences in Shariah rulings among Shariah scholars, one implication of which concerns Shariah screening methodologies in IMFs. For example, in Malaysia, there are two screening strategies employed by the two main Malaysian Islamic indices and subsequently followed by the IMFs.
The FTSE Bursa Malaysia Shariah EMAS (FBMES) employs screening strategies formulated by the Shariah Advisory Council (SAC) of the Securities Commission of Malaysia (SCM), while the FTSE Bursa Malaysia Hijrah Shariah (FBMHS) employs screening strategies jointly formulated by the SAC and the FTSE’s Shariah advisory board operating as Yasaar Ltd. We also add the MSCI Malaysia Islamic index (MSCIMI) as it applies a more stringent screening rule compared to the previous two Malaysian indices.
Importantly, the screening by the SCM focuses mainly on sectoral screening, while Yasaar Ltd. screens investments using both sectoral and financial ratio screening. In general, sectoral screening screens investments from sectors that Shariah prohibits including companies involved in riba, gharar, maysir, and in the production of intoxicating beverages and pork- related industries. In contrast, financial ratio screening avoids companies with high levels of debt and liquidity.
As sectoral screening itself, constraints the number of investments in the portfolio, additional screening imposed may further narrow the number of candidate investments and thus limit diversification potential, increasing unsystematic risk and ultimately negatively affecting risk-adjusted returns. Shariah screening activities and the presence of Shariah advisory board also add costs to fund management expenses. In view of the above, it would be of interest to identify how screening intensity affects IMF performance, risks and management expenses.
Our third motivation is the relatively low penetration rate of IMFs in the market, despite seemingly impressive growth in recent years. In fact, IMFs still contribute only slightly more than 10 percent of the total industry net asset value (NAV) in Malaysia. For the future growth of IMFs in Malaysia, it is then important to understand the fund selection behaviour of investors both Muslim and non-Muslim.
As Muslims invest in IMFs, at least partly because of their compliance with Shariah, it is important for fund managers and policy makers to gain a better understanding of their behaviour given that they consider both financial (risk and return) and nonfinancial (compliance with Shariah) attributes in their investment decisions. This information could help fund managers to design suitable marketing strategies and assist policymakers in identifying information for disclosure in the fund prospectus or annual report. Thus, the question is how these investors make their fund selection decisions. Do they actively identify funds that will perform better in the future before they place their money in the IMFs?
A fourth motivation is that Islamic finance has been widely publicised as an alternative to conventional finance because of its resilience during the recent global financial crisis. This belief comes from the way that Islamic financial products and institutions operate. They are also fundamentally different in concept, and the way they are structured and administered. Hence, this motivates us to investigate how IMFs performed during the most recent financial crisis.
Finally, despite the strong growth of IMFs, there is limited research concerning the performance and fund flow behaviour of IMFs. This may be because of the small number of IMFs and the difficulty in accessing return and other fund characteristic data. However, because of increasing industry interest in Islamic finance, a number of data providers newly collect information on IMFs including Bloomberg, Morningstar, Failaka and Eurekahedge. Thus, we are able to carry out a timely analysis of these important products in a manner that was not possible just a few short years ago.
In summary, analysis of IMF performance, screening intensity and fund flows is of critical importance to investors, practitioners, academics, and regulators in terms of providing a better understanding of the IMF industry, the Islamic finance sector, and the financial sector as a whole. These issues are important, as Islamic investment has emerged as a topic of considerable interest to the academic community, international investors, policymakers and the public at large, particularly with recent significant developments in Islamic fund management in Malaysia.
1.3 Thesis aims and objectives
The central purpose of this thesis is to analyse three complementary aims concerning IMFs in Malaysia, one of the world’s largest markets for Islamic finance. These are the performance of IMFs, the impact of screening on the performance of IMFs, and the behaviour of IMF investors in terms of fund flows.
Our first aim is to examine the performance of IMFs relative to CMFs. This will address the question of how the performance of IMFs differs from that of CMFs in the context of the Malaysian capital market. We focus on the most important asset class in IMFs, equity funds, and use recent data sets as well as comprehensive performance evaluation measures. In addition, we examine if IMFs perform better (worse) than CMFs during bear (bull) markets.
Our second aim is to address the question of how differences in screening methodologies in Malaysian IMFs affect the performance, risk and management expense of IMFs. Given that there are several differences in Shariah screening methodologies in Malaysia, encompassing screening on the basis of product and activity only and screening also for firm leverage and other financial indicators, it is interesting and useful to investigate how this influence the three aspects of IMFs.
For this purpose, we estimate a two-factor model where the first factor is the excess market return and the second factor is the difference between the excess return of restrictive and less restrictively screened Islamic indices. We use the factor loadings from the second factor as a proxy of screening intensity. Our final aim relates to how funds flow into and out of IMFs and whether there is any difference in this behaviour compared with CMFs.
In particular, we consider how investors choose and make their fund selection decisions. The existing literature finds that rational investors care about past performance in that they typically invest in funds that have performed well in the previous period. As IMF investors care about both financial (risk and returns) and nonfinancial objectives (Shariah compliance), we can usefully investigate if they are less sensitive to past performance relative to CMF investors. We employ net money-flows as a proxy to represent investor behaviour.
However, besides past performance, we test the sensitivity of IMF investors to other fund characteristics and examine the loyalty of IMF investors by evaluating the volatility of money- flows. Finally, we investigate the existence of ‘smart money’ in Malaysian IMFs to see if this could partly explain the tremendous recent growth of IMFs in that market.
1.4 Structure of the thesis
The structure of the remainder thesis is as follows:
Chapter 2 Principles of Islamic Finance provides an overview of the history, evolution, principles and development of Islamic finance. This chapter serves to provide a broad theoretical and conceptual background for understanding Islamic finance in general and IMFs in particular. The main principles of Islamic finance to be discussed are the prohibition of riba, maysir, gharar and dealing in forbidden activities and commodities, the sharing of business profits and risks, and the paying and collecting of zakah.
These principles formed the foundation of Islamic finance, which also become the underlying principles of contracts established to facilitate all financial transaction and activities in Islamic finance. Examples of these contracts are mudarabah, musharakah, murabahah, bai muajjal, bai salam, istisna, ijarah, wakalah and qard hassan.
Chapter 3 The Malaysian Islamic Mutual Fund Industry provides the institutional background for the Malaysian funds management industry with a special emphasis on the IMF management market. This chapter provides details on the operational aspects of Malaysian IMFs and regulations relating to the industry.
The chapter also provides important information concerning the industry and the various reasons why the issues of performance, screening, and fund flows are fundamentally important to a better understanding of this key financial market segment.
Chapter 4 A Review of Performance, Screening and Fund Flows in Screened Funds discusses the theoretical and empirical literature relating to managed funds with a focus on screened funds of all types including IMFs. This chapter thus serves as both a background for understanding recent work in this area, as well as providing the necessary guidance for the methodological choices subsequently employed in this thesis.
Chapter 5 Empirical Methodology details the data collection procedures and research design used to examine the performance, screening activity and fund flows in the Malaysian IMFs. The chapter presents the data sources and explains the methods used to investigate these empirical concerns.
The first empirical analysis concerns the performance of IMFs. The second analysis addresses screening intensity in IMFs and its effects on performance. The final analysis concerns money-flows into IMFs including both the determinants of fund flows and the perception of ‘smart money’ in mutual funds.
Chapter 6 Empirical Results reports the empirical findings on the performance, screening activity and fund flows of IMFs in Malaysia. The chapter begins with the results of the analysis of IMF performance, followed by screening activity and finally fund flows of IMFs.
Chapter 7 Conclusion presents a summary of the study and highlights the contribution of this research to the existing literature on IMFs, screened funds, and mutual funds more generally. The chapter also provides some implications for industry policy and industry practice, discusses some of the limitations of the thesis, and suggests some directions for further research.