Islamic Indexes
Khaled Hussein
Islamic Development Bank,
Islamic Research and Training Institute,
P.O. Box 9201,
Jeddah 21432, Saudi Arabia
Email: khussein@isdb.org
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I. Introduction
 Over the past decade, the world of finance
paid more attention to the area of "ethical"
investment.
 For example, the size of ethical funds
jumped from $1.18 to 2.2 trillion in the US
between 1997 and 2000.
2
 Until the 1970s, a great proportion of
the Muslim community was not
involved in any stock market
investments due to Islamic
prohibition of certain business
activities
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 1987 there was a Call from eminent
scholars
 Equity funds at NCB, Al-Baraka Group
 In the 1990s, a major breakthrough took
place in religious rulings related to equity
investment, and since then Islamic equity
funds have started to operate.
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 Islamic equity investment witnessed
strong growth during the second half
of the 1990s.
 In 1996, there were 29 Islamic funds,
valued at US$800 million.
 The RHB Islamic Index was
introduced in 1996
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 By March 2002, the number of Islamic funds rose to
105 with total assets of US$3.3 billion, down from
US$5 billion in 2000
 The International Investor in collaboration with FTSE
Group launched the first Islamic equity index series,
FTSE Global Islamic Index Series (GIIS) at the end of
1998.
 In February 1999 the first Dow Jones Islamic market
index (DJIMI) was launched
 The KLSE Syariah Index, in 1999
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Equity index
 A statistical indicator that provide a
representation of the value of the
equities which constitute it.
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Aims of constructing equity indexes
 to provide information about various types
of investments.
 to encourage companies to disseminate
information that will assist investors in
making decisions.
 to provide criterion to compare
performance of a portfolio relative to the
corresponding index
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Index construction
 Market capitalization weighting
A stock's weight is based on the
outstanding number of shares and
the price per share (S&P 500)
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
Price weighting (DJIA)
A stock's weight is determined by its price only
The concern with such an index is that a stock with
small market capitalization but a high price can have
large impact on the overall index return

Equal weighting
Each stock has the same weight in the index
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Stocks Screening
 The screening is divided into two parts:
 First: an Islamic investor should not buy
shares of companies whose primary or
basic business is unlawful.
 Alcohol, tobacco, pork products,
conventional financial services, weapons,
and entertainment (such as hotels, casinos,
cinema, pornography, and music)
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 Shariah scholars have the obligation
to encourage investors in business
activities that are beneficial to the
society
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 Second: Components of the company revenues
 Leverage:
 Shariah Board of DJIM index allow for acquisition of
shares in companies with debt less than one-third of
market capitalization.
 The FTSE Global Islamic index uses debt/assets
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
Cash plus interest-bearing securities:

To ascertain the level of non-operating interest
income where a negligible amount of such income
does not prohibit the acquisition of shares

Non-operating interest income/revenue (sales)
should not exceed 5% …….

DJIM: (cash + interest-bearing securities)/market
cap. Is less than 33%

FTSE does not have either an interest income or cash
screen
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 Liquidity screen:
 If the Accounts receivable/total assets exceeds
50%, this means the majority of the
company's dealings are in money and not in
goods and services.
 DJIM apply this criterion up to 45%
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How to measure Index performance
 A single model based on the classical CAPM developed
by Sharpe (1964) and Lintner (1965):
(Rit – Rft) = α + β (Rmt – Rft) + ε
Rit is the return on index i in month t,
Rft is the risk-free rate,
Rmt is the return on the benchmark portfolio in month t,
ε
is an error term,
β
is the index's systematic risk, i.e., its sensitivity to
the return of the benchmark.
α is called Jensen's alpha,
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 As an extension of the CAPM model,
Fama and French (1992, 1993) developed a
multi-factor model,
suggesting that stock returns in excess of the
risk-free rate are explained by the sensitivity of
their return with respect to three factors:
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Fama and French (1993) argue that
size,
earnings/price,
leverage,
and book to market equity
have explanatory power in explaining average
returns if each variable is used alone.
In combination, size and book to market equity
seem to absorb the apparent role of leverage and
earnings/price in average returns.
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(Rit – Rft) = α + β (Rmt – Rft) +β1i SMBt +
β2i
HMLt + ε
SMB
The difference between the return on a portfolio of
small capitalisation stocks and the return on a
portfolio of a large capitalisation stocks;
HML
The difference between the return on a portfolio of
high book-to-market stocks and the return on a
portfolio of low book-to-market stocks.
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Hypothesis
Due to increased monitoring costs,
availability of a smaller investment
universe,
and restricted potential for
diversification,
it has been argued that unscreened
benchmarks should outperform
Islamic (ethical) investment.
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Data
• The data set of this study contains the
monthly prices of DJIMI,
its 13 sub-indices (based on size and
industry), and their DJ counterparts.
Data were obtained from the Dow Jones
company database for the time period
December 1995 and July 2003.
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• we use the monthly data for the World Index
All International, established by Morgan
Stanley database, as an appropriate proxy for
the world portfolio.
•
Furthermore, we use the one-month treasury
bill return as a proxy for risk-free rate.
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Jakarta Conference
 DJIMI: January 1996 to December
2004
 FTSE Islamic index: December 1993
to December 2004
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Summing Up
The papers leave us with a paradox: The
positive abnormal returns of Islamic indices
in the bull market period, then negative
abnormal performance in the subsequent
period (bear period).
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Are the abnormal negative returns of Islamic indices attributed
to market inefficiency, where these indices experience huge
gains in the bull market and then underperform their index
counterparts in the downturn period?
What is the exact role of leverage ratio in determining firm
performance under different market conditions?
And do the prevailing interest rates in the market matter? More
investigation is needed to cover these issues, among others, to
be able to provide additional evidence regarding some of the
patterns of Islamic indices’ behavior, and before the results of
this paper can be interpreted conclusively.
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