Islamic ETFs have proliferated within the broad rise of values-based investments including Catholic and ESG ETFs, however, new research indicates these products tend to only outperform ‘sin’ sectors during periods of market instability and high interest rates.
A paper from the Australian National University and University of Sydney, titled The Returns of Faith-Based Mandates in Islamic ETF Methodologies, found only narrow windows of opportunity for Shariah-compliant investments, such as during COVID-19 instability and the subsequent fastest interest rate hikes in four decades.
Examining the returns of the iShares MSCI World Islamic ETF (ISWD) between 2008 and 2021, the authors said ‘sin’ sectors – defence, alcohol, pork and tobacco – outperformed ISWD during the non-crisis period from the beginning of 2010 to the end of 2019 while the ETF either competed with or beat other ‘sin’ sectors, including entertainment and conventional banking.
The report noted increased defence spending, stable pricing power and high profit margins for alcohol and pork industries and evolutions such as the digitisation of gambling during the non-crisis 2010s period.
Similarly, companies excluded on financial ratio screening (FRS) grounds – for accessing ‘cheap debt’ – impeded Shariah-complaint investment portfolios in the pre-COVID-19 era.
“FRS mandates exerted minimal influence on the selection of companies but did reduce the investment pool,” the authors said. “Most notably, they excluded companies that took advantage of the low interest rate environment such as the FAANG stocks.”
Interestingly, most ‘sin’ sectors underperformed ISWD during the COVID-19 pandemic period of December 2019 to January 2021, as lockdowns hampered demand for commercial aircraft, travel and eating out, while increasing default risk for bank-related services.
However, researchers found this advantage was less clearly defined during the Global Financial Crisis (GFC), with most ‘sin’ sectors recording comparable returns to ISWD from June 2008 to December 2009, with only banking significantly underperforming, owing to the “pronounced challenges” facing the sector.
“Results suggest that ‘sin’ sectors generally outperform ISWD during non-crisis periods and record comparable or lower returns during crisis periods,” the authors said.
Much like other values-based investments, leaving some returns on the table may be viewed as a worthwhile trade-off, given the object of their mandate is to align portfolios with beliefs that do not facilitate full market exposure.
“By comprehending the distinctive business attributes associated with faith-based mandates, Islamic economists can devise targeted strategies to enhance market dynamism while ensuring adherence to religious principles,” the research concluded.
