Avoiding Interest-Based Revenues while Constructing Shariah-Compliant Portfolios: False Negatives and False Positives

Ozgur Arslan-Ayaydin, K.M.R. Boudt, Muhammad Wajid Raza

Research output: Contribution to JournalArticleAcademicpeer-review

Abstract

Shariah law prohibits investments in equities of companies for which interest income is a considerable source of revenue. In practice, this is often enforced by prohibiting investments in firms for which the reported interest-based revenues exceed a predetermined percentage of the firm’s total revenue. In this article, the authors investigate an alternative approach that consists of avoiding firms that are expected to have interest-based revenues exceeding the acceptable threshold over the investment horizon. They compare the traditional backward-looking approach with the proposed forward-looking analysis for a sample of S&P 500 firms over the period 1984–2015. Their results show that the forward-looking approach outperforms the backward-looking approach in terms of both fewer false positives (firms classified as compliant when they are not) and false negatives (firms classified as not compliant when they are).
Original languageEnglish
Pages (from-to)136-143
Number of pages8
JournalThe Journal of Portfolio Management
Volume44
Issue number5
DOIs
Publication statusPublished - May 2018

Funding

The authors thank Andres Algaba, Dawood Ashraf, Dries Cornilly, Frank Fabozzi (the editor), Giang Nguyen, and Marjan Wauters for helpful comments and suggestions. Financial support from Shaheed Benazir Bhutto University Dir, Pakistan and the Higher Education Commission, Pakistan is gratefully acknowledged. 1Shariah-compliant equity investors also use screens based on the firm’s liquidity and leverage. These screens have the same classification problem as the one we study for interest-based revenues. See, for example, Derigs and Mar-zban [2009] for an overview of the various screens used in Shariah-compliant equity investing. 2Examples include the investment rules in the prospectus issued by the Dow Jones Islamic Market indexes (DJIM), the S&P Shariah indexes, and the FTSE Shariah indexes. 3The data are quarterly. Our analysis (not reported here for brevity but available upon request) shows that adding more lags or complexity to the time series model does not substantially improve the accuracy of the screening decision. 4We exclude the firms for which the global industrial classification standards (GICS) codes are 20101010 (aerospace and defense), 25301010 (casinos and gambling), 25301020 (hotels, resorts, and cruise lines), 25301040 (restaurants), 25401020 (broadcasting), 25401030 (movies and entertainment), 30201010 (brewers), 30201020 (distillers and vintners), and 30203010 (tobacco), as well as financial firms for which the GICS code starts with 4010, 4020, and 4030, and firms that are active in swine production.

FundersFunder number
Shaheed Benazir Bhutto University
Higher Education Commission, Pakistan

    Keywords

    • Portfolio
    • Shariah
    • screening

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