Does Islamic investment accrue hedging benefits?

This chapter investigates whether investment in shariah-compliant indices (SCIs) provide any hedging benefit to investors during an adverse movement of the capital markets. Contrary to the existing literature where mutual funds and third party constructed indices are used for empirical estimations, we constructed fifteen SCIs by following three mainstream shariah screening criteria in five regions. The sample consists of constituent level data (1712 firms) for the period from January 2008 to December 2013. A logistic smooth transition autoregressive (LSTAR) model is used for empirical estimation because of its capability for smooth transitioning between the states of capital markets such as ‘bull’ and ‘bear’ over the whole sample period. Since SCIs and their benchmarks are structured from the same investment universe, following the same construction methodology and adhering to the same rebalancing frequency, the deviation in performance can be attributed solely to the shariah standards. We document that the risk-adjusted returns of SCIs are, on average, not significantly worse than benchmark indices (BMIs). We find evidence that SCIs largely exhibit lower systematic risk. However, the hedging benefit is not evident in most of the SCIs except for those SCIs from the US market following the shariah screening criteria based on the market value of equity. These findings are robust even after inclusion of additional factors.