Islamic and Conventional Equity Market Movements During and After the Financial Crisis: Evidence from the Newly Launched MSCI Indices

• Author: Viktor Manahov,Sarkar Humayun Kabir,Hafiz Hoque,El Khamlichi Abdelbari
• Date: 01 November 2016
• DOI: http://doi.org/10.1111/fmii.12075
• Published date: 01 November 2016

Islamic and Conventional Equity Market Movements

During and After the Financial Crisis: Evidence from

the Newly Launched MSCI Indices

BYHAFIZ HOQUE,SARKAR HUMAYUN KABIR,

ELKHAMLICHI ABDELBARI,AND VIKTOR MANAHOV

This paper examinesthe relationship between the Islamic and conventional equity indices by

employingthe newly launched MSCI Global Islamic Indices which began in 2008. We argue

for the case of cointegration supported by fundamental, category and habitat theories, and

against cointegration due to the fundamental difference between Islamic and conventional

stocks in terms of debt ratio, accounts receivable and interest bearing securities. We find

Islamic and conventionalequity markets move together despite fundamental differences and

giventhat market microstructure, dividends, capital gains, taxation and governance systems

are differentacross the markets. Almost simultaneous movement of the permanent and cycle

components of Islamic and mainstream equity indices has been supported by the application

of the Beveridge Nelson (BN) time series decomposition technique. Theoretically, the

volatility of Islamic equities should be lower due to their low leverage ratio. Surprisingly,

permanent parts of the Islamic indices appear to be more volatile during the crisis period

and less volatile during the post-crisis period.

Keywords: MSCI Global Islamic indices, financial crisis, cointegration, time series

decomposition.

JEL Classification: C32, F15, G01, G15.

I. INTRODUCTION

The main objective of the study is to investigate the relationship between Islamic

equity indices and conventional equity indices. Although a few studies test the

level of integration of Islamic equity markets (e.g., Arouri et al., 2013 and Dania

and Malhotra, 2013) in different regions, several questions remain unanswered.

Are Islamic and conventional equity markets related during the crisis period and

in the post-crisis period? How do the permanent and transitory components of

Islamic and conventional equity indices move overtime? Is the US still leading in

the Islamic and conventional markets? Who is the closest competitor of the US

since the crisis: Japan or BRICS?1We address these questions in this paper.

The arguments for stock market cointegration are strong. According to the

fundamental theory, comovement in equity prices reflects comovement in funda-

mental values (Barberis et al., 2005). According to the theory of “fundamentals”,

stock returns comove due to either correlated changes in cash flows or correlated

changes in discount rates. Change in the correlation of discount rates in turn is

Corresponding author: Hafiz Hoque, University of York.Email: hafiz.hoque@york.ac.uk.

1BRICS stands for Brazil, Russia, India, China and South Africa. BRICS are distinguished by their

large, fast-growingeconomies and significant influence on regional and global affairs; all five are G-20

members. As of 2013, the five BRICS countries represent almost 3 billion people, with a combined

nominal GDP of US$16.039 trillion, and an estimated US$4 trillion in combined foreign reserves.

C2016New York University Salomon Center and Wiley Periodicals, Inc.

218 Hafiz Hoque et al.

affected by either information about expectedchanges in interest rates or correlated

changes in assets’ rationally perceived risks. Under this view, the only plausible

source of price movement is news about aggregate demand (Barberis et al., 2005).

Markets for conventional and Islamic securities often interact. The standard theory

of portfolio optimization is built on the assumption that different types of securi-

ties share common-factor value determinants (Brockman et al., 2010). The trading

process may reflect these long-term interactions and may exhibit other dependen-

cies as well. Trades may be correlated for non-informational reasons (Hasbrouck,

2007). A trader buying into a conventional index, for example, will place orders

in many Islamic stocks. A trade in a conventional stock, for example, that conveys

information about a factor that is also a value determinant of an Islamic stock may

move the price of Islamic stock.

The second theory is based on the “category” view of comovement analyzed

in Barberis and Shleifer (2003). This theory states that investors first group their

assets in different categories such as small-cap stocks, oil industry stocks, Islamic

equities and invest accordingly in different categories. If a group of “category”

investors are noise traders with correlated sentiment, and if they move funds

from one category to another, their coordinated demand will affect the price

and returns of assets even though cash flows of these assets are uncorrelated. In

contrast to “category” based comovement, Barberis et al. (2005) document the

“habitat” view of comovement. This theory assumes that many investors choose

to trade only a subset of all available securities in the market. Such preferred

habitats may arise because of transaction costs, international trading restrictions

or lack of information (Merton, 1987). More generally, this view of comovement

predicts that there will be a common factor in the returns of securities that are

held and traded by a specific subset of investors. Islamic equities, passed through

both qualitative and quantitative screening processes, can be regarded as a subset

of listed stocks in the stock exchange in a country. Traders, if they choose to

invest in Islamic equities, either because of the investor’s religious beliefs or any

other pertinent reasons, would be looking at a common factor in both Islamic

and conventional markets. This common factor would determine the equilibrium

prices in both markets and thus both markets would be cointegrated.

The stock market has interdependent price dynamics among conventional and

Islamic stocks, but as the dependencies arise from correlated trade directions,

they are inherently temporary. As long as correlation among the error processes

of the conventional and Islamic securities is less than one, each price would

evolve, at least in part, independently of the other. This means that in the long

run, the prices of the two types of stocks would diverge, in principle without

bound (Hasbrouck, 2007). There are many situations, nonetheless, where the

prices are so closely linked by economic factors that boundless divergence is

not possible. An increasing divergence between conventional and Islamic stock

prices would, however, run up against arbitrage. When conventional and Islamic

stocks individually follow random walk (formally, “integrated”) processes, but

there exists a linear combination of these stocks that is stationary, these two

Islamic and Conventional Equity Market Movements 219

variables are said to be cointegrated (for a formal model of cointegration in the

context of market microstructure please see Hasbrouck, 1995). The conventional

and Islamic stocks are both dominated by random walks. The difference between

them is approximately stationary. It implies that they are cointegrated (Engle and

Granger, 1987).

There is a noticeable difference between the US, Japan, Canada and BRICS in

terms of market microstructure, dividends, capital gains, taxation and governance

systems. Although developed markets are more liquid (lower bid-ask spread)

than those that are developing (e.g., BRICS) we see a substantial amount of

equity investment from developed markets to BRICS.2Among other reasons,

unfavorable tax policies in the developed markets (e.g., double taxation in the

US) and zero or low capital gains taxes in the BRICS countries has led to an

increase in the flow of funds to BRICS. The increased flow of funds will increase

information dissemination about aggregate demand, fundamentals and preferred

habitats among those markets. Despite the differences among markets, all these

factors have increased the level of integration among markets (Brockman et. al.,

2010 and Hochstotter et al., 2014).

However, there are fundamental differences between the Islamic markets com-

pared to the conventional markets which may make them fragmented. The Islamic

financial system prohibits the payment and receipt of interest. It also deals with

the Islamic industry screens that restrict investment in economic activities related

to Sharia-forbidden activities. The Islamic industry concentrates its investments

in technology, telecommunications, steel, engineering, transportation, health care,

utilities, construction and real estate (Abd Rahman, 2010). Islamic equities in-

clude real sector investments and exclude investment in financial sectors. Bashir

(1983) contrasts the Islamic and conventional financial systems by highlighting

that Islamic finance is ownership-based and asset-driven, while the conventional

system is interest-based and debt-driven. Theoretically, the volatility of Islamic

equities should be lower due to their low leverage ratio.

Arouri et al. (2013) show that Islamic stock markets were less affected dur-

ing the financial crisis. The application of screening methodologies changes the

fundamental structure of Islamic equities from their conventional counterparts.

Theoretically, firms are required to pay lower interest because of a lower lever-

age ratio. Moreover, lower account receivables reduce the possibility of incurring

lower bad debt in the asset structure of the firms, which is again another fundamen-

tal distinguishing feature of Islamic equities from their conventional counterparts.

Islamic equities, because of these unique features, theoretically could be consid-

ered as safer than conventional equities in general and during financial turbulence

in particular since the requirement of interest payment is minimum for these firms.

During a financial crisis, Islamic equity markets should be less volatile because

of the lower leverage than their conventional counterparts.

2In 2013, $1702 billion was invested by the foreign nationals in the BRICS’sequity markets (BRICS

Joint Statistical Publications, 2014).