Evaluation of shari'ah non-compliance risk exposure in shari'ah stocks screening methodologies

Abstract

Shari’ah stocks screening methodologies had a significant impact in the realm of Islamic finance portfolio stocks since the early 1990s. These enabled a more inclusive investment community among overall Islamic financial community that led to the growth of Islamic financial institutions including Islamic banks and takaful. Over the years different Shari’ah stocks screening methodologies have been developed by the leading indices in different jurisdictions both at the agency and regulatory level. All the newly developed Shari’ah screening methodologies shared a common core i.e. screening out the Shari’ah non-compliant business activities e.g. alcohol, gambling. On the other hand, the threshold of the financial ratio was the distinguishing feature among the methodologies from applications of different juristic rulings. Even though Shari’ah stocks screening methodologies are a vital tool for Islamic equities sphere, there is a lack of empirical research on the Shari’ah governance dimension of the Shari’ah stocks screening methodologies. Therefore, understanding the degree of possibility of Shari’ah compliant stocks to become Shari’ah non-compliant will enhance the level of Shari’ah governance of the Shari’ah compliant stocks. The research aims to fill this gap by providing a Shari’ah governance tool for Shari’ah stocks screening methodologies, which will help Islamic investors and stakeholders to better understand the Shari’ah compliant stocks and the mechanisms of Shari’ah stocks screening methodologies around the world. The sample in this research includes 1440 Shari’ah compliant stocks spanning 69 countries with high market capitalization, over a period between 2010-2016/17. The analysis of the sampled stocks is divided into two phases. The first phase is based on modified discriminant analysis function to accommodate the Five global Shari’ah stocks screening methodologies framework i.e. DJ, S&P, FTSE, MSCI and AAOIFI for the year 2016/17. The results of the analysis categorized the sampled stocks into three different levels of Shari’ah compliance with distinct color codes i.e. green, yellow and red. Where green is the low possibility of becoming Shari’ah non- compliant, and red representing the high possibility of becoming Shari’ah non-compliant based on the score developed from the discriminant analysis function. In the second phase, the sampled stocks were analyzed using the modified discriminate function to forecast the Shari’ah governance level for the stock based on trends from historical Shari’ah compliance level of the stocks i.e. green, yellow and red. Forecast results provide the variations of Shari’ah compliance level of the stocks over the years for a robustness evaluation of 5 global Shari’ah stocks screening methodologies. The results highlight that the Standard & Poor and Dow Jones Shari’ah screening methodologies are more robust than others as they have a highest and stable number of green Shari’ah compliant stocks from the sample 1440 stocks from the year 2010 to 2016/17. The Shari’ah compliance trend from the historical data analysis can be further used to forecast the future Shari’ah compliance direction of the stocks. Further analysis includes ANOVA test to study the variance among mean discriminant scores which overall is significant among the Screening methodologies. Moreover, the Levene test is found significant therefore for posthoc test Games-Howell is used. Findings from an independent one-way ANOVA indicated that the discriminant score differs significantly across the 5 screening methodologies.