Shari’ah-compliant investing has been around for a very long time, however, only started gaining popularity more recently. And it’s understandable why this is. Even though these types of funds still make up a small share of global financial assets, their performance has been solid to put it modestly, earning them a place as top performers. This is why we need to forget the stereotype – Shari’ah compliant funds are not only for Muslim or ethically minded investors, but anyone can invest.
Shari’ah investments of course have a different type of performance signature due to the exclusion of certain sectors or a narrow universe as some might put it. But even with that smaller universe, the notion that Shari’ah funds cannot outperform doesn’t hold. We have seen in the recent past that most of these funds have performed exceptionally well. Investors just need to understand how Shari’ah equity opportunity sets behave through different market cycles. They can then make informed investment decisions when including Shari’ah equity portfolios tactically in their respective investment strategies.
When it comes to the Shari’ah equity investments, the opportunity set is governed by principles and adheres to two key measures, a qualitative and quantitative test. The qualitative criteria exclude any shares whose core business is linked to a non-shari’ah compliant activity, like environmental, social, and governance (ESG) consideration, these include, among others, alcohol, tobacco, gambling, and weapons, but also the charging and receiving of interest. The quantitative criteria is ratio-based, which excludes excessively leveraged companies (30% debt to market cap or asset value) as well as companies where non-core revenue to total revenue is greater than 5%.
After the qualitative and quantitative tests have been met, fund managers can overlay their investment philosophy and build portfolios to meet clients' objectives. Fund managers operate in different market cycles; therefore, assessing market cycles is important as they are the heartbeat of the investment economic system and can help when making investment decisions. Previous research on market cycles is abundant, however, widely published research narrows down the four market cycle phases known as Recession, Reflation, Recovery and Overheat. The indicator we use to track these phases is the Organisation for Economic Co-operation and Development (OECD), which has been found to be the most consistent. The OECD is a multi-dimensional framework covering country specific dimensions of economic activity. The research approach considers both the absolute level and change of the indicator. That is, if the OECD is low and falling, this would be a recessionary cycle; if it is low and rising it would be a reflationary cycle; high and rising would be a recovery cycle; and if is high and falling it would be called an overheating cycle.
To illustrate how Shari’ah funds perform during the varying market cycles, graph 1 below shows the Old Mutual Albaraka Equity Fund, one of our longest-standing Shari’ah funds, against the JSE-All Share Index. This is an award-winning fund, that recently scooped two LSEG Lipper Awards for consistently delivering strong performance.
This is evidence that Shari’ah funds can deliver better over the long term relative to the JSE All Share Index. As shown in graph 1, the Old Mutual Albaraka Equity Fund outperformed the market (JSE ALSI) net of fees. However, investors need to understand the behaviour through the market cycles.
In all these cycles, like any investment product, Shari’ah funds perform differently. In a recession, there may be possible outperformance due to the funds being more conservative with debt and focusing on long-term sustainability. Not to say there is never an impact, but it is to a lesser degree in comparison to other funds that have a wider range of stocks to invest in. In a reflationary cycle, performance is more dependent on the fund’s composition as certain sectors might benefit during this cycle. When faced with a recovery cycle, Shari’ah funds with exposure to healthy growing companies could see strong performance. In an overheating environment, the principles against excessive risk-taking potentially limit gains. Moreover, investors need to understand the risk associated with any given fund.
Diving deeper into the performance of the Old Mutual Albaraka Equity Fund, JSE ALSI, and market cycles, it’s interesting to examine the median returns since the inception of this fund. All phases are positive (as shown in graph 2), furthermore, while both the fund and the JSE ALSI perform poorly in recession and overheat cycles relative to reflation and recovery cycles, it is evident that the Old Mutual Albaraka Equity Fund outperforms in recessions. Moreover, the fund has a lower standard deviation through all the market cycles, as shown in graphs 2 and 3.
We can conclude that from this analysis, Shari’ah funds earned their stripes and should not only be limited to faith-conscious and ethically-minded investors. They have a broad appeal as diversified investment options that address ethical, faith-based, and ESG considerations.
This form of investing offers an attractive alternative for all investors due to its natural quality construct – which is automatically increased by the lower debt ratio. This unique feature enhances attractiveness as a compelling investment option, especially in times like these when interest rates significantly influence market dynamics.
As portfolio managers, managing risk is vital. We are cognisant that the market could turn at any time. That is why building a portfolio that can withstand market shocks is important in times of uncertainty, given geopolitical tensions, global elections and volatile interest rates. For investors seeking ethical and diversified exposure to local and global equity markets, Shari’ah products should be considered as they offer investors a compelling opportunity for superior investment returns, diversification, or even a smoother return path.
In short, do not limit your portfolio’s return potential because you think you are not allowed to invest in Shari’ah funds based on faith differences. These funds have over time proven that they can deliver strong differentiated returns, even in today's turbulent markets.