1. 1 Islamic Indexes Khaled Hussein Islamic Development Bank, Islamic Research and Training Institute, P.O. Box 9201, Jeddah 21432, Saudi Arabia Email: khussein@isdb.orgkhussein@isdb.org

2. 2 I. Introduction  Over the past decade, the world of finance paid more attention to the area of "ethical" investment.  For example, the size of ethical funds jumped from $1.18 to 2.2 trillion in the US between 1997 and 2000.

3. 3  Until the 1970s, a great proportion of the Muslim community was not involved in any stock market investments due to Islamic prohibition of certain business activities

4. 4  1987 there was a Call from eminent scholars  Equity funds at NCB, Al-Baraka Group  In the 1990s, a major breakthrough took place in religious rulings related to equity investment, and since then Islamic equity funds have started to operate.

5. 5  Islamic equity investment witnessed strong growth during the second half of the 1990s.  In 1996, there were 29 Islamic funds, valued at US$800 million.  The RHB Islamic Index was introduced in 1996

6. 6  By March 2002, the number of Islamic funds rose to 105 with total assets of US$3.3 billion, down from US$5 billion in 2000  The International Investor in collaboration with FTSE Group launched the first Islamic equity index series, FTSE Global Islamic Index Series (GIIS) at the end of 1998.  In February 1999 the first Dow Jones Islamic market index (DJIMI) was launched  The KLSE Syariah Index, in 1999

7. 7 Equity index  A statistical indicator that provide a representation of the value of the equities which constitute it.indicator equities

8. 8 Aims of constructing equity indexes  to provide information about various types of investments.  to encourage companies to disseminate information that will assist investors in making decisions.  to provide criterion to compare performance of a portfolio relative to the corresponding index

9. 9 Index construction  Market capitalization weighting A stock's weight is based on the outstanding number of shares and the price per share (S&P 500)

10. 10  Price weighting (DJIA) A stock's weight is determined by its price only The concern with such an index is that a stock with small market capitalization but a high price can have large impact on the overall index return  Equal weighting Each stock has the same weight in the index

11. 11 Stocks Screening  The screening is divided into two parts:  First: an Islamic investor should not buy shares of companies whose primary or basic business is unlawful.  Alcohol, tobacco, pork products, conventional financial services, weapons, and entertainment (such as hotels, casinos, cinema, pornography, and music)

12. 12  Shariah scholars have the obligation to encourage investors in business activities that are beneficial to the society

13. 13  Second: Components of the company revenues  Leverage:  Shariah Board of DJIM index allow for acquisition of shares in companies with debt less than one-third of market capitalization.  The FTSE Global Islamic index uses debt/assets

14. 14  Cash plus interest-bearing securities:  To ascertain the level of non-operating interest income where a negligible amount of such income does not prohibit the acquisition of shares  Non-operating interest income/revenue (sales) should not exceed 5% …….  DJIM: (cash + interest-bearing securities)/market cap. Is less than 33%  FTSE does not have either an interest income or cash screen

15. 15  Liquidity screen:  If the Accounts receivable/total assets exceeds 50%, this means the majority of the company's dealings are in money and not in goods and services.  DJIM apply this criterion up to 45%

16. 16 How to measure Index performance  A single model based on the classical CAPM developed by Sharpe (1964) and Lintner (1965): (R it – R ft ) = α + β (R mt – R ft ) + ε R it is the return on index i in month t, R ft is the risk-free rate, R mt is the return on the benchmark portfolio in month t, ε is an error term, β is the index's systematic risk, i.e., its sensitivity to the return of the benchmark. α is called Jensen's alpha,

17. 17  As an extension of the CAPM model, Fama and French (1992, 1993) developed a multi-factor model, suggesting that stock returns in excess of the risk-free rate are explained by the sensitivity of their return with respect to three factors:

18. 18  Fama and French (1993) argue that size, earnings/price, leverage, and book to market equity have explanatory power in explaining average returns if each variable is used alone.  In combination, size and book to market equity seem to absorb the apparent role of leverage and earnings/price in average returns.

19. 19 (R it – R ft ) = α + β (R mt – R ft ) +β 1i SMB t + β 2i HML t + ε SMBThe difference between the return on a portfolio of small capitalisation stocks and the return on a portfolio of a large capitalisation stocks; HMLThe difference between the return on a portfolio of high book-to-market stocks and the return on a portfolio of low book-to-market stocks.

20. 20 Hypothesis Due to increased monitoring costs, availability of a smaller investment universe, and restricted potential for diversification, it has been argued that unscreened benchmarks should outperform Islamic (ethical) investment.

21. 21 Data The data set of this study contains the monthly prices of DJIMI, its 13 sub-indices (based on size and industry), and their DJ counterparts. Data were obtained from the Dow Jones company database for the time period December 1995 and July 2003.

22. 22 we use the monthly data for the World Index All International, established by Morgan Stanley database, as an appropriate proxy for the world portfolio. Furthermore, we use the one-month treasury bill return as a proxy for risk-free rate.

23. 23 Jakarta Conference  DJIMI: January 1996 to December 2004  FTSE Islamic index: December 1993 to December 2004

24. 24 Summing Up The papers leave us with a paradox: The positive abnormal returns of Islamic indices in the bull market period, then negative abnormal performance in the subsequent period (bear period).

25. 25 Are the abnormal negative returns of Islamic indices attributed to market inefficiency, where these indices experience huge gains in the bull market and then underperform their index counterparts in the downturn period? What is the exact role of leverage ratio in determining firm performance under different market conditions? And do the prevailing interest rates in the market matter? More investigation is needed to cover these issues, among others, to be able to provide additional evidence regarding some of the patterns of Islamic indices ’ behavior, and before the results of this paper can be interpreted conclusively.