EFTA00617310.pdf

An Empirical Assessment of Islamic Equity Fund Returns Author: Raphie Hayat Student number: 1253913 Supervisor: Dr. Roman Kraussl Date: October 2006 University: Free University, Amsterdam Motivation: Master thesis Abstract: Islamic Equity Funds (IEFs) differ fundamentally from conventional equity funds since Muslims are limited in their ability to invest in certain companies and are prohibited to pay or receive interest. The amount of academic research has lagged behind the popularity of these new and interesting funds. This paper aims to fill this gap somewhat by applying common statistical procedures as well as other mainly used performance measures to asses the performance of IEFs for the past five years. The results indicate that IEFs are relatively safe investment vehicles that do not significantly under or outperform their Islamic as well as conventional benchmarks under normal market conditions. During the bear market of 2002 IEFs did however significantly outperform the Islamic and conventional market. Furthermore IEFs seem most attractive as part of a larger fully diversified portfolio like a fund of funds, since they have good systematic risk-to-return ratios. There also seems to be a difference between the abilities of IEF managers, with the managers of Malaysian IEFs having relatively better market timing abilities and the managers of globally invested IEFs having better stock picking abilities. Interestingly, Malaysian IEFs seem to contain a discount on their returns based on their low downside risk. The results furthermore indicate the validity of the CAPM and point in the direction of efficient markets. 1 EFTA00617310 Table of Contents 1. Introduction 4 II. Islamic Investing 6 11.1 The Prohibition of Interest 6 II/ Gharar and Maysir 7 II.3 Equity Investment Criteria 7 II.4 The IEF Industry 8 II.4 A History 8 II.4 B Market 9 11.4 C Specific Risks 10 II.5 Literature Review 11 11.5 A Discussion 14 III. Empirical Analysis 16 III. 1 Performance Measures 16 III.1 A The Average Return 16 III.1 B Jensen's Alpha (alpha) 16 III.1 C The Sharp Ratio (SR) 18 III.1 D The Treynor Ratio (TR) 19 III.1 E The Information Ratio (IR) 20 III.1 F The Modigliani and Modigliani measure (MM) 21 III.1 G The TT measure (Ti) 21 III.1 H Market Timing Ability (gamma) 21 111.1 I Conclusion 22 III.2 Data 22 III.3 Methodology 24 IV. Results 29 IV.1 Overall Total Returns 29 IV.2 Jensen's Model 30 IV.2 A Alternative Benchmarks 32 IV.2 B Conventional Benchmarks 35 IV.3 Alternative Performance Measures 37 IV.3 A Performance Measures with Conventional Benchmarks 39 IV.4 Treynor and Mazuy's Model 41 IV.5 Robustness Analysis: How do IEFs Fare in Bear Markets? 45 IV.3 A Downside Risk 47 V. Conclusions and Outlook 50 2 EFTA00617311 Acknowledgement The road to knowledge, quite like the road to success, is bumpy and full of obstacles. Nevertheless it has been a fun and very interesting road to walk on. My supervisor, Roman Kraussl sparked my interest in this subject and its catalyst was my Muslim background. I wish to thank him for his clear guidance, his useful critiques and his pleasant way of communicating. I would also like to take this opportunity to thank some additional people who helped me during this process. Foremost, I would like to thank Johannes Gunnell, at UBS Investment Bank in Amsterdam. He helped me get the most important component of my empirical analysis, namely the unit prices of the IEFs. Thanks Jojo! Without you, this thesis would really not have been possible. I would also like to thank Ismael Abudher, at Palladyne Asset Management. He provided me with some additional data and provided helpful comments to my research approach. In addition, I would like to thank Hans Visser. He was very helpful in providing some links to relevant websites and conversations with him led to some interesting insights into the nature of IEFs. I particularly enjoyed his concise but very informative book "Islamic Finance", which was very helpful in making this thesis. Furthermore, my gratitude goes out to Herbert Rijken. A healthy discussion with him contributed to the quality of this thesis. Other people who provided me with advise and clarity on their research and whom I am grateful to are: Fikriyah Abdullah, Shamher Mohammed and Tariq Rifai at Failaka International. Last but not least I would like to thank Yannick Maim and Diemer de Vries, two close friends who next to their companionship provided me with useful comments and with whom I had fruitful discussions regarding on this topic. 3 EFTA00617312 I. Introduction Mutual funds are an interesting investment vehicle for people that whish to prosper from financial markets, but lack the knowledge, skill, or time to manage their own wealth. Over the years the number of these mutual funds has increased substantially with the assets invested in the mutual fund industry approximated at $3.7 trillion by 20031. However Muslims are not allowed to invest in standard mutual funds since their faith prohibits them to invest in certain equities, like those of banks or companies that deal in pork, alcohol, pornography and certain entertainment related products. Furthermore Muslims are prohibited to either pay or receive interest, which further narrows their investment universe, excluding for example conventional bonds. To meet the demand of Muslims who still whish to invest in equities, special Islamic Equity Funds (IEFs) have emerged rapidly since the early 90s, when Muslim scholars reached consensus regarding the permissibility of equity investing. Since then, these IEFs have gained considerable popularity among Muslim investors as well as Non-Muslim investors who see IEF investment as a form of Socially Responsible Investing. Despite this popularity, the academic literature on IEFs (and more specifically on their performance) has unfortunately lagged behind. This has negatively affected the already poor transparency on the performance of these funds. This paper intends to mitigate this by answering the question: How have IEFs performed for the past five years in comparison to their benchmarks? In addition to answering this question, the risk and returns characteristics of IEFs during difficult market conditions (bear market) are analysed. Furthermore, this paper aims to give an insight into the nature of Islamic investing, explain the rationale behind it and discuss the main opportunities and challenges for this interesting new investment industry. Finally, this paper also aims to add modestly to the literature on efficient markets and the CAPM. The empirical research consists of five main parts. First, the average total return of IEFs is calculated and compared to their benchmarks. This is done against Islamic as well as conventional benchmarks, so the results are meaningful to Muslim as well as Non-Muslim investors. Secondly, the alpha and beta of each IEF is estimated through regression analysis. The significance of these individual alphas and betas is evaluated as well as the significance of the average alpha and beta, with the use of the t statistics on the estimated and average coefficients. Thirdly, several other performance measures are calculated to assess IEF performance like; the Sharp Ratio (SR), the Treynor Ratio (TR), the Information Ratio (IR), the Modigliani and Modigliani measure (MM), the TT measure (TT). These performance measures are all again based on Islamic as well as conventional benchmarks and the significance of the TT and MM measure is evaluated with the use oft statistics. Fourthly, the market timing ability (gamma) of IEFs is estimated with regression analysis using the Treynor and Mazuy (1966) model. Here, the alphas and betas estimated by this model are also compared to the previously estimated alphas and betas to assess which model is better. Fifthly, the risk and return characteristics of IEFs are evaluated for the bear market year 2002, by evaluating the SRs and MM measures of IEFs during this year and estimating the significance of the average MM with the use of its t statistic. The results are broken down in three geographical categories, because the largest part of IEFs in the sample is invested either globally (category Global) or in Malaysia (category Malaysian), while a small part is invested locally elsewhere (category Other). Martha McNeil Hamilton, The Washington Post, 2003. 4 EFTA00617313 The results of the first part of the research indicate that IEFs on average have underperformed their Islamic and conventional benchmarks, although this is mainly caused by the underperformance of Malaysian funds. The results of the second part indicate that adjusting for risk, IEFs slightly underperforms their Islamic and conventional benchmarks, but that this underperformance is insignificant and robust against alternative Islamic benchmarking. This result, combined with the fact that almost all betas of IEFs as well as the average beta are found to be highly significant, points in the direction of efficient markets and the validity of the CAPM. It also shows that IEFs have a low average beta (0.75) and are thus low risk investments. The third part's result shows that based on alternative performance measures, IEFs on average have outperformed their Islamic and conventional benchmarks, but again indicates that they did so insignificantly. This result also indicate that Malaysian funds are the worst performers among the three groups of IEFs and that IEFs in general are most attractive as part of a larger fully diversified portfolio, like a fund of funds. The results of the fourth part indicate that IEFs on average do not possess market timing ability. Malaysian funds are however found to be the better market timers while globally invested funds seem better at stock picking. The results of this part also indicate that a CAPM regression that does not allow for market timing underestimates alpha when gamma is positive and underestimates alpha when gamma is negative. The final part of the research shows that IEFs significantly outperformed their Islamic and conventional benchmarks during the bear market of 2002, which was somewhat expected given their low betas. Interestingly though the Malaysian funds are found to be the highest out performers while their betas are similar to the average beta of IEFs as a whole. This result was further scrutinised by estimating the downside risk of IEFs using the approach proposed by Ang et al. (2005). This resulted in a behavioural finance explanation of the relatively low returns on Malaysian IEFs, namely that they are less prone to downside movements of the market and are thus perceived as less risky by loss averse investors. The remainder of the research is organised as follows. Section II describes Islamic Investing and provides a literature review. Section III gives an overview of the performance measures used in this paper and discusses the calculations, advantages and disadvantages of each measure. This section furthermore describes the data and discusses the methodology used for the empirical analysis. Section IV presents and analyzes the results. Section V concludes, gives an outlook and suggests improvements to this research. 5 EFTA00617314 IL Islamic Investing Islamic finance is a relatively new phenomenon in the arena of economics and banking (Visser 2004). Although it is common knowledge that Islamic finance is based on the prohibition of interest, its other important features are usually unknown. To clarify, the following provides a concise overview of the rationale behind Islamic finance and its main features. II.1 The prohibition of interest= One of the most prominent features of Islamic finance is the prohibition of riba (interest). Literally translated riba means `increase', 'addition' or 'surplus'. The Sharia (Islamic Law) interprets riba as an addition to the principle. This view implies that payment for the use of money, which is fixed beforehand, is also seen as riba and thus prohibited. This ban on interest is in fact not a purely Islamic trait. Visser (2004) points out that the Christian Church at various times in history banned usura (a technical name for interest) based on passages in the Bible. The prohibition of riba in Islam is based on a number of passages from the Quran (the Islamic sacred book) namely Sum (verse) 2:275, 276 and 278, Sura 3:310, Sura 3:39 and Sura 4:161. Siddiqi (2004) points out that these verses imply 5 reasons why riba is prohibited in Islam namely that it: Corrupts society: this is derived from the association of riba with fassad (corruption) in verse 30. Implies improper appropriation of other people's property: derived from the Quran mentioning riba in verse 4:161 as "cheating others of their possessions". Ultimately results in negative growth: implied by verse 2:276 in which riba is mentioned to lead to "negative growth", this negative growth is interpreted as non-monetary growth, namely the decline in social welfare. Demeans and diminishes human personality: derived from verse 30, as well as from verse 2:276, where the negative growth in society can be translated to individual loss in diginity. Is unjust: derived from verse 2, Siddiqi (2004) admits that the reason why riba is unjust is not clearly stated in the Quran. The author feels that these reasons seem to be incomplete and overlapping. Although Siddiqi admits that the reason why riba should be unjust is unclear, this can also be said about the other arguments. It is for example not clear at all why riba is an improper appropriation of other people's property. Neither is it clear in what way the negative growth in society would manifest itself. Furthermore the last argument is just a generalization of the previous arguments, which all imply the injustice of interest. Still these and similar reasons are commonly used to explain Islam's ban on riba. Although the ban on riba is widely accepted by the Islamic community, its translation to the contemporary economic system is rather ambiguous. Some state that one form of riba concerned a custom in the pre-Islamic Arabia' (Qureshi 1991) and thus would make the ban on it irrelevant for modern day banking. A similar conclusion is reached by Kuran (1995) 2 The following is mainly derived from Visser (2004) 3 This was the custom that if a debt was not paid at maturity, its principle was doubled. 6 EFTA00617315 albeit via a different argumentation, namely that the ban on riba was to prevent debtors being enslaved. Other various Muslim scholars have expressed the opinion that riba as meant in the Quran manifested itself in Muhammad's time in very specific forms, and that its ban can not simply be extrapolated to all forms of contemporary interest. In fact, the Islamic theological research committee at Cairo's Al-Azhar University ruled 21-1 that loans against a fixed interest rate are not forbidden under Islam (Trouw 2002). Still there are many Muslim scholars that do believe that the ban on riba is of relevance for the modem world. This is the view held by many members of the Sha•ia boards of Islamic investment companies. Although this view is quite strict in its interpretation of what riba means nowadays including in it bank interest as well as fixed rate interest on bonds, its proponents do relax Islamic restrictions in other ways (more on this in section II.3) to make Islamic investing possible. II.2 Gharar and Maysir° As noted before, the ban on interest is not the only important feature of Islamic finance. Just as important are the prohibition of gharar (risk) and maysir (gambling). Gharar stands for not knowing the value of a purchased good. According to Visser, the ban on Gharar implies that "commercial partners should exactly know the counter value which is offered in a transaction" (Visser (2004, p. 28)). This ban is derived from hadiths (record of actions and sayings of the Prophet) forbidding the purchase and sale of things like `the catch of the diver' or `the birds in the sky' (El-Gamal 2001). This means that purchasing goods of which the value is unknown beforehand is prohibited. That's why its prohibited for example to buy `the catch of the diver' since beforehand the catch (and thus its value) is unknown. Maysir stands for gambling and its ban comes from its explicit prohibition in the Quran (Sara 2:219, 5:90, 91). It is thus prohibited for Muslims to engage in speculation of any kind to make money, since speculation is seen as a form of gambling. The ban on Gharar and Maysir has far reaching consequences for Muslim investors since it implies that they are prohibited to invest in futures, options and other speculation based derivatives. This also limits the scope for many structured products, which are usually a combination of real assets and derivatives. II.3 Equity Investment Criteria The previous paragraphs have shown that Muslims are in many ways limited in their scope to prosper from financial markets. Investing in shares of companies is permissible however6, albeit under strict regulations. Muslims are not allowed to invest in companies that produce or trade in forbidden goods and services. These goods and services include pork and pork related products, alcohol, gambling, pornography, conventional banking, but also 4 The following is mainly derived from Visser (2004) 5 In Islam, Muslims must abide by the rules laid out in the Quran as well as by the sayings of the Prophet and the rules implied by his handlings in certain situations. These handlings and sayings have been recorded throughout the Prophet's life and are known as hadith. 6 In fact until, the early 90s it was not certain that even investing in shares was permissible (Siddiqi 2002), but since The Islamic Fiqh Academy (a leading authority on Islamic issues) issued a decree that investing in Sharia compliant equities was permissible, this view has been largely adapted by the Muslim community. 7 EFTA00617316 entertainment related products and services like music, cinema and hotels. Furthermore investments in tobacco, arms and defence companies are also advised against. The companies whose core activities do not include the abovementioned goods and services must furthermore adhere to additional criteria: • The debt to total assets ratio of eligible companies may not exceed 33%. • Interest income and other "impure" income may not exceed 5-10W of total income. • The amount of receivables may not exceed 45% of total assets. It is clear from these criteria, that some leniency has been applied to the strict rules of not receiving or paying any interest. Note that in fact these rules imply that a company may actually pay as well as receive interest albeit to a limited amount. These concessions had to be applied since almost every firm has at least some amount of outstanding debt, as well as certain assets reaping interest income. When investing in these companies however, the amount of return made through interest is often subtracted from the total stock/fund return to purify the total return from "unclean" return. Concluding this section, it can be stated that Muslims only have a limited amount of investments possibilities because of the ban on riba, ghamr and maysir and the prohibition of certain goods like alcohol and pork. Furthermore it can be concluded that there is no consensus regarding the precise meaning of riba in terms of contemporary forms of interest and that the ban on riba has a predominantly dogmatic base rather than following economic (one might even say logical) reasoning. II.4 The IEF Industrys Islamic Equity Funds (IEFs) are like Islamic investing a relatively new phenomenon. There is not much known about the market in which IEFs operate and how this industry evolved. The following thus give a brief overview of the history, characteristics and market of the IEF industry. II.4 A History The first Islamic Equity Fund was found in 1986 by the North American Islamic Trust to oversee among others the funding of mosques in America. Between 1986 and 1994 the amount of IEFs as well as the value of assets invested in them was quite small. The amount of IEFs grew rapidly however from 9 before 1994 to over 130 by the beginning of 2006, with the value of assets invested in IEFs growing from $800 min in 1996 to $6 bin in 20039. This increase in growth was caused predominantly by a decree issued by the Islamic Figh10 Academy, which stated that Muslims were allowed to invest in equities within certain parameters, this was not certain before this time. 7 The maximum amount that may be earned through interest and impure income differs between 5-10%, depending on interpretation. 8 The following is derived mainly from 9 (New Horizon No. 130, May 2003 p.2) to Islamic jurisprudence 8 EFTA00617317 After the IEF market started growing in the mid 90s, demand started to arise for more transparency on these funds. There was for example no official Islamic index then to benchmark the returns of IEFs against. The Dow Jones and FTSE, who in 1999 launched the Dow Jones Islamic Market Index (DJIMI) and the FTSE Global Islamic Index Series (GIIS) respectively, first provided this benchmark. The DJIMI is a subset of 2000 Sharia compliant equities included in the broader Dow Jones World Index. The GIIS track about a 1000 Sharia compliant equities and is a subset of the FTSE World Index. Both indices are diversified through a broad range of sectors and regions, with the DJIMI having a high regional exposure to America. Before 9/11 and the bursting of the Internet bubble, many IEFs were overweight in information technology stocks (Siddiqi 2002, Visser 2004, failaka 2002). This was because it was an attractive sector to be in and one, which included companies that passed the Islamic criteria relatively easily. The bursting of the Internet bubble in 2000 however, made Muslim investors reluctant to invest heavily in tech and substituted to more defensive sectors like healthcare. A significant part still is invested in technology stocks though. In fact the DJIMI has a 40% weight in technology and healthcare divided almost equally between these two sectors. Nowadays most IEFs are pretty basic open-ended mutual funds, offering medium to long- term growth based on capital appreciation rather than dividend income. Growth stocks are often favoured, but there seems to be no strong preference for size. Exotic funds like "contrarian funds"" and other behavioural finance based funds are scarce to absent. There are however a limited amount of hedge funds and private equity funds. IEFs are mainly offered by local players, but also some large Investment Banks like UBS, Citigroup and Merril Lynch. Another global Investment Bank, HSBC even has a daughter HSBC Amanah Finance that specifically targets a Muslim clientele. II.4 B Market The market for IEFs is quite large, since there are approximately 1.3 billion Muslims around the world. Furthermore there is a growing middle class of Muslims around the world. India for example has a booming economy with a fast growing middle class and the second largest Muslim population around the world (174 million in 2001). Another example is Pakistan with an average GDP growth of 5% and 178 million Muslims in April 2006. This growing middle class is interesting because the most IEFs have minimum investment thresholds between $200045000, which is sufficiently modest to attract a substantial middle- class clientele (Siddiqi 2002). In fact the IEF industry has already been focussing on this segment. Failaka'2 for example states that of the 15 largest IEFs (in terms of asAPts) only one has a minimum investment over $25,000. But the growing middle class is not the only interesting segment for IEFs to be in. Many "high net worth individuals" in the Middle East are excellent clients for the sellers of IEFs. These are funds that invest in "loser" stocks which have performed badly over a certain period of time since the fund managers believe that stock markets overreact and thus that losers become winners and vice versa. 12 From "Islamic Equity Funds: Analysis and Observations on the Current State of the Industry" —Failaka International INC (2002) 9 EFTA00617318 The amount of money circulating in this area has increased strongly from an already high value since the recent rise of oil prices13. These high net worth individuals are also targeted by some IEFs, which have a minimum investment threshold ranging from ranging from 1 to 5 million dollars. Even non-Muslims are an interesting market for IEFs. Islamic investing is in many ways a form of Socially Responsible Investing. An industry, which had over $2.29 trillion worth of assets in 2005 in the US alone14. The large growth potential of IEFs however is on itself not alone to make the industry flourish. Many caveats (besides return performance) stand in the way of healthy growth in the IEF industry. Failaka for example names: • Distribution channels: these are not properly set up yet to access the most attractive segments, namely the retail investor. • Breadth of Products: the funds offered by Islamic investment firms are not diverse enough. There is a need for more sector and style based IEFs and exotic funds, so as to meet more specific demands of investors. Furthermore the limited amount of IEFs lowers the choice of potential investors. • Fee Structure: the fee structure of IEFs needs to be more competitive, currently IEFs on average charge higher management fees than conventional funds. • Client Education: there is still too much uncertainty regarding the permissibility for Muslims of investing in equity. Potential clients should thus be educated about this and convinced about the permissibility of equity investing. In addition to this list, it can be stated that IEFs are probably not marketed very well. An example of this is the fact that many (even Muslim) investors do not know of the existence of IEFs. Ahamd (2001) also states that marketing channels of IEFs are not effective enough yet to penetrate the small and middle-class savers. II.4 C Specific Risks Because of their nature, IEFs are exposed to specific risks that are normally not bourn by conventional funds. The most obvious risk is that of diversification. Since IEFs have a limited investment universe, they are also limited in their diversification potential. This risk may not be as severe though as might seem at first, since the amount of permissible securities is large enough and contains enough sectors and regions to provide nearly efficient diversification. This conclusion is also reached by Abdullah, Mohammad and Hassan (2002), who find that the diversification level of Islamic funds is slightly less than that of conventional but insignificantly so. This risk is however important in the sense that IEFs are unable to `ride' the returns of certain attractive sectors. IEFs are also prone to changing Sharia rules. The screening criteria for permissible stocks for example seem rather arbitrary (Visser 2004). There is for example no guarantee that Muslim scholars wont condemn a debt to total asset ratio of 33% in the near future to adapt a ratio of 25%. This would off course have major implications for the equities included in Islamic portfolios. Furthermore there is no real consensus regarding the selection criteria for 13 Countries in the Middle East and especially the United Arab Emirates have been known to be large exporters of oil. 14 "2005 Report on Socially Responsible Investing trends in the US"— Social Investment Forum. 10 EFTA00617319 permissible equities. The definition of permissible "impure" income for example already ranges from 5-10%. Since IEFs are relatively new, they often also lack a sufficiently long track record (Ahmad 2001). This makes long-term performance evaluation more difficult. Not only because of the scarcity of data (which in some cases even limits statistical analysis) but also because the behaviour of IEFs through different bear and bull markets can't be evaluated. Next to the lack of sufficient data another caveat of IEFs is that they are not transparent enough (Hakim and Rashidian 2002, Ahmad 2001). Until the Dow Jones and FTSE launched their Islamic indices, there were for example not even any proper benchmarks to evaluate IEF performance against. Some countries in which IEFs operate do not have well defined disclosure requirements, which limit the incentive for IEFs to be more transparent. Since IEFs do not invest in companies with high debt to total asset ratios prone to investing in sub optimally leveraged companies. Furthermore investing in low debt companies may also mean a high exposure to companies that have difficulty in debt financing like start up companies. Since start-up companies are typically small, IEFs might have a high exposure to small growth stocks. From another corporate finance perspective, IEFs may also run the risk of holding shares in companies that over invest. Since companies that have high interest income (which apart from banks is for most companies likely due to a large cash holding) don't pass Islamic screening criteria, IEFs can only invest in companies with relatively small amounts of cash. When these small cash holdings are a result of firms investing in bad projects, just to get rid of the cash, this will later on have a negative impact on the firm's future results. However there are plural reasons why companies have low cash holdings including that these companies are just disciplined, with no unproductive assets on their balance sheet. IEFs can't invest in companies that have receivables that are more than 45% of total assets. This restriction implies that IEFs may run the risk of investing in illiquid companies since low receivables may mean a lower working capital and quick ratio. One can conclude from the previous paragraphs that the IEF industry has in its short history seen extensive growth and that the market for Islamic investing is large enough to be attractive. Islamic investing however comes at the cost of extra risks and the industry still needs to evolve in certain critical areas to fully achieve its full growth potential. II3 Literature Review Fund performance evaluation has been the subject of debate among financial economists for a long time. This debate took a flight after William Sharpe (1964), John Lintner (1965) and Jan Mossin (1966) developed the Capital Asset Pricing Model (CAPM), which is a set of predictions concerning equilibrium expected return on risky assets. The foundation for modern portfolio theory, on which the CAPM is based, was however laid down a few years earlier by Harry Markowitz in 1952 (Markowitz 1952). Mathematically the CAPM is expressed as: E(R)- Rf + fli[E(R„,)- RI ] (1) 11 EFTA00617320 Where E(R,) is the expected gross return on a risky security's i, Rf is the return on a risk free asset, R„, is the gross return of the market portfolio and /3; is the sensitivity of security i's return to the market portfolio estimated by regression analysis. Thus equation (1) shows that according to the CAPM, the expected return on any risky security should be proportional to its sensitivity to the market. This implication is made amongst others by the assumption that security prices fully reflect available information. This is commonly known in financial economics as the Efficient Market Hypothesis (EMH)16. Using the implications of the CAPM, one of the first studies to actually evaluate fund performance and test the EMH was by Michael Jensen (1968). Jensen systematically tested the performance of 115 mutual funds over a period of 19 years. He concluded that only fund significantly outperformed the 500 benchmark after taking into account transaction costs and concluded that the EMH seems to hold well in practice and that mutual fund managers can't systematically outperform the market. Although Jensen's study was pioneering in providing clarity on mutual fund performance and testing the EHM it only used a single measure to define out performance. This measure later became known in financial literature as "Jensens Aplha" (see section I1I.4 B). Some years later McDonald (1974) used multiple evaluation methods to assess the performance of 123 mutual funds during 1960-1969. He concluded that the majority of the funds did not perform as well as the New York Stock Exchange (NYSE) benchmark. Kon and Jen (1979) evaluated mutual funds taking into account that systematic risk is often non-stationary. To do this they divided the sample in three different risk regimes and ran a standard regression for each period. Kon and Jen found evidence of different levels of beta (systematic risk) suggesting that a large number of funds engage in timing activities. Grinblatt and Titman (1989) found that abnormal performance did exist for some mutual funds during the period 1974-1984, but also found that the funds with the abnormal performance had higher management fees. After subtracting these fees and transaction costs, Grinblatt and Titman found no significant out performance indicating that investors cannot take advantage of the superior abilities of excellent portfolio managers by investing in their funds. Chen et aL (1992) used a sample of 83 mutual funds over the period 1977-1984 and evaluated their performance using systematically varying parameter regression. Their main conclusion was that these funds do not possess market timing ability and that there is a trade off between market timing ability and security selection ability. In 1996 an influential study by Elton, Gruber and Blake (1996) criticized previous studies on fund performance stating that they concentrated too much on new methodologies for evaluating performance and didn't pay enough attention to biases in their data. They pointed out that fund returns are often overstated if the sample consists of funds that existed 15 The argument also holds for a portfolio of risky securities, like a mutual fund. 16 The EMH comes in three forms, namely the weak, semi strong and strong form. The weak form of the EMH states that security prices already reflect all information contained in the history of past prices, while the semi strong states that security prices already reflect al publicly available information including past prices. The strong form of the EMH goes even further to state that stock prices reflect all relevant information including insider information. 12 EFTA00617321 continuously over the sample period. Elton, Gruber and Blake argued that since funds that disappeared during this period were not included in the study there was a "survivorship bias" in their results. The reason for this bias being that funds that disappeared did so because of their poor performance. Consequently the funds that were included in the sample were the ones that did well enough to stay alive. This would then lead to overestimation of fund returns since the very bad performing funds were excluded from the sample. Another influential paper was written by Fama and French (1993) who stated that the CAPM model was too simplistic because it omitted other factors that explain stock returns. They proposed a three-factor model, which explains stock returns not only as a function of exposure to the market but also to exposure towards a size and a value factor. Carhart (1997) acknowledged the above-mentioned critiques and assessed mutual fund returns with a survivorship bias free sample and using a multi factor model. Carhart included all known equity funds between 1962-1993 (his sample period) in his study, so also the ones that had disappeared within the sample period. Furthermore Carhart uses a four-factor model to test for abnormal returns, this four-factor model includes the three factors as proposed by Fama and French (1993) and an additional momentum factor as proposed by Jegadeesh and Titman (1993). One of the conclusions of Carhart's study was that Mutual Funds under performed the NYSE by approximately the amount of their investment expenses. This result also indicates that although some funds might get superior returns, extra transaction costs and management fees often offset this. More recently, Bolle and Busse (2004) use Carhart's (1997) four factor model to find that Mutual Funds, which were at the top decile the previous quarter, earned an average abnormal return of 39 basis points over the next quarter, implying persistence in out performance. When evaluated over a longer period however, this result disappears. The overall conclusion seems to be that out performance is a short-term phenomenon. Research on the performance of Islamic Equity Funds (IEF) is much more scarce. This is partly due to the fact that IEF's are a relatively new phenomenon l7 and partly because of the lack of availability of sufficient data. Nonetheless, the following will give an overview of the available literature on IEF performance. One of the earliest studies on Islamic Funds was not until 1997 when Annuar, Shamsher and Ngu (1997) used the model developed by Treynor and Mazuy (1966) to examine the performance of 31 Malaysian mutual funds for the period 1990-1995. Many of these funds are Islamic and thus provide a proxy for Islamic Fund performance. The results are of course biased because conventional funds are also included in the study. Annuar, Shamsher and Ngu found evidence that these Malaysian funds did outperform their benchmark, but were poor at timing the market. Unlike Chen et aL, Annuar, Shamsher and Ngu found a positive correlation between market timing ability and security selection ability. Shamsher, Annuar and Taufeeq (2000) conducted a study on the performance of passive and active Malaysian funds for the period 1995-1999 using various performance measures's. 17 The first IEF started in the late 80's while the first official Mutual Fund was created in 1924. 18 This study is also biased by including conventional funds in the study and thus is only a rough proxy for Islamic fund performance. 13 EFTA00617322 They found that there was no significant difference between active and passive funds and that they both underperformed the Kuala Lumpur Composite Index benchmark. Ahmad (2001) provided a very rough guide to IEF performance by evaluating around 13 IEF's individually. Although Ahmed states that some Islamic Funds outperform benchmarks like the MSCI and states that the IEF industry has outperformed the banking industry, he does not back this with statistical analysis. Thus no clear conclusions can be drawn from his research regarding the performance of IEF's. Abdullah, Mohammed and Hassan (2002) provide a more thorough analysis of the Islamic Equity Fund industry albeit only for Malaysian funds. They analyse 67 Malaysian unit trust funds including 14 Islamic and 53 Conventional Funds using multiple performance measures like the Sharp Ratio, the Modigliani Measure and the Information Ratio. Abdullah, Mohammed and Hassan conclude that both type of funds slightly underperformed the Kuala Lumpur Composite Index (KLCI) benchmark. However this under performance is statistically insignificant and thus holds no economic meaning. Abdullah, Mohammed and Hassan also find that the return of the Islamic and Conventional Funds is quite the same. Their overall conclusion is that IEF's in Malaysia follow the benchmark as well as conventional funds and that they both do this reasonably well. However when taking into account risk, Abdullah, Mohammed and Hassan find that the IEFs perform better than conventional funds during bear markets and that conventional funds perform better than IEFs during bull markets. This implies that investors have the option to switch between these funds depending on the market conditions and their personal preferences. II3 A Discussion It seems that the literature on Mutual fund performance (Islamic as well as conventional) is somewhat ambiguous. Presumably because of the multiple methods used to evaluate fund performance. The existence of survivorship bias may for example have overstated returns of funds in the earlier studies. It is however difficult to estimate how big this survivorship bias was for each study individually. Furthermore the benchmarks used in several studies differ while sometimes using the same type of stocks, Jensen (1968) for example used the 500 benchmark as opposed to McDonald (1974) and Kon and Jen (1979) who benchmark against the NYSE. Also the benchmark used in earlier studies may not be the right benchmark to be used today, this could be because a certain sector dominates a benchmark now, which it didn't in the past. If for example a benchmark contains a significantly higher weight in the technology sector than 15 years ago, it would not be appropriate to use it to evaluate a fund (at present time) that is underweight in tech stocks. The benchmark would however have been sufficient 15 years ago when it wasn't overweight in tech stocks. The assumption in some studies that systematic risk is stationary is also a problem in research on fund performance19. When evaluating funds over a long period of time it might very well be that the systematic risk changed during several sub periods. While some studies acknowledge this phenomenon, others seem to disregard it, which also makes it difficult to compare their results. 19 For example in Jensen (1968) 14 EFTA00617323 Furthermore it is difficult to compare the earlier studies on Fund performance with the more recent studies because of the fact that some studies use performance measures based on the CAPM model to assess abnormal returns, while others use a multifactor model. Examples of the latter are Carhart (1997) and Bollen and Busse (2004) and examples of the former are Jensen (1968), Grinblatt and Titman (1989) and Abdullah, Mohammed and Hassan (2002). Although the result of the literature review is difficult to assess, it seems that many studies find that Mutual funds are not able to outperform their benchmarks, at least not for sustained periods. The overall results of studies on mutual fund performance seem to imply that the semi-strong form of the EMH holds. 15 EFTA00617324 III. Empirical Analysis This section explains the main performance measures used in financial literature to evaluate mutual fund performance by. It discusses the way these measures are calculated to given an understanding of their nature, differences, caveats and advantages. Furthermore, this section describes the data used in this research and gives a detailed description of the methodology used to attain the results. III.1 Performance Measures Assessing the performance of mutual funds requires an understanding on multiple facets of their returns. There are multiple dimensions that have to be taken into account when trying to understand how "well" a certain fund has performed over a specific period. The following gives an overview of the most commonly used performance measures in financial literature and discusses their caveats and advantages. III.1 A Average Return The most basic and simple method to evaluate fund returns20 is by calculating the average total return and comparing it to the average return of the benchmark. Mathematically, average return is defined as: -n2 17 R (2) Here Rp, is the return on fund p at time t and n represents the number of fund returns in the sample. This way of assessing IEF performance is very simple and intuitive, but is seldom the only measure by which funds are evaluated. There are many shortcomings to this measure, but the main argument against it is that it does not take into account the risk taken to achieve a certain return. B Jensen's Alpha (alpha) One of the most prominent performance measures in financial literature is the one developed by Michael Jensen (1966). Jensen's model is based on the CAPM model but has some fundamental differences (explained below) and is expressed mathematically as: R_ — R a p +/3p[R. — Rft (3) = the return on portfolio (or fund) p at time t = the return on the risk free asset at time t