Is Islamic Equity Index Efficient Than India S National Index?

Is Islamic Equity Index efficient than India’s National Index? A Study on Nifty 50 and SHA 50

Dr. Ranjit Singh Assistant Professor Department of Business Administration Assam University (A Central University) Siilchar-788011 Assam, India

Ms. Abida Begum Sultana Mazumder Assistant Professor Department of Management North Eastern Hill University Tura Campus, Meghalaya, India Email: [email protected]

& Ms. ChanchalaTiwari Tapsi Singh Sr. Secondary School Chirand Saran Bihar, India Email: [email protected]

Is Islamic Equity Index efficient than India’s National Index? A Study on Nifty 50 and SHA 50

Abstract The objective of the current study is to investigate the efficiency of SHA50 Index and Nifty50 Index, if any. The study is based on secondary data collected from the BSE website and NSE website. Statistical tools of Kolmogorov–Smirnov Test, One Sample Run test and Auto Correlation test have been used for the study. It is found that the considered markets are not efficient and defythe Efficient Market Hypothesis. Thus, it is inferred that there is a possibility of earning more than the average market return by use of technical analysis in the market.

Key words: Efficient market hypothesis, Ethical fund, Islamic Index, Shariahh Compliant Stocks

Introduction Shariahis the body of Islamic law. The term means "way" or "path". It is the legal framework within which the public and some private aspects of life are regulated for those living in a legal system based on Islam. It is a system of several laws. These laws are primarily based on the Qur'an. It also has strictures regarding finance and commercial activities permitted for Muslims. Thus, for Muslims, certain categories of equity shares of companies have been prescribed for investment. It is popularly called by the Muslims as the portfolio of ‘clean’ stocks. The Shariah explains in detail the Islamic concepts of money and capital. It also explains the relationship between risk and profit. It further goes on elaborating the social responsibilities of financial institutions and individuals. The purpose of this prohibition is to prevent exploitation from the use of money and to share profit and loss. According to Shariah money should be used for a proper economic purpose. It should not be treated as a commodity on which a return can be made by reference to time. Islamic scholars agree that money is simply a means of exchange. It is not an asset. Therefore, it should not grow over time. However, capital can earn the returns derived from the productive use of capital. It is also forbidden for any Islamic institution or investment fund to deal in the following goods: (a) Alcoholic drinks; (b) Pork, ham, bacon and related by-products; (c) Dead animals (i.e., those not slaughtered according to the rules of the Shariah) (d) Gambling machines; (e) Anti-social and immoral goods such as tobacco, pornography, drugs, etc.; (f) Gold and silver, except for spot cash; and (g) Armaments and destructive weapons. It should be noted that there is a prohibition imposed by the Shariahupon the Muslims to buy certain category of equity shares that are not Shariah complaint. So, there is a need to clearly identify the equity shares which are Shariah compliant and which are not. It is also required to identify the Shariah compliant stocks in order to enable the players in the financial market to design a suitable product for the large numbers of Muslims. Otherwise a vast majority of the Islamic population is excluded from the stock market due to the religious constraints. There are number of Shariah compliant mutual funds all over the world. These are designed considering the principles laid down in Shariah. These are also called by the Muslims as ‘ethical fund’ or ‘socially responsible fund’ (DeLorenzo, 2001). Islamic investment funds operate by investors contributing money isinvested so that profit can be earned in a manner compliant with Shariah. The validity of the units, shares or certificates issued in the fund is subject to two conditions. First, they must carry a pro rata profit actually earned by the fund, instead of a fixed return being tied up with their face value. Second, the amounts pooled must be invested in Shariah-compliant companies. All financial institutions that offer Shariah-based services or products will have a Shariah committee or board. These boards are comprised of Islamic scholars and practitioners. They provide the Islamic financial institutions with guidance and supervision. These boards often submit a Shariah audit for the annual report of the Islamic institution. Then they issue Shariah compliance certificates. The Shariah advisory board works closely with the bankers and lawyers to structure instruments. This is done in order to meet Shariah and commercial requirements. Standard documentation has been developed by the financial institutions covering their main areas of activities. However, they will need to refer back to the board whenever there is a deviation to ensure that no inadvertent breach of Shariah or the compliance certificate has occurred. Thus Islamic investment means a joint pool wherein the investors contribute their surplus money for the purpose of its investment to earn halal profits in strict conformity with the precepts of Shariah. The subscribers of the Fund may receive a document certifying their subscription and entitling them to the pro-rata profits actually earned by the Fund (Usmani, 2007). Ethical investing is the use of ethical and social criteria to select, built and manage investment portfolios (Cowton, 1994). However, the economic viability of Islamic investing is a controversial issue. Proponents of Islamic investing in particular and ethical investing in general argue that screening potential investment opportunities with both financial and ethical criteria makes positive social and economic contributions (Sauer, 1997). Whereas the opponents of Islamic investing argue that Islamic funds exclude one or more company groups from their portfolio for nonfinancial reasons like companies involved in some other business not approved by the Shari’ah, such as companies manufacturing, selling or offering liquors, pork, haram meat, or involved in gambling, night club activities, pornography, etc. This may affect the viability of portfolio (Hakim and Rashidian, 2004). The strategy for ethical investment can either be positive or negative. The former being supportive of companies that are particularly approved of in terms of their products, activities or business methods.The latter aims to avoid investing in companies which are involved in unacceptable products or countries, or whose business methods are regarded as unethical. Negative criteria are more usual than positive criteria, with investors starting with a complete listing of quoted companies, and then excluding the unethical minority (Wilson, 1997). In the 1990s, as an outcome of trade with the Middle East countries and financial crisis in Muslim countries, a major breakthrough took place in Islamic rulings. This was also related to equity investment. Since then Islamic equity funds have started to operate. It is also known that the prohibitions of the Shariah law have been applied historically in varying degrees in Muslim communities to prevent un-Islamic practices. But it was noticed that in the late 20th century there were a number of Islamic banks formed to apply these principles to private or semi- private commercial institutions within the Muslim community (Rammal and Zurbruegg, 2007). It has been estimated that there is huge wealthwith the Muslim communities to be invested in the stock market(Hakim and Rashidian, 2004). This amount is growing every year (Hakim and Rashidian, 2004). After 1990, a numbers of Islamic equity funds were launched. In 1996, there were about 29 specialist Islamic funds. The asset under management was valued at US$800 million. By March 2002, the number of funds rose to 105 with total assets of US$3.3 billion(Siddiqi, 2002). Islamic Equity Investment Islamic investing also termed by some "ethical investing", "green investing", "faith investing" and "socially responsible investing" has much in common with modern forms of investing (DeLorenzo, 2001). A widely publicized area of Islamic finance was the development of “screening” methods to identify “Shariahcompliant” stocks. These screens exclude stocks of companies with significant forbidden activities as per the principles of Shariah. The screens also exclude stocks of companies with excessive debt (generally, more than one third of total capital) or interest income (Siddiqi, 2002). The philosophy behind this screening is to avoid trading in debt embedded securities. Debt is not allowed to be traded other than at par. Therefore, companies having debt capital in excess of one third of its market capitalization are no longer Shariah compliant (Kamso, 2013). A typical Islamic equity portfolio includes cross-sectoral holdings. It ranges from technology, telecommunications, engineering, steel, transportation, healthcare, utilities, construction and real-estate (Siddiqi, 2002). Shariah exclude stocks whose core activities are not related to any of the following like interest based banking activity or any other interest related activity, alcohol, gambling, tobacco, arms manufacturing, hotel and leisure industry, life insurance, pornography, packaging and processing of any activity related to pork, pork production, conventional financial services (banking, insurance, etc). However, the list is not exhaustive, but indicative only. The issues arising out of screening of equity shares for framing the Islamic indexare similar. But different Islamic indices usedifferent criteria to screen shares(Hassan, 2002). Dow Jones Islamic Indices uses the criteria like all of the following must be less than 33%- total debt divided by trailing 24-month average market capitalization, sum of a company’s cash and interest-bearing securities divided by trailing 24-month average market capitalization and accounts receivables divided by trailing 24-month average market capitalization (Shariah Screening Criteria, 2013). Of late, theincreasing demand for Islamic equity investment worldwide is felt. Realizing the growing need for Islamic equity investment,the Independent Global Index Company, launched the first Islamic equity index series at the end of 1998. It is known as FTSE Global Islamic Index Series (GIIS). Subsequentlyin February 1999, the first Dow Jones Islamic market index (DJIMI) was launched (Moran, 1999). It was decided by the policy makers that if a financial product can be developed considering the stocks listed in the stock exchange and that are Shariah complaint; it will lead to the inclusion of the Muslim investors into the stock market. Therefore, in the year 2010 Bombay Stock Exchange in association with TASIS had launched SHA 50 index. Later on National Stock Exchange has also launched CNX Nifty Shariah index and CNX 500 Shariah index. Although later on SHA 50 was discontinued by the Bombay Stock Exchange and it was replaced by S&P BSE 500 Shariah. Advocates of ethical as well as Islamic investing argue that a company that adopts and implements an effective corporate responsibility policy is better positioned in comparison to other companies. It avoids any environmental andsocial crises. It helps a company to avoid its reputation damage, higher production costs, lost production, higher security costs, and increased insurance premiums (Sauer, 1997). Opponents of Islamic investing highlight the adverse costs and effects that Islamic screening of shares may involve. They argue that the hidden costs associated with implementing Islamic screening adversely affect investment performance. Therefore, it should not be ignored (Sauer, 1997). Temper, (1991) is of the view that unscreened benchmarks may outperform ethical investment. This is because using Islamic investing criteria to screen shares may cause additional screening and monitoring costs. It also leads to the availability of a smaller investment universe as well as restricted potential for diversification. Temper, (1991) further added that Islamic screening tends to eliminate large firms from the investment universe. Thus, the remaining firms for the investment tend to be smaller and have more volatile returns. It is also difficult to achieve diversification as Shariah principles eliminates or favours certain industries. However, Langbein and Posner (1980) argue that Islamic investment may involve higher riskbut at the same time not necessarily yielding significantly bad returns. This is because Islamic investors too do not invest in clearly unprofitable stock.

Efficient Market Hypothesis In finance, the efficient-market hypothesis (EMH) says that financial markets are "informationally efficient". This hypothesis says that an investor cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information at the time the investment is madeavailable. There are three forms of EMH. These are: "weak", "semi- strong", and "strong". The weak-form of EMH claims that prices on traded assets already reflect all past publicly available information. The semi-strong-form of EMH claims that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong-form of EMH claims that prices instantly reflect even hiddeninformation (Wikipedia, 2013) EMH is an idea partly developed in the 1960s by Eugene Fama. It states that it is impossible to beat the market because prices already incorporate and reflect all relevant information. This is also a highly controversial and often disputed theory. Supporters of this model believe it is pointless to search for undervalued stocks or try to predict trends in the market through fundamental analysis or technical analysis (Investopedia, 2013). According to the EMH, stocks always trade at their fair value on stock exchanges. It makes impossible for investors to purchase undervalued stocks. It also makes impossible for them to sell stocks for inflated prices. Thus, it is impossible to outperform the overall market through expert stock selection or market timing. It says that the only way an investor can possibly obtain higher returns is by purchasing riskier investments (Investopedia, 2013).

Review of Literature Ethical investment goes back to the attempts of some religious institutions to avoid the so-called sin industries such as gambling and tobacco (Murninghan, 1992). Mueller (1991) found that the risk-adjusted returns of unrestricted investments are 1.03% higher than Islamic funds. Luther et al. (1992) on the basis of risk-adjusted measures, found weak evidence to suggest that Islamic unit trust outperform the market. They also found that Islamic trusts are mainly skewed towards small market capitalization and tend to invest in low dividend yield firms. Mallin et al. (1995) argued that Islamic funds have their own characteristics. It may make the comparison with benchmarks such as FTSE somewhat misleading. They also found that beta is lower for the Islamic funds.Mallin et al. (1995) and Singh and Das, (2013) both have found that on a risk- adjusted basis, there is weak performance of Islamic funds. Statman (2000) found that the risk- adjusted returns of S&P 500 were slightly higher than those of the DSI but the difference was not significant. On the other hand, DSI is somewhat riskier than the S&P 500. Hussein (2004) has shown that returns from the FTSE Global Islamic Index are significantly different from its index counterpart FTSE AllWorld Index. Another study by Beikand Wardhana(2009) has reckoned that Jakarta Islamic Index though affected by financial tremors in the short term, but show strong resistance and consistency in the long run in comparison to its US Counter Parts. Other studies performed by McMicken(1997) and Hee (2002)show that Islamic indices prevalent in the southeast Asia capital markets gave higher returns and are less volatile. Also according to the TASIS research report (2010), the Shariah 50 has outperformed the SENSEX and the BSE 500 both. Over this period, annualized volatility for the SHA 50 was also less than both SENSEX and the BSE 500(TASIS Research, 2010). Shachmurove, BenZion, Klein and Yagil(2001) conducted a moving average comparison of Tel- Aviv 25 and S & P 500 Stock Indices. Singh and Das, (2013) found that the returns for the SHA 50 are not only higher, but are also less volatile than those of the Nifty 50 in India. Despite the growing interest in Islamic finance, theempirical studies about Islamic equity investing are very few. Hassan (2002) found that Dow Jones Islamic Market Index [DJIMI] returns are normally distributed and the DJIMI has remarkable market efficiency. Using co- integration and causality analysis, Hakim and Rashidian (2004) found that the DJIMI does not correlate with either Wilshire 5000 index or the three month Treasury bill. They also showed that the changes in the DJIMI are not caused by the Wilshire 5000 or the three month Treasury bill. They concluded that the filtering criteria adopted to eliminate non compliant companies leads to an Islamic index with a unique risk-return characteristics. It is not affected by the broad equity market. A comparison of the raw and risk-adjusted performance showed that the Islamic index out performs the FTSE AllWorld index over a certain period. On the other hand, the Islamic index yielded statistically significant positive abnormal returns in the bull market period. However, it underperformed the counterpart index in the bear market period. It was also found that the Islamic screening does not have an adverse effect on the FTSE Global Islamic Index performance (Hussein, 2004). Hassan, Antoniou and Paudyal (2005) found that Islamic investors apply both Shariah and financial criteria while evaluating investments. Rahman,Yahya and Nasir (2010) investigated the 642 companies listed on the Bursa Malaysia in 2006. These companies are approved Shariah’s compliant companies by the Shari’ah Advisory Council of the Kuala Lumpur Stock Exchange [KLSE]. As for the level of debt criterion, the results showed that 44.07% of the companies listed under the KLSESI are highly geared. However, only 17% of the companies listed under the KLSESI were found to be highly liquid. The results also indicated that if both criteria are compared concurrently, only 198 out of 565 companies listed under the KLSESI conform to the criteria set up by the DJIM.

Objectives of the Study The objective of the present study is given as follows: To investigate the randomness, if any, in the movement of the SHA50 Index and Nifty50 Index thereby negating their efficient form

Hypothesis of the Study The following hypothesis is considered for the present study: H0=There is no randomness in the movement of the two indexes that is the SHA50 and S&P Nifty 50

Justification of Considering SHA50 and Nifty 50 Both SHA50 and S&P Nifty 50 is an index constituted of 50 companies. Both of them have the base value of 1000, though the base year for Nifty is 1995 and that of SHA50 is 2008. Besides it has been also researched by TASIS that Nifty has more number of Shariahh compliant companies Listed in NSE (TASIS Research, 2010).

Research Methodology 1. Data: The data for the SHA50 have been collected from the BSE website and that of the S&P Nifty 50 have been extracted from NSE website and yahoofinance.com. The closing prices for SHA 50 and Nifty 50 have been considered. The period of the study has been considered for a period three years that is 1st January 2008 – 31st December, 2010. 2. Type of study: The study is descriptive in nature. 3. Tools of data analysis: Statistical tools such as Kolmogorov–Smirnov Test, One Sample Run test and Auto Correlation test have been used using Microsoft Excel and SPSS 17.0 to arrive at logical conclusions.

Analysis and Findings The analysis and findings of the study is presented in the following paragraphs:

Kolmogorov-Smirnov Test Firstly, the distribution pattern of the share prices for both the indices was investigated by performing the One Sample Kolmogorov–Smirnov Test.

Table 1 Kolmogorov-Smirnov Test for SHA 50 and Nifty 50 SHA 50 Nifty 50 N 733 741 Normal Parameters(a,b) Mean 868.8965 4646.8523 Std. Deviation 221.86432 968.16807 Most Extreme Differences Absolute .086 .107 Positive .071 .085 Negative -.086 -.107 Kolmogorov-Smirnov Z 2.336 2.900 Asymp. Sig. (2-tailed) .000 .000 Source: Compiled by authors In the table 1, it has been observed that the significant value for both the indices is 0.000. It is below 0 .05, alluding that the distribution is not normal and therefore that the share prices does not follow a random behaviour.

One Sample Run test Since the Share prices do not follow a Normal distribution, it becomes manifest that nonparametric test such as One Sample Run test can be performed to investigate if the two indices follow randomness. The test values against which the runs are determined are considered to be the Mean, Mode & Median. The test showed the following results for Nifty 50 and SHA50: Table 2 Run test with Mean Nifty 50 SHA50 Test Value(a) 4646.8523 808.8965 Cases < Test Value 302 367 Cases >= Test Value 439 366 Total Cases 733 733 Number of Runs 19 13 Z -25.871 -26.205 Asymp. Sig. (2-tailed) .000 .000 Source: Compiled by authors

Table 3 Run test with Mode Nifty 50 SHA50 Test Value(a) 4875.05 868 Cases < Test Value 370 367 Cases >= Test Value 371 366 Total Cases 733 733 Number of Runs 27 13 Z -25.328 -26.205 Asymp. Sig. (2-tailed) .000 .000 Source: Compiled by authors Note: Since there are multiple modes, the mode with the largest data value is used Table 4 Run test with Median Closing prices for Nifty 50 Closing prices SHA50 Test Value(a) 4875.05 868 Cases < Test Value 370 367 Cases >= Test Value 371 366 Total Cases 733 733 Number of Runs 27 13 Z -25.328 -26.205 Asymp. Sig. (2-tailed) .000 .000

Source: Compiled by authors In the tables 2,3 and 4; it has been observed that the significant value for run tests considering the mean , median and mode of both the indices is 0.000 which is below 0 .05 alluding that the distribution is not normal and therefore that the share prices does not follow a random behaviour. Thus the null hypothesis is accepted.

Auto Correlation test To further confirm the relation of the prices on the preceding prices auto correlation is performed. The prices of the SHA50 show that there is a high correlation of 0.99 and that of the Nifty 50 shows a high auto correlation of 0.99. This again confirms the hypothesis that both the indices do not follow a random behaviour.

Conclusion It is been clearly witnessed from the above performed One Sample Run test that both the markets defy the random walk theory and therefore in turn the EMH. The findings suggest that prices do not adjust instantaneously to the infusion of new information in the market. This clearly indicates that the technical trading can be very apt fully applied in both the markets to predict future trends in the share prices and thereby increasing the possibility of earning more than normal returns. Actually this is the paradox of the EMH because both Technical and Fundamental analysis is required to make the market efficient. Wealthof papers and classical studies has been conducted that props the present hypothesis. Ellinger (1955) republished in 1971; Lo and MacKinlay (1999) showed for a weekly U.S. stock indexes that past prices may be used to forecast future returns to some degree. This fact is the starting point in any technical analysis. In another study Lo, Mamaysky and Jiang (2000) showed that technical analysis provides abnormal returns. Frankel and Froot (1987) reject the Efficient Market Hypothesis (EMH) in the foreign exchange market too. More direct support for technical analysis has been given by Pruitt and White (1989) and Shachmurove, BenZion, Klein and Yagil(2001). Thus, it is seen that previous researchers have also not found the presence of efficient market hypothesis in the stock market. So, the present study once again established that efficient market hypothesis is not applicable in case of Islamic index too.

Limitation of the study Though the present study makes a comparison between the Nifty50 and SHA50, it should be noted that the SHA 50 was launched in 27 Dec, 2010 and the remaining values of the share prices, receding back to 1 Jan, 2008 have obtained via back testing, and therefore might not reflect the real share prices. The study also makes no attempt to investigate a pattern or trend in the movement of the share prices over the period of three years considered.

Scope of Further Research More research can be performed on the index, three or five years forward, because then its real values and not the back tested values would be available. Similar studies can be undertaken by considering S&P BSE 500 SHARIAHH index which is recently launched by BSE replacing SHA50. The present study also makes no attempt to investigate the behaviour of the SHA 50 in the bearish market. Such a work would be beneficial so that a better understanding of its performance is available. Besides various methods of technical trading such as moving average, filter tests can also be performed.

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