1.1. Background of the study
The growth of Islamic banking and finance has been very remarkable within the spectra of modern finance. In just over seventy years, modern Islamic finance has grown from initial experiments in Islamic nations to a fully-fledged, viable financial system with a net worth of over $950 billion (Ernst and Young, 2011). Moreover, the growth of Islamic finance has not been limited to traditional Muslim hubs such as Indonesia and Malaysia in the Far East and Dubai and Saudi Arabia in the Gulf Cooperation Council (GCC) region but has also spread into more conventional financial centers (Shubber, 2014). Large financial hubs ranging from Hong Kong, Singapore, the United Kingdom and America have all seen substantial growth in the infrastructure and initiatives to support and adopt Islamic finance as a viable complementary and alternative financial system (Iqbal, 2013).
This rapid growth has seen the proliferation of the services and products offered by modern Islamic finance and this includes deposit-taking facilities, the issue and sale of shares and bonds, Islamic insurance, Islamic mortgages and an increasing number of complex Islamic financial contracts (Jobst, 2012). With this significant growth of Islamic finance into more mainstream financial systems, there is an increased need to understand the performance, structure and interaction of Shariah financial products and services with that of their conventional counterparts. Existing research such as El-Gamal (2012), El-Sheikh (2010) has indicated that whilst Islamic finance is quickly being adopted as an alternative financial system much is still being learned about products and financial services being provided under the Shariah finance umbrella. Much of this existing research focuses upon issues pertaining to both risk management and governance under a Shariah financial framework.
As highlighted by Sundararajan and Errico (2012) the growth of Islamic finance and its increasing prominence within the global economy could lead to increased risk within the Shariah financial system leading to a greater need for the development of risk management tools and structures to meet the needs of market participants. However, the development of risk management tools and financial innovation within Islamic finance is a contentious issue as there is the requirement, unlike conventional finance, to draw a balance between financial and religious principles (Derigs and Marzban, 2014). Moreover, the growth and development of Islamic products and services across the Islamic financial system have meant that there are increased criticisms pertaining to product structures and the scope with which these products and services adhere to fundamental Islamic beliefs (El-Gamal, 2012).
Proponents of Islamic finance believe that many of the issues relating to the development of risk management and Shariah finance as a whole relate to concerns about corporate governance and regulatory standards within the Islamic financial system (El-Hawary, Grais and Iqbal, 2014). These concerns are based mainly upon the fragmentation of the Islamic financial system (major Islamic financial hubs in Malaysia, GCC and UK) and divergences in regulatory standards. This regulatory divergence is not a new matter within the Shariah finance and the creation of central regulatory bodies has shown that concerted effort is being made by the Islamic financial system to address this concern (El-Sheikh, 2010). Whilst effort is being made to address the divergences in regulatory and governance standards there still exists some apprehension that the lack of uniformity within Islamic finance could hamper overall growth and be of increasing detriment to the development of the Islamic financial system in the future (Derigs and Marzban, 2014).
1.2. Research Significance
A key focus of this research project is to examine aspects of Islamic finance from a conventional financial perspective. With the growth of Islamic finance into more conventional financial markets, there would be significant value in examining aspects of Islamic finance from a conventional standpoint. It was thought that this research would provide a firmer understanding and new insight into Islamic financial concepts and issues pertaining to risk management and governance. Part of this examination includes an evaluation of the performance of Shariah-compliant indexes within a conventional portfolio of equity indices. The empirical literature is inconclusive with regards to the benefits of Shariah-compliant equity indexes for both Islamic and conventional investors. Empirical literature such as Elfakhani, Hassan and Sidani (2015) have attempted to compare the performance of Islamic and conventional equity indexes and have also found that there were not consistent arguments for outperformance by Islamic indexes and in some cases, there was even an underperformance of Islamic indexes. The growth of Islamic finance has meant that in order to enhance its attractiveness as an alternative financial system there have to be some investment benefits for not only Islamic but also conventional investors. The existing literature has tried to illustrate this aspect but much of the empirical work focuses only on comparing Islamic against conventional equity indexes without consideration for basic investment strategies such as diversification and portfolio optimization. This clear gap in the literature forms the first key area of research. This study aims to examine the diversification and performance benefits of including an Islamic equity index through a cointegration and Markowitz portfolio optimization analysis…………..