Tag Archives: Investing

Islamic Finance: Engineering Shariah-compliant debt instruments

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Gunn (2008) provided the inspiration for further study into Islamic financing by point out the relative paucity of studies pertaining to Islamic finance.  Gunn (2008) point out that to an extent more so than western religions, Islam demands that its law be integrated into every aspect of a Muslim’s life—spiritual, commercial, professional, legal.  While the majority of firms being traded in the international financial markets comprise capital structures that have integrated interest-bearing debt, Islamic law forbids Muslims from receiving or paying interest; thus, it is extremely difficult for a devout Muslim to operate within modern financial markets.  Gunn (2008) examined the capital structures of both Islamic-compliant and –noncompliant firms in developing countries to determine if Islamic religion had any impact on capital structures of firms operating within traditionally Islamic countries.  There is opportunity to extend the work of Gunn (2008) by examining debt instruments that are used by Islamic financial institutions, offered to Islamic investors, and Islamic mortgages—not traditional components of many of the capital structures she examined.

While Chiu, Newberger, and Paulson (2005) pointed out that no precise numbers exist for the number of Muslims (which I define as an adherent, to any degree, of Islam) nor for the degrees of compliance they have for Islamic law, that Islam is the fastest-growing religion in America (Dar & Presley, 1999), I think, makes it compelling enough a reason to re-explore its impact on fundamental financial theories developed in its absence, such as Portfolio Theory (Markowitz, 1952).  Markowitz (1952) assumes, for example, rational behaviour by investors in quantifying risk. Rational behaviours constrained by Islamic law might be considered nonrational behaviour otherwise.   One gap in the literature identified Chiu, Newberger, and Paulson (2005) was estimating demand for Islamic financing in the US.  Abdul-Rahman & Tug (1999) had made an estimate of market demand for Lariba (Islamic-compliant) mortgages in the US by beginning with an estimate of 1.5 million Muslim households in the US, 50% of which can afford to buy and maintain a home.  They then assumed that 20% of these households live according to Islamic law in general, only 5% to 10% of which they considered “Lariba-Puritan,” or compliant enough to be attracted to Lariba financing.  The final demand of Islamic mortgages they estimated at between 7,500 to 15,000 households for a primary market size of just over $750 million.  While they acknowledge this number to be a “drop in the bucket” compared to total mortgages, they acknowledge that if awareness could be raised such that the legal climate could be changed, the market could be much larger.  Further, it is likely that debt instruments made available to Islamic firms in a commercial setting would represent a market much larger than the limited mortgage estimate Abdul-Rahman & Tug (1999) estimated.

Gunn (2008) found that there was no significant relationship between whether investors were Muslim or not and debt-equity ratios. Yet, it is not clear whether the debt was provided by a Muslim or foreign investor. One possible applied research project would be to determine whether alternative instruments that would fit within North American (SEC, Ontario Securities Commission, etc.) regulations as well as Islamic law would open up additional investment opportunities for Muslims or Muslim-operated firms. It is also possible to investigate whether amending regulation would increase compliance amongst semi-compliant Muslims. While it is possible that Islamic law could be reinterpreted in conjunction with regulatory amendments, one characteristic of Islam is that “what is not expressly forbidden, is allowed,” and thus I believe there is less room to reinterpret Islamic law regarding debt than there is in amending regulation to be more cognizant of religious factors.

Hassoune (2002) measured Islamic bank performance, measured by their Return on Equity (ROE), and found that the profit- and loss-sharing principle behind Islamic financial law makes profitability less volatile over business cycles.  They also found that market imperfections, such as large amounts of non-remunerated deposits, considerably decrease their cost of funding relative to their traditional counterparts.  They conceded, however, that in terms of liquidity—a very topical concern—Islamic financial institutions could be at a disadvantage.

Obaidullah (2001) examined overall market efficiency, not only financial institution performance, and found that Islamic ethics led to a general enhancement of market efficiency, rather than the decrease in efficiency found by Hassoune (2002).  He attributes his finding, admittedly at odds with other studies, to “mistaken notions of efficiency” (Obaidullah,  2002).  Hassoune (2002), however, employed a sound quantitative analysis using defensible metrics and calculations, while Obaidullah relied primarily on a dialectical presentation.  Perhaps an investigation of the points illustrated by Obaidullah (2001) using a quantitative survey approach would yield some insights that would help reconcile Obaidullah (2001) with Hassoune (2002).

Problem Statement

There is a problem amongst Islamic firms competing in Western markets. Despite provisions in the Charter of Rights and Freedoms of Canada that prevents discrimination based on religious bases, systemic factors cause investors to discriminate against Shariah-compliant firms. Islamic law forbids paying or receiving interest on loans. Interest-bearing debt has traditionally comprised an important portion of a firm’s strategic capital structure. The problem has negatively impacted Muslim investors and business-owners because potential investors routinely consider metrics such as debt-equity ratio in their investment decisions. In her doctoral dissertation, Gunn (2008), ascertained that firms in Islamic countries have traditionally compromised by incorporating debt instruments in their capital structures at the cost of being fully Shariah-compliant. In order to In order to try to mitigate the systemic discrimination against Shariah-compliant firms, it is necessary to know more about the performance of compliant versus noncompliant firms. A study that tests whether Western Islamic Shariah-compliant financing instruments are equal in financial performance to traditional debt instruments, and whether informed investors are as accepting of these instruments as traditional debt instruments will provide future direction about whether a solution to systemic discrimination against Islamic businesses could best be remedied by financial engineering or changes to the regulatory environment.

Purpose Statement

Gunn (2008) established that firms in Islamic countries Islamic law notwithstanding, traditionally still incorporate interest-bearing debt into their capital structures; in order to be Shariah-compliant, however, a corporation should not include these instruments.

I therefore propose a summative comparative analysis of matched firms that are fully Shariah-compliant with those firms in Islamic countries that do incorporate debt financing into their capital structures to establish appropriate metrics applicable in their respective economies and whether compliance with Shariah law has a detrimental impact on capital structure. One way I see the research problem in this case is as the case of vegetarianism: “Is adherence to a vegetarian diet [given a typical diet of a given culture] detrimental to an individual’s health?” While nobody would claim that it is not possible to obtain necessary nutrients from a completely vegetarian diet, it is likely that without special dietary considerations, individuals would be lacking in certain amino acids and nutrients not commonly produced by most plants. I would like to investigate whether adherence to Shariah law places companies at a competitive disadvantage relative to their less-compliant counterparts.  The results of this study could lead to future research questions such as whether novel financing instruments that incorporate the notions of shared risk and proportional reward but are not strictly equity-based could be structured to finance firms in Islamic countries in a Shariah-compliant manner.  The purpose of the summative study will be to compare the financial performance of matched Shariah-compliant and noncompliant firms in Islamic countries.

Research Questions

One of the wise pieces of sage advice given during the recent Walden Dallas doctoral residency was that a single doctoral level project should not attempt to both establish a set of metrics as well as use them in application. That said, the initial research questions should include “Are Shariah-compliant financial debt instruments equal in performance to traditional debt instruments?” “Are Islamic investors as likely to incorporate Shariah-compliant debt instruments that do not perform as well as noncompliant ones but are Shariah-compliant into their firms’ capital structures?”  The first research question would be best translated to a hypothesis for a two-tailed type of statistical test; the null hypothesis would be that extant Shariah-compliant debt instruments are equal in performance to traditional interest-bearing instruments; the alternate hypothesis would be that they are not equal in performance.  The second question could be assessed by a survey design using a stratified sample of different segments of investors, asking the likelihood of the various investors, using a Likert scale, of choosing Shariah-compliant instruments and investments given the choice.  The third question would also best be served using a survey design assessing the likelihood of senior and financial managers of firms, also using Likert scales, whether they would choose Shariah-compliant investments and debt instruments given the choice, either as they currently exist, or if new instruments were engineered or the legislative climate changed.

References

Abdul-Rahman, Y. K., & Tug, A. S. (1999).  Towards a Lariba (Islamic) mortgage financing in the United States providing an alternative to traditional mortgages.  International Journal of Islamic Financial Services.  1(2): 1-6. Retrieved from http://www.iiibf.org/journals/journal1/art3.pdf

Chiu, S., Newberger, R., & Paulson, A. (2005). Islamic Finance in the United States. Society. September/October, 2005. 64-8.

Gunn, T. A. (2008). A comparative analysis of the Islamic religion on corporate capital structures of firms in emerging countries. (Doctoral dissertation). Retrieved from http://proquest.umi.com.ezp.waldenulibrary.org/pqdweb?RQT=302&COPT=REJTPUcyODcrNTRjYiszYjBmJklOVD0wJlZFUj0y&clientId=70192&cfc=1 UMI Number: 3305577

Hassoune, A. (2002).  Profitability of Islamic banks.  International Journal of Islamic Financial Services.  4(2): 1-13.  Retrieved from http://www.iiibf.org/journals/journal14/vol4no2art2.pdf

Obaidullah, M. (2001).  Ethics and efficiency in Islamic stock markets.  International Journal of Islamic Financial Services. 3(2): 1-10. Retrieved from http://www.iiibf.org/journals/journal10/obaidvol3no2.pdf

Annual Reports Lie

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What good reason does a firm have to produce annual reports that are designed to give an accurate report on the status of the firm when it can use numbers that make itself appear better than it is?  

Even as a shareholder, I would want a firm I have invested in to get away with as much manipulation as it can get away with so they look as good as possible so that the stock price is as high as they can make it. 

Putting its best foot forward has more benefits than simply making shareholders rich.  Healthier companies have access to more debt and equity funds, more credibility and power to influence the markets in which they play, and are safer to do business with. 

I simply can’t see one good reason for a company to publish anything that does not take full advantage of every opportunity to make itself look good that it can get away with.

Keeping in mind this objective behind financial statements and annual reports, the need to analyze every financial statement critically and individually is patently clear.

Don’t buy stocks

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I don’t care what kind of system you have or what your source of hot stock tips is, don’t buy stocks. 

Before my peers flame me with their opinions on investing, I will qualify that by saying, “Don’t buy segregated securities.  If you want to try to outsmart the markets, have your portfolio desgiend by someone who does it for a living or buy the market.”  

If anyone were to ask if they should buy company XYZ’s stock, I wouldn’t even look up its quote, let alone analyze it.  My answer would be no.   

My rationale is as follows: if you need to ask if XYZ is a good investment, you clearly are not able to use the financial reports to value the stock yourself; further, since you didn’t describe the rest of your portfolio, you obviously were considering buying it without regard to diversifying any of its risk or whether it aligned with your investment objectives and horizon. 

Sure, people who aren’t finance experts have made lots of money buying and selling stocks.  But since they aren’t able to determine at what price the stock is overvalued and at what price it is undervalued, they made that money purely by luck.  For every lucky stock trade that does make more money than a risk-free t-bill, there are myriad others that either lost money or earned less than investing the money in a t-bill would have.  Statistically, then, you have a better chance of having more money in the end if you do not buy the stock, since 100% chance of earning 0% return on the stock and only a  will still leave you with more money than any probability of losing any amount.

“But in the long term the stock market consistently outperforms risk-free t-bills,” you argue. 

Yes and no.  Yes, on average, stock prices have always risen over the long-term.  Business cycles and periodic recessions guarantee drops in stock prices will occur.  And anyone who bought Bre-X or Nortel will tell you, while the market as a whole always increases in value over time, it does not mean that all stocks individually will increase in value in the long run.   That is why even though it seems a sure bet that a given stock will make you a millionaire, statistically, you have a better chance of ending up with more money in the end if you invest in an optimially-diversified portfolio comprising a combination of more than one security, securities that are known to react oppositely to each other with respect to economic conditions, and risk-free securities; even though this will necessarily reduce your potential returns, it also guarantees three critical things:

  1. Should unforeseen circumstances cause your company’s stock price to plummet, investments in other companies will mitigate the drop to your overall investment, mitigating the specific risk;
  2. Oppositely-reacting securities will mitigate any price drops due to economic conditions, mitigating the volatility due to business cycles; and
  3. Risk-free securities will guarantee a minimum value and reduce the impact of  market-wide factors such as recession. 

Integrating those types of securities in both long and short positions also helps dampen portfolio fluctuations due to intrinsic systematic risk in the markets.

[Obviously, if you're well-versed in finance and know how to maximize the returns from that stock while diversifying away as much of its risk as possible, then I wouldn't tell you not to buy because you wouldn't have to ask me in the first place.   And if you are a finance MBA or a CFA and still asked, I would still tell you not to, which would mean you were less risk-averse than I, in which case, you might as well disregard my risk-averse policy.]