Enhancing the Shari’a Screening Methodologies: An Empirical Analysis

This chapter dives into empirically analysing how to improve Shari’a-compliant equity screening methodologies. Building on the recommendations from experts interviewed in the previous chapter, it explores two enhancements. The first method involves replacing existing, indirect methods for measuring interest-based activities with more precise measures. Currently, screening relies on debt ratios to estimate interest expense and cash ratios to estimate interest income. This new approach proposes directly analysing a company’s interest income to revenue and interest expense to total expense ratios. The second enhancement focuses on adjusting screening thresholds based on the development of the Islamic finance industry (IBF) in a particular country. The rationale is that since the introduction of Shari’a-compliant equity indices in 1999, the IBF industry has grown significantly, but screening thresholds haven’t kept pace. This method proposes stricter thresholds for countries with well-developed IBF sectors and looser thresholds for those in earlier stages. The chapter analyses three pre-selected portfolios using both existing and proposed methodologies. For the first portfolio (Nasdaq 100), the analysis finds that the new method excludes fewer stocks than the current method due to missing data on interest income and expense ratios for many companies. This highlights a potential challenge for implementing the new approach.