Have Faith in the Market? A Quantitative Portfolio Optimization for Global Shari’ah-Compliant Indexes

Abstract

Shari’ah-compliant investments grew 128% to reach $25.9 billion in 2022, highlighting rapid growth and increasing relevance of Islamic finance. Islamic finance prohibits interest (riba), excessive uncertainty (gharar), and speculation (maysir) while promoting fairness, transparency, and social responsibility. This research evaluates optimal portfolios constructed from 29 global Shari’ah screened indexes. Three optimization methods are applied: mean-variance optimization (MVO), multi-objective optimization (MOO), and a Shari’ah-based model proposed by Masri (2018). Performance is measured by return, volatility, Conditional Value-at-Risk (C-VaR), and Sharpe Ratio.

The empirical approach backtests across a 2-year span (2023–2024). The MVO portfolio outperforms all conventional benchmarks (Dow Jones, FTSE, and S&P) in absolute and risk-adjusted terms. In an extended 12-year backtest (2005–2014, 2023–2024), the MVO portfolio underperforms only the FTSE benchmark on a risk-adjusted basis due to higher volatility and Technology sector exposure. Notably, in the high-volatility years of 2008 and 2020, the MVO portfolio outperformed the benchmark average annual return by net margins of 8.1% and 9.4% respectively. This reinforces prior studies suggesting that Shari’ah screened portfolios may offer upside potential during market instability.

In the 2-year backtest, the MOO portfolio achieves the lowest volatility and downside risk with returns equal to the benchmark average. Its risk-adjusted performance makes it suitable for risk-averse investors. The Masri portfolio delivers higher returns than the benchmarks but with greater volatility, more extreme C-VaR, and lower Sharpe Ratio. This reflects a return-focused strategy grounded in Shari'ah principles. The optimization models show that Shari’ah-compliant portfolios maintain competitive performance at varying risk preferences.

With a broader investment universe and more quantitative portfolio construction methods than existing literature, this research demonstrates that Shari’ah-compliant portfolios exhibit competitive performance to conventional benchmarks. The results contribute to the growing study of Islamic finance and its integration into modern portfolio theory.