Avoiding Interest-Based Revenues While Constructing Shariah-Compliant Portfolios: False Negatives and False Positives

Abstract

Shariah law prohibits investments in equities of companies for which interest income is a considerable source of revenue. In practice this is often enforced by prohibiting investments in firms for which the reported interest-based revenues exceed a predetermined percentage of the firm's total revenue. We investigate an alternative approach that consists of avoiding firms that are expected to have interest-based revenues exceeding the acceptable threshold over the investment horizon. We compare the traditional backward looking approach with the proposed forward looking analysis for the sample of S&P 500 firms over the period 1984-2015. Our results show that the forward looking approach outperforms the backward looking approach in terms of both less false positives (firms classified as compliant, when they are not) and false negatives (firms classified as not compliant, when they are compliant).

Keywords: Interest-based revenues, Islamic finance, Misclassification, Shariah screening

JEL Classification: C00,G11