Volatility linkages and value gains from diversifying with Islamic assets

Abstract

Islamic assets, assets compliant with ethical and religious norms as codified in Sharia law, broaden the investor base. Do such investments contribute to mean-variance efficiency, and if so, how? Using daily data on stock, bond, and money market indices from nine Islamic countries and 37 non-Islamic ones from May 2007 to June 2010, we show that adding Islamic assets to an existing portfolio of conventional (non-Islamic) assets can expand the mean-variance frontier and thereby create additional value through diversification. The “specialness” of Islamic assets comes from a smaller set of common information and a lower degree of cross-market hedging between Islamic and conventional markets. This reduces volatility linkages between Islamic and conventional assets relative to volatility linkages between two conventional assets. Including one Islamic asset lowers volatility linkages by up to 3.16 percentage points after controlling for country-level fixed effects and time-varying characteristics. Low volatility linkages are key to increasing diversification benefits that arise from improvements in the global mean-variance portfolio. Our research contributes to the international business literature by highlighting the potential benefits of bridging religious, ethical, and cultural differences to add new markets to an incomplete international market structure and in so doing increase diversification benefits.