A new paradigm and new strategies for shariah-compliant portfolio optimization : how to practice in Indonesia.

Abstract

In this paper we analyze the effects of different strategies to construct Shariah compatible financial portfolios. The difference between conventional and current Shariah portfolio management is the application of sector screens and financial screens by which the asset universe is reduced. Yet, here different schools of scholars define different screening rules leading to significant differences with respect to compliance, but also with respect to performance. After analyzing this discrepancy we propose several new strategies to apply the inconsistent rule systems and a new paradigm for defining Shariah-compliance. Under this new paradigm compliance is attributed to the portfolio and not to the individual assets of the universe. We report results of an empirical study analyzing the potentials of these strategies and of the paradigm and how to practice in Indonesia. We can show that under the proposed concepts Shariah-compliant portfolios can be realized which have return and risk profiles comparable to the conventional non-constrained portfolios.