Ethical investment and Shari'ah-compliant investment compared: can investors benefit from diversification?

This study assesses the extent of correlation between ethical investment and Shari’ah-compliant investments in different economic situations. By employing a battery of time series investigation techniques, this study aims to determine if the nature of the relationship between the funds changes in the non-crisis period and during the 2007 crisis period for three developed markets and major financial centers i.e. US, UK and Japan. By estimating the short- and long-term dynamics between the ethical and Islamic indexes, and the extent of cointegration between the two funds, our analysis aims to help fund managers as well as investors in the composition of their portfolio by answering the following question: should investors chose one of the two funds or can they further diversify by investing in a fund of funds containing both ethical and Islamic funds for better risk to return performance? Our findings show that ethical and Islamic funds in the three major financial centers have a significantly different behavior in the short run as well as in the long run. This study shows that in the US as well as in the UK and Japan, there are potential diversification benefits for active investors in the short run, as well as for passive investors in the long run before the crisis in the US and in both sub periods in Japan and UK.