Shari’ah screens complement ESG integration by investors in Emerging Markets

In a new report released with Refinitiv, the RFI Foundation has extended analysis done earlier with INCEIF to investigate the impact of combining Shariah and ESG screens. The new research applies the same methodology and data source with more recent figures covering the period immediately prior to the start of the COVID-19 pandemic through late 2022, focusing only on companies located in Emerging Markets. The new results show a convergence in the general trends similar to that identified for developed markets in the earlier sample.

The results show higher investment performance for Shariah-compliant and lower-ESG-scoring companies when compared to higher ESG-scoring companies (especially higher-ESG-scoring companies that are Shariah-compliant). The conclusion is not that ESG and Islamic investments are incompatible, but more likely that they have impacts that can offset or reinforce existing risks.

For example, ESG scores reflect non-financial sources of risk associated with a company’s actions, whether past, present or future. The risk embedded in low ESG scores is expected to have financial impact, but the significance of the impact depends on other characteristics of the company. Shariah screens also impact the financial risk of a company by avoiding those with substantial debt and interest payments.

Conceptually, it may be possible to imagine higher possible rewards from lower-ESG-scoring companies in situations, or over timeframes, during which the risks are not realized. In this domain, by adding Shariah screening to the subset of lower-ESG-scoring companies, the results may reflect a greater trimming of downside when compared to capping of potential upside as a result of the Shariah screens.

By contrast, higher-ESG-scoring companies that are Shariah-compliant may have the benefit of robust risk mitigation from the two screening methodologies, but may over a shorter time horizon not capture as much upside. This would be consistent with the finding from our earlier research that emerging market companies that are Shariah-compliant and have higher ESG scores were among the strongest performers, followed by Shariah-compliant companies with lower ESG scores.

What is clear across many years and different market conditions is that Shariah screens and ESG screens are not independent of one another in how they affect the investment universe. There has still been only limited public research investigating the connection. The impact of the conclusions of this research suggests value is available for all investors, and especially for Islamic investors looking at how best to integrate ESG into their investment processes.