Is there a sacrifice cost of leverage constraints? The case of Islamic equity investments

The Islamic equity screening standards specifically forbid investment in equities of companies with high financial leverage and low investment in real assets. We investigatewhether constraint on financial leverage and higher investment in real assets (operating leverage) results in lower performancefor investors in Islamic equity portfolios (IEPs). By utilizing the monthly constituent level data from three regional markets: USA, Europe and Japan, and two Shari’ahscreening standards: MSCI and AAOIFI for the period 2000-2013, we structured six IEPs. Two additional factors similar to the ones created by Fama and French (1992) are constructed to account for the cost of financial and operating leverage. The empirical findings suggest that investors sacrifice potential returns by holding constrained portfolios especially if they are using book-value (MSCI)based financial screening. However, such sacrifice cost is not evident from IEPs adopting the market-value(AAOIFI) based financial screening. Our results imply some clear implications for investors and policy makers.