From Binary Screens to Continuous Compliance: A Shariah Screening Measure for Portfolio Design

TL;DR

This paper introduces a continuous measure of Shariah compliance for portfolios, enabling nuanced assessment beyond binary pass/fail standards, with implications for portfolio construction and risk management.

Contribution

It develops the first continuous Shariah compliance index (CSCI) integrating multiple standards into a transparent scale, improving measurement and portfolio design.

Findings

CSCI maps binary standards to a common compliance scale.

Threshold-based portfolios vary compliance intensity with modest performance trade-offs.

CSCI scores are not reliably linked to higher expected returns.

Abstract

Islamic equity screening relies on multiple binary rulebooks that often classify the same firm differently. This paper develops a Continuous Shariah Compliance Index (CSCI) on $[0,1]$ that embeds the published business-activity and financial-ratio thresholds of six leading standards in a single transparent measure. Using CRSP/Compustat U.S. equities from 1999-2024 with lagged accounting inputs and monthly portfolio formation, we document four results. First, existing binary standards map to distinct regions of a common compliance scale, so firms that receive the same pass/fail label can still differ materially in compliance strength. Second, CSCI-threshold portfolios provide a transparent way to vary compliance intensity while retaining economically meaningful diversification, although baseline risk-adjusted performance declines modestly as thresholds tighten. Third, the September 2023 DJIM/S&P methodology change admits firms with materially lower CSCI scores than firms that remained compliant under both the old and new rules. Fourth, in cross-sectional return tests, CSCI is not reliably associated with higher expected returns once standard characteristics are controlled for. The main contribution of CSCI is therefore measurement and portfolio design rather than the discovery of a new priced factor.