Commonality dynamics

To understand the mechanism of stock classification effect on stock return comovement, it is helpful to look at the time series graph of same class return comovements of the two classes of stocks. Figures 3,4, and 5 show the monthly plot of equally weighted average of same class beta coefficients for Islamic and conventional stocks estimated using firm-year monthly rolling over regression of equations (8) and (10) for stock return comovement and liquidity commonalities respectively. The graphs show a big shift in average beta coefficients of same class comovements around 2008. The divergence in same class comovements is clear in the case of return comovement in which Islamic stocks comovements stay above 0.3 but conventional stock return comovements drop below that level.

The best way to examine the dynamic effect of Sharia stock classification on stock comovements, we use the difference-in-differences approach and test the effect of introducing Sharia stock classification on the comovements of Islamic and conventional stocks. The application of difference-in-differences approach requires exogenous shock to the effect of classification on stock return and liquidity comovements. We think that the publication date of the first Sharia classification report by Dr. Al-Fozan is a good quasi-natural experiment because it is unlikely that

publication of Sharia stock classification affects firm fundamentals directly. Difference-in-

differences methodology compares comovements of a sample of treatment firms that have been classified as Sharia compliant or Islamic to that of control firms that have not been classified as Sharia compliant (conventional) firms, before and after the release of Sharia stock classification reports.

We construct a treatment group that includes all stocks that have been classified as Islamic in the first classification report and a control group of stocks that includes all stocks that have not been classified and were listed in stock market during that time.

Figure 3: Same-class stock return comovements

This figure shows monthly plot of equally weighted average of same class beta coefficients for Islamic and conventional stocks estimated using firm-year monthly rolling over regression of equations (3) for stock return comovements for the period from 2002-2015.

Figure 4: Same-class stock liquidity commonality (Amihud’s (2002) illiquidity)

This figure shows monthly plot of equally weighted average of same class beta coefficients for Islamic and conventional stocks estimated using firm-year monthly rolling over regression of equations (5) for

stock liquidity comovements measured using Amihud’s (2002) illiquidity measure for the period from

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Same class stock return comovement

Conventional Islamic -1.5 -1 -0.5 0 0.5 1 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Same class stock illiquidity comovement

Figure 5: Same-class stock liquidity commonality (Turnover)

This figure shows monthly plot of equally weighted average of same class beta coefficients for Islamic and conventional stocks estimated using firm-year monthly rolling over regression of equations (5) for stock liquidity comovements measured using stock turnover for the period from 2002-2015.

We follow Fang et al. (2014) and retain firm-quarterly observations for both treatment and control firms for a seven-year window centered on the classification report publication year and estimate the following regression:

𝐶𝑜𝑚𝑖.𝑡 = 𝒂 + 𝐛 𝑇𝑟𝑒𝑎𝑡 ∗ 𝐵𝑒𝑓𝑜𝑟𝑒1+ 𝐜 𝑇𝑟𝑒𝑎𝑡 ∗ 𝐶𝑢𝑟𝑟𝑒𝑛𝑡

+ 𝐝 𝑇𝑟𝑒𝑎𝑡 ∗ 𝐴𝑓𝑡𝑒𝑟1+ 𝐞 𝑇𝑟𝑒𝑎𝑡 ∗ 𝐴𝑓𝑡𝑒𝑟2&3+ 𝐟 𝐵𝑒𝑓𝑜𝑟𝑒1+ 𝐠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 + 𝐡 𝐴𝑓𝑡𝑒𝑟1_{+ 𝐢 𝐴𝑓𝑡𝑒𝑟}2&3_{+ 𝐣 𝑇𝑟𝑒𝑎𝑡 + 𝜺 (11)}

The dependent variable 𝐶𝑜𝑚𝑖.𝑡is firm i’s beta coefficient estimated from either stock returns or

liquidity quarterly regressions using equations (8) and (10) above. The variable Treat is a dummy

that equals one for treatment firms and zero for control firms, 𝐵𝑒𝑓𝑜𝑟𝑒1 is a dummy that equals

one if an observation is from the year before the release of classification report (year 2007) and

zero otherwise, 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 is a dummy that equals one if an observation is from the year of the

publication or release of classification report (year 2008) and zero otherwise, 𝐴𝑓𝑡𝑒𝑟1is a dummy

-0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Same class stock turnover comovement

that equals one if an observation is from the year immediately the year of the publication of

classification report (year 2009) and zero otherwise, and 𝐴𝑓𝑡𝑒𝑟2&3 is a dummy that equals one if

an observation is from two or three years after publication year (years 2010 and 2011) and zero otherwise; the omitted group (benchmark) therefore comprises the observations two or three years before publication year (years 2006 and 2005).

We report the regression results estimating equation (11) in table 17. The key coefficient

estimates are interaction coefficients 𝐛, 𝐜, 𝐝, and 𝐞. In the columns of stock returns and Amihud’s

illiquidity, we observe statically insignificant coefficient estimates of 𝐛 which suggests that,

before the release of classification reports, there is no significant difference in stock same class return comovements or liquidity commonality between Islamic and conventional stocks. Moreover, in all the three columns in table 17, we observe statically significant coefficient

estimates of 𝐜 and 𝐝 coefficients, suggesting that, compared to control firms, treatment firms have

a higher return and liquidity commonalities with other stocks from same class. The overall conclusion from table 17 is that the difference in stock return and liquidity commonalities between Islamic and conventional stocks was not statically different until the release of Sharia stock classification report and that the difference was statically significant during the first two years after the publication date of the first classification report.