Islamic portfolio insurance for market risk management: a comparative analysis of traditional and Islamic portfolios on the Malaysian stock exchange

Purpose Along with the phenomenal growth in Islamic finance, interest in stocks of companies that use halal practices has risen considerably. This has given rise to the issue of the management of the systematic risk of Islamic stock portfolios. The use of derivative products in managing systematic risk is not permissible by Islamic law; they cannot be used to manage the systematic risk of Islamic portfolios. This study aims to analyze the performance of the Islamic Option-Based Portfolio Insurance (OBPI) and Constant Proportion Portfolio Insurance (CPPI) methods on Sharia-compliant stock portfolios. It compares their performance to conventional OBPI and CPPI strategies on conventional stock portfolios. Design/methodology/approach The sample consists of the daily Malaysian government T-Bill and Sukuk data and end-of-the-day price data of the stocks traded in the Malaysian Stock Exchange between 2015 and 2020. The OBPI and CPPI strategies were applied to six 16-stock Islamic portfolios using Sukuk, and their performance was compared with that of six 16-stock conventional stock portfolios. Portfolios are classified into (based on their volatilities) high, medium and low-risk portfolios, and the performance of the portfolio insurance (PI) strategies was compared at these three risk levels. Findings The study’s findings reveal that Islamic insurance strategies used for Shariah-compliant portfolios generally provide the expected benefits. Islamic portfolio strategies perform as well as (in certain cases better than) their conventional counterparts. In general, in most cases, the Islamic PI methods outperform the buy-and-hold strategy on a risk-adjusted basis. The CPPI strategy outperforms the OBPI strategy. CPPI offers the best results with the multiplier 5. Practical implications PI methods (CPPI and OBPI) are based on a dynamic rebalancing scheme of risky and nonrisky assets. When applied with a marketable Sukuk on Islamic stock portfolios, it is perfectly permissible by Islam. The results of this study show that it can be easily implemented in Islamic stock portfolios and is a viable alternative for the management of systematic risk. Originality/value To the best of the authors’ knowledge, this is the first empirical study to analyze the performance of Islamic PI methods, and is the first study to empirically show that Islamic PI is a viable alternative for managing the market risk of Islamic stock portfolios. The study is expected to contribute to the traditional PI literature and the Islamic Finance literature in this context. Moreover, the Islamic PI strategies presented in this paper and the results of their application on actual data will guide and encourage practitioners to manage the market risk of Islamic stock portfolios.