Do Shariah-ESG indices offer downside risk protection? Regime-dependent evidence from Sukuk and Islamic equity benchmarks

Abstract

This study aims to examine whether Shariah-compliant environmental, social and governance (ESG) indices and Sukuk benchmarks provide regime-dependent downside risk protection during crisis episodes, addressing an empirical gap in the crisis-period tail-risk behaviour of Islamic finance instruments at the intersection of religious screening and sustainability constraints. The analysis is motivated by the growing institutional demand from Gulf Cooperation Council (GCC) and Middle East and North Africa (MENA) sovereign wealth funds, Takaful operators and Islamic fund managers for evidence-based regime-sensitive portfolio frameworks. A two-state student-ν Hidden Markov Model (HMM) is estimated for five Shariah-ESG and Sukuk indices over 2013–2025 (n = 2,894 observations), spanning three macro-financial stress episodes: the 2018 emerging-market sell-off, the COVID-19 shock of March 2020 and the Federal Reserve tightening cycle of 2022. Regime-dependent conditional value-at-risk (CVaR) is computed at the 95% confidence level; bootstrap permutation tests (B = 5,000 replications) assess statistical significance. Economic value is quantified via the Jobson–Korkie Sharpe ratio test and certainty equivalent return (CER) under mean-variance utility (γ = 3). Crisis-regime CVaR deteriorates significantly across all five indices (p < 0.001). Sukuk tail losses are 3.7–6.9 times smaller than Shariah equity counterparts during crises. Developed-market Shariah equity maintains near-zero co-movement with GCC Sukuk (ρ < 0.13) during joint stress episodes, preserving diversification benefits precisely when most needed. An HMM-signal strategy overweighting Sukuk to 80 % in crisis regimes improves the Sharpe ratio from 0.82 to 1.00 (Jobson–Korkie z = 5.98, p < 0.001) and delivers a CER gain of 45.4 basis points per annum, remaining positive after 20 basis point transaction costs. To the best of the author’s knowledge, this is the first study to apply endogenous latent-state HMM regime identification with regime-conditional CVaR estimation to the Shariah-ESG and Sukuk asset class jointly. The study makes three contributions: methodologically, it introduces a regime-switching framework that endogenously separates crisis from tranquil dynamics without ad hoc threshold specification; empirically, it establishes that GCC Sukuk and Developed Shariah equity maintain near-zero crisis-period co-movement – a structural exception to general Islamic finance contagion patterns; and practically, it provides actionable evidence for regime-dependent portfolio construction for GCC and MENA Islamic institutional investors.