Leverage Risk, Financial Crisis, and Stock Returns: A Comparison among Islamic, Conventional, and Socially Responsible Stocks

According to the financial press, firms with low leverage have lower distress risk due to their reduced exposure to the credit market, especially during credit crises. Compared to their conventional and socially responsible (SRI) counterparts, sharia compliant (SC) stocks are low-leverage stocks. Our hypothesis is that SC firms would be less sensitive to leverage risk and thus would be ideal for wealth preservation during declining market environment. We find that the leverage risk factor performs consistently across various categories of firms and its impact is more pronounced during the recent financial crisis. However, we also find that compared to the conventional stocks, SC stocks are also quite sensitive to the leverage factor. In contrast, the SRI class of stocks has the least sensitivity to leverage risk factor, suggesting they can be attractive for wealth preservation during credit crises.