Islamic finance continues to gather pace with a recent report estimating that Sharia-compliant assets now exceed $1.7 trillion and are projected to reach $2.7 trillion by 2010.

But that is not without its challenges and debates. Amongst other challenges that have been highlighted, there is continued debate on the need for a central "Sharia Council" to introduce standardisation across the industry. It is important that we balance this need against that for continued product innovation and the ability to introduce new solutions to the market in a timely manner. The industry doesn't need to be constrained but governed.

The growth to date has been focused on the development of institutional and corporate structures, but there is increased discussion on the need to further develop Sharia-compliant investing. To date Sharia-compliant investing has been perceived by many investors as underperforming the conventional investment market. In fact a recent report shows that Islamic investors continue to choose conventional investment solutions over Sharia-compliant structures, indicating that they may be putting their religious beliefs second to investment performance. But recent market volatility has shown contradictory results, and has highlighted the strengths of Sharia investments.

Conventional equity funds have been hit hard by the subprime fiasco and continue to suffer the ongoing effects of the credit crunch. For Sharia-compliant equities, 2007 was a strong year with Islamic indices outperforming their conventional counterparts and are continuing to do so till now in 2008.

Figure 1 highlights the strength of Sharia equity funds from early on in the 2007 subprime crisis. Sharia performance tracked conventional equity markets in the early days, and at the "official start of the crisis" in February 2007, The Dow Jones Islamic Developed World Index began its move away from the declining MSCI World Index and has shown consistent outperformance to date.

Sharia-compliant structures have many screens and requirements that should be recognised as contributing to this outperformance. The oft-quoted aversion to the financial services sector is only one of those. In addition, the Sharia filters resulted in an overweight of cyclical sectors such as information technology, health care and energy and underweight for more defensive stocks such as consumer staples and utilities. These sectoral allocations resulted in further outperformance relative to the industry's conventional counterpart. This trend has been consistent since December 2006.

Figure 2 highlights the common view that the industry and financial ratio filters for Sharia compliance limit the universe of investible stocks, potentially impacting performance in a negative manner. However, Sharia investors appear to have benefited from the characteristic exclusions and the favouring of sectors that have proved resilient in the current economic climate.

Of greater significance has been the due diligence procedures associated with stock/company selections that are mandated under Sharia principles; the exclusion of highly leveraged companies became a key factor through this period.

Strength

Highly leveraged companies suffered over the recent period, and stocks showing lowest level of debts on their balance sheet outperformed by almost 35 per cent (see Figure 3).

Quantitative ratio filters mean that the Sharia-complaint universe is generally made up of companies with strong cash flows, robust returns on equity, and a solid balance sheet.

These characteristics have clearly been rewarded in a period of credit and liquidity constraints, whilst the volatility in stock prices of highly leveraged firms significantly increased through the recent market downturn.

The need for stringent research to ensure compliance, both pre and post the purchase of any stock, is another key benefit of Sharia investing. In considering total debt to market capitalisation off-balance sheet debt has to be considered as well and research has to be extensive. Avoiding excessive stock trading and adopting a buy and hold strategy also tends to fare well for Islamic funds as constant trading can tend to drag down a portfolio's overall performance.

In conclusion, we believe there is a strong argument to support the notion that Sharia investing is not the "poorer cousin" of its conventional counterpart, but is a viable alternative approach.

Whilst the behaviour of Sharia funds at the individual fund level is no different to conventional counterparts in that some will outperform and others will underperform, recently Islamic indices have highlighted that their low-debt, non-financial, socio-ethical approaches work in market downturns. This trend was not unique to the MSCI World vs DJ Islamic, but can be seen across the US, Europe and the Asia Pacific markets.

The writer is senior executive officer for SEI in the Middle East.