Japanese funds proved an unexpectedly poor investment in 2006 but investors have been urged to keep faith with the world’s second- biggest economy.

After 40 per cent growth in Japanese funds in 2005, several experts predicted another good year for Japan in 2006. They were wrong. Rapid depreciation of the yen against sterling and flat markets resulted in Japan funds turning into damp squibs.

The average Japan fund dropped in value last year by 10 per cent. In contrast European funds, excluding the UK, were up 17.5 per cent while UK funds were up 16 per cent.

Experts say that, despite the problems of 2006, investors cannot afford to ignore Japan, especially if they want a balanced portfolio exposed to all the world’s major markets. Many are advising that Japan funds or investment trusts should make up 6 to 10 per cent of most equity portfolios.

Japan remains a major world market unlike any other. For one thing, it is far below its peak of the late 1980s. The Nikkei 225 soared to its all-time high of 38,915.87 points on December 29, 1989. Ten years ago it was hovering at 21,000. In early 2003 it dropped as low as 7,600. Today it has recovered to over 17,500.

This unpredictability and the stuttering recovery of the past four years caught many investors on the hop last year. The recovery under way since 2003 faltered as base rates rose, regulatory investigations into share dealings dented market confidence and a consumer-led recovery was slower to get off the ground than expected.

UK investors were hurt by the yen dropping from ¥200 to the pound to ¥240 to the pound. This 20 per cent fall in the value of the yen badly hit any fund profits made in Japan. Funds investing in smaller companies fared even worse.

One of the most popular funds, the £260m Legg Mason Japan Equity fund, saw its value drop by 40 per cent in 2006. The biggest fund in the sector, the £700m Schroder Tokyo fund, which invested in large and medium-sized companies, experienced a 6.5 per cent fall in value. But, despite the poor year last year, investment experts say it’s worth remembering that most funds are still up an average of 30 per cent over the past three years (see box for details).

Investment expert Justin Urquhart Stewart, marketing director of Seven Investment Management, says recent woes have highlighted the volatility of Japan. The effects of 10 years of deflation and an unpredictable currency were major factors which investors needed to understand, he says. But he remains positive about the prospects in spite of the risks and recent poor performance.

He says investors should look for broadly-based funds with recovery possibilities such as CF Morant Wright Japan and Legg Mason Japanese Equity, highlighting these as well-managed funds with the ability to “bounce back”.

Investment adviser Justin Modray of London-based Bestinvest argues that Japan should remain a core holding for investors but no-one should expect an overnight miracle. “Our view is that there is nothing fundamentally wrong with Japan. Fund managers are still confident it will improve but perhaps not as quickly as hoped,” he says.

“At the moment we are neutral but we believe investors should have 8-10 per cent of their equity portfolio in Japan. I think this year is likely to do better than last year. We do rate JP Morgan Japan for new investment. If you want a real punt Legg Mason is worth looking at.”

In terms of Isas, he says that anyone looking to invest the full £7,000 could consider putting about £1,000 into Japan as a long-term bet.

Japan fund managers expect a better year this year after many were caught out in 2006 but investors should not expect a rapid recovery.

Andrew Rose, manager of the largest unit trust investing in Japan, the £700m Schroder Tokyo fund, says he expects markets to improve by about 10 per cent this year and company profits by about the same amount.

Japan still trades on a premium to other major markets. At the end of 2006, the Nikkei 225 was on a price/earnings ratio of 21.5, compared to just over 14 for the FTSE All Share and around 18 for the S&P 500, America’s index of largest companies.

“Japan was disappointing in 2006 after we saw growth of 40 per cent in 2005. Expectations at the beginning of 2006 were too optimistic about the speed at which domestic Japan was going to recover. It was only during the course of the year that reality bit.”

However he remains optimistic that the Japanese economic recovery will get back on course. He adds that, because Japanese markets often follow a different cycle to other world markets, Japanese funds could be a useful balancing feature in investors’ portfolios. “Japan is more likely to dance to its own tune than other major markets,” he says.

Hamish Dingwall, manager of the £450m Baillie Gifford Japanese Fund, says the consensus is that the Japanese economy will continue growing at a steady space.

Fidelity’s recovery-focused Japan Special Situations fund was badly hit last year with a 27 per cent fall but its more widely spread Japan fund fell only 8 per cent. It says it expects an improvement this year.

“According to a market outlook survey among local investment professionals conducted by the Nikkei Financial Daily in January, the majority of professionals maintain a bullish outlook for Japanese equities in 2007,” the company says.