Japanese exposure dumps funds into the also-rans

December is a month for both celebration and for taking stock. Against the music of carol singers in the City, analysts and fund managers are taking time out by analysing the performance of key sectors, stocks and funds in the past year. The consensus seems to be that it was “a year of two halves”.

Markets roared from January until May and pushed up shares in riskier sectors such as technology, commodities, mining and oil and gas. But five months on, the walls came tumbling down and gains made by riskier stocks and funds reversed as investors grew jittery, scared by the prospect of increased inflation and a slowdown in the global economy.

Some investors were still licking their wounds in late July when the second-half recovery began. Traditional defensive sectors such as utilities and tobacco bore much of the responsibility for the resurrection.

Corporate bonds, meanwhile, had a dull year, just scraping a positive return. Yields, meanwhile, were more mercurial, jumping from 4.87 per cent to 5.44 per cent during the period. And while fears about another rise in interest rates in the UK made investors a bit gun-shy, the volatility in stock markets meant that demand for bonds never waned. “Fears over rising interest rates and inflation have taken their toll in the bond markets, although not to the extent you might have expected,” says Justin Modray, an adviser with Bestinvest, the UK advisory firm.

The markets offered a few surprises; the most ironic being the abysmal performance by companies in Japan. At the start of the year, strategists predicted Japan would outperform: a poll by the Association of Investment Trust Companies found that most fund managers expected Japan would surpass other markets this year on the back of a strong performance in 2005.

This prophecy was not fulfilled. Japan proved the weakest region by some margin, its fortunes trampled by allegations of securities law violations at a small technology company called Livedoor in January, which led to a broad sell-off and the collapse of the trading system of the Tokyo Stock Exchange. The 20 worst-performing funds of the year were all Japanese equity funds, with annual losses ranging from 17.8 to 48.56 per cent.

“Japan had a great year [in 2005] and was well set for this year until the incident at Livedoor,” explains Ryan Hughes, a Skandia fund manager who manages the firm’s Japanese funds. “The market was spooked by the fact that the management of the group wasn’t telling the truth and what you saw was a flight to quality en masse and a heavy sell-off in Japanese mid and small cap stocks.”

Some argue that much of the selling was unmerited and the country will bounce back as scores of stocks there, particularly in the mid and large cap sector, are undervalued.

“The underlying economy is doing pretty well. But people don’t understand the economics of price deflation and how that’s had an effect there and that’s led them to underestimate the growth in the Japanese economy. The small-cap market there is largely overheated, but lots of larger companies in Japan have seen strong profits growth and their share prices have gone nowhere,” says Robin Geffen, who manages Neptune’s Russian fund – the top-performing fund of 2006.

In other regions, the demise of the US dollar hampered the performance of North American and technology funds and “masked some reasonable underlying performance”, according to Modray. The depreciation of the greenback to the sterling – the exchange rate now stands at almost $2 to £1 – sends a warning to those who do not pay attention to currency risk. Its 12 per cent fall this year severly impaired the perfomance of US assets upon their conversion into pounds.

Investors who made the most money in the past 12 months were those who kept their money in European small caps, commercial property or Chinese and Russian funds. “Specialist areas were the areas of dominance,” says Mark Dampier, head of research at Hargreaves Lansdown, the brokerage.

In Europe, smaller companies held sway over other parts of the market, but their lead over large cap stocks narrowed in the year and some expect money will shift into bigger companies next year.

Philip Dicken, manager of Threadneedle’s Pan European Smaller Companies fund, the leading fund in that sector, invested heavily in engineering and industrial groups, particularly in groups doing business in Asia.

“In China, a lot of local companies don’t have the knowledge. They don’t innovate, they imitate, so these companies are a big draw for them. The reason why European small caps have done well is they have been around for decades,” Dicken says. Aveva, a software group which provides services to plants, oil rigs and power stations, and Ramirent, a Finnish group which rents out construction tools and equipment for building sites, were two favourites this year.

Interest in real estate investment trusts (Reits), set to launch on the first day of the year, inspired investors to pump money into commercial property funds. As a result, SWIP’s European Real Estate, Premier Pan European Property Share, Skandia Global Property Securities and Aberdeen Property share funds found their way into the list of the top 20 performers.

Ben Ritchie, manager of Aberdeen’s Property Share fund, says commercial property funds are seeing the benefits of “double arbitrage”. Not only did commercial property holdings rise in value, but anticipation about the introduction of Reits helped to narrow the gap between the discount of the shares of property companies to their net asset values.

As a rule, European small cap and commercial property funds eclipsed most other sectors and asset classes. But Russia and China also merit a look as Neptune’s Russia & Greater Russia and Chinese funds – both managed by Robin Geffen – fared better than most others in the past 12 months, reporting a 49.89 and 42.5 per cent return respectively.

Geffen thinks the Chinese and Russian economies are more stable than India’s or Europe’s. “They might be political systems you don’t feel as comfortable with, but they do offer a structure that creates stability and if you are investing in an emerging market, that’s extremely important,” he argues.

The number of people milling through Moscow’s stores underscores how quickly Russia is turning into a consumer-driven society. Geffen has shifted much of the fund’s big-name resource holdings into local food retailers and manufacturers, banks, brewers and mobile phone companies. “There’s a large and growing middle class and wide circulation of wealth. The increasing interest by Russians in investing in their own stock market and building up pension funds fascinates me. I still think Lukoil, Gazprom and Norilsk Nickel will continue to outperform, but my job is to find parts of the economy that are growing the fastest,” he says.

The Chinese are also looking to invest in local brands. So Geffen argues against buying shares in US multinational groups such as Coca-Cola to gain exposure to the Chinese economy. “The Chinese don’t aspire to drinking Coca-Cola at McDonald’s and the cost of their domestic beer and wine falls well below that of any drinks imported,” he argues.

Fund managers and advisers are quick to avoid making New Year predictions with any certainty given the unfounded optimisim about Japan last January. But the one tip many offer is not to follow the herd when deciding what to buy. “Whatever is most popular among private clients should make you nervous,” says Dampier of Hargreaves Lansdown.