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Superficially, Japan funds have weathered the present storm rather well, with the Topix index outperforming the FTSE All-Share during the credit crisis and sales being buoyed by those wishing to stay invested.

During the last few years, optimists have been telling investors Japan was finally the land of the rising equity market, its dark days behind it. When it comes to risk-averse and politically stagnant Japan, however, sceptics are never hard to find.

Chris Taylor, fund manager of Neptune’s £9.8m Japan Opportunities fund, says Japan’s economy, the sector and its prospects for investors are all “moribund”. He argues it is sterling’s strength that has skewed perception in favour of Japan’s performance recently, when in local currency terms the Topix was down 17 per cent compared with the FTSE All-Share’s fall of 14.5 per cent.

“The underlying conditions in Japan haven’t really changed; if anything they have deteriorated,” he says. “Throughout the last 20 years it’s been a great diversifier mainly because it keeps going down while everything else went up. After a three-year recovery it looks like it is going back to somnambulant.”

The International Monetary Fund doesn’t view the country as a “sleep-walking” monolith, however. Its mission chief for Japan, Daniel Citrin, forecasts a soft landing for the slowing economy, evading recession. He supported the Bank of Japan’s neutral stance on interest rates and said while its consumer price inflation increased by 1.3 per cent in May, the IMF’s measure of core inflation, which excludes fuel and food prices, fell by 0.1 per cent.

Japan has lingered in a deflationary environment for more than a decade. The OECD’s latest economic outlook for Japan, published in June, expects a slow increase in Japan’s underlying inflation from its zero position. Yet bearish investors such as Henderson Global Investors, in its weekly economic and market update, speak only of “rising inflation and a deteriorating labour market. The Japanese economy is heading for recession.”

Mr Taylor says the inflation argument is over-egged, stating Japan’s preference for domestic food producers over imported foods and its greater reliance on liquified petroleum gas than oil for its energy, therefore insulating its inflation rates from spikes in oil prices. Oil and commodities account for barely 1 per cent of the Topix compared with a global indices average of 12.5 per cent.

The abrupt resignation of prime minister Yasuo Fukuda after less than a year in office and the resignation of the preceding prime minister Shinzo Abe exemplifies the political instability that has dogged the second-largest economy in the world. Its inefficient use of labour, ageing population and rejection of immigration are millstones around the economy’s neck, providing little of interest for investors.

Natasha Chetwynd, manager of the £48.6m Resolution Japan fund says: “Japan can be characterised as one big job-creation scheme, where there is full employment with some people doing very little. If those people were better used, there is less of an issue. There is enormous scope for increasing productivity, such as encouraging more women into the workforce.”

The OECD says “structural reforms are needed to boost productivity” and Ms Chetwynd agrees that “Japan needs more dynamism in its economy, but I’m not sure where that will come from”. She says Japan’s well-capitalised banks and post-peak real estate appear good value at present, although she feels investors are wary of “a value trap” in Japan. She says 60 per cent of companies on Topix are trading below book value – including global brands such as Nissan – and that many of the smaller companies have no way of unlocking value, making investors sceptical about the inherent worth. “They just seem too cheap,” she says.

Many who have invested in Japan over the last 20 years have had their fingers burnt, and the “enormous internal problems within Japan”, she says, mean investors ignore bearish commentators at their peril.

Ryan Hughes, senior fund manager of the £22m Japanese Equity Blend fund at Skandia Investment Management believes Japan multi-manager funds efficiently tackle the volatility in the sector and provide diversified exposure. The multi-manager has six underlying funds, including the value-driven £576.5m Schroder Tokyo and the growth-orientated £109m Martin Currie Japan Alpha fund. “In certain markets like Japan it can be very difficult to pick funds because of access to information. It lends itself well to the multi-manager concept.”

While he feels Japan is in a key position to benefit from burgeoning Asian tiger economies, there may be a flip side: Ms Chetwynd says global giants such as Sony are losing their mantle to more efficient Asian companies. Once the lynchpin of the economy, Japan’s automotive industry has also taken a dip, with demand flagging thanks to reliable public transport and long-lasting autos curbing the public’s need to replace older models. Japanese manufacturers are locating new plants outside Japan – an indicator of how they see the country’s prospects, Mr Taylor believes.

While the average investor in Japan made a loss over one and three years, by 10.3 per cent and 7.6 per cent respectively, Mr Taylor’s fund has outperformed the sector over three months, one year and three years by as much as 20 per cent. His strategy has been to avoid exporters, automotives, financials, big consumer electronics and focus on global-leading Topix stocks and companies which are pre-2002 cheap with strong fundamentals, or which are best-in-breed in world-leading sectors. Additionally, 20-50 per cent of the portfolio is held in cash to protect against credit crisis ripples.

Anna Lawlor is deputy features editor at Investment Adviser