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On the face of it, Japanese Smaller Companies is the least attractive IMA sector. Medium-term performance has proved little short of disastrous. Over one year to 26 August, the funds in the sector have lost 25.4 per cent. Over three years, they have lost 38.6 per cent. As Japan again flirts with recession, the time to invest is almost certainly not now.

But over the longer term, the picture starts to brighten. Over five years to 4 September, according to Financial Express, the MSCI Japan Small Cap index returned 22.7 per cent – still less than 38.9 per cent for MSCI Japan, but well into the black. From 2 August 1999 to 4 September 2008, performance dipped to 8.7 per cent for MSCI Japan Small Cap. This is still a considerable improvement on the 6.2 per cent loss you would have made if you had invested in MSCI Japan directly.

Magnus Spence, chief operating officer of Dalton Strategic Partnership, which has a £44.1m Melchior Japan Opportunities fund, observes Japanese smaller companies are simply extremely cyclical. Between September 2003 and January 2006, for instance, MSCI Japan Small Cap shot up over 110 per cent. Mr Spence cites a number of key reasons for why its stocks wound down so tortuously to present levels.

“Towards the end of 2005, they were getting overvalued,” he says. “Second, we had a lot of corporate scandals in the sector. Third, there has been an asset allocation shift. Investors can get a much greater return from the Greater China markets if they want riskier holdings in the region.”

Far from decoupling from the US sub-prime crisis, he observes, Japan has been battered even further. The drain on the capital markets has obliterated the brief fashion for J-Reits and left small property firms battling for financing and survival.

But despite the short-term noise, Mr Spence says the result is a longer-term buying opportunity. “Valuations are on a 33-year low. Earnings growth is still real and in some cases is a hell of a lot better than the market as a whole. Japan is never going to be loved by international investors in the current climate, but at the end of next year, it will bounce very strongly. Investors who are prepared to time that will make a huge amount of money,” he predicts.

According to Mr Spence, Japanese smaller companies court investors more effectively than larger Japanese corporations and are often headed by younger, more dynamic management. They also stand to benefit from Japanese expertise in fashionable areas such as energy efficiency. “At the slightly wackier end of the spectrum, the Japanese are incredibly good at making small things. Nanotechnology should play to their strengths.”

Japanese smaller companies are also a play on wealthy Chinese consumers, who are penetrating deeper into the market for high-end local fare such as electronic goods and cars. There are also select opportunities in domestic markets, Mr Spence adds. “If you take the returns, we all know CPI is dead in Japan, but there has been a shift to niche retailers.”

This varied longer-term potential is roughly confirmed by the active management community that Dalton inhabits. Despite this, the Japanese Smaller Companies sector contains just eight portfolios, all less than £150m in size. The average comes in at just £40.2m, the smallest of any IMA peer group.

The top performers over 36 months to 26 August, the £11.4m Swip Japanese Smaller Companies and £125.2m Baillie Gifford Japanese Smaller Companies funds, have each underperformed MSCI Japan Small Cap over one, three and five years to 4 September. But between 2 August 1999 and 4 September 2008, the Swip fund gained 31.3 per cent against 8.7 per cent for the index. Admittedly, the Baillie Gifford fund lost 22.9 per cent over that period, but the Swip fund proves outperformance is at least possible, if not universal.

Swip has been disarmingly honest about these results. “Destroyed” is the word Nick Duncan, the firm’s investment director, uses to describe short-term smaller company performance. Like many an investor in the country, he has seen foreign money withdrawing steadily from the market, leaving progressive downgrades in its wake.

“The hedge funds were playing a lot in the smaller companies market in 2005. They’ve been reducing their money. The retail investors have been pulling out as well,” he says. “Last year the market was rational in a sense. This year you’re seeing a wholesale derating in the asset class, irrespective of fundamentals. We do a lot of fundamental analysis, but the fundamentals don’t matter at the moment.”

Mr Duncan only sees overseas capital returning to smaller companies when the economy hits a point of maximum pain. Swip’s own generalist £8.3m Japanese fund has very little small-cap exposure at present. But as the peer group is currently trading on mid to high single-digit p/e ratios, he feels there is potential for it to return to favour. The time to start preparing for investment is now, he says, as valuations could bottom out in the next three to six months.

Mr Duncan sees sector-specific opportunities in technologies such as clean energy and fibre optics. In the telecoms sector, Swip’s smaller company manager, Kaori Ishii, has backed this up with a 760 basis points overweight in information technology. But Mr Duncan warns active managers are only likely to profit from the rebound provided they diversify their portfolios adequately. “You wouldn’t want to have stock-specific risk in any one firm.”

For UK investors, the top-10 names in Ms Ishii’s portfolio will be a good deal less familiar than Sony or Toyota. It is unlikely even many active managers have heard of Cocokara Fine Holdings, Samco, Uyemura, Daihatsu Diesel, MEC, Hokuto, SAN-A CO, Ozeki, Osaka Securities Exchange or Nippon Seiki. But just as that has not turned UK investors off weighting more to emerging markets, it may not prove a problem if Japanese smaller companies bounce next year.

Nick Rice is chief reporter at Investment Adviser