THERE has been a lot of chatter about the dollar lately. The pointy heads in the economics profession seem to be growing increasingly strident about the possibility of a collapse in the US currency.

Cheaper dollars might be good news for anyone who takes holidays across the Atlantic, but it is less fantastic for investors. One group that could be hit particularly hard are those who have been riding the extraordinary recovery in Japanese smaller-company funds.

Japan’s hesitant recovery hangs in large part on the yen remaining competitive against the dollar. A dollar collapse would hit many smaller companies which are directly or indirectly dependent on exports.

A glance at the TrustNet website, which compares fund performances, shows that three of the top 20 unit trusts and open-ended investment companies over one year are Japanese-orientated. Melchior Japan Opportunities, Invesco Perpetual Japanese Smaller Companies and M&G Japan Smaller Companies are all currently focused on the smaller end of Japan’s stock market.

The one-year performances have been stellar, ranging from Melchior Japan’s 29 per cent to Invesco Perpetual’s 32 per cent. That, however, has to be put in context. Anyone who has held M&G’s fund over the past five years has at best got back to roughly where they started, while Invesco’s investors are still down by about half.

Returns have not been helped by Japan being in recession for much of the period since 1989. The hope is that the nadir was April last year, when the stock market started a robust rally, led by smaller companies.

John Hatherley, of M&G, the fund management group, says that Kenichi Ura, manager of its Japan Smaller Companies fund, was boosted by a mixture of “value plays and niche technology companies”.

Since the summer, however, the following wind seems to have died and performance is now down to the stockpicking skills of the fund manager, Mr Hatherley says.

The big question is whether managers of Japan funds have those skills. Magnus Spence, of Dalton Strategic Partnership, the firm behind Melchior Japan, believes that some do — even if he is none too sanguine about the bigger picture.

“Overall, we are not particularly bullish on Japan, nor have we been for the past three years,” he says. “But if you are prepared to believe that there are areas of the Japanese economy that are leading not just their own economy but the world, then there are some interesting areas in which to invest.”

Mr Spence cites companies such as Access, which develops browsers that allow third-generation mobile telephone users to surf the internet. The shift to mobile technology is akin to the move from mainframe to personal computers in the 1980s, he maintains.

But Tony Roberts, a manager on the Invesco Perpetual Japan fund, is much less gung-ho on the prospects for smaller Japanese companies. He highlights the improbably named Topix Mother’s index, which groups a number of Japan’s new economy stocks. “A lot of the companies seem very young and there seems to be a mania in Japan again in the internet space,” he says.

Bloomberg figures suggest that the average earnings multiple for the index’s constituents is a heroic 243 times.

Even the more staid “metal bashers” on the Topix Second Section, which covers smaller companies, look vulnerable if Japanese exports are hit, Mr Roberts suggests.

That could happen if the dollar melts down, but Antonio Villarroya, of Merrill Lynch, thinks that the Japanese authorities will do their utmost to prevent it. He argues that recent signs of economic weakness in Japan will increase the pressure on the Government and the Bank of Japan to support the dollar.

So the jury remains out on Japan and its smaller companies. The best that can be said is that, on the law of averages, a 13-year recession should prompt a recovery that lasts more than 19 months.

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