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If the last two years have taught us anything, it's that markets hardly ever do what we expect them to. Shares in rotten companies aren't supposed to soar. Asset classes like shares, bonds and commodities do not generally move in tandem. And highly-remunerated fund managers are supposed to beat passive trackers. This year, more than most, showed that past performance is indeed no guide to the future!
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Nevertheless, here's our take on what fund investors might expect in 2010. We've broken it down into geographical regions.
UK - combine income & growth
The economic outlook is miserable, but Standard Life Investments suggests you should keep a heavy weighting to UK equities, because the stock market is supported by favourable valuations. In addition, a high percentage of the UK market's earnings are derived from overseas earnings, in particular, the FTSE 100 where this accounts for more than 50 per cent of earnings growth.
Ted Scott, strategy director at F&C UK, says investors should combine growth and income fund exposure because if the bull market continues, defensives will not offer much intrinsic growth, but late cyclicals that haven't rallied hard yet, will. He expects a short-term correction in which financials and general retailers are likely to underperform.
In terms of performance, Mr Scott expects income funds to do a bit better than growth funds because most income stocks underperformed in 2009. Exchange-traded funds (ETFs) and trackers may also do well if larger companies outperform.
Robert Pemberton, investment director at HFM Columbus, also expects a good performance from UK equity income funds which hold high-yielding, defensive large caps. "Given that we expect sterling to come under pressure next year, diversification into overseas equity income funds, like Newton Global Higher Income Fund and Ignis Argonaut European Income Fund, is a sensible option," he adds.
Other UK funds worth looking into:
• Schroder Income Fund for its strong long-term performance record.
• Edinburgh Investment Trust, managed by Neil Woodford, and likely to prosper in next year's market conditions, but cheaper than his open-ended funds.
• db x-trackers FTSE 100 ETF - easy access to large caps with a competitive total expense ratio (TER).
Europe - head north, avoid ETFs
Investors may be encouraged by France and Germany's early recovery from recession, but problems remain, particularly in southern Europe, underscored by rating agency Fitch's decision last week to downgrade the sovereign rating of Greece.
The best performing European funds over the last year have tended to be focused on northern Europe, and many managers argue that funds in this area tend to benefit from a bottom-up approach to stock selection. "This is a good reason not to get exposure to Europe via an ETF," says Martin Bamford, managing director of independent financial adviser (IFA) Informed Choice.
Despite risks such as exporters' vulnerability to euro appreciation and a sharp slowdown in global trade, Standard & Poor's reports that many Europe fund managers expect further market upside, in particular, in France and Germany. Large-cap managers also highlight the number of multinationals listed on European markets, which make a large proportion of their earnings outside Europe and have little exposure to this region, although these are vulnerable to a strong euro.
European fund managers also argue that Europe is better placed than the US for a recovery, as there are more cyclicals in its markets, and European stocks remain cheap relative to their US peers.
European funds to bet on:
• BlackRock European Dynamic boasts a strong long-term performance.
• Cazenove European for its geographical flexibility, which is important in the current environment, and its consistent performance.
• SR Europe Investment Trust, capital growth without neglecting income. This fund offers exposure to emerging Europe and boasts a strong long-term performance.
US - a surprise on the upside?
The US could surprise on the upside and investors should maintain exposure here, as the US equity market is supported by easier monetary and fiscal policy, argues Jeremy Tigue, manager of Foreign & Colonial Investment Trust.
The US is coming out of recession quicker than the UK and third-quarter corporate profits have been better than expected. This could be reflected in equity income next year, as Standard & Poor's initial S&P 500 dividend estimate for 2010 is $23.67 - 6.1 per cent higher than 2009.
Healthcare stocks are cheap, but could rally after US healthcare reforms are concluded in the coming months. Another area with low valuations which could do well is tech stocks, according to Tom Walker, whose mandates include the Martin Currie North American Fund (factsheet here) and North American Alpha Fund (factsheet here). He says there should be strong demand growth coupled with more capital expenditure, and large caps such as Apple, Google and Hewlett Packard featuring in his top 10 holdings.
But beware of a short-term correction in the first half of 2010, says Simon Dorricott, analyst at Standard & Poor's Fund Services. He adds that if US quantitative easing stops this could also temper markets, most likely in the second half. Consequently, some of the retail funds distributed in the UK, such as the Standard Life American Equity Unconstrained Fund (factsheet here ) , whose fund managers have demonstrated strong stock picking skills, have received an A rating.
Other US funds to watch in 2010:
• Neptune US Opportunities - top of its sector over the long term, with a good manager in Felix Wintle.
• iShares MSCI North America replicates, net of expenses, the MSCI North America Index. This ETF has delivered sector outperformance, and is cheaper than its active managed peers.
Japan - a contrarian play?
Japan is currently unloved by many investors, but could prove to be the ultimate contrarian play. Mr Tigue argues that even a slight improvement in sentiment among foreign investors and increased buying of shares could create a stock market rally, as currently the Japanese market is largely held by domestic investors.
Investment manager Ashburton has also recently refocused its Asia Pacific Equity Fund to concentrate solely on equity growth in Japan. This was done to ensure that the fund does not overlap with Ashburton's China and India funds, but also because Japan is expected to surprise positively among the high growth economies in the rest of Asia.
Japan bulls also cite increasing trade with growing Asian countries such as China, benefiting Japanese services companies as well as green technology companies, as factors playing in this economy's favour. If the Yen weakens - as expected - this would offer a further boost and Japanese firms could enjoy the highest prevailing rate of earnings expansion globally, says Chris Taylor, manager of the Neptune Japan Opportunities Fund. He adds that Japanese companies are also becoming more shareholder-friendly, with increasing dividends and share buy-backs.
Valuations, in general, are low following a market fall towards the end of the year, partly due to negative sentiment towards the new government. UK investors could benefit doubly from this by investing in a Japan investment trust, as these are also running at discounts to their net asset value (NAV). However, historically, returns from open-ended Japan funds are better. Others argue in favour of an ETF because it can be difficult to beat the market.
However Standard Life Investments is advising investors to "stay very light" in terms of Japan exposure, given the threat to profit margins by deflation and limited policy response from the government.
Japan funds to watch:
• Neptune Japan Opportunities - for its strong outperformance of sector peers.
• iShares MSCI Japan ETF - as many active managers in this space struggle to outperform the market.
• Schroder Japan Growth - an investment trust which has consistently outperformed the sector - its wide discount presents a buying opportunity.
Emerging markets - set to soar
Emerging markets seem set to be one of the growth stories of 2010, but most fund managers agree that it is not exports which lie at the heart of this story, as was initially thought, but rather the rise of the domestic consumer.
Ewan Thompson, manager of the Neptune Emerging Markets Fund, comments: "While the outlook for infrastructure, materials and manufacturing remains very positive in the medium term, we believe that moving into 2010 the most exciting investment opportunities will be found in the consumer sectors across emerging markets."
Chris Palmer, Gartmore's head of global emerging markets, expects corporate earnings growth to drive emerging markets in 2010. He says: "We estimate that earnings will grow by 25 per cent in 2010 compared with the price/earnings ratio of 13 times as of October 2009. At the same time, the return on equity from emerging market companies is over 40 per cent higher than that of the MSCI World Index."
Mr Palmer believes that, while the market rally of the past few months was characterised by an initial rebound from depressed levels of valuation, the next phase will be driven by growing corporate profits. Companies that can finance their growth through their own cash flows will have a key advantage - and here emerging market companies with their lower debt levels have the upper hand over their developed world peers.
While most financial advisers tend to favour generalist emerging markets funds, as these spread the risk across different geographical areas, Bryan Collings, manager of the Ignis HEXAM Global Emerging Markets Fund, believes country allocation will be crucial going into next year. He says: "Country allocation is as important as ever. By the end of 2010, we expect China, Russia and Turkey to have delivered strong returns. Growth in China could be much higher than 10 per cent, despite the central bank's pre-emptive attempts at monetary tightening."
With China set to continue its dominance in the emerging markets sphere, Anthony Bolton's imminent move to Hong Kong to manage a new portfolio dedicated to investing in China and China-related opportunities could be one fund to watch in 2010. While Fidelity keeps mum over whether the fund, expected to be launched in March next year, will be available to retail investors - Mr Bolton's impressive track record, together with the strong case for China, will certainly make this a compelling investment proposition.
Mr Pemberton says that, while 2009 saw the economic balance of power tilting even further towards Asia and the emerging markets, valuations are starting to look a little stretched and any corrections can be quite savage. But, as he believes exposure on a long-term basis is essential, he recommends buying on pullbacks. "First State Asia Pacific Leaders Fund and JPMorgan Emerging Markets Fund are good solid choices, while Allianz RCM BRIC Stars is a higher octane fund choice," he says.
Other emerging market favourites:
• Aberdeen Emerging Markets Fund - one of the top sellers on the Hargreaves Lansdown Vantage platform, this fund remains a favourite on the open-ended side, thanks to its diversified focus across high-quality companies.
• Templeton Emerging Market - one of the oldest investment trusts offering exposure to emerging markets investment trust and managed by industry veteran Mark Mobius, this fund continues to outperform.
• Barclays Wealth Emerging Markets Optimiser - for exposure to emerging markets without putting your capital at risk. The closing date for this structured product is 28 December.
See also: Onwards and upwards for ETFs
For more fund data, see our fund data tool...
Read more articles about funds on our funds and finance page...
While there is a strong case of emerging market funds going into 2010, analysts believe managers of UK-based emerging market funds will face stiff competition from early 2010 when offshore-domiciled funds are included in the UK's Investment Management Association (IMA) sectors.
An analysis of Lipper data by HSBC Global Asset Management and Baring Asset Management shows that in each of the main emerging market categories (China, India, Latin America and global emerging markets), the top three performing funds over the past year have been based in either Luxembourg or Dublin, rather than the UK.
This outperformance trend is also clear when analysing three-year performance statistics. Over this 36-month period, the top performing funds in the China, India and Latin America sectors were offshore funds. The exception was the broader emerging markets sector, where the top performing fund was domiciled in the UK. (All data to 30 October 2009, source Lipper.)
David Chellew, head of market position at HSBC Global Asset Management, comments: "This change could see the emerging markets peer group expand significantly, introducing a whole new range of leading funds and managers. This increased visibility of offshore funds will level the playing field."
Investors are likely to be spoiled for choice as the number of funds available in some sectors increase substantially. Of funds with a track record of one year or more, there are approximately five times as many offshore funds as UK domiciled funds. For example, there are 31 UK domiciled funds in the UK Global Emerging Markets sector compared with 166 funds in the same peer group offshore. Within each of the India, China and Latin America sectors, there are less than five UK domiciled funds, but more than 35 offshore funds under each category.
Offshore funds to be added to the IMA's ranking will have Financial Services Authority (FSA) approval, which means investors will pay capital gains tax (CGT), currently at 18 per cent, as opposed to the 40 to 50 per cent tax imposed on the sale of shares in offshore funds that are not FSA approved. However, UK-domiciled funds generally tend to have lower total expense ratios (TERs) than overseas domiciled funds, which will often also charge performance-related fees.
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