Mutual funds that invest in Japan have blossomed. The average Japan stock fund soared 32.8% in calendar 2005, and registered an average annualized gain of 27.2% over the three-year period. This buoyancy emanates from optimism over the September re-election of Prime Minister Junichiro Koizumi, a political victory that pushed up Japan’s equity markets nearly 20% in the fourth quarter alone.

The buoyant Japanese economy is also finding support from significant corporate restructuring, a reduction of bad loans in the banking industry, rising property values, easing deflation, an improving domestic economy, the possible privatization of the huge national postal savings system, and a mountain of cash flowing in from foreign investors. Japan was the top-performing developed market in 2005, and observers seem confident this economic recovery can sustain itself this year.

One of the best mutual funds in the category, the $1.97-billion Fidelity Japan Smaller Companies Fund (FJSCX) focuses on the small-cap space of the vast Japanese market. Manager Kenichi Mizushita keeps a large, diversified portfolio–over 200 holdings–with information technology (23.6%), industrials (23.5%), and consumer discretionary (22.8%) representing the dominant sectors. It is believed that such consumer-oriented companies should benefit greatly from the resurgence of Japan’s domestic economy and personal spending.

Launched in late 1991, the $377-million T. Rowe Price Japan Fund (PRJPX) has been around long enough to weather most of the country’s lengthy bear market. Lead manager M. Campbell Gunn stays with a larger-cap bias–the fund’s median market cap is about $7.5 billion. As such, top holdings include such well-known companies as Canon, Mitsubishi, and Toyota Motor. The portfolio’s largest sector, financials at 24.8%, is well positioned to bloom under an increasingly improved picture of reduced bad loans and healthier balance sheets.