Investment funds that focus on foreign equities started the new year with very strong returns in January, according to preliminary data released today by Morningstar Canada.

Ten of the 42 Morningstar Canada fund indices posted returns greater than 2% for the month, all of them representing equity categories that invest primarily outside Canada.

“Twenty-one of the 23 developed markets that make up the MSCI World Index posted gains in January,” said Morningstar Canada fund analyst Philip Lee, in a news release. “The index, a gauge of global equity markets, rose 1.8% (in local currency terms) for the month. Notably, the U.S. equity markets continued to roll as data showed signs that the world’s largest economy will likely experience a soft landing instead of a recession. This boosted global equity funds because U.S. equities represent a substantial chunk of their assets.”

Fund categories specializing in small and mid-cap stocks generally outperformed their large-cap counterparts last month. The U.S. small/mid cap equity fund index had the third best return among all fund indices with a gain of 3.5%. Directly behind with a 2.9% return was the global small/mid cap equity fund ondex.

The best performing fund index for the month was health care equity, gaining 3.8%. “The health care sector can be volatile and is driven by events such as new drug developments and merger and acquisition activity,” Lee said. “One of the sector’s heavyweights, Abbott Laboratories, announced that it is selling its diagnostics business to GE for US$8.1 billion in cash.”

In second place with a 3.6% gain in January was the fund index that tracks the tiny real estate equity category. Real estate stocks did particularly well in Canada last month, as evidenced by the 6.4% gain by the S&P/TSX capped real estate ondex. With just 10 distinct fund mandates and $785 million in assets, this is the smallest of Morningstar’s equity-based fund categories.

The U.S. equity fund index started the year with a 2.6% gain, as stronger-than-expected economic indicators helped stocks south of the border. This led the Federal Reserve, the U.S. central bank, to leave its key interest rate unchanged at 5.25% on the last day of the month. “Stocks promptly rallied after the Fed’s announcement,” Lee said.

The European equity fund index, last year’s third best performer with a 33.7% gain, also had a strong showing in January, up 2.2% thanks in part to growth out of Germany and the British pound’s 1.3% gain against the Canadian dollar. Among the other major equity categories, global equity gained 2.1%, international equity was up 2%, Asia Pacific Rim equity advanced 1.2% and emerging markets equity grew by 0.8%.

Continuing the trend set out in 2006, Canadian equity funds in general lagged behind their non-Canadian peers last month. The purely domestic and large-cap focused Canadian equity fund index gained 0.8%, matching the return offered by the S&P/TSX 60 index. Meanwhile, the Canadian anchored equity fund index, whose funds are permitted to hold as much as 50% of their assets in foreign-based holdings, fared better with 1.5%. Canadian small and mid cap funds followed the global trend by outperforming their large-cap brethren, though the gap was less pronounced with domestic funds; the Canadian small/mid cap equity fund index gained 1.6% for the month.

Overall, 37 of the 42 Morningstar Canada Fund Indices made gains in January, with each of the five holdouts representing fixed income categories. The worst of these was Canadian long duration fixed income, which lost 0.6% for the month. The only other negative results for January belonged to Canadian inflation-protected fixed income (-0.3%), Canadian core fixed income (-0.3%), global fixed income (-0.1%) and Canadian short duration fixed income (-0.1%).

Final performance figures will be published next week.