* Recent asset flows into Japanese funds may reverse
* Stock plunge likely erased chunk of 1-yr fund returns
* Cheap Japan stocks also offer opportunities -fund managers
HONG KONG, March 14 (Reuters) - The plunge in Japanese shares threatens to arrest a nascent revival of investor interest in the country, after wiping out a big chunk of Japan-focused equity funds' one-year returns.
Some of the $1.5 billion that flowed into the funds such as Fidelity's Japan Advantage fund and Nomura's Japan Brand Equity fund over the past three months, may reverse course as investors weigh the economic impact of the country's worst disaster since World War Two.
The resurgent interest, after $3.2 billion of outflows from the funds last year, has been put to test by the 8.9 magnitude quake and the ensuing tsunami, which may have killed more than 10,000. Japan has also been grappling with radiation leak from an earthquake-damaged nuclear power plant.
"The market will be very cautious about buying Japanese shares even though the value of Japanese shares are attractive after falls," said Hiroshi Arano, adviser at Mizuho Asset Management in Tokyo.
"The market will see the condition of the actual state of the Japanese economy over the next two to three months, before making any concrete decision."
The benchmark Nikkei average slumped 6.2 percent on Monday. The massive selloff on the Tokyo Stock Exchange wiped out some $287 billion from the market's value on Monday.
That drop could have sharply cut into the 4.4 percent average return made by Japan-focused equity mutual funds in 2010 and the 4.9 percent gain during the first two months of 2011, data from Thomson Reuters Lipper showed.
The slump could have also hurt Japan-focused hedge funds, which posted their best annual returns in five years last year, rising 8.3 percent, data from fund tracker Eurekahedge showed. Their return up to end-February in 2011 stood at 3.3 percent.
The nuclear crisis has worsened the outlook, some said.
"The Japanese economy is still fragile, so markets may take all of this quite hard, at least until we have more clarity into the true state of affairs inside the reactor," Kirby Daley, senior strategist of Newedge's prime brokerage unit, which provides services to hedge funds, said in Hong Kong.
While hedge funds could have theoretically survived the slump better than long-only funds through hedging, a prime broker said not many were hedged to the extent they would have liked.
"Nobody would have ever known that the extent of the damage was this huge," the Tokyo-based prime broker said.
However, one hedge fund manager likely to have benefited from the slump in the Japanese stock market is Hugh Hendry, partner at London-based Eclectica Asset Management.
Hendry said in January that he had gone short Japanese industrials by buying credit default swaps on a basket of stocks to guard against a slowdown in Chinese economic growth. Eclectica declined to comment.
The damage caused by the earthquake is potentially greater than the initial estimate on Friday and at worst, forecasts from some economists suggest the world's third-largest economy is in danger of slipping back into recession. [ID: nLDE72D0QZ]
Fund managers said it could have serious implications for sectors such as tourism, semiconductors and chemicals in Japan but a sharp drop also makes cheap Japanese shares a buy.
Even before Monday's drop, more than half of Japanese firms traded below book value, while the MSCI Japan Index traded at more than a 20 percent discount to its 10-year median forward price-to-earnings ratio, a reason to invest for value investors.
"The plunge in the Japanese market today could be the worst following the quake. We're planning to add some shares at dips," said Jiang Yi-chien, manager of Prudential Financial's Japan-Korea Fund in Taipei.
Also giving hope to investors is history.
A 6.8-magnitude earthquake in Kobe in Japan killed 6,400 in January 1995 and erased 2 percent of Japan's gross domestic product. Yet Japan's GDP for the whole of the first quarter of 1995 rose at an annualised rate of 3.4 percent.
"A few days into an initial market sell-off can often offer good entry points at near-term lows," said Joshua Smith, a senior product specialist at RCM Asia Pacific.
"Today, the Japanese market is under-owned and has become the least expensive market measured, say, on a price-to-book basis." (Additional reporting by Antoni Slodkowski in TOKYO, Faith Hung in TAIPEI and Sinead Cruise and Laurence Fletcher in LONDON; Editing by Muralikumar Anantharaman)