(Reuters) - Hong Kong and China shares suffered their biggest annual loss since the 2008 financial crisis as mounting fears about China, worries about a global recession and heightened volatility in financial markets trumped cheap valuations.

Tight monetary policy in China, concerns about bad loans and corporate governance issues saw investors sharply pare exposure to China this year, particularly in the second-half.

The Hang Seng index ended 2011 down 20 percent, roughly in line with other Asian markets but significantly underperforming the S&P 500, which is poised to finish the year little changed.

The Shanghai Composite ended the year down 21.7 percent.

On Friday, the Hang Seng rose 0.2 percent while the Shanghai Composite rose 1.2 percent.

The China Enterprises index of top Chinese firms listed in Hong Kong, the most popular route for foreign investors managing China portfolios, fell 0.1 percent, taking its losses for the year to nearly 22 percent.

The last trading day of the year was marked by low turnover with investors continuing to favour large-cap defensive utility and telecom names as data pointing to a slowing Chinese economy gave investors further reason to stay on the sidelines.

China's factory activity shrank again December as demand at home and abroad slackened, a purchasing managers' survey showed, reinforcing the case for pro-growth policies from Beijing to underpin the world's second-largest economy.

The key is what measures China implements to offset the slowdown, said a Hong Kong-based trader at an American brokerage, adding that global factors are also hurting China's domestic economy.

With China's economy on track to slow for a fourth successive quarter and global markets still dominated by headlines on Europe's debt crisis, investors in Hong Kong have gravitated towards defensive sectors, a trend that continued on the year's last trading day.

Utilities Hong Kong & China Gas Co Ltd and CLP Holdings Ltd both rose 0.8 percent, while telecom major China Mobile Ltd ended the day 1.2 percent higher.

China's no.2 operator China Unicom was the year's top performing blue-chip, rising 46.7 percent.

Chinese consumption companies Want Want China Holdings Ltd and Tingyi (Cayman Islands) Holding Corp, the latest inclusions to the Hong Kong benchmark index, were among the weakest performers, falling 1.4 and 1.3 percent, respectively.

European retailer Esprit Holdings was the worst performer this year, with almost three-quarters of its market cap wiped out.

The Hang Seng Index is closing the year trading at about 9.2 times forward 12-month earnings forecasts, according to Thomson Reuters I/B/E/S, representing a 25 percent contraction in valuations over the past year.

Earnings expectations have come off sharply with analysts, on average, forecasting 12.5 percent growth in earnings next year compared with an over-30 percent growth projection last December.

While conditions in the early part of next year are likely to remain volatile, analysts expect to see a turnaround in the second half.

The positive news is that the government will gradually shift to policy easing and market liquidity may improve, CICC analysts said in a note, adding, however, that the key to next year's performance would be whether the easing was enough to offset the negative impact of weakening fundamentals.