Commentary

Year ended December 31, 2009

For the year ending December 31, 2009, the Matthews Asian Growth and Income Fund generated a return of 41.44%, while its benchmark, the MSCI All Country Asia ex Japan Index, rose 72.53%. During the fourth quarter, the Fund gained 4.24%, versus a 6.59% increase in the benchmark. Over the course of the year, each share of the Fund paid approximately 44 cents, or about 3.8% of the Fund’s initial share price, in income via semi-annual dividends.

Just as 2008 was a year in which financial markets defied nearly every expectation, so was 2009. The breathless pace at which stocks and other financial assets regained a portion of their nominal value was remarkable. Also remarkable was how quickly economic activity in Asia—particularly in China—resumed an expansionary path.

For some market observers, the surprise of the year was that the Chinese economy did not collapse amid a Western recession. Earnings growth seems to again be underway in Asia. However, while fundamental conditions have improved, they have been eclipsed by a sharp increase in stock prices. Yields on Asian fixed-income markets are near historic lows, and equity prices are not far from record highs, leaving a reduced margin for error. Looking forward, relatively high valuations may pose a challenge to the continued outperformance of Asian equity markets.

The Fund’s strategy has been sorely tested over the past two years. Historically, the Fund has made use of U.S. dollar-denominated convertible bonds to achieve a degree of capital protection when conditions were adverse for equities. However, dollar credit markets were at the epicenter of the financial collapse in late 2008; consequently dollar-denominated convertibles in Asia offered no safe haven. As markets rallied violently in the first half of 2009, the Fund’s risk-averse strategy meant that the stocks it favored—those of established, mature companies capable of sustained dividend payments—were not central beneficiaries of the market’s recovery. Instead, premiums were assigned to the stocks of riskier businesses, small companies and deeply cyclical industries. Amid such conditions, the Fund’s recent performance was largely in line with our expectations, with some notable disappointments in Japan.

Some of the Fund’s largest gains in 2009 resulted from portfolio shifts undertaken at the outset of the year. One critical decision was to place greater weight on the technology sector, especially on companies in the computer and semiconductor industries. A year ago, such companies suffered from severely depressed valuations despite stable financial positions and relatively attractive growth prospects. Ironically, while the market perceived many of these companies to be financially weak, few had much debt. With strong balance sheets and reasonably stable cash flows, some semiconductor and computer-related firms have become substantial payers of dividends. Ultimately, two such companies made the largest contribution to the Fund’s performance: ASM Pacific Technology, one of the world’s largest manufacturers of assembly and packaging equipment for semiconductors, and VTech Holdings, a leading maker of cordless phones, as well as educational electronics and video games.

The Fund also benefited from a shift toward industrial conglomerates, particularly those with underlying exposure to energy and agricultural products. Historically, the Fund has eschewed direct investment in such businesses as their sharp cyclicality makes it difficult to value or to assess the quality of their management. However, at the beginning of 2009, we recognized a number of industrials that had seen precipitous declines in their share prices. Their common denominator was indirect or diversified exposure to energy and commodities. This was attractive, as the diversified nature of these companies could yield consistency in cash flow, thereby shielding the portfolio from the worst aspects of the commodity cycle. We added a few such positions, notably Singapore’s Keppel Corporation, one of the largest offshore oil rig builders in the world. We were attracted to Keppel for its secure balance sheet, with cash reserves and a manageable level of debt; and for its diversified operating structure that offered exposure to property and infrastructure projects alongside the oil industry. Keppel is also one of the largest dividend-paying companies in Singapore, paying out approximately US$385 million in dividends during 2008 (the firm has not yet declared final dividends for the 2009 financial period).

Other positions, such as convertible bonds, contributed mixed results to Fund performance. Some of the Fund’s positions performed in line with our expectations, gaining as credit markets stabilized and as their underlying conversion values rose. However, some of the convertibles issued by small and mid-size companies were hampered by continued distress in credit markets. Capital markets were not disposed toward issuance in the first half of the year; and thus, smaller companies faced some challenges when attempting to refinance their balance sheets. However, issuance has recently resumed in earnest and will hopefully lead to healthier future supply and valuations in convertibles.

The greatest detractor to performance arose from the Fund’s exposure to the Japanese market. At the beginning of the year, the Fund held two positions in large-capitalization Japanese real estate investment trusts (REITs)—Japan’s large-cap REITS underperformed small-cap REITS in 2009. It also held a position in one of Asia’s largest software companies by market capitalization, Trend Micro. Over the course of the year, the Fund added three other positions in sectors spanning pharmaceuticals, technology and industrial equipment. Collectively, these investments have done little to promote the Fund’s performance and have cost us the opportunity to invest elsewhere in Asia.

The Fund’s roughly 10% weighting to Japan is at a historic high. We strongly believe that value in select Japanese companies—especially mid-size industrials and technology companies—is compelling. Admittedly, Japan may lack an obvious catalyst to spur broad-based market performance. Nevertheless, as the country’s stock market has stagnated over the past two decades, investors have overlooked a number of companies. Most of these firms are global leaders in a given technology or marketplace, and most also enjoy substantial operating leverage should an economic recovery ensue. A few have taken to paying dividends, with some growth visible over time. Though such companies are worthy of strong consideration, we, nevertheless, do not intend to actively increase the Fund’s weighting in Japan as we believe this to already be a substantial allocation.

As we look forward, a number of risks present themselves for the year ahead. As mentioned previously, relatively rich valuations may prove an impediment to continued gains. If inflation in the region does resurface, we believe that it will have a pronounced effect on staples, food and subsidized forms of energy. The Fund has sought some exposure to this possibility via its positions in agricultural and soft-commodity companies. A third risk may arise from the increased propensity for trade tensions, which may likely be directed toward China and its currency policies. If tensions escalate, stock markets may be shaken.

However, ahead of all these risks is the Fund’s greatest challenge: to continue to refashion and adapt its strategy in light of the region’s ever-evolving markets. Despite its caution, the Fund has always pursued growth; and indeed, there are new growth industries emerging in Asia, especially in health sciences, software and financial services. Thus, the Fund’s mission for the next decade is the same as the last: to retain its conservative philosophy and approach, yet probe emerging pockets of growth, investing in areas not well represented in benchmark indices or widely present in investors’ portfolios.

The views and opinions in this commentary were current as of December 31, 2009. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Funds' future investment intent.

Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.

As of 12/31/2009, the securities mentioned comprised the Matthews Asian Growth and Income Fund in the following percentages: ASM Pacific Technology, Ltd. represented 1.3% of the Fund. VTech Holdings, Ltd. 1.4%, Keppel Corp., Ltd. 2.1% and Trend Micro, Inc. 1.5%.