Commentary

Period ended June 30, 2010

For the first half of 2010, the Matthews China Fund declined –2.55%, while its benchmark, the MSCI China Index, dropped –5.98%. Chinese shares accelerated their decline in the second quarter amid investor concerns over inflation, overheating in the property market and growing labor costs. For the quarter ended June 30, the Fund was down –5.26%, while its benchmark was down –4.48%.

After a strong performance in 2009, Chinese equities were weak during the first half of 2010. While China’s GDP grew at 11.9% in the first quarter, investors focused more on signs of economic overheating as inflation rose to over 3% and property markets also continued to increase. In addition, the increasing cost of labor became the latest issue as foreign joint ventures in China have been forced to raise salaries substantially amid growing labor unrest at their factories. China has sent clear messages that it will not allow its economy to grow at a pace that is out of control, and the government has been rolling out various tightening measures to moderate the growth. So far, loan growth has slowed, policies aimed at tightening property markets seem to be taking effect and China’s latest currency moves may help curb inflation over the long term. It seems likely that China may achieve a “soft landing” toward the end of the year, with economic growth gradually slowing and inflation under control. However, uncertainties, including a worsening of the European debt situation and a sharp decline of Chinese exports, still exist. We are also cautious on the overall quality of bank loans and expect to see some deterioration in nonperforming loans going forward.

During the six month period, both the Fund’s overweight and stock selection in certain sectors, such as consumer discretionary, consumer staples, information technology and industrials, helped it outperform its benchmark. Our cautious moves in the financial sector enabled us avoid the steep declines experienced by banks and property companies. In the second quarter, our more defensive positions in utilities and mass market retailing served us well during the volatile market environment. Conversely, our relative underweight in telecommunications services was a detractor to performance as China Mobile performed strongly in the first half of the year. While China Mobile is one of our largest holdings, our weighting in it is much smaller than that of the benchmark.

We added two new stocks to the portfolio during the second quarter that illustrate how we seek to capitalize on emerging long-term growth trends in the domestic market: Digital China Holdings and Sands China. These two companies represent some of the developments in China’s rapidly growing service industry and are reflective of China’s new consumer behavior. Digital China is one of the country’s leading information technology (IT) firms focusing on distribution and IT services. China’s demand for IT services has grown as companies move up the value chain and improve productivity. As the number one IT vendor in China, Digital China’s top clients include local governments, major state-owned enterprises and foreign multinational companies. The company is developing rapidly in the IT services arena, leveraging its huge client base and strong research and development facilities. Sands China operates resorts and casinos in Macau, which has already surpassed Las Vegas to become the largest gaming market in the world. Sands China is changing the landscape of Macau’s gaming market by offering Las Vegas-style casinos. It has already achieved market share of more than 20% and is one of the strongest players in Macau.

Over the history of the Fund, we have been following the evolution of consumer patterns in China and seeking companies in their initial stage of growth that we believe will benefit from the coming consumer trends. When we first launched the Fund in the late 1990s, Chinese consumer demand centered mostly on basic necessities such as white goods and home improvement products. The average per capita income was approximately US$800 at the time. Today, the average income has increased to nearly US$3,000. With rapid growth in income levels, Chinese consumer demands have gradually shifted toward higher-end luxury products, banking and insurance services, health care, education and information services. Over the years, the Fund’s investment focus in consumer areas has also shifted, from white goods to personal computers, cell phones, banking and insurance companies and technology services firms. In this changing environment, we will maintain our consumer-focused approach to investing in China.

The views and opinions in this commentary were current as of June 30, 2010. 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 6/30/2010, the securities mentioned comprised the Matthews China Fund in the following percentages: China Mobile, Ltd. represented 3.3% of the Fund. Digital China Holdings, Ltd., 1.1% and Sands China, Ltd. 0.6%.