Commentary

Year ended December 31, 2009

For the year ending December 31, 2009, the Matthews China Fund gained 78.30%, outperforming its benchmark, the MSCI China Index, which rose 62.63%. Strong momentum for Chinese equities continued in the fourth quarter, with the Fund advancing 11.89%, versus the benchmark gain of 9.56%.

After performing poorly in 2008 amid the widespread global financial crisis, Chinese stocks staged a robust comeback in 2009, and China demonstrated that its economy can be driven by internal growth, rather than relying on exports. Although official numbers have yet to be released, China should be able to achieve its goal of maintaining GDP growth of 8% for the year. Fixed-asset investments and consumption were key drivers of China’s growth; however, the traditionally important export sector became a drag on growth. China’s US$590 billion stimulus program played a key role in boosting the economy through various areas of infrastructure, and the purchasing power of Chinese consumers that was triggered by the program was quite impressive. Domestic demand in areas ranging from automotives to luxury goods, electronic appliances and real estate recovered rapidly during the year.

China’s increasing internal growth bodes well for the Fund, which has long held overweight positions in the country’s consumer-related sectors in anticipation of growing domestic consumption. This year, the strategy was particularly rewarding. The Fund’s holdings in the consumer discretionary, consumer staples, information technology and financials sectors contributed the majority of the portfolio’s gains.

One investment criteria for the Fund’s domestic-oriented holdings is that they are either a leader in their industry or have the potential to be a leader with impressive brand recognition. Although the Chinese consumer sector offers strong growth potential, it is also very competitive and, in many cases, fragmented. Only industry leaders with strong branding are most likely to survive. One of the Fund’s holdings, Ports Design, has become one of China’s most recognized high-end fashion brands. Originally a lesser-known Canadian manufacturer of women’s and men’s clothing and accessories, Ports Design entered the Chinese market in the early 1990s. The company hired top international designers—based overseas— imported all its raw materials from Europe and positioned itself as a luxury brand. The company manufactures all its products in China with a high level of quality control. As an early entrant to the country, the firm gradually built up its brand name through advertising placements, sponsorships and store openings in prime locations in major Chinese cities. Today, Ports Design enjoys a high profit margin and exemplifies the rewards to shareholders of successful brand building.

In the financial sector, China took some noteworthy steps during the year to further open its capital markets to both domestic and foreign investors. A NASDAQ-style exchange for start-ups was launched in Shenzhen, opening up a new source of funding for entrepreneurs. China is also actively preparing to create an international exchange that would enable foreign companies to be listed domestically in the country. Meanwhile, China continues to be one of the most active places for initial public offerings (IPOs), providing investors more opportunities with its expanding stock market universe. A total of US$55 billion was raised through Chinese IPOs on both domestic and overseas markets during the year and the Fund participated in several of them.

An IPO we invested in was Sinopharm Group. For years, the Fund has sought investments in China’s growing health care industry—a sector in which it can be difficult to find solid companies. The public offering this year of Sinopharm Group—China’s largest pharmaceutical distributor with a total market share of about 11%—caught our attention. We were impressed by the company’s strong domestic distribution networks and successful track record of acquisitions. We continue to look for other leaders in the health care industry to add to the portfolio.

While the Fund’s main focus is growth, we are also cautious about valuations and strive to ensure that we are not overpaying for this growth. The Fund became more aggressive in building its consumer and financial holdings; in particular, we took advantage of a sell-off in the stock market in late 2008 and early 2009 to add to property-related companies. Toward the end of 2009, after our consumer holdings posted strong gains, we started to trim some of these positions and switched our focus to companies in industries such as telecommunications and infrastructure. Valuations in these lagging industries are relatively cheap while growth prospects remain intact. We also started to build positions in companies that we believe should benefit from the global economic recovery, including Li & Fung, a global apparel supply chain manager, and China Merchants Holdings International, a conglomerate that operates container and cargo terminals, port transportation and container manufacturing.

As we enter 2010, the Chinese central bank raised its reserve ratio by 50 basis points (0.50%) for the first time since June 2008, sending a clear signal about government concerns over inflation and an overheating economy. China’s economy expanded 8.9% in the third quarter of 2009, even as the bank lending that drove its recovery slowed. While economic growth continues to accelerate, China seems to be keenly aware of the negative side effects of excessive financial liquidity that has mostly resulted from its earlier stimulus program. We believe that the central bank will continue to fine tune its expansionary policy and seek moderate loan growth while managing inflation. Drastic tightening measures are not expected to occur in the near term as policymakers have reaffirmed a moderately loose monetary policy.

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 China Fund in the following percentages: Ports Design, Ltd. represented 1.6% of the Fund, Sinopharm Group Co., Ltd 0.8%; Li & Fung, Ltd. 2.2% and China Merchants Holdings International Co., Ltd. 2.3%.