Commentary

Quarter Ending March 31, 2008

For the three months ending March 31, 2008, the Matthews Japan Fund declined –4.19%, while its benchmark, the MSCI Japan Index, dropped –7.75%. The Japanese market, measured by the Tokyo Stock Price Index, slipped below 1200—its lowest level in the past three years. Meanwhile, the yen rose more than 10% against the U.S. dollar, the sharpest quarter-to-quarter rise since the third quarter of 1999.

Performance during the first quarter was strengthened by stock selection, particularly within the consumer discretionary, consumer staples and information technology sectors. On the other hand, the Fund’s stock selections within the health care sector were a drag on performance for the quarter.

Reflective of a weak market, defensive sectors such as consumer staples and utilities performed well, whereas health care, one of the more defensive sectors, held back the Fund’s performance mainly due to the lack of a new drug pipeline. During the quarter, the financial sector, surprisingly, performed in line with the market, despite ongoing problems in the U.S. mortgage and credit markets.

Inflation has become a problem globally as basic commodity prices have skyrocketed, and Japan has not been able to escape this. The difference, however, is that this is a welcome trend in Japan as prices of most day-to-day items rose for the first time in as long as 10 to 30 years, depending on the product. Remarkably, milk prices, for example, saw their first price hike in nearly 30 years. As a result, February’s core consumer price index rose 1.0% year-over-year, marking the highest year-to-year rise in the last 10 years. The apparent increase in inflation suggests that Japan’s crippling era of deflation may finally be coming to an end.

During the quarter, the Fund initiated several new positions including two notable global large-cap firms. We added Toray, a leader in the carbon fiber industry and Fanuc, well-known in the field of robotics and factory automation. As with many quality Japanese stocks, valuations for these companies became quite attractive, and presented themselves as unique investment opportunities.

Toray is a global leader in the production of carbon fiber, for which there is an expected increase in applications. Because the material is so lightweight yet incredibly strong, there is a growing demand for it in industries including aviation and automotives. These industries are seeking more fuel-efficient materials in light of higher oil prices. The Fund took advantage of the company’s weak stock price caused by news of production delays of a new Boeing 787 aircraft, which will use the company’s carbon fiber in its wings and body.

Fanuc, a leader in the design and production of robots used in factories around the world, has seen the rapid automation of auto plants in Asia as a growth driver. A third of Fanuc’s total company sales now come from Asia, excluding Japan. The company maintains an operating margin of more than 40%, which is unmatched by its peers or any other global manufacturer. Fanuc also has a significant amount of cash on its balance sheet, as well as strong cash flow.

Japan, in our view, stands to be a clear beneficiary of the Asian growth story for a long time to come. Just as many of the global companies in the West have shifted their focus to emerging economies across the globe, many Japanese companies are shifting from a U.S.-only focus to doing business within Asia as well as the Middle East.

The views and opinions in this commentary were current as of March 31, 2008. 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 3/31/08, Toray accounted for 1.6% of the Matthews Japan Fund and Fanuc accounted for 1.8% of the Fund.