Commentary

Period ended June 30, 2010

For the first half of 2010, the Matthews China Dividend Fund gained 1.56%, while its benchmark, the MSCI China Index, declined –5.98%. For the quarter ended June 30, the Fund fell –1.06% and the benchmark declined –4.48%. In June, the Fund made its inaugural semi-annual distribution of 12.07 cents per share.

Chinese equity markets were volatile during the first half of 2010 as investors found reason to fret about the potential impact of a bubble bursting within the real estate sector, rising inflationary pressures and the potential for a “hard landing” in terms of slowing GDP growth. The Chinese government is facing the difficult balancing act of maintaining sufficient fiscal and monetary stimulus to ensure ongoing economic growth, without having it result in inflation within both the general economy and asset prices. This balancing act became apparent during the first six months of the year as the government tried to put the brakes on the real estate sector in which rising prices in larger cities increasingly made affordability an issue. The government imposed directives in quick succession in an attempt to dampen speculative activity, both by banks, developers and property buyers. For buyers, minimum down payment requirements were increased from 20% to 30% for second homes, and in some localities, loans for third homes were no longer available. The real estate sector is important to the Chinese economy, as it provides jobs, generates tax revenues and constitutes an important part of the banking sector’s loan book. It is also a cornerstone in the creation of a consuming middle class.

A needed upgrade of China’s housing stock combined with ongoing urbanization underpins the structural demand for housing. To attract capital to the sector, asset values will likely have to appreciate over time. However, appreciation in excess of household purchasing power creates affordability issues. Given the scale of the structural shortage of housing in China and the above-mentioned balancing act, the volatility surrounding the real estate sector is likely to continue for years to come. The Fund is currently achieving exposure to this structurally important sector via holdings in Hong Kong and Singapore due to the greater degree of transparency compared to that of mainland banks and developers.

During the second quarter, the “de-pegging” of the renminbi (RMB) and rising wages in China’s manufacturing industries underscored the rationale for Fund’s focus on investing in companies that cater to the domestic household. In effect, these developments amount to a transfer of wealth and purchasing power to Chinese workers from consumers in countries that import Chinese goods. With currency appreciation, Chinese companies with dollar-denominated input costs can purchase greater quantities of raw materials for the same amount of RMB. The Fund will continue to focus on domestically oriented companies.

The Fund’s holdings within the health care sector continued to be the main contributors to performance year-to-date. On a capitalization basis, the Fund’s investments in small- and medium-size companies contributed most to performance. The Fund invests extensively in companies with a market capitalization of less than US$5 billion since such smaller firms often have higher dividend growth potential. The Fund tries to complement this exposure with holdings in larger companies in an effort to balance growth in dividends, with the potential for greater stability and higher yields often offered by larger firms.

We, like other foreign investors who do not invest in Chinese A shares but are trying to achieve liquid exposure to RMB-denominated assets, often must do so via proxies. China Mobile, China’s largest telecommunication company and the Fund’s second-largest holding is one such proxy. China Mobile encapsulates the scale of the Chinese population and few companies can match its ability to generate RMB-based cash flow. The company has about 550 million subscribers, who pay about $11 a month on average in subscription fees. Annually, the company generates US$31 billion in cash flow from operations, while it has US$34 billion in net cash on the balance sheet. Even after spending US$17 billion on capital expenditures and US$7 billion in dividend payments, it still has an excess of US$6 billion. The company does, however, face ongoing challenges from downward trending subscription fees. Because China Mobile is a state-controlled enterprise, ultimately, the government’s interest takes priority over minority shareholders. The Fund generally tries to steer away from state-controlled companies and instead invest in companies run by entrepreneurs in which rising profits are the main objective. However, with a market capitalization of US$200 billion, a listing in Hong Kong and an ADR (American Depositary Receipt), the company offers liquid exposure to an asset with the potential to generate growing RMB earnings. Furthermore, the company trades at a dividend yield of 3.5%, making it a prime candidate for the Fund.

The first half of 2010 underscored the longer-term attractiveness of investing in Chinese dividend-paying companies that have a domestic orientation. These companies stand to benefit both from potential currency appreciation as well as the rising purchasing power enjoyed by households as wages increase. These will be important structural factors underpinning both earnings and dividend growth over the long term.

There is no guarantee that a company will pay or continue to increase dividends.

TThe 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 China Mobile, Ltd. represented 4.8% of the Matthews China Dividend Fund.