Commentary

Period ended June 30, 2010

For the first half of 2010, the Matthews Japan Fund returned –4.58%, while its benchmark, the MSCI Japan Index fell –2.65%. For the quarter ended June 30, the Fund returned –8.04%, while its benchmark fell –10.07%.

While Japan remained one of the best-performing markets in the world during the first six months of 2010, its strong rally came to an abrupt halt at the end of April, as did the rally in most other major stock markets around the globe. A combination of strong export earnings and cheap valuations for Japanese equities helped support the rally in the first quarter. However, a slowdown in China’s economy and a sudden appreciation of the yen against the euro in the second quarter drove the index lower in May and June. All major drivers of Japan’s economy slowed, including export growth, industrial production and job creation. For the country’s economy to expand, real export growth is important. Western economies—Japan’s export partners for many decades—still suffer from prolonged economic woes, however, the bright spot is that many Japanese companies are now shifting their focus from the West to the East, where economic growth is stronger. As a result, concern is emerging over the direction and trajectory of the Chinese economy as this is an increasingly important market for many Japanese exporters.

The Fund has been seeking "emerging growth" companies that are either companies with dominant market share that have recently gone public or older, more established companies that have identified new growth drivers for their business. Examples of these drivers include Asia’s growing pool of consumers with rising discretionary income and “green” technologies that address the limitations of available energy in emerging markets such as China. These drivers could lead to margin expansion and the potential for higher returns on investment. The Fund also looks for compelling valuations. Our portfolio construction is formed on a bottom-up basis, one stock at a time rather than through sector allocation. Fund holdings such as consumer firms Pigeon and Rinnai represent the Fund’s emerging growth plays, while Japan Real Estate Investment Trusts (J-REITs) are held in part for their dividend yield.

Late in the second quarter, Unicharm Petcare, one of the Fund's core emerging growth stocks was acquired by Unicharm, its parent company. Unicharm Petcare was one of the portfolio’s best performers year-to-date, however, as a result of the acquisition, the Fund will no longer participate in the company’s growth.

By sector, the Fund’s industrials holdings included both positive contributors as well as the portfolio’s two worst performers for the first six months of 2010: The Japan Steel Works (JSW) and machinery firm Kubota. JSW’s performance was negatively affected by the collapse of the euro while Kubota, an agricultural machinery company, was hampered by slower orders from China following delays in China’s farming subsidy program. Financials also yielded mixed results, though the sector itself performed on par with the market. The bulk of our J-REIT holdings positively contributed to performance. Meanwhile, Goldcrest, Kenedix and Nomura Holdings detracted from performance in part because investor sentiments toward this sector soured due to Europe’s debt issues. In addition, these three financial firms tend to be more sensitive to general market fluctuations. While the benchmark holds large pharmaceutical companies, the Fund’s exposure to the health care sector is via medical device makers, which continued to be solid performers year-to-date. One of the Fund’s new holdings in this area, Asahi Intecc, was among the health care sector’s top performers. The firm has a global market share of 20% to 25% in its main product which is used in catheter treatments for coronary diseases. Sales for this product, known as PTCA guideware, have grown at a five-year compound annual growth rate of 21% as catheter treatments are one-third the cost of open heart surgeries. While developed countries have been the main market for the product, sales to China are expected to grow.

We believe that in the years to come more innovative Japanese companies should continue to grow—either in overseas markets or within Japan. Meanwhile, companies that have not rethought their strategies will continue to be a drag on the market. In this sense, the major indices may not be a good gauge with which to track Japan’s more compelling equities. The Fund’s ability to find more interesting growth companies in the Japanese market over the last few years has been encouraging. Looking ahead, potential risks may come from Japan’s pace of export growth, particularly to Asia.

Looking ahead, the buying momentum of the overall Japanese market may not be as strong as it was six months ago due to much-improved foreign ownership during the period. However, valuations still remain attractive, and we continue to be optimistic about the growth potential of some of the country’s more progressive companies even in this challenging environment.

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 Japan Fund in the following percentages: Pigeon Corp. represented 3.6% of the Fund, Rinnai Corp. 1.9%, The Japan Steel Works, Ltd. 2.0%, Kubota Corp. 2.5%, Goldcrest Co., Ltd. 2.0%, Kenedix, Inc. 1.0%, Nomura Holdings, Inc. 1.5% and Asahi Intecc Co., Ltd. 1.9%.