Commentary

Quarter Ending September 30, 2008

For the third quarter ending September 30, 2008, the Matthews Japan Fund fell –14.46%, compared with its benchmark, the MSCI Japan Index, which declined –17.60%.

In relative terms, the Japanese market held up better than many other equity markets around the world during the period. A global recession obviously threatens the growth of the Japanese economy, and macro data has indicated a slower economy ahead. However, there is one clear difference between Japan and other major countries, and that is a lack of leverage. Japan’s corporate balance sheets and households have cash. Japanese companies, especially financial firms, spent years off-loading debts up until a few years ago and now appear to be fiscally healthy. For years, foreign investors have been vocal about leveraging company balance sheets to increase return on equity, but Japan has been very slow to accept this practice. Increasingly, mergers and acquisitions by Japanese companies this year have indicated more of a focus on external growth. Ironically, during the quarter we saw some of Japan’s major financial companies play a bigger role on the global financial stage: Mitsubishi UFJ took a stake in Morgan Stanley and Nomura Holdings announced it would acquire part of Lehman Brothers. The acquisitions mark a notable change from the conservative expansion strategies that have defined Japanese institutions over the past two decades.

Fund performance during the third quarter was helped by stock selection in the consumer staples and health care sectors. Our long-term holdings in medical device makers Sysmex and Terumo performed well due to consistent earnings power and growth in overseas markets. Both companies are positioned as mid- to high-end medical device manufacturers, which have traditionally been marketed in developed countries. Our recent meetings with management, however, have revealed a growing need for reliable and safe medical equipment in Asia and in developing countries elsewhere. We find this expansion very encouraging.

During the quarter the Fund increased its J-REIT exposure from 5% of the portfolio to 10%. We added a basket of smaller but higher-yielding REITs with 8% to 12% dividend yields. After a research trip to Japan, we were attracted by the average dividend yields of more than 6% for the sector. By comparison, the average Japanese dividend yield is 2% and the Japanese Government Bond (JGB) yield is 1.5%. The market has been severely punished because of the increasing risk of short-term refinancing problems in Japan’s real estate market, and we do believe some weak real estate companies, particularly condominium developers, may undergo bankruptcy in the coming months. In fact, following the end of the quarter, one of the smallest J-REITs failed. While this segment is not without serious risk, our risk/reward analysis of the REIT sector overwhelmingly favors owning this sector. We believe J-REITs are a natural home to yield-seeking retail investors in Japan as they were substantially invested in high-yielding bonds and some currencies including those of Australia, New Zealand and South Africa. The tide has changed in the last few years for those who enjoyed yen “carry trades"—borrowing at low interest rates in Japan and investing at higher rates in other countries—as interest rate spreads are declining and currencies have weakened.

Japan’s equity market appears to be more stable among developed nations, with a relatively strong outlook for the yen. As we reflect on the state of the U.S. economy during the quarter, we find it reminiscent of Japan 10 years ago. It took time for Japan to come out of its own economic downturn but now, well-managed Japanese companies look more attractive on a relative basis because of their solid balance sheets. We continue to explore the best values in Japan for this Fund.

The views and opinions in this commentary were current as of September 30, 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 9/30/08, Sysmex Corp. accounted for 3.4% of the Matthews Japan Fund, and Terumo Corp. accounted for 1.8% of the Fund. The Fund held no positions in Mitsubishi UFJ, Morgan Stanley, Nomura Holdings or Lehman Brothers.