Commentary

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Quarter Ending June 30, 2008

During the first half of 2008, the Matthews Asian Growth and Income Fund declined –8.04%, while its primary benchmark, the MSCI All Country Asia ex-Japan Index, fell –21.10% and the MSCI All Country Far East ex-Japan Index dropped –18.21% during the same period. On June 25th, the Fund paid a semi-annual distribution of approximately 68 cents per share, of which about 25 cents represented income, and 43 cents was capital gain.

During the second quarter, markets around the world, and especially in Asia, continued the slump that commenced earlier in the year. Asian shares were hit particularly hard, by a dual set of headwinds: inflation and energy prices. Throughout the region, inflation measurements suggest that price increases for most goods and services are running at levels not seen in a decade. Meanwhile, high and rapidly rising prices for oil, coal and other resources have given markets pause. Energy prices have risen to such levels as to prove daunting for many Asian governments, several of which have been forced to abandon energy-related subsidies for consumers for fear of incurring enormous fiscal liabilities.

The twin difficulties of inflationary pressures and high oil prices put central banks in the region in an awkward spot. Most central banks have half-heartedly tried to quell inflation by raising interest rates or by other means. However, most banks have moved cautiously, as there is considerable concern that high oil prices, against the backdrop of what may be a slowing global economy, might temper Asian growth and demand. The fear that such central bankers share is that as they act to reign in inflation, they will do so at a time when the growth of their respective economies may already be drifting lower—and thus their actions could initiate or aggravate a downturn in growth.

Such fears weighed heavily on markets, as they discounted the likelihood of rising rates and the possibility of slower growth. The Fund was unable to escape such downside in markets. However, we are generally pleased that the Fund’s defensive nature is reflected in its relative outperformance for the period. We have for some time now been wary of valuations in the region: fundamental growth in the region has been strong; but after five years of nearly uninterrupted gains in share price, very few segments of the market offered the sort of low valuations that this Fund seeks as a means to shelter financial storms. However, despite these general concerns, we have remained fully invested throughout the recent cycle, without retreating to cash.

We remain fully invested for two reasons. First, at Matthews we strongly believe that it is often impractical to attempt to time market cycles, and thus we adopt a discipline of being fully invested over longer horizons. Second, during market volatility such as the present, it is important to return to the original investment premise: that is, it remains an exciting time to be a long-term investor in Asia’s economic evolution. This is particularly true now when the Fund has begun to identify a handful of new opportunities emerging as a result of the market’s contraction.

One such opportunity came in the form of a convertible bond issued by a smaller company called FU JI Foods. FU JI is engaged in the industrial catering business in mainland China. In its large-scale, centralized kitchens, it has the capacity to prepare 1 million meal sets per day, and deliver to canteens and cafeterias in corporate parks throughout the country. Though FU JI"s business model is relatively simple, it represented the emergence of yet another new industry in China, unique to the current landscape, but comparable to businesses overseas. Efficiency, hygiene and cost pressures are forcing the market to transition away from sub-scale “mom and pop” caterers to industrial players. FU JI is the largest such caterer in the country, and yet it has less than 1% share of the national market. Despite its small size, and the substantial competition it faces in the market, FU JI enjoys profit margins vastly superior to those of comparable caterers in Europe. In order to finance its growth, the company issued a Chinese renminbi-denominated convertible bond, a relatively rare instrument in the Asian landscape, and one in which the Fund has established a small position. Convertible bonds, such as the one issued by FU JI, illustrate the Fund’s aim: to discover investments that trace the evolution of Asia’s markets, yet offer some downside protection even amidst volatility.

The Fund’s experience has been mixed amidst the market’s decline. For several years now, the Fund’s largest exposure has been to SK Telecom, South Korea’s largest and most profitable mobile phone company. Unfortunately, the position has been one of the largest detractors to performance so far this year; its shares have stumbled due to increasing regulatory burdens at home, and some misfiring investments abroad. Yet we remain convinced of the company’s strong fundamentals, particularly its strong cash flow, which in turn underwrites an attractive dividend on the company’s shares.

Meanwhile, the Fund has taken up the largest sector exposure to technology and light manufacturing it has had in several years. A number of companies in such industries have seen their valuations depressed on perceptions of a cyclical decline in growth. Yet we have added several such companies to the portfolio, having found them to be well-run, to offer strong cash flow, and to have strong balance sheets. These new positions have performed marginally to the Fund’s benefit in the short-run. More importantly, however, we believe that such companies will be well positioned to trace the rise of consumer demand in Asia, whether for electronics or manufactured goods. It is this evolution that is at the heart of the Fund’s construct, and what makes us enthusiastic long-term investors in Asia, despite what are currently rocky markets.

The views and opinions in this commentary were current as of June 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 6/30/08, FU JI Food and Catering Services Holdings, Ltd. accounted for 1.5% of the Matthews Asian Growth and Income Fund and SK Telecom accounted for 2.9% of the Fund.