Commentary

Quarter Ending June 30, 2008

During the first half of 2008, the Matthews Japan Fund was down -7.29%, while its benchmark, the MSCI Japan Index, fell –5.46%. In the same period, the Tokyo Stock Price Index declined -4.07%.

During the first half of 2008, Japan’s economy grew due to strong export demand from Asia, Europe and the Middle East. In this sense, it is safe to say that Japan is less dependent on the U.S. than it once was. However, a healthy U.S. economy is still a requisite for a healthy global economy. When the U.S. economy does recover, we believe, Japan should also benefit. During the second half of 2008, we believe that inflation will pose an even bigger issue for Japanese companies, as we expect companies will have a tough time transferring higher costs to customers. However, inflation tends to put upward pressure on wage growth, which should be positive for Japan’s domestic demand. We believe this should discourage the Bank of Japan from cutting its current 0.5% key policy rate.

During the second quarter of 2008, the Fund fell –3.23%, while the MSCI Japan Index rose 2.48%, and the Tokyo Stock Price Index gained 2.42%. After hitting a low in the middle of March, the Japanese market rallied in April and May, led by foreign buying of large-cap firms as is typically the case in major rallies. After a long absence from the Japanese market, foreign investors returned mainly to cover short-selling, and continued buying throughout the second quarter—a major factor behind the market’s relatively strong performance during this period.

The Fund’s concentration in small- and medium-cap firms held back performance during the market’s surge. More specifically, the rally in Japan’s financial sector was led by the country’s top three mega-banks: Mitsubishi UFJ, Mizuho and Sumitomo Mitsui financial groups. Our exposure in the Japanese mergers and acquisitions, wealth management and real estate industries also suffered in part because of lackluster retail investment activity stemming from a battered global economy. Contributing to the continued weakness in the small-cap arena was the dearth of Japanese retail investors in so-called emerging new markets, such as the Tokyo Stock Exchange’s Mothers market (Market of the High-Growth and Emerging Stocks) and the Osaka Hercules exchange.

Three sectors that helped the Fund's performance during the first half of the year were consumer staples, industrials and energy. Some of these companies offer exposure in consumer businesses we expect should grow, such as the Japanese pet care business and China’s baby care industry. The Fund also added holdings in the industrials sector, which have been positive for performance. The decision to add them was triggered by attractive valuations and global leadership in each sub-segment. Our presence in the energy sector also served the Fund well as a result of rising oil prices.

As for Japan’s domestic political landscape, a general election is likely to take place by the end of this fiscal year. With Japanese Prime Minister Yasuo Fukuda’s approval rating at a historic low, the market may welcome change. Company earnings should remain relatively healthy, provided there are no drastic changes in the exchange rate as most companies already discounted a strengthened yen in March, at the end of the fiscal year for Japanese firms.

Finally, we are seeing some progress in Japan’s corporate governance. While this year’s annual shareholder meetings in June did not reveal ground-breaking progress, we did note dramatically increased pressure from domestic shareholders for higher returns. Japanese companies are well-aware of greater expectations from shareholders, and have raised dividend payout ratios to almost 30% of earnings in the last fiscal year-end, along with increasing share buybacks, which accounted for about 20% of earnings. Overall, we are cautiously optimistic about the Japanese equity market going forward, with an eye on the long-term growth prospects for each holding in the portfolio.

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, Mitsubishi UFJ Financial Group, Inc. accounted for 2.7% of the Matthews Japan Fund. The Matthews Japan Fund holds no positions in Mizuho Bank, Ltd. and Sumitomo Mitsui Banking Corp.