Commentary

Quarter Ending June 30, 2008

For the six months ending June 30, 2008, the Matthews Korea Fund lost –24.09%, while its benchmark, the Korea Composite Stock Price Index (KOSPI), declined –21.12%.

The Korean equity market faced various obstacles during this period, including a weakened currency, high inflation and dampened consumer sentiment. A weak currency is generally positive for exports, and as the Korean won has fallen against the U.S. dollar, Korean exports have remained strong. Auto-related sales were up 9.2% for the first half of the year, compared to a year ago. However, a steep currency depreciation does more harm than good to the economy, particularly in light of high energy costs. South Korea’s recent challenges have also involved falling currency reserves and rising short-term foreign currency debt. Inflation has negatively impacted domestic consumption, which is already at a low. Foreign investors continued to sell Korean equities during the first half of the year, and foreign ownership in KOSPI-listed securities fell to a low not seen since about 2001. The combined effects of a weaker won and record oil prices kept South Korea’s current account balance—the country’s broadest measure of trade—at a deficit for the first six months of the year.

Hopes for positive change were high with the late-February inauguration of President Lee Myung Bak, a former chairman of Hyundai who was welcomed by Korea’s business community. President Lee pledged to cut taxes and speed up deregulations to encourage investment and boost economic growth. But just months after taking office, Lee’s administration met with backlash over a U.S. beef trade deal that the public felt could expose them to mad cow disease. Following extensive public protests in May, President Lee amended the import deal, publicly apologized for not being more sensitive to concerns and reshuffled his cabinet. Despite his efforts, however, the beef issue remains largely unresolved and demonstrations continued into June.

The second quarter did, however, see some notable progress with South Korea’s neighbors to the North. In June, North Korea made a gesture toward dismantling its nuclear program by demolishing a cooling tower at its main nuclear reactor. The action was welcomed by nations involved in multilateral talks with North Korea. In particular, the U.S. government said that it would lift some economic sanctions against the isolated country, and remove it from a U.S. State Department list of state-sponsored terrorism. The moves seem to be encouraging steps that could signal greater regional cooperation.

During the second quarter of the year, the Fund trailed its benchmark primarily due to its positions in financials, particularly in brokerage firms, as well as in consumer sectors. The weak equity market and an increase in the number of new brokerage licenses continued to dampen the outlook for the brokerage industry. Weak domestic consumer sentiment and slow growth in real disposable incomes hurt the consumer sector. The Fund’s small-cap exposure also detracted from performance during the first half of the year. Small-cap companies are typically more volatile than large-cap companies, and premiums enjoyed by small-cap firms were eroded during the period’s weak equity environment. Additionally, some small-cap companies suffered currency woes as most did not anticipate the won’s rapid depreciation. However, we remain committed to these firms and their long-term prospects.

On a company basis, the biggest contribution to Fund performance came from LG Electronics, which benefited from stronger-than-expected mobile phone sales, and diverse exposure to emerging markets. LG has been a pioneer in emerging markets, such as China and India, and currently dominates market share in the appliances segment of several of these markets. During the first half of the year, Samsung Electronics also held up well, benefiting from the expected recovery of the memory chip industry and market share gains in the mobile phone handset market, especially in the U.S. Generally, large-cap companies fared better than small- to mid-cap companies during the downturn.

The Fund’s worst performers during the period were Samsung Securities and Kiwoom Securities, which faced intensifying competition in the domestic brokerage business. The overall profitability of the industry declined as competition to attract new clients intensified amid the weak market environment. Though the financial sector has suffered from an unclear regulatory environment, intensifying competition and subdued domestic sentiment, it still holds one of the most attractive valuations in the region, particularly in banks and brokerage firms. We believe that our financial holdings in the Fund are well-positioned to benefit once the sector recovers from currently unfavorable conditions.

In recent years, the Korean equity market has been led by segments of the industrials sector. This has been due in part to limited supply capacity and increasing demand from emerging countries. While the margin expansion of some industrial companies has been impressive, it is hard to believe that the current margins are sustainable in the long term, especially given increasing capacity within the emerging countries. We have evaluated long-term investment opportunities within the industrials sector, especially in the components and specialized parts industries, but the Fund continues to underweight industrials compared to its benchmark. The Fund continues to maintain overweight positions in the consumer, financials and information technology sectors. We believe that in the long term, these sectors will create sustainable value and returns for shareholders.

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, LG Electronics accounted for 1.9% of the Matthews Korea Fund, Samsung Electronics accounted for 8.5%, Samsung Securities Co., Ltd. accounted for 2.5%, and Kiwoom Securities Co., Ltd. accounted for 1.8% of the Fund.