Commentary

Period ended June 30, 2010

For the first half of 2010, the Matthews Korea Fund declined –4.18%, while its benchmark, the Korea Composite Stock Price Index (KOSPI), lost –3.77%. For the quarter ended June 30, the Fund was down –5.49% and the benchmark fell –7.13%.

During the first half of the year, Korean equities exhibited increased volatility, with the market initially in positive territory during the first quarter as the global economic recovery continued and Korean exporters recorded strong results. Entering the second quarter, the Korean market declined as geopolitical tensions increased between North and South Korea following the North’s attack on a South Korean navy ship. Despite the market volatility, however, domestic consumer sentiment remained positive during the first half of the year with department store sales recovering and confidence rising among consumers.

Among the top-performing stocks in the Fund during the first six months of the year was Seoul-based snack food manufacturer, Orion Corp. Orion is a dominant manufacturer and distributor of snack items such as biscuits, chewing gum and candies. Orion started its snack business in the 1950s and the company grew to become one of Korea’s dominant confectionary makers. In early 2000, Orion began expanding overseas, predominantly to China. It has significantly expanded its presence there, as well as in Russia and Vietnam. This year, Orion’s sales in China are expected to be larger than its domestic sales and Vietnam should account for about 25% of Orion’s international sales.

Large Korean companies such as Samsung, LG Electronics and Hyundai Motors have been strong in the global market for some time but we are now seeing small-to-medium size consumer companies with dominant domestic positions expanding into overseas markets, particularly in other parts of Asia. These firms are able to leverage both the expertise they have gained in Korea and the fact that Koreans share similar consumer tastes and cultural backgrounds with Chinese and some Southeast Asian consumers. According to the management team at Orion, the firm was able to use similar product concepts and brands to successfully penetrate the Chinese market. Superior product quality and better branding also helps Korean companies like Orion win over consumers elsewhere in Asia.

Among the biggest detractors to Fund performance during the period was LG Electronics. While LG has built a strong name, especially in emerging countries, and expanded its market share in televisions and other white goods, its mobile phone division has suffered. The company lacks a smart phone product offering and the stock price declined during the first half of the year as a result. LG is expected to launch an entire series of smart phones in the second half of the year, and we remain optimistic that the company can regain some of its lost market share and profitability in the mobile phone business.

On a sector basis, consumer-related stocks performed well while financials suffered, mostly due to a lack of clarity related to the government’s banking sector reforms. Valuations for Korean banks and insurance companies remain very attractive and financial holdings remain a major portion of the portfolio.

Looking forward, ongoing tension between North and South Korea could lead to short-term market volatility. However, we believe that, judging from prior conflicts between the two countries, tensions should not leave a long-lasting market impact. Currency volatility, on the other hand, remains a key risk for Korean companies that conduct business abroad.

The Korean won has been among the most volatile currencies in the region. In 2008, the won was the second worst-performing currency in the OECD (second only to Iceland’s krona). As Korea’s growth outlook became favorable earlier this year, the market attracted heavy flows of foreign capital, in part funded by negligible interest rates in the U.S. and other developed countries. But when the European debt crisis began, foreign investors started to sell off Korean equities, pushing the won lower.

Recognizing the recent currency volatility, the South Korean government started to devise a plan that should stabilize capital flows. In mid-June, the government set limits on the buildup of foreign exchange derivatives that are believed to influence the volatility. Foreign banks will be required to cut holdings in currency derivatives to 250% of equity capital and domestic banks to 50%.

While it is hard to assess the potential impact of this policy to the market, it should minimally impact the fundamentals of the companies in which we invest. We remain focused on identifying Korea’s long-term economic developments and companies that stand to benefit from this evolution. We believe that Korea is well-positioned to benefit as the region grows and markets recover globally.

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 Korea Fund in the following percentage: Orion Corp. represented 1.9% of the Fund. Hyundai Motor Co. 2.4%, Hyundai Motor Co., Ltd., 2nd Pfd. 1.9% and LG Electronics Inc. 2.2%.