Matthews China Fund

Period ended 31 March 2012

Performance figures discussed in any of the Fund Manager Commentaries reflect that of the Institutional Accumulation Class Shares (USD).

For the one-year period ending 31 March 2012, the Matthews China Fund returned -8.83%, while its benchmark, the MSCI China Index, returned -12.65%. Volatility among Chinese equities remained high during the period as the stocks were swayed by their own set of macroeconomic events including weak domestic economic data and worries over a hard landing. During the first two months of 2012, stocks posted gains as investors were encouraged by signs of easing monetary policy and an improved global economic outlook.

The most important economic events during the period were the government’s efforts to fight inflation and the continued decline of inflation during the second half of the period. This decline was in line with government expectations, which allowed authorities to shift monetary policy toward further easing. In February, the central bank cut the bank reserve ratio by 50 basis points (0.50%)—its second cut since November.

For the 12-month period, the Fund saw negative returns from nearly all major sectors except utilities, health care and telecommunication services. For the first three months of 2012, the Fund benefited most from holdings in consumer discretionary and information technology, both of which were overweight the benchmark. Hotel, casino and education-related companies continued to post strong growth and momentum. Conversely, consumer staples holdings were among the biggest detractors to Fund performance, as we maintain an overweight in this sector. While some service-related consumer stocks performed well during the most recent quarter, we continued to see an overall slowdown of retail activity within the country. Department stores, supermarkets, apparel makers and airlines have all reported weak sales data over the past two quarters. We believe the tighter economic policy that China carried out for most of last year was the main cause.

We made some small changes to the portfolio during the period, exiting some industrial sector positions. Earlier this year, we initiated a position in China Mengniu Dairy, a producer of milk, ice cream and yogurt, and one of China’s largest dairy companies. China’s dairy industry is one in which we believe long-term growth potential is strong. The industry famously underwent some product safety and quality issues some years back and is still under consolidation as a result. We believe that as a leader in the field, Mengniu should benefit from further industry consolidation.

One recent banking sector concern has centered on the issue of local government funding in China. In late February, we dedicated time on a research trip to further evaluate this financing platform, and found assurance in the legitimacy of some of the projects funded via this channel. The projects had reasonable cash flow for debt repayment, and we found that new lending through these vehicles was reasonably limited.

Although there are signs of stabilisation in property markets throughout many Chinese cities, monetary tightening polices should continue to be in place for some time. Property markets may still come under pressure, but it appears that leverage in the property market is very low. Despite some persistent skepticism amongst commentators, overall, we continue to believe that a hard landing in China is unlikely and economic activities will gain momentum as monetary policies gradually ease.