Matthews China Fund Commentary for the fourth quarter 2014.

For the year ending December 31, 2014, the Matthews China Fund fell -4.42% (Investor Class) while its benchmark, the MSCI China Index, returned 8.26%. For the fourth quarter of the year, the Fund returned 2.11% (Investor Class) versus 7.17% for the Index.

Matthews China Fund: Market Environment

The year 2014 was a challenging one for the Chinese economy. The country has continued efforts to rebalance its economy, shifting toward further development of its domestic consumption and services, and away from a reliance on more traditional exports, infrastructure and fixed asset investments. Meanwhile, top line growth rates have slowed amid this transition.

During the fourth quarter, China’s central bank surprised financial markets by lowering the one-year renminbi benchmark interest rates for the first time in over two years, cutting its one-year lending rate by 0.4% to 5.6%. China has already taken more measured steps to stimulate its slowing economy, supporting select areas, such as small and rural businesses as well as government property projects for low income housing. However, these measures have not been sufficient. Economic indicators, from investment growth to factory production to retail sales, continued to be weak, indicating that China would likely miss its annual growth rate target of 7.5%. The latest interest rate cut boosted expectations that China would begin a new monetary easing cycle with more cuts in its interest rates and reserve ratio going forward.

Matthews China Fund: Performance Contributors and Detractors

For both the fourth quarter and the full year, the financial sector performed very well, and Fund performance was helped by our portfolio holdings in Chinese banks, insurance and property companies. However, compared with the benchmark’s nearly 42% weighting in the financial sector, the Fund had a significantly lower weighting of about 20%, which was a primary reason for its relative underperformance. While we believe China’s overall banking system does not generally pose major systemic risks, we do have concerns over the potential deterioration of the asset quality of the banks.

Detractors to performance over the fourth quarter included oil and gas-related holdings such as China Oilfield Services and Kunlun Energy. Significant oil price declines during the quarter negatively impacted these companies.

During the one-year period, the consumer discretionary and consumer staples sectors were underperformers as China has yet to see any meaningful improvement to overall weak consumer sentiment. For example, budget-focused hotel operator Homeinns Hotel Group underperformed on concerns of a supply glut and weaker pricing power. Sands China, the largest mass market gaming operator in Macau, also underperformed given more government scrutiny on gambling activity in Macau. Overall, we have been consolidating our holdings over the year, and continue to retain what we believe are best-in-class companies.

Matthews China Fund: Notable Portfolio Changes

During the fourth quarter, we continued to build positions in China’s A-share market. We added two more new names to this space, Jiangsu Hengrui Medicine and Kweichow Moutai. While Jiangsu Hengrui is the market leader in Chinese pharmaceuticals, Moutai—China’s most well-recognized premier brand of white liquor—saw challenges.

Jiangsu Hengrui possesses strong R&D capabilities and operates in the country’s attractive and rapidly growing oncology drug space. For Moutai, sales volumes recently contracted due to the government’s anti-extravagance campaign. However, its strong brand positioning has enabled it to maintain its overall profitability. We expect that sale volumes have now troughed, and look forward to any opportunities for recovery.

In the fourth quarter, we exited China Life Insurance, which has been highly correlated with the A-share market due to its investment exposure in the market. However, its core business in the life insurance sector has lagged behind that of another of our portfolio holdings, Ping An Insurance. Given our new capability to invest directly in the A-share market as qualified institutional investors, we exited the position in order to focus on the life insurance industry’s stronger players.

Matthews China Fund: Outlook

While Chinese equities rallied strongly toward the end of the year amid expectations of further monetary easing, we continue to seek more concrete evidence of an earnings recovery across sectors that will support a more sustained rally. China seems determined to continue its process of economic rebalancing, and while this may translate into slower top line growth, the quality of growth should be more solid and sustainable. We are encouraged by some initial achievements in this structural transition and continue to focus on finding good long-term investment opportunities that will benefit from this shift.

The views and opinions in this commentary were current as of December 31, 2014. 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 Fund’s 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 12/31/2014, the securities mentioned comprised the Matthews China Fund in the following percentages: China Oilfield Services, Ltd. 1.3%, Kunlun Energy Co., Ltd. 1.2%, Homeinns Hotel Group 2.1%, Sands China, Ltd. 1.9%, Jiangsu Hengrui Medicine Co., Ltd. 1.7%, Kweichow Moutai Co., Ltd. 1.8% and Ping An Insurance Group Co. of China, Ltd. 3.1%. As of 12/31/2014, the Fund held no positions in China Life Insurance. Current and future portfolio holdings are subject to risk.

Matthews China Fund Q4 2014 Letter