I do quite a bit of fansubbing im not an encoder so someone correct me if im wrong on some parts but ill shed some light on this. Also i realize my consistency in thought sucks and so does my wording so forgive me for that.
Firstly~ VLC sucks don't use it. Use MPC. If you need help setting it up ill help you on irc. As far as fonts go If its mkv file you can change them yourself. Grab a program called Aegisub and you can change it to your liking. That will make a .ass file you can use later. Softsub and turn off the mkv fonts. Fonts also are not supposed to be colorful. If they are they are distracting to the viewer in most cases. Although in some cases it is good if it blends into the background. If you don't notice the subs but still read them the font style is doing its job. Better to be a bit plain that to be bad and out of place. As far as not having them show up on your psp that is because its mkv. mkv is a container that holds sub file fonts audio and video files. So your psp may be able to read the video and audio in the mkv but not the font file in it. People do this because 1. Hardsubbing is bad it ruins the picture quality in most cases unless your a good encoder. 2. Its faster and easier to do and everyone loves fast good subs. 3. The viewer can change it themselves if they do not like the subs. If the fonts you see are bad try a different group. The more well known groups normally have better fonts with a few exceptions.
Hardsubbing went out of style long ago. The reason the op and ed are hardsubbed is because almost no PC can handle AFX karaoke. If it moves or changes color it will be hard on your pc. Frames will be dropped and overall making it more a nuisance. Signs are hardsubbed for this reason and because of some limitations in vsfilter (Which i dont understand so i wont try to explain it, Ask a typesetter or encoder) Some typesetting is able to be subbed yet im not sure what kind. (I think its anything but /t and muti line, don't worry about it) Some of the good looking font is created by mixing 3 or more styles and laying them on top of each other. Makes font look very nice but is hard on some pc's so that is hardsubed. Some groups hardsub for no reason because they support dvd burning or because they dont want people to steal their subs.
As far as putting subs on your psp try this.
http://forums.animesuki.com/showthread.php?t=47693
Turning the file into mp4 should do the trick and will do its best to keep quality. AVI has strict limitations so I wouldnt suggest that if you wanna keep quality but if its your preference then use it.
That's what I miss about AVI files. I just fail to see the point of H264 anime. It is a waste of time, and space to have anime MKV files. AVI was easier and just more convenient. *shrugs*
I dont want to criticize you but PLEASE PLEASE PLEASE explain this to me. My reaction to this is the same as when I found out the Chinese cap to avi and not to .ts or .mn2ts. H264 provides a higher quality video and picture than xvid. AVI has strict limitions that mkv does not. MKV is limitless it can hold just about anything while avi can not. H264 MKV gives higher quality picture and faster subs while AVI just loses quality and takes longer.
TL;DR Softsubbing is more convenient
And for all you font stylers out there. Your font should look like this http://www.ji-hi.net/k-on/CoalGuys/09-dialog4.png
Not like this http://www.ji-hi.net/k-on/Aasasubs/09-dialog4.png
Dont complain about DVD subs looking like they do. Thats a limitation in the dvd format itself not the companys fault. Dont blame them blame the world for not producing new technology.
Once again I apologize for my horrible wording of ideas. If anyone needs playback help of mkv Come on IRC and I will assist you.