No. The medium-term case for holding quality remains sound, backed by healthy fundamentals, reasonable relative valuations, and quality\u2019s diversifying properties, even if the current cyclical environment is not yet fully supportive. Investors should maintain exposure to the quality factor within equities, and those that saw their allocations fall due to recent underperformance should consider rebuilding. We expect patient investors will be rewarded for maintaining exposure\u2014particularly those that implement actively and focus on businesses whose profitability is genuinely durable rather than relying on backward-looking index definitions of quality.<\/p>\n
Historically, quality has outperformed broader equities in 71% of rolling five-year periods since 1980. But that hasn\u2019t been the case lately. Quality has lagged sharply in the last two years, with the MSCI World Quality Index having lagged the MSCI World Index by nearly 10 percentage points, one of the worst two-year windows for quality in nearly two decades. The shortfall reflected strong performance from AI-linked technology names outside the quality index, including Broadcom, Micron, and Palantir, as well as quality\u2019s underweight to financials.<\/span> 1<\/a><\/sup> Within financials, banks benefited from higher-for-longer rates and more resilient credit conditions than investors expected after the 2023 banking turmoil. These dynamics were powerful, but look more like a temporary period of unfavorable market leadership than a lasting impairment of quality. The medium-term case for quality remains intact.<\/p>\n First, fundamentals remain supportive. The MSCI World Quality Index\u2019s return on equity (ROE) stands at 34.2%, near the top of its historical range and about twice that of the MSCI World Index. Broad market profitability has also risen, compressing quality\u2019s relative ROE advantage, but historically, similar compressions have often preceded reversals rather than signaling a lasting loss of quality\u2019s edge. Consensus earnings forecasts tell a similar story. The MSCI World Index is expected to grow earnings faster in 2026, but the gap narrows materially in 2027 when quality is expected to outgrow the broader index.<\/p>\n Second, relative valuations also look reasonable. On an absolute basis, developed markets quality still appears expensive, trading at roughly 25x normalized cash earnings versus a long-run median of 15.6x. But the broad market is more expensive, making relative valuation the more useful lens. Quality has historically traded at about a 33% premium to the broader index; today that premium is about 27%, well below the roughly 50% peak reached two years ago. While not a glaring discount, it does suggest a more favorable entry point.<\/p>\n Third, quality\u2019s portfolio role also remains intact. It has historically held up better in weaker economic environments and lagged in stronger cyclical expansions. That asymmetry matters in a market dominated by a narrow set of US leaders. The United States now represents about 64% of the MSCI ACWI, and the top ten companies account for roughly 24% of the index. For portfolios heavily exposed to that concentration, quality offers broader return drivers and downside protection if market leadership broadens or growth weakens.<\/p>\n These benefits depend on implementation. Many passive expressions of quality, including the MSCI World Quality Index, carry meaningful exposure to software and mega-cap tech. Traditional quality measures are backward-looking: high ROE, low leverage, and stable historical earnings do not guarantee a company\u2019s competitive position will survive disruption. Software, for example, screens well on many quality metrics, which means passive approaches may concentrate in a segment where AI could be eroding durability. More broadly, the dispersion AI is likely to create within quality\u2014between genuine compounders and companies whose durability is proving less secure\u2014strengthens the case for active management.<\/p>\n The main near-term risk is that the macro backdrop may not yet favor quality. Many quality baskets overlap with crowded mega-cap growth and AI names, leaving the factor exposed to more duration sensitivity than the broader index. Quality has historically done best heading into slowdowns or rate-easing cycles that cushion long-duration equities. A more resilient growth environment or persistently higher rates could remain a headwind.<\/p>\n Quality is still worth holding. Recent underperformance has not undermined the rationale, and we expect patient investors will be rewarded for maintaining exposure. But the payoff may not come quickly, as the cyclical conditions that typically favor quality\u2014weaker equity markets and falling rates\u2014are not clearly in place today. A more constructive tactical view would likely require either more attractive relative valuations or clearer evidence that the economic cycle is beginning to turn. The better course is to maintain exposure, define it carefully, and implement it selectively, focusing on businesses whose profitability is genuinely durable.<\/p>\nFootnotes<\/h2>