Quality on the Back Foot: What happened and implications going forward

Why invest in Quality and what is it?

Quality as a style of investing has typically been associated with three outcomes – outperformance versus the broader market over the long-term, a smoother path of returns with lower volatility, and greater resilience in in periods of market distress.

The definition of what constitutes a Quality company is more subjective and less easily defined compared with investing with a Growth or Value approach. In general fund managers with a Quality approach look to invest in companies with strong balance sheets, lower levels of debt, higher profitability and less volatile earnings.

Different interpretations of “Quality” largely reflect differences in opinion around whether current measures of Quality can be sustained into the future. For this reason, fund managers that apply a Quality approach tend to incorporate forward looking qualitative considerations alongside historical quantitative metrics. Examples of these more subjective considerations include whether a company has a competitive advantage, operates with barriers to entry within its industry, has brand recognition and pricing power.

What has happened Quality?

In recent years Quality as a style of investing has delivered returns at odds with its long-term outperformance. Quality has been lagging the broader market since 2021 with the performance gap widening in 2025.

The graph below shows the relative twelve-month rolling performance of MSCI World Quality versus the MSCI World. In 2025 Quality experienced its largest drawdown in 20 years, underperforming the broader market by over 10% before rebounding slightly towards the end of the year.

Figure 1: MSCI World Quality vs MSCI World

Source: Bloomberg.

This underperformance of Quality was seen across all regions globally, though there were differences in terms of the magnitude of underperformance. Outside of the US, Quality underperformed the broader Developed World ex-US index by 20% over the last three years^₁, one of its worst ever drawdowns. This can be explained in part by the strong performance of cyclical and value-oriented sectors such as Financials, Materials and Industrials in Europe and Emerging Markets. Companies in these areas have higher debt levels and greater cyclicality in their profits, characteristics that Quality oriented portfolios generally avoid.

In the US the underperformance of Quality has been more muted. Many of the largest index constituents in the US within the Technology sector score highly on quality metrics such as return on equity, profitability and low leverage. A notable example of this is Nvidia whose share price rose by 36% in 2025. In the US, Quality has a greater overlap with the AI theme that led the market last year.

Why has Quality underperformed?

The underperformance of Quality accelerated post the April 2025 market lows as market participants adopted a risk-on position that persisted throughout the rest of the year. Analysis from Willis Towers Watson indicated that market volume in the US became increasingly driven by retail and short-term traders as shown below. These market participants trade more on sentiment and short-term momentum signals rather than on an assessment of the fundamental value of a company.

Figure 2: Retail and short-term trader activity

Source: Willis Towers Watson, data for US equity volume by market participant as of 30/09/2025

The high level of retail, short-term oriented trading activity translated in strong returns for objectively lower quality stocks, many of which have neither revenue nor profits. The chart below starkly illustrates this, showing how speculative behaviour led to outperformance from poor quality companies in 2025.

Figure 3: Low Quality rally in US markets

Source: Willis Towers Watson, average performance of companies in each category (2025 total return, US dollar terms. The Y axis for the graph highlighted is “US dollar % return in 2025”)

While the high level of retail participation and short-term, momentum driven trading contributed to the underperformance of Quality last year, there were other significant factors causing this. The imposition of tariffs by the US turned out to be less damaging than those announced on “Liberation Day” but there remained considerably uncertainty around tariff levels and frequently announced changes by the US administration. Quality companies tend to be those that have achieved success in expanding beyond their domestic markets and are more vulnerable to US tariff uncertainty as a result. The decline in the US dollar relative to the euro and Japanese yen also created headwinds for exporters from these regions.

Difficulties in Software and Healthcare

In 2025 we witnessed the continued underperformance of companies in the Software and Healthcare sectors. Both sectors are considered to possess the types of attributes favoured by quality investors and account for a meaningful allocation in Quality indices and active portfolios. In recent years there have been sector specific headwinds leading investors to question the sustainability of their quality characteristics.

The Healthcare sector has long been viewed as possessing durable Quality attributes. These include the recurring nature of healthcare earnings supported by favourable demographics, advances in drug development, and a growing addressable market in Emerging Markets from rising gross domestic product GDP²per capita growth. Throughout 2025 however, policy uncertainty around drug pricing reform dominated the healthcare sector, particularly in the US. The sector is also considered to be much more vulnerable to tariff uncertainties given the global nature of healthcare companies’ supply chains and sources of revenue. Other factors included government funding cuts in the US, negatively impacting those companies that provide infrastructure for drug trials and that are engaged in vaccine development.

Meanwhile the Software sector is viewed by many as facing an existential crisis from the threat of disruption from Artificial Intelligence (AI). Software companies were historically viewed as high margin, low capital intensity businesses with high levels of contractually based recurring revenue. The growing threat from AI as an alternative solution to managing data has led to sharp declines in share prices across the sector. The ability of AI to write code is seen by many as reducing barriers to entry leading to increased competition for incumbent software providers. A recent research note from Goldman Sachs compared the disruption facing the software sector as comparable to the impact on the newspaper industry when advertising moved online in the early 2000s.³

Implications for investors?

The market environment for Quality companies has been particularly challenging over the past year for the reasons outlined. However, we believe that there is merit in investing in companies that demonstrate the types of characteristics that quality stocks possess. In our view it is unsustainable that highly indebted companies that are currently unprofitable can continue to outperform those companies that have a track record of consistent earnings generation and generate sufficient cashflow to support future growth in their business.

What the market environment last year confirmed to us is the importance of combining historical quantitative metrics with forward-looking qualitative considerations. There have been numerous examples over time of companies and sectors that enter secular decline, dating as far back to the demise of the horse drawn carriage industry in the early 1900s due to the mass adoption of the automobile.

For these reasons we favour an active approach to investing in Quality over a purely passive approach and continue to believe that Quality investing can provide a premium to the broader market return.

¹Schroder Equity Lens, February 2026

² GDP is gross domestic product, the standard measure of economic activity.

³ Goldman issues a blunt warning to beat up software stock investors