Quality funds that lagged in the Q2 rally now have the better argument

THE SECOND quarter of 2026 was a triumph for momentum and a trial by fire for quality. Across its range of developed-market strategies, Harding Loevner, an active-equity manager known for a strict quality bias, found itself trailing its benchmarks by a stretch. Its Global Equity composite rose 10.6%, compared with a 15.1% gain in the MSCI ACWI Index. The International Equity composite returned 13.2% against the MSCI ACWI ex-US Index's 14.7%. Even its Emerging Markets composite, which surged 19.2%, was left behind by the MSCI Emerging Markets Index's 24.2% rip. One could read the pattern as a simple indictment of the quality approach. A closer look suggests something more structural: the market was rewarding cyclical momentum in AI hardware, and that reward has already begun to unwind.

The second quarter's narrative was straightforward. An Iran ceasefire in April sent oil prices plunging to around $70 a barrel, relieving inflation fears and lifting risk appetite. Corporate earnings then exceeded expectations at a clip that defied the usual scepticism - 85% of S&P 500 companies beat analyst forecasts, and aggregate earnings were on track to grow 36% year-on-year. Growth stocks outperformed value by nearly double the spread: the MSCI ACWI Growth Index rose 19.8% to the Value Index's 10.6%. The artificial-intelligence trade, particularly hardware and semiconductor beneficiaries, drove the lion's share of returns.

That is precisely where quality-focused managers face a dilemma. Harding Loevner's mandate is to invest in high-quality, growing companies, which in practice means favouring firms with durable competitive advantages, strong balance-sheets and consistent returns on capital. Semiconductor companies, for all their brilliance, are cyclical. When the cycle is ascending, quality filters tend to underweight them relative to benchmark indices. That is what happened in the second quarter. Harding Loevner was not wrong about its companies. It was simply on the wrong side of the market's temporary reward function.

The trouble is that reward functions have a way of turning. July 2026, barely a month after the second quarter closed, delivered a swift lesson. Semiconductors came under sharp pressure as investors questioned whether hyperscalers' soaring capital expenditure on AI infrastructure would generate commensurate returns. The MSCI World Semiconductors Index fell 13.2%. SK Hynix, a South Korean chip maker, collapsed 35%. Samsung Electronics dropped 21%. The Nikkei 225, heavy with technology, fell almost 8%. Over the month, value stocks outperformed growth by more than six percentage points. - a near mirror of the second quarter's dynamics.

The reversal reveals the structural fault line beneath the rally. Artificial intelligence has been an extraordinary earnings engine: information technology and communication services accounted for roughly three-quarters of aggregate S&P 500 earnings growth, with the so-called Magnificent Seven leading the way. But concentration is not diversification. When profits cluster in a handful of sectors, the market's best quarters become the worst stress-test for any strategy that avoids crowding. Quality managers who underweight overheated semiconductor names or over-extended hyperscalers will lag. That is the price of not participating in a consensus frenzy.

To be sure, quality investing has suffered repeated and embarrassing underperformance in recent years. The 2023-24 tech rally humiliated it. The second quarter of 2026 did so again, albeit on a smaller scale. The case against quality is seductive: why pay a premium for a predictable compounder when a momentum trade can deliver triple-digit growth for ten consecutive quarters? The answer is not sentimental. It is arithmetic. Momentum strategies capture trend while it lasts but offer no protection when the trend reverses - or when valuation runs out of runway before earnings does. Quality strategies capture neither the full upside nor the full downside of a cycle. Over time, that asymmetry is supposed to compound.

The deeper question is whether the current market structure is changing the arithmetic. The AI investment cycle is unlike previous technology booms in its scale and in its spread across the supply chain, from chip design to data-centre construction to power generation. That breadth should, in principle, broaden the pool of quality beneficiaries. But it has not, yet. The market's returns remain concentrated. The second quarter's outperformance for AI hardware was spectacular, and the July sell-off was equally swift. What this suggests is not that AI is a bubble but that the market's pricing of AI exposure is impatient. Investors rewarded actual near-term profits - the "sellers" of hardware and chips - far more than the "spenders" building the infrastructure. Then, when those sellers' valuations stretched and earnings sustainability came into question, the bid evaporated.

That impatience is the quality manager's eventual ally. Firms with durable margins, pricing power and capital-allocation discipline will not participate fully in the upward surge. They will not bleed as violently in the correction. Over a sequence of rallies and reversals, that discipline should prevail. Whether it does depends on one assumption: that the AI cycle is generating genuine productivity gains rather than a capital-expenditure arms race that enriches equipment vendors while delivering diminishing returns to the end users. The second quarter's earnings data leans towards the former. The July volatility warns that the market is not yet convinced.

The broader lesson for investors is familiar but worth restating. Underperformance in a single quarter, even a spectacular one, is rarely evidence that a strategy is broken. It is more often evidence that the market's temporary reward function does not match the manager's long-term return model. Harding Loevner's Q2 results were the price of not chasing semiconductors at the top of the cycle. July's reversal suggests that price may already have been worth paying.

The risk for quality managers is not that momentum will return in July's image. It is that the AI cycle proves durable enough to justify the multiples that were rejected in the second quarter. If hyperscalers' return on AI investment proves as robust as their guidance suggests, quality filters that shy away from the trade will lag not for one quarter but for several. That is a plausible scenario. It is not yet an inevitable one.

The better approach, for active and passive investors alike, is to acknowledge that no single style owns the market's next chapter. Quality without exposure to technological dynamism becomes value-trap investing by another name. Momentum without regard to valuation becomes a waiting game for disappointment. The portfolio that recognises both truths - and allocates accordingly - will not win every quarter. It should, over time, win the argument.