Quality investing delivered one of its worst years on record in 2025. Except when it didn’t. Some quality funds posted top-quintile returns while many languished at the bottom, a divergence so dramatic it demands explanation. The story isn’t that quality failed; it’s that the market split quality investors into winners and losers based on a single tactical choice.
“Quality” funds in 2025
87 funds and ETFs have “quality” as part of their name; 60 of those 87 funds trailed their peers in 2025. Most funds that pursue “quality” as an investment strategy do not have the word in their name; we’re using these 88 to offer a snapshot of the larger quality universe.
Sixteen international funds have “quality” in their names; 11 of those 16 trailed their peers in 2025. So did nine of the 10 small cap “quality” funds.
But four of the five Great Owl funds with “quality” in their names outperformed. Great Owls are MFO’s designation for funds that consistently place in the top 20% of their peer group for risk-adjusted returns over pretty much all trailing time periods; three of the four outperformers were passive funds with GMO Quality as the active exception.
Best relative performers in 2025: Westwood Quality AllCap (8.4% above their peer group), FlexShares US Quality Large Cap Index (8.1% above), iShares MSCI USA Quality GARP ETF, a Great Owl fund (6.8%), FlexShares International Quality Dividend Dynamic Index, Invesco S&P International Developed Quality ETF, and GMO US Quality (all at 6%).
Worst relative performers: GQG Partners US Select Quality Equity (19.4% below their peer group) and WisdomTree International Hedged Quality Dividend Growth (16.8% below their peer group).
Best absolute performers in 2025: American Century Quality Diversified International ETF (up 38%), FlexShares International Quality Dividend Dynamic Index (up 37%), and FlexShares International Quality Dividend Index (up 35.3%).
Worst absolute performers: WCM Mid Cap Quality Value (-7.2%), WCM SMID Quality Value (-7%), and GG Partners US Select Quality Equity (-4.5%).
The outperformers list, both in relative and absolute terms, was dominated by passive strategies that didn’t have the option to second-guess themselves, succumb to career risk, or rotate anywhere.
GMO’s Ben Inker calls quality “the weirdest market inefficiency in the world.” High-quality companies with strong balance sheets, stable earnings, and disciplined capital allocation deliver superior returns with lower volatility than run-of-the-mill equities. It’s about the closest thing to a free lunch in investing. And yet, investors routinely overpay for speculative lottery tickets while neglecting these tangible but boring attributes.
We’ll walk through(1) why quality works over complete market cycles, (2) why it diverged so sharply in 2025, and (3) what that divergence means for investors going forward.
Why Quality Works
The evidence for quality’s long-term advantage is overwhelming and consistent across decades, geographies, and market conditions. GMO’s research spans three decades and shows that high-quality stocks offer 60% higher returns and 30% lower volatility than low-quality stocks. The pattern holds everywhere: high-quality cyclicals deliver 200% of the returns with 30% lower volatility than low-quality cyclicals; high-quality small caps offer 150% of the return with 30% less volatility; even high-quality junk bonds (BB-rated) offer 300% of the returns and 50% lower volatility than low-quality (CCC) junk bonds.
This isn’t a US phenomenon. Research from Europe and emerging markets shows identical results: quality delivered 15.0% annualized returns versus 8.4% for the benchmark, with lower volatility (14.2% versus 23.4%). Amundi Institute found that quality “delivers a statistically significant alpha that cannot be explained by loadings on conventional equity factors such as market, value, size, and momentum” across most world regions.
Recent validation from major institutions confirms quality’s endurance. The CFA Institute’s December 2025 study found that the MSCI World Quality Index outperformed the broader market in 100% of 10-year periods since 1998, a perfect record. Over rolling 10-year periods, quality beat the market 85% of the time, and outperformed growth stocks 85% of the time over decade-long horizons (versus only 49% on a quarterly basis). Lazard Asset Management’s 25-year analysis shows quality companies outperformed their regional peers everywhere: US companies by 260 basis points annually, emerging markets by 600 bps, Japan by 430 bps, and Europe by 300 bps.
But there’s a deeper mechanism at work beyond simple behavioral bias. GMO’s November 2025 analysis points to career risk as a key driver of persistent mispricing. Quality tends to lag during surging markets, causing managers to trail benchmarks and disappoint clients. For investment professionals judged on quarterly returns, quality’s long-term track record offers little comfort when they’re underperforming right now. This career pressure leads many managers to underweight quality despite knowing its long-term edge, reinforcing the very underpricing that creates the opportunity.
The asymmetry is striking: GMO’s Ben Inker notes that “high-quality stocks outperform low-quality stocks in down months by over three times the amount they underperform in up months!” The CFA Institute study confirms this pattern during the 2008-09 financial crisis: quality fell 33% peak-to-trough and recovered in just over three years, while growth stocks fell more than 40% and took more than five years to recover.
We tracked the performance of select quality funds through March 2024, charting their lifetime performance against peers. Without exception, these high-quality portfolios crushed their peers in the long term and when markets were at their worst. In rising markets, they made strong absolute gains while trailing quality-agnostic peers, the exact asymmetry that creates career risk for managers but long-term opportunity for patient investors.
Price matters, of course. Overpaying for quality cuts returns and reduces the margin of safety. GMO’s research tracking quality stocks back to 1928 shows that the cheapest half of the quality universe dramatically outperformed quality stocks purchased at any price. But Lazard’s research adds crucial nuance: in their 25-year study, the most expensive quality companies delivered solid but unspectacular returns (7.1% annually). Surprisingly, the cheapest quality companies performed worst of all (4.3% annually). The sweet spot was quality companies at moderate valuations (7.9-10.6% annually).
Why did cheap quality underperform? Persistence. Only 62% of the cheapest quality companies maintained their quality metrics in the following year, compared to 88% persistence for moderately-priced quality companies. The market often marks down quality companies for good reason, as perceived threats to their ability to sustain high financial productivity. As Lazard notes, “investors should be wary of buying the most expensive high-quality companies, you can overpay, even for a fundamentally robust company. At the same time, investors should be aware of the dangers of being seduced by very cheap valuations, often companies will be cheap for a reason.”
Why Quality Diverged in 2025
Quality didn’t fail in 2025; it bifurcated dramatically based on how managers navigated a market where speculation trumped fundamentals. The dispersion tells the story: GMO US Quality ETF (QLTY) gained 21.3% in 2025 while GQG Partners US Select Quality (GQEPX) fell 4.5%, a 26-percentage-point spread between two funds run by talented managers committed to quality principles.
Three distinct phenomena drove the divergence:
The Valuation Discipline Penalty
From our earlier analysis, we know that GQG entered 2025 expecting a market rotation from growth to value. They dumped quality tech holdings in favor of quality defensives, financials, healthcare, and industrials. It was a disciplined call grounded in valuation work: tech had gotten expensive, and quality investors shouldn’t overpay. The rotation never came. Tech mega-caps kept surging, and GQG’s defensive positions lagged.
GMO articulated the challenge in their November 2025 analysis: “The recent period of AI-related enthusiasm across markets has stretched expectations, particularly where narratives have overshadowed fundamentals. We see a risk that investors may conflate cyclical surges in capital expenditure with sustainable long-term profit streams.”
Their response? “Participate selectively through well-financed, diversified businesses with proven capabilities rather than speculative names.” In other words: stay with quality tech (Microsoft, Alphabet) that has proven capabilities, not speculative AI plays with lottery-ticket appeal. GMO kept their quality tech positions; GQG rotated to cheaper quality defensives, expecting mean reversion. Both managers were right about quality; GQG was wrong about timing.
The sector data confirms GQG’s tactical misstep. Among 2025’s quality fund outperformers, Information Technology appeared in two-thirds of top holdings while Utilities appeared in none. The worst performers concentrated in Industrials and Utilities, exactly where GQG rotated seeking cheaper quality. GQEIX’s top sectors are Utilities and Financials, a quality portfolio in the wrong sectors. GMO’s top sectors? Information Technology and Health Care. Both managers bought quality companies; GMO stayed where quality was scarce and valuable (expensive tech), GQG rotated to where it was cheap and unloved (defensives). In 2025’s speculative market, scarce quality commanded premiums for a reason.
Fidelity’s November 2025 perspective reinforces this evolution. Their managers emphasize that the old distinction between “blue chip” and “growth” has blurred: “Think of companies like NVIDIA, big, consistent growers that are incredibly high-quality businesses with incredible margins on cash flow and dominant share positions in their industry.” Quality in 2025 meant owning expensive tech, not rotating away from it.
The Speculation Surge
Small-cap quality collapsed in 2025. This reflects the same speculation-over-fundamentals dynamic at a different scale. Where large-cap quality managers could stay with proven mega-cap tech, small-cap quality managers faced a market dominated by unprofitable, high-volatility speculation.
Grandeur Peak’s data shows an 11% annual performance gap between high-quality and low-quality international small-caps, with low-quality winning. The chart is startling: over the five-year period ending 2025, the lowest quality quintile in international small and mid-caps dramatically outperformed the highest quality quintile. Grandeur Peak identifies the winners: “businesses related to bitcoin, precious metals, defense, quantum computing, and artificial intelligence.” These companies lack current profitability, stable cash flows, or any of the traditional quality metrics, but they soared on narrative and speculation.
Royce Investment Partners, managing small-cap quality strategies for decades, titled their November 2025 commentary “Waiting on the Small-Cap Quality Rebound.” They note that “the initial rebound for small-caps from this year’s low on 4/8/25 through the middle of the fourth quarter has so far been led by low quality factors such as stocks with low or no returns on invested capital and higher debt levels.” Their analysis shows that previous small-cap leadership phases started the same way, with early gains going to low-quality and high-growth stocks, but higher-quality companies taking over leadership as upswings matured.
International Quality: No Clear Haven
Some sources suggested international markets provided refuge from US speculation. JP Morgan’s Q3 2025 Factor Monitor claimed “absent this same phenomenon, international equity factors posted another strong quarter.” But our fund data tells a different story, with over two-thirds of our international quality funds underperforming in 2025.
However, Lazard’s long-term data shows international quality remains fundamentally sound. Over their 25-year study period, quality companies in international markets delivered substantial alpha against local peers, 600 bps annually in emerging markets, 430 bps in Japan, and 300 bps in Europe. The 2025 divergence appears to be a global phenomenon of speculation over fundamentals, not a US-specific dynamic.
Where Quality Goes From Here
Quality’s defensive value persists across complete market cycles. The CFA Institute’s December 2025 study noted that during the 2008-09 crisis, quality’s dividend yield (1.25%) was nearly double growth stocks’ (0.69%), meaning quality returns came from both price appreciation and income. More importantly, quality demonstrated “persistent returns,” longer sustained periods of outperformance when winning, which compounded gains over time.
Multiple sources point to attractive current valuations. Ruchir Sharma, writing in the Financial Times in November 2025, observed that “quality just suffered one of its worst relative declines ever in developed markets, lagging behind the broader market by almost 10 percentage points over the past year.” He notes that while US-dominated global stock market averages are pricey and trading well above their historical trend, “the quality corners of those markets are trading below trend.”
Leuthold Research’s November 2025 analysis shows quality versus junk performance back at long-term trend support, the same level that marked the last major bounce in 2021. GMO notes that quality has become “more inexpensive” in the US as speculative fervor drove money into low-quality names.
Major asset managers are positioning for recovery, not retreat. Fidelity’s November 2025 guidance encourages investors to keep “wish lists” of high-quality stocks they’d like to own if prices come down during volatility. “One of the big advantages I have is a long-term time horizon, which allows me to take advantage of volatility the market may provide on a short-term basis,” says Sonu Kalra of Fidelity Blue Chip Growth. The message: “With quality stocks, fortune favors those who wait.”
GMO’s positioning is similarly opportunistic. They acknowledge that “in an environment marked by uncertainty, elevated valuations, and rapid technological disruption, we believe quality is more relevant than ever. It provides a framework for navigating complexity, avoiding speculative excess, and anchoring portfolios in businesses built to last.”
The Strategic Choice: Staying Flexible Within Quality
The 2025 experience reveals an important lesson about executing quality strategies. Both GMO and GQG are excellent managers committed to quality principles, but they made different tactical choices that produced dramatically different results. The evidence suggests both approaches work over complete cycles but require different execution.
Lazard’s 25-year research offers guidance: valuation discipline adds significant value, but it must be nuanced. Their study found middle-valued quality companies (valuation deciles 2-8) delivered 7.9-10.6% annually with 75-90% persistence of quality metrics. The most expensive decile (7.1% annually, 88% persistence) and the cheapest decile (4.3% annually, 62% persistence) both underperformed.
This suggests a “Goldilocks” approach: avoid paying extreme premiums, but don’t be seduced by deep discounts that often signal quality erosion. The GQG experience in 2025 shows the risk of rotating away from expensive quality when quality commands premiums market-wide. The better strategy may be maintaining quality exposure while being selective about valuations within the quality universe.
Put differently: the “quality at a reasonable price” (QARP) approach works over time, but 2025 demonstrated that “reasonable” must be defined relative to the quality premium in the current market, not relative to historical norms. When quality is scarce and commands premiums broadly, insisting on historical valuation multiples means rotating out of quality entirely, which proved costly.
The Bottom Line
The consistency across independent sources is striking. CFA Institute, GMO, Fidelity, and Lazard, writing in late 2025 with different methodologies and timeframes, all reach the same conclusions: quality works over complete cycles, delivers superior risk-adjusted returns, and provides crucial downside protection when markets turn.
The 2025 divergence was painful for valuation-disciplined managers who rotated away from expensive quality tech, but it hasn’t changed quality’s fundamental advantages. The bifurcation revealed something important: in a speculative market where quality companies command premiums, the winning move was maintaining exposure to proven quality (even at elevated prices) rather than rotating to cheaper alternatives hoping for mean reversion.
For patient investors, the current setup offers an opportunity. Quality stocks have suffered one of their worst relative declines in decades and are trading below their historical trend relative to the broader market. As GMO frames it, quality provides “protection through the inevitable storms of the short term and superior compounding over the long term.”
The evidence supports measured optimism: quality works, current underperformance creates entry points, but success depends on maintaining exposure through difficult periods while remaining flexible about valuations. The GQG experience teaches that even great managers can be wrong about timing tactical rotations. The GMO experience teaches that staying with quality through expensive periods can work when quality remains scarce and proven capabilities matter.
Time and patience, as Fidelity notes, can do much of the heavy lifting. Quality’s record is clear: it wins over complete market cycles by crushing low-quality stocks when bad times hit, while lagging only modestly in surging markets. For investors who can tolerate short-term career risk, or who aren’t subject to quarterly performance reviews, the quality anomaly remains one of the most reliable sources of long-term alpha.
As Ben Inker puts it, we still don’t have a plausible explanation beyond “investors are weirdly stupid.” But GMO’s career risk framework suggests it’s more nuanced: investors aren’t stupid, but the incentive structures under which they operate systematically underprice quality’s long-term advantages. That’s not likely to change soon, which means the quality anomaly, “the weirdest market inefficiency in the world,” will likely persist for patient investors to exploit.
Minor disclosure: Chip owns the GMO US Quality Equity ETF in her non-retirement accounts (and is feeling smug about it); we have no financial interest in, or other relationship with, GMO.
