Market Commentary and Fund Performance

Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data current to the most recent month end, and standardized performance can be obtained by viewing the fact sheet or by clicking here.

Market Highlights

Japanese equities delivered mixed performance in July 2026. The TOPIX rose 2.30% during the month.

During the first half of the month, the market entered a correction phase as concerns grew over elevated valuations in artificial intelligence (AI) and semiconductor-related stocks, which had risen sharply in prior months. A sharp decline in the U.S. semiconductor index served as the catalyst for the pullback. Investor sentiment deteriorated following declines in U.S. technology stocks and the Korean KOSPI index, leading to significant weakness in Japanese AI and semiconductor-related names as well. Renewed tensions in the Middle East also weighed on Japanese equities. On the other hand, bank stocks and domestic-demand-oriented sectors continued to attract investor interest, supported by expectations of higher interest rates.

In the second half of the month, concerns intensified regarding the semiconductor industry’s outlook and competitive dynamics as recent developments highlighted the rapid progress of Chinese AI developers and chip-related companies. Semiconductor-related stocks declined further alongside weakness in Korean equities and U.S. semiconductor stocks, pushing the Nikkei 225 to its lowest level in approximately two months. While semiconductor stocks underwent a significant correction, investors also rotated into defensive sectors as downside risks to corporate earnings eased following a decline in oil prices after the United States refrained from conducting a large-scale attack on Iran.

As a result, the Nikkei 225 remained under pressure throughout the month and ended July substantially lower than at the end of June. In contrast, the TOPIX traded in a relatively narrow range and ultimately finished the month higher.

The Fund’s Performance

In this environment, the Fund (HJSIX) returned 0.41% in July, outperforming its benchmark, the Russell/Nomura Small Cap™ Index, which returned 0.30%.

This month, key positive contributors to the Fund’s performance included Maeda Kosen Co., Ltd., Hokuhoku Financial Group, Inc., and Saizeriya Co., Ltd.

Maeda Kosen’s share price rose despite the absence of company-specific news, as investors appeared to favor companies with relatively stable earnings and limited exposure to the technology sector amid a correction in high-tech stocks. Hokuhoku Financial Group benefited from renewed investor interest in the banking sector amid speculation that the Bank of Japan (BOJ) could be pressured to raise interest rates as the yen continued to weaken. The company’s share price was also supported by its stock split and the effective relaxation of eligibility requirements for shareholder benefits. Saizeriya announced its third-quarter results, and buying interest strengthened as the company suggested the possibility of price increases.

Meanwhile, key detractors from the Fund’s performance included Daihen Corporation and Towa Corporation. AI-related stocks faced broad selling pressure during the month as investors reassessed the outlook for AI investment returns and became increasingly concerned that AI-related capital expenditure may be approaching a peak. Sentiment was negatively affected by reports highlighting the cost competitiveness of Chinese AI technologies, a sharp rise in memory prices, and developments such as Meta’s plan to provide external access to its computing resources. As a result, shares of Daihen and Towa declined and detracted from the Fund’s performance.

July Commentary

Against this backdrop, we believe it is important to consider these developments from a longer-term investment perspective. Since the beginning of July, signs of a change in market sentiment have begun to emerge in AI-related stocks, which had risen sharply until recently. One catalyst was intensifying competition surrounding AI, particularly from China. Reports that Kimi K3, a large language model developed by Chinese start-up Moonshot AI, offers performance comparable to advanced U.S. AI models at a significantly lower cost attracted considerable market attention. This, in turn, raised concerns about the competitive advantages of U.S. AI companies and the potential returns on the substantial investments being made in AI.

This is not the first time such concerns have emerged. In January 2025, semiconductor-related stocks corrected following the announcement by China’s DeepSeek of a high-performance, low-cost AI model. The AI industry is characterized by extremely rapid technological innovation and elevated market expectations, making share prices highly sensitive to news related to technological advances and competitive developments.

At the same time, we believe it is important to distinguish short-term market reactions from long-term industry trends. While developments such as the emergence of lower-cost AI models may create periods of volatility, they do not necessarily undermine the broader adoption of AI. Moreover, AI-related investment has already reached an enormous scale and, in many cases, is closely tied to national industrial strategies and security considerations. For these reasons, we believe the possibility of a significant near-term contraction in AI-related investment remains limited.

AI is also an important theme when evaluating investments in Japanese equities. Japan has many companies that provide the equipment, materials, components, and inspection technologies required for advanced semiconductor manufacturing. While it is not necessary to understand every technological detail, changes in the AI ecosystem have important implications for the growth prospects of many Japanese companies and therefore remain a theme that deserves close attention.

Our investment focus remains on companies that can capitalize on technological developments while maintaining differentiated, high value-added business models. This view has not changed. With that in mind, we would like to examine both the opportunities and risks presented by AI by looking back at previous periods of industrial transformation and technological change.

The semiconductor industry’s long-term growth has been supported by continuous technological innovation rarely seen in other industries, including advances in miniaturization, processing power and chip architecture. Importantly, technological progress has consistently reduced the cost of computing and data storage while improving performance, thereby creating new sources of demand. In other words, the industry’s growth has not been simply supported by higher prices, but by cost reductions that led to performance improvements.

From this perspective, we believe the sustainability of the recent sharp rise in memory semiconductor and electronic component prices requires careful consideration. These current price increases appear to reflect supply-demand conditions and supply constraints rather than improvements in performance. North American hyperscalers that are leading AI infrastructure investment continue to make substantial capital expenditures but higher component prices that are not accompanied by corresponding performance improvements can reduce the efficiency of those investments. As a result, while AI investment is likely to continue expanding over the long term, investors may place greater emphasis on cost-effectiveness and returns on investment.

Another point that should not be overlooked is the rapid adoption of low-cost, open-source AI models from China by U.S. companies. As the availability of low-cost models increases, differentiation at the foundation model level may become more challenging. This could lead investors to place greater emphasis on profitability and returns on investment when evaluating U.S. AI companies. As a result, investment decisions across the AI ecosystem may become increasingly disciplined.

That said, these changes should not necessarily be viewed as a headwind for the AI industry. As AI capabilities continue to evolve, particularly with the advancement of agentic AI systems that can think and act autonomously, the source of value creation may shift from foundation models toward application and service layers. In such an environment, competitive advantage may depend less on access to the most advanced model and more on the ability to deliver solutions that enhance productivity and generate economic value for users.

However, there are also points that warrant caution. History provides examples of industries in which previously differentiated products and technologies became increasingly commoditized following the entry of Chinese competitors. Supported by a large domestic market and government-led support, China initially built competitiveness in labor-intensive industries such as textiles before expanding into more sophisticated manufacturing industries such as consumer electronics. In recent years, China has invested enormous resources to develop its domestic semiconductor industry.

A similar dynamic could emerge within the AI industry. Alongside players whose actions are primarily driven by commercial interests, there are also participants that operate with the support of their national governments to support their national strategies and industrial policy objectives. As a result, competitive dynamics may not always be explained solely by traditional market principles or economic rationality.

Even under these conditions, there has been no major change in our investment approach. We continue to focus on companies that can translate technological innovation into business opportunities while maintaining high value-added products and services. In industries shaped by rapid technological change, short-term fluctuations in earnings and sentiment can often lead to large swings in market valuations. At the same time, such periods of uncertainty can create attractive investment opportunities. The market’s attention is often concentrated on the most visible themes and companies, causing businesses with strong competitive positions and structural growth prospects to be temporarily overlooked. We believe that identifying these mispriced opportunities remains one of the most important sources of long-term investment returns.

We will continue to focus on identifying companies that can build and sustain competitive advantages over the medium to long term through technological innovation, while avoiding being overly influenced by short-term market sentiment. For readers interested in a further discussion of this investment philosophy, we would encourage you to refer to our previous monthly commentaries.

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