Tracking error can be found in every type of managed portfolio—and it doesn’t always hurt your performance.
There’s a fading but lingering misconception that socially responsible investing (SRI) means sacrificing returns against a benchmark. When evaluating the pros and cons of responsible investing, investors often worry they must accept weaker returns if they construct a portfolio that reflects their environmental, social, and governance (ESG) priorities.
The source of this concern can often be traced to confusion around tracking error. By understanding what’s behind a portfolio’s deviation from the performance of its benchmark, investors will see that incorporating ESG characteristics doesn’t have to mean sacrificing performance. Let’s take a look at where tracking error comes from and how to make it work in a responsible portfolio.
What does tracking error mean?
Every managed portfolio behaves differently from its benchmark, even if the manager tries to track the benchmark perfectly. Tracking error is a standardized way of thinking about this difference in performance, which occurs in just about every type of equity portfolio—active, passive, socially responsible, or otherwise.
To be more precise, tracking error tells us the performance range of the portfolio relative to the benchmark 68% of the time. If we double the tracking error, that tells us what the range is 95% of the time. If we triple the tracking error, that tells us what the range is 99.7% of the time. This is just the familiar normal distribution curve we all learned about in statistics class, but for the purposes of thinking about the likelihood of excess portfolio return.
If a portfolio has tracking error of 1%, it means it outperformed the benchmark by less than 1% or underperformed it by less than -1% about two out of three years, and it outperformed the benchmark by 1% to 2% or underperformed it by -1% to -2% about one out of three years. See the illustration below. When the stated tracking error is smaller, the spread of the performance differences tightens around 0%. When tracking error is larger, the spread of the performance difference widens to the right and left.
Expected return distribution for portfolio with 1% annual tracking error
Source: Parametric. For illustrative purposes only. A return distribution with larger (smaller) tracking error would be expected to have a wider (narrower) range than that shown.
It’s important to remember that tracking error describes the size of the difference in relative return, not whether it was positive or negative. But the greater the tracking error, the greater the possibility for very negative or very positive excess returns. This can make it easier to mistake short-term performance patterns for longer-term patterns for the casual observer.
What produces tracking error in socially responsible portfolios?
When a manager uses ESG data to screen or reweight the holdings in a portfolio, it causes the constituents and their weights to differ from the benchmark. This will be the case even if the manager is trying to track a broad market index rather than make active stock picks. You can see this by analyzing MSCI’s ESG Leaders and Enhanced Focus Index series, which each use very distinct ESG incorporation techniques.
Construction of MSCI ESG indexes versus parent index
Source: MSCI, 11/30/2020. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
The MSCI USA ESG Enhanced Focus Index is far more similar to the parent index in several respects. It has a similarly large number of holdings; it holds the largest constituent of the parent index at a similar weight; and its 10 largest holdings are similar in weight to the parent index. The MSCI USA Leaders Index holds half the number of constituents, it doesn’t hold the Enhanced Focus Index’s largest constituent at all, and its 10 largest constituents are all held at about twice the weight of what they are in the parent index. Furthermore, the Enhanced Focus Index uses multifactor optimization that tries to match the factor characteristics, such as size or momentum, of the parent index in addition to the sectors, while the Leaders Index controls only for sector representation.
As you might expect, tracking error for the USA ESG Leaders Index is significantly higher than that of the USA ESG Enhanced Focus Index. This means we would expect the difference in return relative to the parent index to be consistently greater for the ESG Leaders Index than for the ESG Enhanced Focus Index.
As we covered earlier, tracking error just tells us how big performance differences are, not whether they are positive or negative. If the differences tend to offset each other, with as many positive periods as negative periods, cumulative excess return will trend toward zero over time, even if tracking error is large.
However, even when excess return is offsetting over the long run, you can easily see short-run periods in which it appears to display persistent direction, with clusters of consistently positive or consistently negative excess return. When tracking error is larger, those differences tend to be larger, and cumulative return during those periods will be more noticeably negative or positive. This can make it more likely that the casual observer will confuse temporary return patterns with a persistent return pattern. This is especially true when trying to work with ESG data sets with limited histories.
Below we plot the monthly deviations for the MSCI USA Enhanced Focus Index and the MSCI USA ESG Leaders Index against the parent index. The MSCI USA ESG Leaders Index has experienced pronounced clusters of both outperformance and underperformance over the last 10 years, and one would presumably expect to see a similar pattern over the coming years. But focusing on shorter time frames, one might have thought the index tended to experience only outperformance or only underperformance.
Monthly deviations of MSCI ESG indexes versus parent index
Sources: Parametric, MSCI, 11/30/20. For illustrative purposes only. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
How should investors approach tracking error when building a responsible portfolio?
Tracking error comes down to a trade-off between achieving returns that match a given market exposure and honoring responsible investing criteria. An investor who strongly prefers to match the returns for a selected market exposure will be better served by lower tracking error. An investor with especially strong commitment to their responsible investing criteria may be willing to accept higher tracking error to achieve their ESG goals.
Assuming no persistent bias in the direction of returns, a portfolio with high tracking error can still end up with cumulative returns quite similar to the benchmark over the long run. Understanding the likely interim variation can help investors know what to expect with their responsible portfolio and be better prepared for the uncertainty.
The bottom line
Implementing responsible investing mandates is complex. Owning a socially responsible portfolio that differs from the benchmark will always introduce the potential for tracking error. To understand the effect of socially responsible investing on portfolio performance, we advise investors to focus on the potential magnitude of tracking error rather than the direction of differences. Investors who pursue responsible investing may still obtain returns that capture the risk-return characteristics of the selected benchmark.