General Manager of Sustainable Investment Solutions Rebecca Hu offers a deep dive into how we approach tracking error at Ethic, and how it can be a powerful asset for advisors to understand.

Key Takeaways:

• An Asset in Sustainable Investing: Tracking error measures how closely a portfolio replicates or deviates from its benchmark, making it a key tool in communicating with clients about the tradeoffs in balancing sustainability and financial priorities.
• Our Approach to Portfolio Construction: Ethic uses tracking error alongside impact metrics to communicate the financial and sustainability profiles of our custom-built portfolios.
• Values and Risk Tolerance: Clients’ values influence their tolerance for tracking error; those passionate about specific issues or wanting to challenge the status quo may accept higher tracking errors to align with their values.

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The Ethic Approach

Tracking error is an important metric in investment management used to gauge the difference between the returns, or predicted returns, of a portfolio and its benchmark index. In a passive benchmark tracking investment strategy, it quantifies how closely a portfolio follows the index or securities it aims to track. This measure is especially important in the context of sustainable investing, where we can help communicate the tracking error differences between a sustainable portfolio and the underlying index it seeks to track.

Tracking error is expressed as the standard deviation of the difference between the portfolio's returns and the benchmark's returns over a specified period. A tracking error of 0% means the portfolio perfectly replicates the benchmark's returns, while a tracking error of 2% indicates that the portfolio's returns deviate from the benchmark by 2% on average.

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Tracking Error in Portfolio Construction

When we construct a sustainable portfolio for a client, we use sustainability data that is relevant to the client’s sustainability priorities; things like Climate Change, Women’s Rights, or Education. We use that data to select the companies that are included in the portfolio i.e. we may not select a company that is involved in highly extractive fossil fuel industries. Typically our portfolios will hold 200-300 companies that are more aligned with the investors sustainability priorities compared with the underlying benchmark, which can hold 500-1000+ companies. Our portfolio construction process then uses a multi-factor optimization to design a portfolio that either minimizes tracking error to the underlying benchmark using the factor profile of each company or balances it with tax loss harvesting. When we go through a portfolio with a client, we use summary metrics like predicted tracking error, as well as impact metrics like carbon ownership reduction, to communicate the financial and sustainability profile of the portfolio we have constructed. 

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A Powerful Tool for Communication

In sustainable investing, the amount of tracking error a client is willing to take on is often related to their beliefs in sustainability. Using tracking error to communicate these tradeoffs can help advisors understand the client’s investment goals. There are two main ways we see this manifest. 

The first is for clients that feel very passionately about certain sustainability issues - if you feel passionately about a certain issue, say a client whose spouse died of lung cancer, you may not want to invest in any company that is connected with any form of tobacco product - either producing products or selling them - this can have higher tracking error impacts on the portfolio - but tracking error helps the client and advisor understand the predicted difference due to incorporating this more aggressive criteria into the investment approach. 

The second way we see sustainability beliefs come through in tracking error decisions is for clients who understand and believe that by investing in many benchmarks there is bias to maintain the status quo - a corporate model of extraction and misalignment of financial “value” that does not include the real costs (externalities) to society. If you are invested in the S&P 500, you are investing in the largest companies based on their size or value in the current market. An example is that companies that have made profits in extractive industries are often significant portions of the index. A client who is investing to see a more regenerative world often is willing to take on quite a bit of tracking error to the existing benchmark - which represents business as usual and a world they do not want to invest in. We’re really excited about these types of clients because they are very engaged with future innovation and pushing the industry forward on what sustainable investing can achieve. In these cases, a higher tracking error can represent a stronger acceptance of deviating from the status quo. 

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We’re excited about both the sustainability implications of and financial metrics we can use to tell stories about the portfolios we construct - as well as developing new and innovative ways of understanding risk - both traditional and impact risk - in the future. 

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