You’ll often hear members of our team talk about tracking error in the context of the portfolio creation and management process. It’s a particularly important consideration for passive managers like Ethic that seek to closely mimic index performance. In fact, our goal is to outperform on impact and client experience while closely tracking the underlying benchmark. Here’s our primer on this concept. 

Tracking error, like tracking difference, is a metric used to assess a portfolio’s returns against those of the benchmark. However, there is a key distinction: tracking difference, as the name suggests, simply compares the portfolio’s performance with that of the benchmark over a given period of time. Tracking error evaluates the variability of a portfolio’s tracking difference during that same time period. This can be an important measure for investors that value consistency and predictability. 

Tracking error is just one of many measures that financial advisors and their clients may wish to evaluate when scoping out a potential investment solution. But for those that are keen to achieve index-like returns while expressing their values and enjoying tax management capabilities, direct indexing solutions like Ethic’s might just be a desirable option.‍

How is tracking error calculated?

When a portfolio manager has a broad set of historical data at their disposal, they can calculate tracking error as the annualized standard deviation of tracking difference data points.

The equation for calculating tracking error can be expressed as: 

Tracking Error = Standard Deviation of (Portfolio Return - Benchmark Return)

While the above method is useful for calculating historical (“realized”) tracking error, what happens if a client wants to get a sense for their portfolio’s predicted (“ex ante”) tracking error? The good news is, you needn’t reach for your calculator. Ethic has partnered with leading investment research firm MSCI Barra, using its multi-factor Global Equity Model to calculate each portfolio’s predicted tracking error against a selected benchmark. This enables the advisor to run through a number of potential scenarios with their client as they design an appropriately tailored portfolio.  

What’s a “good” tracking error? 

The answer to this question really depends on the individual investor’s preferences and objectives. Low tracking error is an indication that a portfolio or fund is closely following its benchmark index, which may be viewed as a good or bad thing depending on the context. For example, active portfolio managers typically exhibit higher tracking error because they assume greater risk in their quest for excess returns. Given that these managers’ mandate is to beat the market, low tracking error could be viewed by their clients as a distinctively negative outcome.  

How does Ethic approach tracking error?

At Ethic, we use an approach called direct indexing to create custom passive equity portfolios that seek to closely track the performance of their underlying index. This means that a client can start with a broad benchmark like the S&P 500 and then customize it to reflect their personal values, desired factor exposures, and tax mandates. However, as different modifications are introduced, the new version of the index can start to look markedly different from the original in terms of constituents and weighting—and tracking error may emerge. It’s important to remember that this doesn’t necessarily mean the portfolio is likely to underperform the benchmark; tracking error just indicates a predicted variance in either direction. We believe transparency is key from the outset of every engagement, so we work closely with the advisor to determine an appropriate tracking error budget. This allows us to construct and manage a portfolio in line with the client’s unique investment objectives and risk tolerance. 

Consider one scenario we see from time to time at Ethic: A socially responsible investor comes to us with entirely reasonable concerns about anticompetitive business practices, worker treatment issues and data privacy snafus at Big Tech companies. Driven by an unwillingness to profit from business activities they find objectionable, and sometimes a desire to send a message to the companies involved, the investor requests that we completely eliminate exposure to these companies. While the motivations are understandable, it’s impossible to overlook the reality that these companies make up a sizable portion of major U.S. indexes. Therefore, removing them entirely may introduce a higher level of tracking error than the client anticipated, necessitating a conversation about how best to balance competing sustainability and financial priorities. 

Ethic is committed to providing advisors with the necessary tools to help them navigate these discussions with confidence. Our educational materials are designed to support informed conversations about the sustainability issues that matter most to clients, while our platform can model different scenarios until we arrive at a solution that reconciles the client’s different needs. In the scenario detailed above, the client might ultimately choose to screen out a handful of companies with particularly egregious labor practices, slightly overweight companies with a strong track record of treating their workers and suppliers well, and then use their proxy voting rights to shape more responsible corporate behaviors throughout the remainder of their portfolio. 

Certain tax situations may also bring tracking error tolerance to the forefront. Many clients come to Ethic with existing portfolios that have embedded gains and, in many instances, concentrated positions. Liquidating these assets and starting over could generate a massive tax bill and introduce additional tracking error, neither of which are ideal. That’s why we use a tax-aware process to gradually transition a client’s positions over time, identifying any overlap in holdings and determining the amount of taxable gains the client can reasonably absorb without deviating too far from benchmark exposure. On an ongoing basis, we can optimize to manage the client’s tax liability and tracking error—all while incorporating the most up to date financial and sustainability data—to help the client achieve greater impact and after-tax returns.  

The substantive conversations that arise from these types of situations are a perfect opportunity for advisors to showcase their expertise and differentiated service offering. Perhaps more importantly, though, they represent an ideal forum for clients to share what’s most important to them: their hopes, fears, concerns, ethical convictions, and more. Advisors that engage in active listening, and show that they are attuned to clients’ functional and emotional needs, will be well positioned to cultivate the foundational trust on which lasting relationships are built.

Questions? Get in touch via welcome@ethic.com.