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ESG and “Tracking Error”

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How closely should you expect your portfolio’s returns to mirror the performance of its benchmark?

Investment professionals answer that question using a measurement called tracking error, which describes the difference between the return that a portfolio or fund receives and the return of the benchmark it tracks (i.e., an index like the S&P 500). This divergence may result in both over or under performance of the portfolio due to the difference in its active risk.

The higher your portfolio’s tracking error, the more active risk you are taking on and, consequently, the more returns may differ from the benchmark over a given period of time. Incorporating ESG investment strategies may increase your portfolio’s tracking error. How much depends partly on the ESG investing approach you use.

ESG Investing’s Impact on Tracking Error

Although there are varying definitions for ESG investing methodologies, the four approaches commonly used by investors are typically, but not always, defined as follows.

Before making any ESG investment decision, ask your financial advisor how it could affect your active risk relative to appropriate benchmarks. That information can help you set reasonable expectations — one of the keys to a successful investment plan.

Read more about different approaches to ESG here.

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ESG and Tracking Error

Understand your active risk relative to appropriate benchmarks.

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Disclosures

This document is a general communication being provided for informational and educational purposes only and is not meant to be taken as investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions or inflation. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein.

LEGAL, INVESTMENT AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.

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