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.