Misconceptions Over ESG Returns May Be Associated with Tracking Errors

Socially responsible investments do not have to sacrifice returns to help people invest with their values.

In the latest Parametric research, Jennifer Sireklove, Managing Director, Investment Strategy, Parametric Portfolio Associates, argues that when evaluating the pros and cons of responsible investing, investors often worry they will see weaker returns if they follow a portfolio that reflects environmental, social, and governance (ESG) principles. She added that 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,” Sireklove said.

Sireklove explained that the tracking error tells us how big performance differences are between the fund strategy and its underlying benchmark or holdings, 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,” Sireklove said.

Sireklove clarified that tracking error is a trade-off between achieving returns that match a given market exposure and honoring responsible investing criteria. Consequently, an investor who strongly prefers to match the returns for a selected market exposure will be more satisfied with lower tracking error. whereas an investor with especially strong commitment to their responsible investing criteria may be willing to accept higher tracking errors to achieve 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,” Sireklove said.

Instead of focusing on how much a socially responsible portfolio may differ from the benchmark due to tracking errors, investors should try 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,” Sireklove concluded.

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