What is tracking error and why do we avoid it?
For investors who want to keep pace with the stock market, the S&P 500 – which accounts for about 80% of the total US stock market – is the most relevant benchmark. Investors who want to capture the returns of the market typically buy “index-tracking” funds that adjust their allocation to match that of the S&P 500 or other stock market indices.
The index-tracking approach is predicated in part on the idea that, in the long run, markets are better than individual investors at picking the right investments. By introducing tracking error, you get farther away from the market-wide investment allocation which can cause your returns to suffer.
How is tracking error determined?
Tracking error reflects the tendency of some types of stocks to be effected by some risks and other types of stocks being affected by other risks.
It’s generally measured by one standard deviation of the difference in investment performance between a portfolio and its benchmark over a defined period.
A portfolio whose benchmark returns 6.7% with a tracking error of 1.03%, will return 6.7% +/- 1.03% about two-thirds of the time.
How much tracking error is too much?
A relatively small tracking error can lead to large opportunity costs over time thanks to compounding.
By divesting from fossil fuels, for example, you introduce tracking error into your portfolio because its allocation differs from that of the overall stock market.
The energy, utilities, and materials sectors — which tend to be some of the most carbon-intensive — are subject to different economic risks than, say, technology & IT or communication services.
In a 2015 paper, Chicago law professor Dan Fischel calculated that fossil fuel divestment would have led to a 0.6 percentage point decrease in annual investment returns on average over the last 50 years.
If fossil fuels continue to dominate the energy sector and that sector plays the same role in the economy as it did over the last 50 years, this can impose a steep cost in foregone returns over long investment horizons.