Indexing Talk: The Tracking Error Trade-Off

Jen Blaha: What if your portfolio was headed off course and you didn't even know it? Today, we talk tracking error, the subtle signal that helps tell you when your investments are straying from the plan. I'm Jen Blaha, director of Investment Intelligence here at Allspring Global Investments, and welcome to SpringTalk. Today, I'm joined by John Campbell, senior portfolio manager and head of the Systematic Core Equity team. John, thanks for being here today.

John Campbell: Hi, Jen. Thanks for having me.

Jen: All right, so I think I'm generally in the minority with my excitement about talking about investment risk, but I think today I'm in like-minded company with you, John. So, I'm excited to hear your perspective from a portfolio manager on this. But let's just ease into this. When investors are asked their risk tolerance, what we're really trying to get at is how much volatility or uncertainty they're willing to take on with their investments. And there are a number of ways to articulate this and measure this, but one thing that you and I look at is tracking error. I wondered if you could explain to people what tracking error is and why it is so critical for investors to understand for both passive and active equity strategies?

John: Yeah, I'd be happy to. So, just for a definition, tracking error is basically the performance deviation between a portfolio and its benchmark. And this is a good measure to help you understand the risk that a strategy is taking or the consistency of performance over time. So, it really gives a good snapshot of information about the volatility of a given strategy. I do want to point out a couple of nuances around tracking error, and one is that you can look at tracking error either in an ex-post or an ex-ante manner. So, ex-post tracking error is simply just looking at a past performance, the stream of returns, and looking at what the actual realized deviation was. That's great. But when we're talking about tracking error, for the most part in either active management or direct indexing, we're talking about ex-ante tracking error or a forecast of projected tracking error. That means you have to have some means of making that forecast and we usually use a risk model. So, it's important to have the right tools to forecast tracking error. But I also want to make the point that tracking error is just one metric, and it's really meant to describe a potential distribution of outcomes. And so, what do I mean by that? Tracking error is basically just looking at the one standard deviation of returns relative to a benchmark, and because it's a statistical measure, you have to think about this distribution. Or if you think of it in the normal distribution terms, for example, if you're looking at a strategy with a predicted tracking error of 1%, then you can interpret that to mean over the course of the year, about two-thirds of the time you would expect your results to fall within plus or minus 1% of the benchmark. Additionally, looking at a three standard deviation event—so 99% of the time—you would expect the portfolio with a 1% predicted tracking error to fall within plus or minus 3% of the benchmark. So, it's important to remember it's one statistic and it can go in both directions.

Jen: John, you mentioned direct indexing there, and that is something that has seen a lot of rapid market growth over the past couple years. And what that product does is it’s not only taking into consideration the risk and having a lower tracking error to its benchmark, it's also trying to maximize that tax alpha. And so, there's a bit of a tug-of-war there between the risk and the alpha piece of this. As the portfolio manager of our direct indexing products, how do you generally balance out that tug-of-war between those, or how do you think that portfolio managers think about that?

John: This is a very, very important topic, and I guess the most important thing is this starts out with a conversation between a client and their advisor and us and it's all about understanding what the client's risk tolerance is. So, once we know what the client's risk tolerance is or their limits of acceptable tracking error, then we can use that. And in the ongoing management of our direct indexing portfolios, our goal is going to be stay within the limit and try to reduce tracking error when possible but also take advantage of the volatility inherent in markets and loss harvest where we can. So, as you say, it's a tug-of-war. It's a bit of a balancing act. I do want to just point out a couple of things about our direct indexing offering. We offer two different types of tax management—what we call standard and enhanced. In our standard offering, the typical tracking error target or limit is about 1%. And in the enhanced tax-loss-harvesting strategy, we’ll allow tracking error to go up to 2%. And so, with that wider tracking error bound, that gives us more opportunities to harvest losses along the way. I'll also mention that many times a direct indexing account is funded by securities that the client already owns. And so, they're bringing to us a portfolio that already has some embedded capital gains. A really important part of the process at the beginning is for us to do an analysis—a transition analysis—and provide the client and their advisor a menu of choices or several scenarios of that trade-off between tracking error and taxes. So, the client gets to choose how much they're comfortable with in gains realization or the initial amount of tracking error. Then, of course, in the ongoing management, we will continue to try to loss harvest and maintain the acceptable limit in tracking error.

Jen: That's great. People love choices, so I think that's great to hear. If we were to pivot a bit to more active equity strategies, within those, we generally see a higher tracking error. While that higher tracking error isn't necessarily a bad thing, it's very important to understand what the drivers of that tracking error are. So, what are some guardrails that you put around your portfolios when thinking about that and those contributions to risk?

John: Yeah, this is a very important point. So, tracking error is a desirable outcome in an active strategy. What do I mean by that? A minute ago, we talked about how tracking error can be outperformance or it can be underperformance. Well, if you're hiring an active manager, your hope is that you're going to get outperformance or what you might call upside tracking error. And so, that tracking error is being pursued for a reason. Usually, the active manager has an investment philosophy that identifies ways to identify good-performing stocks from poor-performing stocks. And so, they're actively seeking out changes or differences from the benchmark in an effort to outperform. When you look at the broad swath of money managers—managers that use a fundamental approach to stock selection—the main thing that they're doing to manage tracking error is they're trying to figure out what securities they want to own and then what weight. Oftentimes, they're also mindful of their sector and industry exposures. Then, when we look at quantitative managers, they're doing those things as well, but we're also using a sophisticated risk model and sometimes optimization techniques to also try to manage our exposures to individual factors—style factors, as we like to call them. So, there is a spectrum of management types and management approaches to tracking error. But in the active space, it's all about trying to get tracking error for a good reason to outperform the market.

Jen: Absolutely, John. Taking a little turn, in our circles, we’ll often throw around terms like common factor risk or stock-specific risk or even beta. How do those come into play when you are managing risks for products like your direct indexing or even beyond into other active equity strategies?

John: Yeah, absolutely. So, we’ve focused so far just on this one metric—tracking error—which is a really good catch-all metric for looking at the potential risks in a portfolio. But it is very important to be mindful of the sources of that tracking error. And so, you mentioned things like beta or other style factor exposures. In our direct indexing strategies, we're also very mindful to put guardrails around our individual factor exposures and also our individual stock weights. And why do we do that? Well, different factors have different volatilities. And so, a small exposure to one factor like beta could have big implications relative to other factors. So, it's just important for us to manage the distribution of our risks that go into creating that overall tracking error figure.

Jen: So, we've talked about quite a bit today. What is one key thing that you want investors to remember about balancing that tracking error with either the tax-managed alpha or just active returns in general?

John: I like the way you put it. It is a balancing act. And I think the most important thing that I want people to take away is that if you're going to take on tracking error, you need to do it with intention and with discipline. So, in the direct indexing framework, you may be willing to accept some tracking error in pursuit of tax alpha. In an active strategy, you'll take on tracking error to try to outperform the benchmark. But the most important thing is the understanding of the sources of that tracking error, and you never want your investors to be surprised by an unexpected outcome.

Jen: No, you certainly don't. Well, thank you so much for joining me here today. I've had a blast talking about this. I could do this all day, but I really appreciate your insights here on tracking error.

John: Thank you, Jen.

Jen: And to our audience, thank you for joining us on SpringTalk.