As expected, all the responsible investing indexes showed tracking error compared to the market indexes as a result of limiting the number of eligible securities. Using ESG criteria in stock selection introduces portfolio biases and causes performance to deviate from the benchmark. Not only did the responsible investing index results show tracking error, there were statistically significant differences across the various indexes — suggesting some responsible investing indexes more closely matched the broad market than others.
Rates were measured from the inception for each ESG index, ranging from 1994 to 2003, and calculated through July 1, 2016, with the MSCI USA IMI ESG index showing the lowest tracking error at 1.75%, and the DJSI U.S. the highest at 3.4%.
Specifically, we compared the MSCI USA IMI ESG index and Calvert U.S. Large Cap Core Responsible index with the Russell 3000 because these two indexes include smaller-capitalization stocks. Average tracking error for the MSCI USA IMI ESG index was meaningfully lower than the 2.67% for the Calvert U.S. Large Cap Core Responsible index.
The remaining three responsible investing indexes were compared with the S&P 500 given their primarily large-cap focus. MSCI KLD 400 Social had a 2.57% tracking error, lower than the 2.86% for the FTSE4Good US and the DJSI U.S. divergence — all by statistically significant differences.
Tracking error does not introduce absolute risk, but is a source of relative risk vs. a benchmark. Institutional money managers, for example, might be constrained by client mandates to limit tracking error within specific ranges and against specific benchmarks.
What drives tracking error?
Variations in tracking error are byproducts of the responsible investing process itself. The five responsible investing indexes use explicit ESG criteria to select a smaller subset of stocks — ranging from 23% to 80% of the number of stocks in the broad-market benchmark — resulting in portfolio characteristics that differ from the market. As of Dec. 31, for example, the MSCI USA IMI ESG index held 1,162 stocks, or 39% of the number in the Russell 3000.
Decisions about how stocks are rated, selected and managed differentiate responsible investing indexes from each other and the broad market. Company assessments may vary depending on the ESG approach, the range of factors considered, and relative emphasis on the “E,” “S,” or “G” components. Differences in index characteristics include sector/industry weighting, market capitalization and number of holdings.