Direct indexing offers investors an equity index-based portfolio that may be personalized to reflect their goals, tax situation and values. This personalization may affect the performance of the portfolio relative to the reference index—but to what degree? Predicted tracking error (PTE) is a measure that may help convey a portfolio’s potential deviation from reference index performance.

The terms tracking difference and tracking error are used frequently with regard to exchange-traded funds (ETFs). Predicted tracking error is generally used for direct indexing portfolios because PTE is forward-looking, rather than historic. PTE may give investors more insight into what to expect from their investments as they customize their portfolios.

Unlike predicted tracking error, tracking difference and tracking error are historical

Tracking difference measures the difference in returns—positive or negative—between a portfolio and its reference index over a specific period of time. If a portfolio outperforms its reference index, it will have a positive tracking difference. If it underperforms the reference index, the tracking difference will be negative.

Tracking error measures the variability, or volatility, of a portfolio’s performance above or below its target reference index. Tracking error is often measured using standard deviation—usually displayed as annualized—and is based on historical performance.

Tracking error (TE)
This portfolio has a tracking error range of 1% to 2% above or below the return of the reference index.

Predicted tracking error is a more useful measure for direct indexing

PTE estimates the variability, or volatility, of a direct indexing portfolio’s future performance over or under its target reference index. PTE is also often measured in standard deviation, usually annualized. PTE may provide insights into how a direct indexing portfolio might perform relative to its reference index over the coming one-year period.

PTE may change as a portfolio becomes more customized

Direct indexing portfolios generally start with some measure of PTE due to the expected future tax loss harvesting strategies. Because they may seek to sell stocks in the portfolio at a loss to offset gains in others, the performance is likely to deviate slightly from the reference index. If an investor chooses to customize the portfolio by excluding certain stocks or a group of stocks, the PTE range may increase. The chart below illustrates the default PTE range of a hypothetical direct indexing portfolio, as well as the additional PTE that could be expected from greater personalization of the holdings.

Taken together, the tax loss harvesting and stock exclusions increase the PTE to a range of 2.5% to 3.5%. However, that higher PTE and the actual tracking difference of the portfolio—which may exceed that PTE range—may be worthwhile if it enables the investor to accomplish one or more important goals, including:

• Earning after-tax returns that may exceed those of the reference index
• Achieving diversification benefits by excluding concentrated holdings
• Investing according to their values

Summary

Predicted tracking error is a useful metric for direct indexers to understand as they customize their portfolio. PTE is a forward-looking measure of tracking error that seeks to indicate how a portfolio may perform relative to its reference index.

As the holdings of a direct indexing portfolio are tailored to the needs of an individual investor, the PTE range could expand beyond the initial default range and the actual tracking difference may exceed the PTE range. Investors may find that the tax-loss harvesting and ability to make exclusions offer benefits that outweigh the potential to deviate from the reference index in a given year.