A long-only equity manager wants an ESG thesis. Excluding three sectors that make up 14% of the benchmark creates how much tracking error, and how does that compare with a best-in-class tilt targeting 1%? Recommend one.

The exclusion creates about 2.2% of tracking error, more than twice the tilt's 1%, so recommend the tilt. Dropping 14% of the benchmark is a 14% bet on the spread between the excluded sectors and the rest, whose volatility is 15.7%. That uses 30% of a 4% tracking error budget on a bet chosen for values, not return. The tilt uses 6% and leaves the budget for stock picking; exclude only what clients require.

A statement of what the manager believes and how the portfolio will express it. Either the manager believes ESG risks are mispriced and will cost shareholders money, which is a return view, or the clients want certain businesses out regardless of return, which is a values constraint. The two lead to different designs. It is like a restaurant choosing a vegetarian menu because it will sell better, against choosing it because the owner will not serve meat: the first gets tested against sales, the second does not.

Write the active position down. The fund holds 100% in the rest of the market; the benchmark holds 86% there and 14% in the excluded sectors. So the fund is 14% long the rest and 14% short the excluded basket, and its tracking error is 14% times the volatility of the spread between them. With volatilities of 16% and 22% and a correlation of 0.7, that spread moves 15.7% a year, so tracking error is about 2.2%.

Because it moves money between similar stocks. Active shareHalf the sum of the absolute differences between fund and benchmark weights: the share of the portfolio that differs from the index. counts how much of the portfolio differs from the index; tracking error measures how differently it behaves. Swapping one power utility for a cleaner one changes 18% of the holdings but little of the behaviour, because stocks in the same sector move together; removing whole sectors changes less of the list but much more of the behaviour. The tilt's 18% active share with 1% tracking error against the exclusion's 14% with 2.2% shows exactly that.

Because tracking error budgets add in variance, not in straight lines. 2.2% squared is 30% of 4% squared: nearly a third of the fund's room to differ from the index is spent on a bet the stock pickers did not choose. In a year the excluded sectors beat the rest by 15 points, the fund lags by 2.1 points from that alone, and the manager must explain a shortfall that has nothing to do with skill.

The tilt as the core, with exclusions kept to the short list that clients or the mandate actually require, and an engagement policy for the companies the fund keeps. Build the ESG view where it can be tested as a return view, inside sectors, and keep the budget for the manager's real edge. Say the limit: ESG scores from different providers often disagree, so a tilt is only as good as the score behind it, and the board should see which provider is used and why.