We suggest using tracking-error breakpoints as a framework to analyze the impact of customization. Portfolios with 1% tracking error to each other are largely indistinguishable. Strategies begin to deviate materially from their reference portfolios around 2% tracking error. Double that figure to 4% and the pair of portfolios begin to serve as reasonable diversifiers for each other. If tracking error doubles again to 8%, the two portfolios can serve meaningfully different roles in meeting an investor’s objectives. Another point of reference is that the tracking error between the Russell 1000 Growth and Russell 1000 Value indices has been around 9% historically. Investors often use these style indices as benchmarks for separate allocations in their portfolios.

The relatively modest customization to the cap-weighted portfolio to exclude weapons, tobacco, and gaming creates a similarly modest impact, generating tracking error of 0.35% for the Cap portfolio. The same exclusion creates comparably mild tracking-error impacts ranging from 0.23% to 0.31% for the other three portfolios compared to their respective starting portfolios. Given the small weight of weapons, tobacco, and gaming companies in the starting portfolios, their exclusion generates minimal tracking error to the core cap-weighted benchmark. The Value portfolio’s tracking error to the core cap-weighted benchmark grows very slightly from 7.95% to 8.08%, while RAFI’s and Deep Value’s tracking error to the core cap-weighted portfolio remains effectively unchanged at 4.30% and 10.85%, respectively.⁴ Excluding weapons, tobacco, and gaming causes only a modest impact across all four starting portfolios. The customized portfolios track their respective starting portfolios more closely than the S&P 500 and the Russell 1000 track each other.