Why is ESG investing a concern for investors who are cautious of high tracking error?

Investors who are cautious about high tracking error are primarily concerned with how ESG investing can impact their portfolio's alignment with a benchmark index. The correct answer highlights that the perception of exclusion in ESG investing can lead to a distortion of sector and country weights within a portfolio relative to the benchmark. This happens because ESG criteria often lead to the exclusion of certain companies or industries that do not meet sustainability standards, potentially skewing the portfolio's composition significantly away from the benchmark.

As a result, the investor's portfolio may not perform in sync with the benchmark due to these reallocations, leading to a higher tracking error, which measures how much a portfolio's returns deviate from the index it aims to replicate. This misalignment can be a critical concern for investors who prioritize minimizing tracking error, as they seek to maintain a return profile that closely matches their benchmark's performance.

The other options, while relevant concerns in their own right, do not directly capture the essence of tracking error related to sector and country weight discrepancies. For instance, the limitation of securities due to ESG criteria addresses investment universe size, but does not succinctly deal with the impact on benchmark tracking. Similarly, excluding high-performing stocks due to ESG factors is a valid concern, but it addresses performance risk