Ethical Investment and Portfolio Theory: Using Factor Analysis to Select a Portfolio

Ethical investments are a now a considerable sector in the investment market, with the Financial Times running the headline “Green and ethical investment comes of age” (Shepherd, [1]). Claudia Quiroz (lead fund manager for Cheviot Climate Assets Fund) predicts a strong future for ethical investment, with sustainable investment becoming a growing theme (Hoskin [2]). Much previous research in the “ethical investment” field divides investments into two categories: acceptable or unacceptable. This paper builds on the work of Barracchini and Addessi [3], in viewing how “ethical” an investment is to be a different dimension—each investment is seen as being on a continuum, from “least ethical” to “most ethical”. This paper takes the work of Barracchini and Addessi [3] from a theoretical construct to an approach which can be applied by practitioners. In order to make a workable method, this paper uses conventional portfolio analysis (which focus on risk and return), combined with principal components analysis in order to minimize the risk of a portfolio. It adopts a specific functional form for the saver’s utility function, to assess which assets appears most desirable using that person’s values.