Abstract
Portfolios and indices that have been specifically constructed to have low risk attributes have received increasing interest in the recent international literature. It has been found that portfolios constructed by targeting low risk assets have predominantly outperformed portfolios constructed to have higher risks. This anomaly has led to renewed interest in constructing low volatility portfolios by practitioners. This study analyses a variety of low volatility portfolio construction methodologies using sectors as building blocks in the South African environment. The empirical results from back-testing these portfolios show significant promise in the South African setting when compared with a market capitalization-weighted benchmark. In the empirical analysis in the South African environment two techniques stand out as being superior low volatility construction techniques amongst the seven techniques assessed. Furthermore, the low volatility portfolios are blended with typical general equity portfolios (using the Shareholder-Weighted Index (SWIX) as a proxy). It was found that these blended portfolios have useful features which lead to enhanced performance and therefore can serve as effective portfolio strategies.
Highlights
Support for the low volatility anomaly stems from the criticism of the Capital Asset Pricing Model (CAPM), which states that assets with high systematic risk are expected to earn higher expected returns, while low beta assets are expected to have lower returns [33, 40]
Seven low-volatility construction techniques were assessed using sectors as building blocks in South African markets. These portfolios were rebalanced annually and their performances were compared with a market capitalization-weighted index (ALSI)
1. all the sector-based low volatility portfolios outperformed the All Share Index (ALSI) at significantly lower risk, resulting in higher risk-adjusted returns, 2. the low-volatility portfolios posted a lower drawdown when compared with the ALSI, which implies that they can recover from losses quicker than the ALSI, and
Summary
Support for the low volatility anomaly stems from the criticism of the Capital Asset Pricing Model (CAPM), which states that assets with high systematic risk are expected to earn higher expected returns, while low beta assets are expected to have lower returns [33, 40]. Black pointed out that when investors are restricted from using leverage or borrowing, they tend to buy high-risk assets thereby leaving the low-risk assets under-priced. This evidence has led to an increasing interest in the formation of low volatility portfolios that have lower risks out-of-sample than market-cap-weighted portfolios, and have higher risk-adjusted returns out-of-sample than market-cap-weighted portfolios. Baker et al [2] gave some behavioral reasons as to why some investors may create an excess demand for high-risk stocks that have historically underperformed They argued why investors might typically avoid buying low-risk stocks. The reasons Baker et al [2] put forward were:
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