Understanding the low volatility anomaly in the South African equity market
The Capital Asset Pricing Model (CAPM) advocates that expected return has a linear proportional relationship with beta (and subsequently volatility). As such, the higher the systematic risk of a security the higher the CAPM expected return. However, empirical results have hardly supported this view as argued as early as Black (1972). Instead, an anomaly has been evidenced across a multitude of developed and emerging markets, where portfolios constructed to have lower volatility have outperformed their higher volatility counterparts as found by Baker and Haugen (2012). This result has been found to exist in most Equity markets globally. In the South African market the studies of Khuzwayo (2011), Panulo (2014) and Oladele (2014) focused on establishing whether low volatility portfolios had outperformed market-cap weighted portfolios in the South African market. While they found this to be the case, it is important to understand if this is truly an anomaly or just a result of prevailing market conditions that have rewarded lower volatility stocks over the back-test period. As such, those conditions might not exist in the future and low volatility portfolios might then underperform. This research does not aim to show, yet again, the existence of this 'anomaly'; instead the aim is to dissect if there is any theoretical backing for low volatility portfolios to outperform high volatility portfolios. If this can be uncovered, then it should help one understand if the 'anomaly' truly exists and also if it can be expected to continue into the future.
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