IEsailor wrote:
Investment Advisor: It is well-known that investing in mutual funds reduces portfolio risk through diversification. It is also true that past investment performance is often related to future investment prospects. Therefore, to help my clients earn high returns with low risk, I select a group of mutual funds that meet the client’s objectives and then invest the client’s assets in the fund that has delivered the highest returns in this group over the past 2 years.
Which of the following statements, if true, would demonstrate a serious flaw in the approach of the Investment Advisor?
A. Managers of many mutual funds that have delivered the highest returns over the past several years have already used up their best investment ideas and are unlikely to sustain this level of performance in the future.
B. Mutual funds span a wide spectrum of investment styles and performance objectives and no single fund is suitable for every investor.
C. Many individual investors choose to manage their own portfolios rather than consult an investment advisor.
D. The funds that have had the strongest past performance tend to continue to outperform other funds with similar objectives for many years in the future.
E. The number of clients served by the investment advisor has declined by nearly 50% over the past 5 years.
OFFICIAL EXPLANATION
The strategy of the investment advisor is based on selecting the fund that has delivered the highest returns within the peer group that meets the client’s objectives. One of the major assumptions underlying this strategy is that the funds that have delivered the best returns will continue to do so in the future. If this assumption is inaccurate, the strategy of the investment advisor will be seriously weakened.
(A) CORRECT. This answer choice demonstrates a serious flaw in the logic of the investment advisor. If it is true that the best-performing fund managers have already used their strongest ideas and are unlikely to sustain this level of performance in the future, then the advisor’s winner-oriented strategy is unlikely to deliver high returns.
(B) Since the investment advisor selects the fund from the group that meets the client’s objectives, this statement does not weaken the advisor’s strategy.
(C) Since the advisor’s strategy is oriented only towards her clients rather than the public in general, the fact that many investors choose to manage their own portfolios is outside the scope of the argument.
(D) This statement, if true, would support rather than weaken the advisor’s strategy. If the funds with strongest past performance continue to outperform others, the advisor’s strategy is likely to yield high future returns.
(E) Since this answer choice does not provide any specific reason for the decline in the advisor’s clientele, it is not relevant to the effectiveness of the advisor’s strategy. This decline could have occurred for a variety of reasons unrelated to investment returns. For example, the decline in the clientele could have resulted from the fact that the advisor moved from a larger metropolitan area to a smaller town with fewer active investors.
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