George Judas, CFA, manages a small capitalization mutual fund. Judas only invests in companies with low price to earnings ratios. Judas states that research suggests that returns on both small capitalization and low P/E companies are anomalous, in that they will provide investors with superior risk-adjusted long-term returns. Judas' supervisor counters with the following two observations.
Observation 1:The research does not adequately account for the level of risk of small capitalization and low price to earnings ratio companies.
Observation 2:The research on small capitalization and low price to earnings ratio companies suffers from a small sample bias.
Are the supervisor's observations most likely correct?
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A. B. C.Explanation
The supervisor's observations question the validity of the research cited by George Judas, who claims that investing in companies with low price-to-earnings (P/E) ratios and small capitalizations can provide superior risk-adjusted returns. Let's analyze each observation and its implications:
Observation 1 states that the research fails to adequately account for the level of risk associated with small capitalization and low P/E ratio companies. This observation suggests that the research may not have considered or properly measured the risks involved in investing in such companies. Risk is an essential factor in evaluating investment opportunities, and if the research has not appropriately addressed it, the conclusions drawn from it may be incomplete or inaccurate. Therefore, Observation 1 raises valid concerns about the research and suggests that the claims made by George Judas may not be supported by a comprehensive risk analysis.
Observation 2 suggests that the research suffers from a small sample bias. In other words, the research may have been conducted on a limited number of companies or may have focused on a specific period or market condition. Small sample bias refers to the potential distortion of results when the sample size is too small to accurately represent the entire population. If the research only analyzed a small subset of companies or a limited timeframe, its conclusions may not be generalizable to the broader market or over a longer time horizon. Consequently, Observation 2 points out a potential flaw in the research methodology and implies that the findings may not be reliable or applicable beyond the specific conditions studied.
Considering these observations, we can conclude that both Observation 1 and Observation 2 raise legitimate concerns about the research cited by George Judas. Therefore, the supervisor's observations are most likely correct. The correct answer would be C. Only Observation 2 is correct.