What is a potential impact of incorrectly chosen indexes in returns-based style analysis?

In returns-based style analysis, selecting inappropriate or poorly correlated indexes can significantly distort the evaluation of an investment's performance. When an incorrect index is used, the analysis may not accurately reflect the true risk-return profile of the portfolio being assessed. This misalignment can lead to misleading interpretations, where the performance appears stronger or weaker than it actually is.

For instance, if a growth-focused equity portfolio is compared against a value index, the analysis might suggest that the portfolio is underperforming when, in reality, it may simply follow a different style that aligns poorly with the benchmark used. This discrepancy provides a false sense of how well the investment is performing relative to the market, leading to potentially flawed investment decisions based on inaccurate conclusions about risk and returns.

Consequently, relying on incorrect indexes can fundamentally undermine the integrity of the performance evaluation, making option B the most accurate representation of the potential risks associated with incorrect index selection in this analytical approach.