Dollar-weighted returns are particularly useful for which type of investor?

Dollar-weighted returns, also known as internal rate of return (IRR), are particularly suitable for investors who frequently trade because this measure accounts for the timing and magnitude of cash flows into and out of an investment portfolio. Specifically, as these traders make numerous transactions, their returns are driven by when they invest or withdraw funds and the performance of the investments at those specific times.

This measure effectively captures the impact of changes in asset allocation and market movements that happen as trades are made. For active investors who engage in frequent trading, understanding dollar-weighted returns provides critical insight into the true performance of their investment strategy as it reflects the real returns they experience given their specific cash flow situation.

In contrast, passive investors generally do not trade frequently, which makes dollar-weighted returns less relevant to their overall investment strategy. Similarly, institutional investors might have a more diversified and longer-term focus that relies on different performance indicators. Lastly, buy-and-hold investors typically do not make regular cash flows into and out of their investments, making more conventional return measures like time-weighted returns a better fit. Hence, for those who frequently trade, the dollar-weighted return is valuable for evaluating their actual investment performance based on their dynamic trading behavior.