A dollar-weighted return provides a return between two points in time, incorporating all the cash in-flows, such as dividends, interest, and contributions, and all cash out-flows, such as withdrawals, from the portfolio. The dollar-weighted return differs from the simple arithmetic return and the time-weighted return because it gives more weight to periods where more funds are in the account or portfolio.
For example, imagine a retiree who is withdrawing funds from his account, slowly depleting the account. The dollar-weighted return will be weighted more toward the earlier days of the account and less toward the latter days, because there were more funds in the account in the early days. If the performance in the account was worse at the earlier date, but then improved over time, the dollar-weighted return will weight the earlier performance greater because more money was in the account. But this does not accurately reflect the portfolio manager’s actual performance. For this reason, portfolio managers typically do not report dollar-weighted average returns. They can be useful, however, in determining whether a customer will meet some financial goal by a specified time.
Conceptually, a dollar-weighted return is the internal rate of return on an investment. It is calculated in the same manner as the internal rate of return on any investment, by figuring the return that is necessary to achieve a net present value of 0 given the increase in the investment, and all cash in-flows and out-flows.
