Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Is the Internal Rate of Return (IRR) considered a dollar-weighted or time-weighted return?

1. Dollar-weighted return

2. Time-weighted return

3. Neither

4. Both equally

The correct answer is: Dollar-weighted return

The Internal Rate of Return (IRR) is classified as a dollar-weighted return. This classification stems from the fact that IRR takes into account the timing and magnitude of cash flows, reflecting the actual amount of money invested and returned over time. Essentially, it gives more weight to the periods when larger cash flows occur, thus influencing the rate of return calculated. This characteristic of IRR makes it particularly influential for evaluating investments where cash flows occur at different times and amounts, such as private equity or real estate investments. Investors seeking to understand how well their actual investments have performed, considering both the cash put in and the cash received, use IRR for decision-making purposes. In contrast, a time-weighted return does not account for the size of cash flows and focuses instead on the performance of an investment independent of the investor’s cash flows. This method is often used to compare the performance of various portfolio managers without the influence of additional investments or withdrawals by the investor. Thus, the appropriate designation of IRR as a dollar-weighted return emphasizes its relevance in situations where the timing and amount of cash flows are critical to assessing investment performance.