There seems to be some confusion as to what “time-weighting” actually means. The term was coined in the 1968 Bank Administration Institute (BAI) standards. The BAI proposed three ways to calculate returns:
- the “exact method,” whereby we revalue the portfolio for any cash flow
- the “linked IRR,” where we geometrically link subperiod (e.g., monthly) returns which were derived using the internal rate of return (IRR); this is similar to the Modified Dietz formula
- the time-weighted method, where instead of geometrically linking, we link returns based on the length of time between flows.
The third method can produce returns which are in error, thus it’s been abandoned. However, the term “time-weighting” remains in our lexicon. But do we “weight” time? Nope! In fact, time has no bearing whatsoever on our returns. If we link a one day return, with a one week, one month, one quarter, one year, and one decade return, we will obtain a cumulative return across the full period, but in no way do we give extra “weight” to any of these periods.
In no way do we weight time in time-weighting. Granted, we weight cash flows based on their time in the Modified Dietz and Linked IRR, but this wasn’t the source of the expression. Time-weighting simply means that we are eliminating or reducing the impact of cash flows. That’s it! No time weighting.