High-Water Mark Loyalty: The Investor’s Safety Net
A high-water mark represents the pinnacle value an investment fund or account has attained. Frequently referenced in the arena of fund manager remuneration, this mechanism guarantees that managers receive performance-based fees only when exceptional results are achieved, thereby shielding investors from unwarranted expenses in times of subpar performance.
Key Insights
- Fulfills a Protective Function: A high-water mark ensures investors are exempt from redundant performance fees.
- Benchmark for Compensation: It serves as the crucial threshold for determining fund manager bonuses.
- Clarity in Fees: Investors are charged fees solely on gains that exceed previous best performances.
- Supporting Managers and Investors: Balances rewarding managers for fruitful management while securing investors’ returns.
Unraveling the High-Water Mark Mechanism
A high-water mark ensures that investors do not bear the brunt of performance fees during periods of underperformance. Furthermore, it eliminates the possibility of paying these fees multiple times for identical performance levels. This approach diverges from a hurdle rate, which marks the minimum profit a hedge fund must achieve to levy an incentive fee.
High-Water Mark Illustrated: A Comprehensive Example
Consider an investor in a hedge fund typical of the industry, charging a 20% performance fee. Assume an initial investment of $500,000. Within the first month, the fund appreciates by 15%, bringing the total to $575,000. The $75,000 profit attracts a 20% fee ($15,000).
- The high-water mark here is defined at $575,000.
- For any losses thereafter, fees apply only when the fund surpasses this high-water mark.
- If the fund dips to $460,000 and subsequently jumps 50% to $690,000:
- Without a high-water mark, the investor would face staggered double fees on gains from $460,000 to $690,000.
- With the high-water mark in place, fees would apply only from $575,000 to $690,000.
Why High-Water Marks are Indispensable
By adhering to this protective measure, performance fees are fairly assessed, safeguarding investor interests. Envisage the previous scenario without the protective umbrella of a high-water mark, leading to a steeper performance fee billing — $61,000 versus $38,000.
The Enigma of the “Free Ride”
During downturns, savvy investors might enter funds priced below high-water marks, effectively benefitting from subsequent gains without immediate performance fees; termed a “free ride”. Conversely, alternate funds mitigate free riding by adjusting terms to collect fees on any performance recovery, balancing new and existing investor positions.
Related Terms: performance fee, hurdle rate, assets under management, net asset value, portfolio manager.
References
- Goetzmann, William N., Ingersoll Jr., Jonathan E., and Ross, Stephen A. “High-Water Marks and Hedge Fund Management Contracts”. The Journal of Finance, vol. 58, no. 4, August 2003, pp. 1685-1718. Download PDF.
- RQSI. “An Overview of Hedge Fund Fees”.
