High Water Mark (Investment) - Explained
What is the High Water Mark for an Investment?
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Table of ContentsWhat is the High-Water Mark in an Investment?How is the High-Water Mark for an Investment Used?High-Water Mark in PracticeValue of a High-Water MarkHigh-Water Marks and the "Free Ride"
What is the High-Water Mark in an Investment?
A high-water mark is the maximum value at which an investment fund or account can culminate. A high-water mark is typically used to benchmark performance of fund managers. This system ensures that the fund manager acts with responsibility and discretion while handling client funds. The fund manager either is rewarded for achieving a high - water mark or is made responsible for bringing the fund value above the high - water mark in case its value depreciates.
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How is the High-Water Mark for an Investment Used?
High-water marks not only negate possibilities of investors having to reward poor performance of fund managers, but also remove duplicity in payment of performance-based incentives.
High-Water Mark in Practice
As an illustration, let us assume that an investor has made an investment of $1 million in a hedge fund. Now, lets say he has agreed to pay a performance fee of 20% to the fund manager. The fund performs well and gains 20% in the first month, leaving the investor with a fund value of $1.2 million - a profit of $200,000. Currently, the high-water mark for the investor is $1.2 million, and the investor pays 20% of profits, that is $40,000 to the fund manager.Suppose the fund loses 20% of its value the following month, leaving the investor with a reduced fund value of $960,000. A set high-water mark guarantees that the investor is relieved from the obligation of paying performance fee for any future gains from $960,000 to $1.2 million; the investor only has to pay performance fee for any subsequent gains that the fund attains after achieving the high-water mark amount.Finally, let us say in the third month, the fund gains 40%. The investor is now left with an inflated fund value of $1,344,000. With a high-water mark in place, the investor now only owes 20% of the difference between the current and previous high-water marks in performance fees. This equates to 20% of ($1,344,000 - $1,200,000), that is $28,800.
Value of a High-Water Mark
A high-water mark is of unquestionable value vis--vis high-value investments via fund managers. In the above example, without a high-water mark in place, the investor would have had to pay a performance fee of 20% of ($1,344,000 - $960,000), that is $76,800, a whole $48,000 more than what they actually ended up paying!
High-Water Marks and the "Free Ride"
It is a widespread notion that investors buy during dips, that is during a period of underperformance. A high-water mark in place ensures that a fund may choose to offer a free ride to investors that invest in the fund at a net asset value (NAV) below the high-water mark. These investors are exempt from paying a fee during the period that the fund rises in value from the NAV at the time of subscription to the high-water mark. However, this exemption is at the sole discretion of the fund in question as not all funds offer free rides.