High Water Mark (Investment) – Definition

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High-Water Mark (Investing) Definition

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.

A Little More About What is a High-Water Mark for an Investment

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, let’s 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-à-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”.

References for High Water Mark

Academic Research on High-water Mark

Effort, risk and walkaway under high water mark contracts, Chakraborty, I., & Ray, S. (2010). In this paper, the authors model a hedge fund style compensation contract in which management fees, incentive fees and a high water mark (HWM) provision drive a fund manager’s effort and risk choices as well as walkaway decisions by both the fund manager and the investor. The paper suggests that the renegotiation of the HWM leads to significantly higher risk and lower effort choices by fund managers and substantially decreases investor welfare.

Effort, risk and walkaway under high water mark style contracts, Chakraborty, I., & Ray, S. (2008). In this paper, the authors model a hedge fund style compensation contract in which management fees, incentive fees and a high water mark (HWM) provision drive a fund manager’s effort and risk choices as well as walkaway decisions by both the fund manager and the investor. The paper suggests that the renegotiation of the HWM leads to significantly higher risk and lower effort choices by fund managers and substantially decreases investor welfare.

Options on Hedge Funds under the High Water Mark Rule, Atlan, M., Geman, H., & Yor, M. (2005).  This paper explores the impact of the fast growing hedge fund industry on individual and institutional investors. The goal of the paper is to propose a valuation of plain-vanilla options on hedge funds which accounts for the high water market rule.

Asset management, High Water Mark and flow of funds, Barucci, E., & Marazzina, D. (2016). Operations Research Letters44(5), 607-611. In this paper, the authors analyze the asset managers portfolio problem when he is remunerated through a High Water Mark incentive fee and a management fee, and the assets under management are characterized by in/outflow of funds as a function of the performance of the fund with respect to a benchmark.

Optimal investment strategy under time-inconsistent preferences and highwater mark contract, Chunxiang, A., Li, Z., & Wang, F. (2016). Operations Research Letters44(2), 212-218. This paper considers the optimal investment problem for a fund manager who has time-inconsistent preferences and is compensated with a HWM contract. The time preferences of fund manager is described by the stochastic hyperbolic discounting function. The paper aims to show more that the fund manager has present-biased preference, there is the greater inclination to increase the proportion in risky asset.

Return to the high water mark: the rule of reason after Leegin, Slowey, W. B. (2008). Competition L. Int’l4, 9.

Pricing Variable Annuity Contracts with HighWater Mark Feature, Belyaev, V. M. (2011).  This paper explores the concept of variable annuities (VA). The paper shows that the value of VA contracts depends on the time between observation dates. Corrections due to this effect are calculated and compared with Monte-Carlo results. Good agreement between analytical formula and numerical calculations of VA values is demonstrated.

The Effects of Different Volatility and Management Fee Dynamics on High Water Mark Option Pricing, Tang, J., & Yau, S. S. T. (2006, December). In Decision and Control, 2006 45th IEEE Conference on (pp. 6696-6701). IEEE. The purpose of this paper is to examine the impact of incentive scheme, including basic management fee (MF) and incentive fee (IF), on exotic option pricing. Since high water mark (HWM) is the benchmark usually employed by the incentive scheme of hedge fund industry, this paper develops the framework of HWM lookback option pricing in stochastic volatility models.

Optimal effort under highwater mark contracts, Zhao, L., Huang, W., & Ba, S. (2018). Economic Modelling68, 599-610. This paper develops a model measuring the optimal effort of a risk-neutral hedge fund manager in a continuous-time framework. The paper finds that  find that the manager’s effort depends on the ratio between the fund’s assets under management (AUM) and the high-water mark (HWM), and endogenous fund liquidation has key influence on the dynamics of the effort.

Study of optimal portfolio of hedge fund with high watermark incentive fees under knightian uncertainty, WU, T. T., FEI, W. Y., & LIANG, Y. (2015). Journal of Anhui Polytechnic University2, 018. This paper studies the strategy of the fund manager’s portfolio as the volatility of the asset price has Knightian uncertainty. Results show that while hedge fund managers maximize the expected utility of the terminal fees including management fees, performance fees and a risky asset are disturbed by a G-Brownian motion

High Water Mark Bias-A New Hedge Fund Index Bias, Skeggs, J., & Liu, L. (2014).  This paper explores different varieties of approachs for benchmarking hedge fund strategies with emphasis based on peer-based and manager aggregate indices. In this paper, the authors add to the existing literature by documenting a new hedge fund index bias – High Water Mark Bias (“HWM Bias”).  The paper include both a empirical study of the bias using the Newedge CTA Index, and provides a theoretical framework for quantifying the HWM Bias for any index.

High water mark in insurance, Roach, R., & Taylor, I. (2018). Superfunds Magazine, (433), 24. The Insurance in Superannuation Voluntary Code of Practice is helping to focus funds’ attention on insurance benefit design and communication to members. This paper explains why adopting parts of the Code could be good for members and a market opportunity for funds.

High Water Mark for Comparative Advertising, Payne, A. (2015). Managing Intell. Prop.252, 17.

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