- A high-water mark is the highest level in value an investment account or fund has reached.
- A high-water mark is often used as a demarcation point in determining performance fees that an investor must pay.
- The purpose is to protect investors from paying a fee for poor performance, and from paying a fee repeatedly every time the fund earns a profit.
- With a high-water mark, the investor pays a fee that only covers the amount the fund earned between the point of entry and its highest level.
Understanding High-Water Mark
A high-water mark ensures that investors do not have to pay performance fees for poor performance, but, more importantly, guarantees that investors do not pay performance-based fees twice for the same amount of performance
High-Water Mark Example
For example, assume an investor is invested in a hedge fund that charges a 20% performance fee, which is quite typical in the industry. Assume the investor places $500,000 into the fund, and, during its first month, the fund earns a 15% return. Thus, the investor’s original investment is worth $575,000. The investor owes a 20% fee on this $75,000 gain, which equates to $15,000.
At this point, the high-water mark for this particular investor is $575,000, and the investor is obligated to pay $15,000 to the portfolio manager.
Next, assume the fund loses 20% in the next month. The investor’s account drops to a value of $460,000. This is where the importance of the high-water mark is noted. A performance fee does not have to be paid on any gains from $460,000 to $575,000, only after the high-water mark amount. Assume that in the third month the fund unexpectedly earns a profit of 50%. In this unlikely case, the value of the investor’s account rises from $460,000 to $690,000. Without a high-water mark in place, the investor owes the original $15,000 fee, plus 20% on the gain from $460,000 to $690,000, which equates to 20% on a gain of $230,000, or an additional $46,000 in performance fees.
Value of a High-Water Mark
The high-water mark prevents this “double fee” from occurring. With a high-water mark in place, all gains from $460,000 to $575,000 are disregarded, but gains above the high-water mark are subject to the performance-based fee. In this example, beyond the original $15,000 performance-based fee, this investor owes 20% on the gains from $575,000 to $690,000, which is an additional $23,000.
In total, with a high-water mark in place, the investor owes $38,000 in performance fees, which is $690,000 less than the original investment of $500,000 multiplied by 20%. Without a high-water mark in place, which is below industry standards, the investor owes a 20% performance fee on all gains, which equates to $61,000. The value of a high-water mark is unquestionable.
A high-water mark both protects the fund’s investors from double fees and motivates the fund’s managers to perform well, in order to earn fees.