high-water_mark

A High-Water Mark is the highest peak in value that an investment fund or account has ever reached. Think of it as a financial “personal best.” This mechanism is a crucial feature in the fee structure of many hedge funds and other alternative investments, designed to ensure that fund managers only earn a performance fee on new profits. Essentially, the manager is rewarded for growing the investor's capital beyond its previous peak value. If the fund's value drops, no performance fees are charged until it recovers all its losses and surpasses that old peak. This protects investors from paying fees for mediocre performance or for a manager simply making back money that was previously lost. It's a simple but powerful concept: you only pay for climbing to new heights, not for scrambling back up to a point you've already been.

The beauty of the high-water mark lies in its fairness. It directly links the manager's pay to the investor's positive experience. Let's break it down with a simple scenario.

Imagine you invest €100,000 in a fund that charges a 20% performance fee, calculated using a high-water mark.

1. Year 1: Strong Growth. The fund does well, and your investment grows to €120,000.
   • Profit: €20,000 (€120,000 - €100,000)
   • Performance Fee: 20% of the profit, so 0.20 x €20,000 = €4,000.
   • New High-Water Mark: The new peak value is set at €120,000.
2. Year 2: A Downturn. The market corrects, and your fund's value drops to €110,000.
   • Performance: The fund is below its €120,000 high-water mark.
   • Performance Fee: €0. The manager earns nothing because they haven't generated new profits above the previous peak.
3. Year 3: The Recovery. The fund rebounds strongly to €135,000.
   • Performance: The fund has surpassed its €120,000 high-water mark.
   • Fee-Eligible Profit: The fee is calculated only on the profit above the high-water mark: €135,000 - €120,000 = €15,000.
   • Performance Fee: 20% of this new profit, so 0.20 x €15,000 = €3,000.
   • New High-Water Mark: The bar is raised again, this time to €135,000.

The high-water mark is a key component of the classic 'Two and Twenty' fee model popular among hedge funds. This model consists of two parts:

• A management fee: Typically 2% of the total assets under management (AUM). This is charged annually regardless of the fund's performance to cover operational costs.
• A performance fee: Typically 20% of the fund's profits. This is the part that is subject to the high-water mark.

For any long-term investor, especially one following a value investing philosophy, understanding the high-water mark isn't just academic—it's a critical tool for assessing if a fund is structured in your favour.

The primary benefit of a high-water mark is that it aligns the fund manager's interests with yours. A manager is incentivized to:

• Pursue sustainable, long-term growth rather than taking wild risks for a short-term gain.
• Focus on capital preservation, because they know that any losses must be fully recovered before they can earn a performance bonus again.
• Avoid a “heads I win, tails you lose” scenario. It prevents them from collecting fees year after year on volatile, see-sawing performance that ultimately leaves the investor with no real gains.

While a high-water mark is a great pro-investor feature, always read the fine print in a fund's prospectus. Be aware of a few potential “gotchas”:

• Reset Provisions: Some funds include a clause that resets the high-water mark after a certain period of poor performance, for example, every 12 or 24 months. This is very disadvantageous for the investor, as it allows a manager to “wipe the slate clean” and start earning performance fees again without making up all prior losses.
• Fund Closure Risk: If a fund is significantly below its high-water mark (a situation known as being deep “underwater”), the manager may have little incentive to continue, as the prospect of earning a performance fee is remote. This can lead them to shut down the fund and launch a new one, effectively resetting the high-water mark for themselves.
• Combining with a Hurdle Rate: For an even better deal, look for funds that combine a high-water mark with a 'hurdle rate'. A hurdle rate is a minimum return the fund must achieve (e.g., 5% per year) before the performance fee kicks in. This ensures you're not just paying for performance that you could have achieved in a simple, low-cost index fund.