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A high-water mark ensures fund managers are not paid performance fees when they perform poorly.

If an investment loses value over a specified period of time, which is defined in the prospectus, its manager must recoup the losses and return the fund’s value above the high-water mark before he or she is entitled to a performance fee.

It works like this:

Sally puts $100,000 into an actively managed investment that includes a 20% performance fee. In the fund’s first year, it falls 10% from its high-water mark. At the end of year 1, no performance fee is paid.

In year 2, the fund’s value increases 15% over the previous high-water mark. The fund manager’s performance fee is based upon the 5% above the previous high-water mark that its value climbed.

If in Year 2 the fund grows by only 5%, the manager is not entitled to a performance fee because the fund has not topped its high-water mark.

High-water marks are frequently applied to hedge funds and their managers. They align investors’ interests with those of the fund managers’. 

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