Loading the player...

What is a 'High-Water Mark'

A high-water mark is the highest peak in value that an investment fund or account has reached. This term is often used in the context of fund manager compensation, which is performance-based. The high-water mark ensures the manager does not get paid large sums for poor performance. If the manager loses money over a period, he must get the fund above the high-water mark before receiving a performance bonus from the assets under management (AUM).

BREAKING DOWN 'High-Water Mark'

High-water marks ensure that investors do not have to pay performance fees for poor performance, but more importantly, guarantee that investors do not pay performance-based fees twice for the same amount of performance.

High-Water Mark in Practice

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 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 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.

High-Water Marks and the "Free Ride" 

Several things can happen when an investor enters a fund during a period of underperformance. For instance, at Goldman Sachs Asset Management, an investor who buys into the fund at a net asset value (NAV) below the high-water mark will enjoy the upside from the subscription NAV to the high-water mark without paying a fee. This situation is known as a "free ride." It allows new investors to benefit from buying into an underperforming fund without penalizing existing investors. Other funds may avoid the "free ride" by charging a performance fee for any positive performance. 

RELATED TERMS
  1. Incentive Fee

    An incentive fee is a fee charged by a fund manager based on ...
  2. Cover On Approach

    Cover on approach refers to sale of a short position as a security's ...
  3. Costs And Expenses

    Costs and expenses are the expenses associated with running a ...
  4. Layered Fees

    Layered fees are a type of fee schedule that leaves investors ...
  5. Mark To Market - MTM

    Mark to market (MTM) is a measure of the fair value of accounts ...
  6. Investment Manager

    An investment manager is a person or organization that makes ...
Related Articles
  1. Managing Wealth

    How To Optimize Your Portfolio and Reduce Fees

    Investment fees aren't avoidable altogether, but there are strategies investors can employ to keep those fees at bay and reduce the impact on returns.
  2. Taxes

    2 Ways Hedge Funds Avoid Paying Taxes

    Learn about two strategies hedge funds use to minimize their tax liabilities. Read why some hedge funds are in the reinsurance business in Bermuda.
  3. Investing

    Are Fees Depleting Your Retirement Savings?  

    Each retirement account will have a fee associated with it. The key is to lower these fees as much as possible to maximize your return.
  4. Tech

    Are Financial Advisor Fees Too High?

    Fees charged by financial advisors run the gamut. Are you getting a fair deal or paying too much?
  5. Investing

    Mutual funds: Management fees versus MER

    Having a clear understanding of the fees charged by a mutual fund is a significant component to making an informed investment decision.
  6. Financial Advisor

    How Mutual Fund Companies Make Money

    Read about the many different kinds of fees and sales charges mutual fund companies can use to generate revenue from those who invest in their shares.
  7. Investing

    Hedge Fund Due Diligence

    Analyzing a hedge fund will help you determine whether it's a good investment and a good fit.
  8. Investing

    A Guide For Picking Long Term Mutual Funds

    Learn about considerations for investors when buying shares in a mutual fund for a long-term investment, including fees, type of management and portfolio goals.
  9. Trading

    Is Amazon Stock Topping Out at $1,000?

    Amazon stock hit psychological resistance at $1,000 in May and has made no progress since that time.
RELATED FAQS
  1. The Difference Between Hurdle Rate and High Water Mark

    Find out the difference between hurdle rates and high water marks. Learn how they are used by hedge funds to calculate incentive ... Read Answer >>
Trading Center