A high-water mark doesn’t only mark the highest value a fund has reached; it can also be a factor in the fund’s fee structure. When a high-water mark is part of a fund’s contract, you only pay a performance fee on returns above the previous mark. The effect is that if an investment falls in value, then you won’t have to pay the performance fee on returns that increase your account back to the previous high value. This acts as an incentive for the fund manager(s) to keep setting new high-water marks. For example, look at how a high-water mark clause can affect the performance fee that you pay as a hedge fund investor. First, assume you have $1 million invested in a fund, and over the course of a year, the investment grows by 15%. You will have earned $150,000, and your account value will be $1.15 million at the end of the year. If you’re required to pay a performance fee of 20% of the profits, your fee will be $30,000, or 20% of the $150,000 profit made. Second, consider that instead of earning 15% in a year, the investment lost 15% after your account had grown to $1.8 million after several years. Because you lost 15% for the year, there are no profits; thus, you have no performance fee. Since 15% of $1.8 million is $270,000, you’d have $1.53 million in your account.
How Does a High-Water Mark Work?
A hedge fund high-water mark is set each time the value of a fund exceeds the previous highest price. The watermark does not drop; it only rises. When the fund generates returns higher than the watermark, the fund can charge you fees for the value of the returns that are higher than the mark. If the fund generates returns that do not increase its price above the watermark, you do not pay the performance fee. Hedge funds have fee structures they follow that let you know upfront how much you’ll owe. The most common hedge fund fee structure requires a 2% annual asset management fee and a fee of 20% of the profit you earn from the fund. This arrangement is called the “Two and Twenty.” Here’s how a high-water mark, as part of a fund’s performance fees, would work with a fee structure of 20% of the profits made each month. In the next year, you gained 10% on your $1.53 million. While that is a 10% profit for the year, you would only have $1.68 million in your account. Since that is short of the previous high-water mark of $1.8 million, you wouldn’t owe the performance fee of 20%. If in the next year the account grows by 20%, then you’d have an account value of $2.02 million. You would owe the 20% performance fee on the profits earned above the $1.8 million high-water mark. In this case that would be $2.02 million - $1.8 million = $220,000 x 20% = $44,000.
High-Water Mark vs. Hurdle Rate
In addition to a high-water mark, hedge funds may also have a hurdle rate. The hurdle rate is the minimum return that a fund must earn before the performance fee applies. This is often in addition to the high-water mark. For example, say you invest in a fund with no high-water mark. The fund’s value dropped $10,000 in two months. The following month, $2,000 in returns were generated. Since there were returns, you’d need to pay fees of 20%—you’d make $1,600 that month. If you were then lucky enough afterward to experience a steady rate of $2,000 in returns per month ($1,600 after fees), it would take you over eight months to recoup your total losses. With the clause, it would only take five months—still a long time, but shorter than a fund without it.
