High-Water Mark

A high-water mark is the highest net asset value per share that a fund has reached at the end of any period for which a performance fee was assessed. It is used as a threshold: the manager earns a performance fee only on gains that take the fund above that level. If the fund loses value, the manager receives no performance fee until the losses have been recovered in full, so that investors do not pay twice for the same performance.

The term is borrowed from the line left by water at its highest level. It is a standard feature of hedge funds and is found in some mutual funds, managed accounts and other vehicles that charge fees linked to returns. It is often combined with a hurdle rate, which requires a minimum return before any fee is due, and it is the open-ended fund counterpart of the clawback provision used in closed-ended private funds.

The fee is calculated at the end of each performance period, typically a year or a quarter, a point known as crystallisation. If the net asset value per share, after the management fee, is above the existing high-water mark, the fee is charged on the excess and the mark is reset to the new, higher value. If it is at or below the mark, no fee is charged and the mark stays where it was.

Suppose a fund starts at 100 per share and charges 20 per cent of gains. In the first year it rises to 120 before the fee. The fee is 20 per cent of 20, or 4, leaving 116, which becomes the high-water mark. In the second year the fund falls to 100; no fee is due and the mark stays at 116. In the third year it rises to 125. The fee is charged only on the 9 above 116, giving 1.80, and the new mark is 123.20. Without the mark, the manager would have been paid on the full 25 gained in the third year, most of which only restored earlier losses.

A single fund-wide mark creates unfairness when investors enter at different prices. An investor who buys while the fund is below its mark would enjoy gains up to the mark free of any fee, while one who buys above an earlier price might pay for performance earned before arriving. Funds address this in several ways.

• Series accounting. A new series of shares is issued at each dealing date, each with its own high-water mark, and series are merged once they have all paid a fee.
• Equalisation. All investors hold the same share, and credits or debits are applied at subscription so that each bears the fee appropriate to its own entry point.
• Investor-level calculation. In partnership structures the fee is calculated on each investor's capital account.

These calculations are carried out by the fund administrator as part of fund accounting and are among the more error-prone parts of producing a price.

A permanent high-water mark never falls. Some funds use a modified or resetting mark, which is lowered after a set period or reduced by a percentage, so that the manager can earn fees again without recovering all losses; investors generally resist these. A hurdle may be a fixed percentage or a benchmark, and may be soft, where the fee applies to the whole return once the hurdle is cleared, or hard, where it applies only to the excess. In regulated European funds, performance fees may also be measured against a benchmark index, with any underperformance carried forward and made up before a fee is paid.

The mark aligns pay with long-term results: a manager is rewarded for new gains, not for volatility around the same level. It also affects behaviour in ways that are less welcome. A fund far below its mark earns only the management fee, which makes it hard to retain staff, and the manager may be tempted to take more risk to get back above the line or to close the fund and start a new one with a fresh mark. Investors who redeem after a loss give up the benefit of the mark, since the fee-free recovery belongs to those who stay. After the losses of 2008 many hedge funds were well below their marks, and a number closed for this reason.

Rules on performance fees vary. In the United States, registered investment advisers may charge performance-based fees only to clients meeting a financial threshold, and mutual funds are restricted to symmetrical fees that rise and fall around a benchmark. In the European Union, guidelines issued by the European Securities and Markets Authority in 2020 for UCITS and certain alternative funds require a performance reference period of at least five years where a fund uses a resetting model, and require the fee model to be disclosed clearly in the prospectus. The management company is responsible for the fee model and its disclosure.