When investing in a fund or managed portfolio, the fee structure typically consists of management and performance fees. While management fees are a fixed percentage of the assets under management, performance fees will vary based on the returns achieved.
A high-water mark is used by some managers in the calculation of performance fees, acting as a buffer to protect investors from bearing these charges when they are not profiting from their investment.
High-water mark definition
The high-water mark is the highest valuation point an account has reached. This serves as a benchmark that helps to keep the investment manager responsible for the performance of the portfolio and ensures that their compensation is aligned with the performance of the portfolio and thus the interests of investors.
If the account is below the high-water mark, the manager will have to exceed the same threshold before being eligible for a performance fee. It therefore also ensures that the investors do not pay the performance fee more than once for profits made if the value of the account fluctuates greatly.
How does the high-water mark work?
The high-water mark is a measure that can only go up and shifts whenever the account reaches a new higher value at a predetermined valuation period. If fees are calculated on a monthly basis, the high-water mark will be determined monthly as well, and the investment manager will only be paid performance fees if the account value exceeds the high-water mark level.
If the account loses value before recovering subsequently, no fees will be paid until the high-water mark is crossed.
High watermark example
For example, an investor invests $100,000 in a managed account charging a 20% performance fee. At the end of the first month, the account turns a 10% or $10,000 profit after accounting for management fees. The performance fees charged would be $2,000 and the high-water mark would be shifted up to $108,000.
The next month, assume the portfolio suffers an $8,000 loss, leaving the account value at $100,000, the investor is not liable to pay a performance fee to the investment manager till the account value exceeds$108,000, the previously set high-water mark.
If in the third month, the portfolio recovers and returns a 10% profit, the account value will have recovered to $110,000. In this case, the investor will only be charged the performance fee on the difference between the new account value ($110,000) and the previous high-water mark ($108,000), which is $400 (20% of $2,000), rather than 20% of the full $10,000 profit for the month.
Having a high-water mark is a plus for investors
The presence of a high-water mark not only protects the investors from paying more when the fund is not performing but motivates the investment manager to achieve consistent performance. This ensures that the interests of the investment managers are aligned with the investors in achieving consistent investment returns.
Contact us at Ortega Capital for more information.