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High water mark (HWM)
Introduction
A “High Water Mark” (HWM) is a performance based fee model most commonly applied by professionally managed investments. The high water mark is sometimes referred to as the “hurdle rate”.
Usage And Applications
In the same way that a body of water will leave a mark on a surface at the highest point that it touches, in managed investments a high water mark serves as a performance threshold that must be reached by the fund before an investment manager receives a performance fee.
This performance based fee is supposed to incentivize the investment manager to produce incrementally more positive performance for her investors over time. Investors do not pay the HWM fee until performance exceeds the previously established water mark. To this end, the client only pays more when they receive more.
High water marks are synonymous with “2 and 20” fee model. Many actively managed funds which charge a 2% annual fee and 20% of profits based on a high water mark. In recent years in the industry, the fixed annual fee is being compressed as a result of fierce marketplace competition and increased scrutiny on discretionary investment managers ability to reliably outperform their benchmarks. High water marks remain a popular remuneration model for performing managers and continue to be well accepted by sophisticated investor clients.
Examples Of Use
Mr. Client is invested in the ABC Global Trend Following Fund. The fund is an absolute return fund that trades futures with the primary objective of producing market neutral positive performance over the medium term. The fund charges 2% of AUM p.a, charged monthly, along with a 20% performance fee, charged quarterly and based on a high water mark.
The performance based fee would be charged as follows.
Share Price in Q1: 10 USD
Share Price in Q2: 12 USD > exceeds HWM? = Yes –> performance fee = 2*.2
Share Price in Q3: 11 USD > exceeds HWM? = No –> performance fee = not taken
Share Price in Q4: 11.5 USD > exceeds HWM? = No –> performance fee = not taken
For the fund manager to receive a performance fee again the share price of the fund would have to exceed 12 USD.
Sources & Further Reading
- CFA Institute – Focus On Fees
- AIMA – In Concert: Exploring the alignment of interests between hedge fund managers and investors