Estably Blog | Knowledge
The High Water Mark principle
Published on 25.01.2024
The high water mark principle is a concept from the world of finance that can be applied to the fee structures of asset management companies or funds.
We explain the basic idea behind the high water mark, reveal the advantages and disadvantages and use a specific example to show how a performance-related fee is calculated using the high water mark principle.
In our explanatory video, we use various scenarios to show how the performance fee is calculated according to the high water mark principle.
High Water Mark as a safety net for investors
The high water mark principle is a concept in finance that ensures that fund managers or asset managers only charge a performance fee for new gains.
Think of it like a high water mark: Only if the fund exceeds a previous high, i.e. the “water mark” rises, are fees due.
If the performance falls below this mark, the next fee is only due when the high water mark is exceeded again. This protects investors from paying fees for volatile or inconsistent performance and motivates the fund manager or asset manager to perform consistently well, as they are only rewarded when they actually add value for investors.
Put simply, the High Water Mark is the highest value your investment has ever achieved.
Advantages of the High Water Mark principle
The High Water Mark principle offers investors several advantages: It protects you from being charged performance fees again for the same performance. This principle ensures that fees are only charged on actual gains and not on the compensation of losses (more on this in the example).
In addition, it promotes a fair and performance-based remuneration structure between the fund manager and investors, resulting in a stronger alignment of interests. It also contributes to transparency by setting a clear benchmark for the calculation of performance fees. This makes it easier for you as an investor to understand the costs and ensure that you only pay for genuine performance.
Overall, the High Water Mark principle increases trustworthiness and incentive compatibility in the relationship between investors and fund managers.
Points of criticism and possible risks of the High Water Mark principle
Despite its fairness for investors, there are also criticisms of the high water mark principle.
One possible point of criticism is that fund managers or asset managers could take a higher risk in order to exceed the high water mark and thus maximise their fees. This could lead to an increase in risk that is not in the interests of investors.
There is also the danger that managers could become demotivated if the portfolio value falls too low, as reaching the high water mark appears unrealistic.
In addition to these points of criticism, it should be added that asset managers must strictly adhere to the contractually agreed investment guidelines. This means that they are prohibited by law from taking an unauthorized high risk.
Example of calculating the performance fee according to the high water mark principle
For Estably, the performance fee is 10% according to the high water mark principle.
You open a custody account with €50,000.
We increase your assets to €55,000 by the end of the year.
The difference of €5,000 between the deposit and the end of the year serves as the basis for calculating the performance fee of 10%.
In this case, the fee is €500 (10% x €5,000).
Your high water mark is €55,000
The next year is slightly worse.
The value of your custody account falls from €55,000 to €52,000 by the end of the year.
We do not charge a performance fee in this year.
Thanks to the High Water Mark, we therefore only charge the performance fee of 10% on the newly created added value of €55,000 to €58,000.
In this case, it amounts to €300 ((€58,000-€55,000) x 10%).
The new high water mark is now €58,000.
Note: With Estably, the level of the high water mark is always measured at the end of the year. Even if in this example the portfolio had broken through the €58,000 level during the year, the new high water mark would still be €58,000, as this is the value at the end of the year.
Conclusion: The High Water Mark principle as an effective tool for performance evaluation
The high water mark principle ensures that managers only receive a performance fee if the invested capital outgrows the highest achieved value, the so-called “high water mark”.
This motivates fund managers and asset managers to perform consistently well and protects investors from paying fees for mediocre performance. By using this principle, investors can maximize their profit opportunities while minimizing the risk of unnecessary additional costs.
In practice, the high water mark principle has established itself as an effective instrument that leads to fair and performance-related remuneration in asset management.
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