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# High water mark

#### Kavita.bhangdia

##### Active Member
Hi David,
Please can you explain me the meaning of high water mark?

Thanks,
Kavita

#### brian.field

##### Well-Known Member
Subscriber
It depends on context but it usually means an highest point. For example, consider an engineer that has to determine how high to build a wall to ensure the chances of a flood rising above the wall are below a certain level. The engineer will be interested in historical high water marks......from which there will like be one unique highest water mark.

Consider the DOW Index.....the high water mark during the 90s internet bubble would refer to the highest point the DOW reached during that period....

#### QuantMan2318

##### Active Member
Subscriber
To add to Brian's explanation here, historically, I think it had to do with shipping. Say a Ship was launched from a Shipyard , there would be a series of marks on its Hull ( the front part called as the Bow ), showing the level upto which it can float and the higher we load a Ship, more and more it sinks into the Water; so the safest point upto which the Ship can be loaded is the Highest Water Mark - so they can fill her with cargo only till the Ship breached the highest of such marks. ( It is called Plimsoll line after Samuel Plimsoll which supplemented Lloyds' efforts in marine insurance - see again Risk Management, to prevent over loading and over insurance )

Same can be said for our profession - the highest level of loss that we are prepared to take is a high water mark. Also for model validation, we can check the historically highest loss as a High Water Mark (so far)

#### ShaktiRathore

##### Well-Known Member
Subscriber
hi
If High water mark initially at day 0=H0=100(initial fund value=100)
if the return for the fund is 10% for day 1 then the fund value becomes 100*1.10=110>HWM=100 threfore 110 becomes the new HWM,110 exceeds the previous HWM of 100 therefore manager receives performance fees of 20%*(110-100) .
Now if the return for the fund is -5% for day 2 then the fund value becomes 110*.95=104.5 this is< HWM=110 therefore the manager receives no performance fees.
if the return for the fund is +5% for day 3 then the fund value becomes 1.05*104.5=109.725 this is still< HWM=110 therefore the manager receives no performance fees.
if the return for the fund is +5% for day 4 then the fund value becomes 1.05*109.725=115.21125 this is > HWM=110 therefore 115.21125 becomes the new HWM,115.21125 exceeds the previous HWM of 110 therefore manager receives performance fees of 20%*(115.21125 -110) .
thanks

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#### David Harper CFA FRM

##### David Harper CFA FRM
Staff member
Subscriber
Thanks @ShaktiRathore I was just going to refer to that question!

@Kavita.bhangdia Below is from Stowell's Investment Banks, Hedge Funds, and Private Equity (which previously was in the FRM), upon which my practice question is based.

High-Water Marks and Hurdle Rates -- Introduced in Stowell Chapter 11 (previously assigned in FRM, but dropped and replaced by Mirabille)
High-Water Marks and Hurdle Rates [Stowell Chapter 11]: A high-water mark relates to payment of performance fees. Hedge fund managers typically receive performance fees only when the value of the fund exceeds the highest net asset value it has previously achieved. For example, if a fund is launched with a net asset value (NAV) of $100 per share and NAV was$120 at the end of the first year, assuming a 20% performance fee, the hedge fund would receive a performance fee of $4 per share. If, however, at the end of the second year, NAV dropped to$115, no performance fee would be payable. If, at the end of the third year, NAV was $130, the performance fee would be$2 instead of $3, because of the high-water mark—that is, ($130 − 120) × 0.2. Sometimes, if a high-water mark is perceived to be unattainable, a hedge fund may be motivated to close down. See Chapter 15 for more discussion of high-water marks. In addition, some hedge funds agree to a hurdle rate whereby the fund receives a performance fee only if the fund’s annual return exceeds a benchmark rate, such as a predetermined fixed percentage, or a rate determined by the market, such as LIBOR or a T-bill yield. High-Water Mark -- Stowell's further detail High-Water Mark [Stowell Chapter 15] A hedge fund high-water mark is a mechanism that is implemented to make sure that managers do not take a performance fee in the current period when the fund has had negative performance over previous performance fee periods. The high-water mark is the colloquial term for a “cumulative loss account.” A cumulative loss account starts with a zero balance at the beginning of any performance period (monthly, quarterly, or yearly, as determined by the firm), and it records net losses during that period. See Exhibit 15.1 for an example of high-water mark calculation. It is estimated that only one in ten hedge funds received performance fees during 2008 because of losses and application of high-water marks. This created significant compensation pressures for many funds since their management fees were insufficient to keep the business going, which resulted in significant downsizing of headcount and office space. The high-water mark is designed to benefit investors by preventing a manager from taking a performance fee on the same gains more than once. However, the high-water mark also creates a perverse incentive for the hedge fund manager to either take extra risk to generate returns high enough to deplete the cumulative loss account so that a performance fee will be paid, or to close down the fund and start again. Both actions could be damaging to investors, forcing them to either request redemptions at inopportune times, or continue with their investment with a potentially higher risk profile. If a hedge fund manager shuts down a fund, the investor might suffer disproportionate losses as assets are sold in a fire sale environment. However, to keep money invested in the fund under a higher risk profile may also not be in the investor’s best interest. Moreover, taking money out to invest with another manager might subject the investor to the same high-water mark issue. As a result of this conundrum, in some cases, it might make sense for investors to consider modification of the high-water mark. An alternative to the standard hedge fund high-water mark is a modified high-water mark: resetting the high-water mark to the current fund level under circumstances where to do so better aligns everyone’s interest, amortizing losses over a several-year period to enable some modest level of performance fees during this period, or rolling the high-water mark over a more extended period. A modified high-water mark may create value for investors by keeping a manager in the game and reducing the incentive of the manager to take excessive risk. As a quid pro quo, some hedge fund managers may be willing to accept lower performance fees. Exhibit 15.1 High-Water Mark Example An example of the mechanical application of the cumulative loss account and high-water mark calculation follows: Hedge fund NAV 01/01/06:1,000,000

Hedge fund NAV 12/31/06: $1,200,000 (total after expenses, including the management fee expense) Gain:$200,000
Less performance fee: $40,000 [20% of$200,000]
Cumulative loss account: $0 Hedge fund NAV 01/01/07:$1,160,000

Hedge fund NAV 12/31/07: $1,000,000 (total after expenses, including the management fee expense) Gain: ($160,000)
Less performance fee: $0 Cumulative loss account:$160,000

Hedge fund NAV 01/01/08: $1,000,000 Hedge fund NAV 12/31/08:$1,100,000 (total after expenses, including the management fee expense)
Gain: $100,000 Less performance fee:$0
Cumulative loss account: $60,000 Hedge fund NAV 01/01/09:$1,100,000

Hedge fund NAV 12/31/09: $1,300,000 (total after expenses, including the management fee expense) Gain:$200,000
Less performance fee: $28,000 [20% of$140,000]
Cumulative loss account: \$0

The concept of the high-water mark is theoretically similar to the “claw-back” provision found in many private equity funds in that its purpose is to make sure the manager is not overcompensated for underperformance. However, the high-water mark is distinctly different in that it is prospective in nature (whereas the claw-back is retrospective in nature). The high-water mark is applied to a hedge fund manager on a going-forward basis, so the manager will need to get the fund’s account back up to the high-water mark before a performance fee can be taken.