Hedge fund incentive fees are often called a “free option” since the fund manager can win, but can’t lose.  Since managers can influence the volatility of their funds, many assume that this asymmetry will always give the manager an incentive to “swing for the fences”.

But with so many hedge funds starting off 2009 well below where they were a year ago, we thought it might be useful to examine whether this axiom holds true in the existence of the ubiquitous high water mark.  Last year, two academic studies published before most hedge funds took a dive under water address the impact of high water marks on manager incentives and decision making.  Now is probably a good time to have a second look at them.

The first, by Stavros Panageas of the University of Chicago and Mark Westerfield of the University of Southern California, finds that high water marks mitigate the manager’s potential benefits from goosing their fund’s volatility.  The duo points out that the value of the manager’s “free option” is based on the extent to which the fund is below its high water mark (or, to use the option analogy, below its strike price).  So swinging for the fences and losing has a direct impact on the wealth of the manager.

In a real sense, the “free option” is actually an infinite series of future (annual) options, each with new strike prices in relation to the fund’s value.

In their words:

“A bolder portfolio today could help increase the probability of crossing the current high water mark, but it will also increase the probability that the assets in the fund will be substantially lower next period, while the high water mark will remain unchanged. In the latter case the value of future options will decline, as the assets in the fund will be lower for the same value of the high-water mark. Hence, future options will become more ‘out of the money’.”

So lower moneyness means less value in the option for the manager – an outcome than can make a manager think twice before pointing to center field and taking that Babe Ruth-sized swing for the fences.

While Panageas and Westerfield’s study assumes the hedge fund in question has an infinite life span, the second study, by Susan Christoffersen of McGill University and David Musto of Wharton, recognizes that as small businesses, hedge funds fold on a regular basis.  Thus, investors who are below the high water mark can be shut out of their well-earned performance fee holiday if the manager unilaterally calls it quits.  This can mitigate the negative effect of high water marks on the value of the managers’ “free option”.

Christoffersen and Musto also point out that high water marks can divide investors according to their  tenure in the fund.  As they write,

“…with a HWM, old investment invests on better terms after a loss, because it does not pay the incentive until the loss is made up, whereas new investment has no loss to make up, and therefore pays higher expected fees. So if expected profits after a loss are zero for new investment they must be positive for old investment.”

This is going to be a big issue in 2009.  Most investors are about to embark on a year-long performance fee holiday (which, as an aside, will likely drop the average cost of a hedge fund in 2009 to below that of many mutual funds).  But new investors – or even new assets from existing investors – will face a high water mark of the fund’s NAV on the day of their new investment.

With dramatically different pay-offs, it’s not a huge stretch to imagine potential infighting among hedge fund investors as new entrants pay markedly higher fees than old ones.  The problem is that these “new” investors might just be those who have redeemed from other funds and have reallocated back to the asset class in the form of a different fund.  Just as loyal investors face the frustration of watching their manager give up as a result of  being too far below the high water mark, many other investors will likely frustrate their own chances of success by switching horses – only to have their high water marks reset.