New research illustrates wide-ranging implications of the ubiquitous “high water mark”

Fees 21 Jan 2008

Remember when Goldman Sachs, smarting from mega-losses in its quant hedge funds, offered new investors a one-time opportunity to invest at a reduced fee (1% management fee plus 10% of profits, instead of 2% and 20%)?  At the time, we suggested that such a fire sale can have unintended consequences (see related posting).  Unlike dropping the price of, say, a car, dropping the fees on an investment fund directly impact the value created by the product.  So fiddling with the price can make the quality of the product look better – a particular benefit for the supplier when the product may not be performing very well.

Now a new academic study by Sugata Ray and Indraneel Chakraborty at Wharton reveals that messing around with performance fees can have a material impact on the manager’s effort, the fund’s volatility and even the manager’s propensity to “walk away” from the fund altogether.  As the authors acknowledge, their findings support common intuition – that managers are more likely to buckle down when the high water mark (“HWM”) is in sight, more likely to swing for the fences when it’s not, and more likely to walk away when they feel it’s totally out of reach.

We’ll get into these effects below.  But first, here is the authors’ take on the Goldman situation we discussed in August.  It clearly illustrates the mechanics by which a seemingly benign metric can have such wide-ranging implications:

“The central role of the high water mark in the compensation structure is readily apparent. Following the credit related market correction in August 2007, a well known hedge fund at a bulge bracket bank, which had lost a lot of money and was reportedly 12% below its high water mark, had a `sale’ on new fund inflows. Fees charged on new money introduced to the fund would be a 1% annual management fee and a 10% incentive fee for any profits generated.  That is, a `1/10′ structure rather then the standard `2/20′. The implications of such a move were manifold.  Original monies in the fund were far enough away from their high water mark that employees were sufficiently discouraged about prospects of ever hitting the high water mark (and earning substantial bonuses) to consider leaving and joining other funds. As a result of this, original investors in the fund were questioning whether the fund would be able to maintain their team through this crisis and were considering withdrawing funds. Another worry of the investors would be that managers would tak on inordinate amounts of risk in a desperate attempt to create returns above the high water mark. The infusion of new capital, which would come in fresh, without a high water mark, alleviated these concerns. Employees would still be able to earn incentive fees (and thus bonuses) on this new money immediately, although they would be at the rate of 10% rather than the full 20%. The original investors were reassured that the fund would be able to maintain their team and would not withdraw their funds.”

The fact that in most cases the HWM (or its analogue, the hurdle rate) is fixed doesn’t change the central conclusion here – that proximity to it will impact effort, investment strategy and manager behavior.


The study finds that managers who are close to their HWM have a subsequent 6-month return that is 2.8% higher than those managers who were 10% below their HWM.  On the surface, this could simply show that funds which haven’t messed up recently are less likely to mess up going forward.  But the researchers are quite clear about their alternate inference:

“We interpret this as evidence of additional effort expenditure by managers in funds closer to the HWM.”


The study also finds that funds which are 10% below their HWM have a standard deviation over the next 6 months that is 1.6 percentage points higher than those funds that remained close to their HWM.  Again, one might conclude that higher volatility funds are more predisposed to be 10% below their high water mark.  Or, as the authors suggest, one might conclude that these managers start to scramble in an effort to make a performance fee.

To determine which is true, the researchers explore whether the higher volatility of the underwater funds is commensurate with the returns they hope to generate.  It turns out that the “swing for the fences” managers aren’t actually heavy hitters that just happen to hit the ball hard as a matter of course.  Instead, it appears they truly are swinging in desperation.  The study finds that for every 1% of standard deviation taken by the fence-swinging 10%-below-HWM managers, there is a pay-off of 0.6% additional return.  But for every 1% of standard deviation added by a close-to-HWM manager, there is a pay-off of 1.6%.  In other words, it seems the underwater managers have a lower information ratio.

At a certain, point, however, even a desperate manager who will swing at anything gives up any dreams of hitting a home run.  As the authors say:

“…there is some continuation value of the contract for the agent and if performance falls below a certain point, the fund manager will voluntarily cut back risk to increase probability of fund survival (and that of the 2% a year annuity) although this would be suboptimal from the point of view of hoping to hit the HWM and making incentive fees.”


This may be the dimension of high water marks that casual observers find most incredulous.  As intuition suggests, when a fund experiences a major drawdown, its managers become disincentivized.  In other words, the value of the embedded option in the performance fee (“you can win, but you can’t lose”), decreases.  Or, put another way, the manager’s compensation essentially falls.  Ergo, their eyes – and resumes – begin to wander.

What raises the ire of so many industry observers is that fact that it was usually these very managers who caused the drawdown in the first place.  Yet investors seem sanguine about the whole thing – adding incentives like a board of directors re-pricing options when the stock price falls.

The study does suggest that underwater managers are more likely to walk away.  But the benchmark they use is way underwater.  Like Marianas Trench underwater.  Managers who needed to make a 100% return to get above the HWM were 1.55 times more likely to walk away than managers at or around their HWM.  With drawdowns like that, however, we wonder if the managers a) were actually fired b) quit the industry and grew hemp in British Columbia or c) killed themselves.

Far from an obscure academic exercise, this analysis can have extensive implications for hedge fund investors, funds of funds, and hedge fund marketers, say the authors.  As they conclude:

“The implications of such relationships are manifold: from portfolio allocation decision of real-money managers, to marketing decisions on the part of hedge funds, and even to academic modeling decisions in terms of how to accurately characterize behavior of investors and fund managers. These, and many other, applications would benefit from a closer look at the impact of the HWM structure on fund manager and investor behavior.”

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