The Function of the High-Watermark: Not What You Think

The Function of the High-Watermark: Not What You Think

A new paper in the Journal of Accounting and Finance discusses hurdle rates and high watermarks, and how they affect, or at least correlate with, performance.

A hurdle rate is a minimum contractually specified rate of return that a hedge fund must achieve in order to collect performance fees. A high watermark, on the other hand, is the highest peak in value that a specific fund has historically attained. If a fund’s value has retreated from that mark, then a particular incentive system may condition the collection of any performance fee upon reaching and exceeding same.

Both ideas sound like incentive systems, designed to align manager’s goals with those of the investors.

But the authors of the new study, Sangheon Shin of the College of Business Administration, Alabama State University, Jan M. Smolarski of the College of Business Administration, University of Texas Pan American, and Gökçe A.Soydemir , College of Business Administration, California State University Stanislaus, don’t think these systems work as incentives. Indeed, they argue that “a high-watermark is negatively correlated to hedge fund performance while hurdle rate has no significant effect on performance.”

A Signal, not an Incentive

That doesn’t mean that these systems don’t serve any function. It means they don’t serve the function that is most often mentioned. But perhaps they serve another. Shin et al believe that in fact these systems are signals, useful as marketing tools. The assure investors that their money will be safe with these particular managers. From the point of view of those investors, they are risk management tools rather than incentives for performance.

As support for this hypothesis, the authors tell us that the hedge funds that take riskier positions in the markets are those that are most likely to offer to restrict their own fee collection through one or the other or both of these systems.  This suggests that the managers who make those riskier decisions are the ones who most need to prove to investors that “your money is safe with us,” so they need such self-imposed limits. If it’s at risk from adverse markets, at least it’s safe from excess pay-outs.

The authors accordingly offer some advice to investors. If you’ve built a portfolio that includes hedge fund positions, and you’ve done so working on the premise that hurdle rates and high-watermarks improve hedge fund performance, “some modifications may need to be made” as to your allocations.

The study also discusses the significance of a lockup period. This is the element of illiquidity accepted by an investor in a hedge fund so that the managers in that fund have long-term discretion as to how to use their money. They need to be illiquid vis-à-vis their investors so that they can earn an illiquidity premium in their underlying markets.

Data presented by Shin et al. indicates that the length of the lockup period has a positive relationship to performance.

Lock-up periods are usually short, roughly one financial quarter long, with some variation based on investment strategy.

These authors do not find any correlation between lock-up period and the offer of a high watermark. On the other hand, funds with a longer lockup period are somewhat more likely to offer a hurdle than those with a shorter. The authors don’t offer any explanation as to why the length of the lock-up would correlate with one of these restraints on fees, but not correlate with the other. That’s just the way the numbers come out.

Three Years Before

Their results are, as they observe, consistent with those of a 2014 study by the same authors (though Soydemir of CSUY was the lead author in that case) which appeared in the Journal of Economics and Finance.

That earlier paper also went into the differentiation of hedge funds by strategy. It found that hedge funds with either an emerging market or a fixed income strategy are “significantly more likely to offer a hurdle rate than other types of funds.” At least as regards emerging markets funds, that finding supports the “signaling” hypothesis. EM funds are often seen as especially risky and any extra quantum of reassurance can presumably help quiet investor unease on that point.

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