High-Water Mark

What it is

A high-water mark (HWM) is the highest historical value an investment fund or account reaches. It is commonly used to determine when fund managers earn performance-based fees: managers collect incentive fees only on gains that exceed the previous peak value.

Why it matters

The HWM protects investors from:
* Paying performance fees after periods of loss until the prior peak is recovered.
* Paying the same fee twice on the same gains (the “double fee” problem).
It also aligns manager incentives with long-term performance: managers must recover losses before earning additional incentive fees.

How it differs from a hurdle rate

A hurdle rate is a minimum return the fund must achieve before charging an incentive fee. The HWM is a peak-value threshold that determines whether incremental gains are eligible for incentive fees. Both can coexist in a fee structure but serve different purposes.

Example

Assume a fund charges a 20% performance fee and an investor starts with $500,000.

1. Month 1: +15% → value = $575,000. Fee = 20% of $75,000 = $15,000. New HWM = $575,000.
2. Month 2: −20% → value = $460,000. No fee; HWM remains $575,000.
3. Month 3: +50% → value = $690,000.

With a high-water mark:
* Only gains above $575,000 are subject to the 20% fee: ($690,000 − $575,000) = $115,000 → fee = $23,000.
* Total fees paid = $15,000 + $23,000 = $38,000.

Without a high-water mark (i.e., fees charged on all positive performance):
* Manager would charge 20% on the $230,000 gain from $460,000 to $690,000 = $46,000, plus the earlier $15,000 = $61,000.
The HWM thus prevents a substantial additional fee on the recovery portion of the gains.

The “free ride” issue

When a new investor buys into a fund at a net asset value (NAV) below the HWM, they can benefit from the fund returning to the HWM without paying performance fees on that recovery—this is called a “free ride.” Some funds accept this as protecting existing investors; others mitigate it by charging performance fees on any positive performance for new subscriptions until some conditions are met.

Key takeaways

• A high-water mark ensures investors don’t pay incentive fees until prior losses are recovered.
• It prevents paying performance fees twice on the same gains and helps align manager incentive with recovery and outperformance.
• Be aware of potential “free rides” for new investors and check fund-specific fee rules and any hurdle rates that may apply.