Saturday, July 12, 2008

High Watermark

A "high water mark" is often applied to a performance fee calculation. This means that the manager does not receive performance fees unless the value of the fund exceeds the highest net asset value it has previously achieved. For example, if a fund were launched at a net asset value (NAV) per share of $100, which then rose to $130 in its first year, a performance fee would be payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If in the third year the NAV per share rises to $143, a performance fee will be payable only on the extra $13 return from $130 to $143 rather than on the full return from $120 to $143. This measure is intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. However, this mechanism does not provide complete protection to investors: a manager who has lost money may simply decide to close the fund and start again with a clean slate assuming that he can persuade investors to trust him with their money. Some funds also specify a hurdle rate, which states that the fund will not charge a performance fee until its annualized performance exceeds a benchmark rate, such a fixed percentage, over some period. This links performance fees to the ability of the manager to do better than the investor would have done if he had put the money elsewhere. Funds which specify a soft hurdle rate charge a performance fee based on the entire annualized return. Funds which use a hard hurdle rate only charge a performance fee on returns above the hurdle rate.

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