New research illustrates wide-ranging implications of the ubiquitous “high water mark”
Jan 21st, 2008 | Filed under: Investment Management FeesRemember 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:
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