The High Water Mark(et): A potential lifesaver for underwater HF investors
Sep 14th, 2009 | Filed under: Investment Management Fees, Today's Post
The asymmetry of a performance-based fee is often seen as a “free option” for hedge fund managers. After all, say critics, managers can win but they can’t lose.
Throughout the brief history of hedge funds, academics and researchers have attempted to measure the value of this option. And quite often regulators implicitly acknowledge the existence of this transfer of value from investor to manager by banning performance fees or by requiring them to be symmetrical (the SEC’s regulation of mutual funds jumps to mind).
But when a hedge fund is under its high water mark, no performance fees are charged and the value of the option is minimal (at least until the fund gets close to the high water mark). Put another way, investors in under water hedge funds have earned a performance fee holiday. But when they redeem their investment during this holiday, the holiday ends. If/when they buy another hedge fund, the high water mark is reset at the subscription NAV and the performance fees begin anew.
In aggregate, this amounts to self-destructive behavior on the part of investors and is tantamount to a transfer of wealth from investors to managers. As we pointed out in June: More…
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There are a few issues the investor should consider before maintaining or acquiring a position into a fund under its high water mark:
1. The likelihood of style drift is very real. Let’s not kid ourselves, the managers want that performance fee and will be very tempted to undertake excess risk to derive excess returns, or engage into strategies (flavors of the day) that are not coherent with the core competency to reach the high water mark within a shorter time frame that the core strategy would suggest.
2. An analysis and attribution of the elements explaining why the manager is under the high water mark should be addressed. The systemic issues that affected the market should not be the only explanation. Does the manager truly deploy a hedge fund strategy? Did he “style drift” in the midst of the market mayhem? Was he selling volatility? Was he short Gamma?