High Water Marks: The other hedge fund “lock-in”

Fees 08 Feb 2010

high water mark 2The fable of The Wind and Sun tells the story of how the Wind and Sun argued over who was more powerful.  Seeing a passerby wearing a coat, the Wind blew as hard as he could to blow it off the man – to no avail.  The Sun, on the other hand, shone on the man, lifted his spirits (and his body temperature) – and basically cajoled him to remove his own coat.

As they develop ways to keep investors in their funds during times of lacklustre performance, a new study suggests that hedge fund managers might find this fable to be somewhat instructional.

One of the great ironies of 2009 was that so many investors were “locked-up” in gated hedge funds at a time when the fee levels they faced – the very fee levels that raised the ire of so many in the recent past – were at an all-time low.  In September 2008, we noted that hedge fund investors the world over were about to go on a lengthy performance fee holiday since so many of their funds were well below their high water marks.

Still, many wanted out and managers began to halt redemptions.  As the gates began to come down, many commentators decried the callousness and alleged self-interest of those hedge fund managers.

But according to a new academic paper, many of the “gated” investors actually have wanted to stick around (at least, assuming a stampede to the exits by co-investors could be averted).   George Aragon of Arizona State University and Jun Qian of Boston College describe the ubiquitous high water mark as a sort of self-imposed gate for investors.  By comparing the asset inflows and outflows of funds with and without high water mark provisions, they say that,

“Our model also predicts that HWMs provide a lock-in mechanism that serves to reduce fund outflows following poor performance…compared to funds without a HWM, investors are less likely to remove capital from HWM-funds following poor performance, as they perceive this as a better opportunity going forward.”

Further, the researchers found that actual outflows cannot be explained solely by the use or avoidance of redemption gates.  In other words, many investors actually opt to stick around in the tough times.  Writes the duo:

“Overall, our findings cannot be explained by a greater use of share redemption restrictions by HWM funds, and are consistent with the lock-in mechanism that retains investors after poor performance in HWM-funds.”

Like redemption gates themselves, HWM provisions can benefit investors by reducing the traffic heading for the exits (i.e. reducing the likelihood of what Aragon and Qian call an “inefficient liquidation” of the fund).

In fact, not only do investors seem less inclined to run from underperforming funds with HWMs, but they seem to strongly prefer well performing funds with a HWM over strongly performing funds without one.  The authors chalk this up to investors’ beliefs that the manager essentially has “asymmetric information” about their own true skill level – and their assumption that a great manager is more likely to offer a possible fee holiday since he/she probably believes they will never actually have to provide it to investors.

Overall, the study finds that funds with a HWM tend also to have a higher performance fee (to make up for the downside of the HWM we conjecture), come from younger firms, have longer redemption notices and are more likely to have a lock-up (ironically).  (See table below constructed with data from the paper).

high water mark

So while commentators cry foul over redemption restrictions, we wonder how many gated investors are secretly glad that their fellow movie goers have been forced to sit in their seats, rather than run for the exits. (After all, the movie is now provided at a discount).

While funds will likely always have to use brute force to stave off investor panic, they should apparently also take a page from Aesop and consider the power of a little cajoling.

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