High-water Mark Principle
A high-water mark is the highest value that a fund has reached. The high-water mark principle is to ensure that the manager does not get paid performance fee for recent poor performance. If the manager loses money or makes less money over a period, he must take the fund value above the previous high – that is the high-water mark -- before receiving a performance fee.
Here is how it works. The calculations here are as per SEBI's regulations on HWM.
Example
Let us assume that an investor has invested Rs1 crore in one of our schemes and this is how the performance has been for the first four years
Let us assume that an investor has invested Rs1 crore in one of our schemes and this is how the performance has been for the first four years
In the first year, the fund earns Rs 19,00,000 (19%) and as our performance is above the hurdle rate of 10% we would be entitled to get performance fees. Now the high-water mark to beat for the following year is Rs 1.18 crore. The next year, the fund earns a 11% gross return. Although the gross return is above the hurdle rate, considering the Fixed fees, other expenses and the hurdle level, the value arrived is not above the high water mark so we are not entitled for any performance fees. A new high-water market is set at Rs 1.28 crore. For the same reason despite positive performance in third year, we are not entitled to performance fees. A new high-water mark is set at Rs 1.40 crore.
Fourth year being the year of negative return, there is no performance fees. The high-water mark is continues to be at Rs 1.40 crore.
Fifth year with a 55% gross return, the amount arrived after considering fees and hurdle level is above the previous high-water mark of Rs 1.40 crore, hence that entitles us to claim for the performance fees. And accordingly the new high-water mark is set at Rs 1.54 crore.
Fees and HWM principle are calculated and applied for each investor depending on his or her entry into the PMS.
The hurdle rate ensures that investors do not have to pay performance fees for poor performance, while the HWM guarantees that investors do not pay performance-based fees twice for the same performance.
This page was updated on 22.7.24 for further clarity
The above illustration is only meant to explain what high watermark and hurdle rates mean. It doesn’t fully represent what happens in a real portfolio, where investor account have inflows and outflows. For example, someone might invest Rs 50 lakhs year one and withdraw Rs 10 lakhs the next year after making a profit. As you can see – such changes -- inflows and outflows are not shown in the example on the website (as also in SEBI’s website) because it will complicate matters. The illustration was designed to convey the concept of HWM and HR.
If we include these inflows and outflows, we cannot rely on beginning and ending assets under management (AUM). For instance, if someone invests 50 lakhs on January 1st and the portfolio grows to 65 lakhs by December 30th, but they withdraw Rs 15 lakhs on December 30th, the AUM goes back to 50 lakhs. In this case, should we not be entitled to a performance fee because the AUM hasn’t changed as on yearend? We should be entitled because the NAV has changed even though the opening and ending AUM is the same. On the other hand, if portfolio value is unchanged and an investor puts in another 15 lakhs on December 30th making it Rs65 lakhs, should we get a performance fee based only on AUM change? No.
If a user starts with Rs 50 lakhs on Year 1 and then puts Rs 15 lakhs five months later, his base investment is neither Rs 50 lakhs nor Rs 65 lakhs. His Rs 50 lakhs has worked for the whole year and Rs 15 lakhs has worked for part of the year. So, opening closing AUM are not the basis of performance, when there is inflow and outflow. In such cases, we would have to rely on the change the net asset value (NAV). This is what is done in practice as explained in the investor agreement.