The highest peak in value that an investment fund/account has reached. This term is often used in the context of fund manager compensation, which is performance based.
The high-water mark ensures that the manager does not get paid large sums for poor performance. So if the manager loses money over a period, he or she must get the fund above the high watermark before receiving a performance bonus. For example, say after reaching its peak a fund loses $100,000 in year one, and then makes $250,000 in year two. The manager therefore not only reached the high-water mark but exceeded it by $150,000 ($250,000 - $100,000), which is the amount on which the manager gets paid the bonus.
A high-water mark ensures fund managers are not paid performance fees when they perform poorly. If an investment loses value over a specified period of time, which is defined in the prospectus, its manager must recoup the losses and return the fund’s value above the high-water mark before he or she is entitled to a performance fee.
Sally puts $100,000 into an actively managed investment that includes a 20% performance fee. In the fund’s first year, it falls 10% from its high-water mark. At the end of year 1, no performance fee is paid.
In year 2, the fund’s value increases 15% over the previous high-water mark. The fund manager’s performance fee is based upon the 5% above the previous high-water mark that its value climbed.
If in Year 2 the fund grows by only 5%, the manager is not entitled to a performance fee because the fund has not topped its high-water mark.
High-water marks are frequently applied to hedge funds and their managers. They align investors’ interests with those of the fund managers’.