Next, let`s assume the fund loses 20% next month. The investor`s account falls to a value of $460,000. This is where the importance of the deep-sea leash is established. There is no need to pay a performance fee for winnings from $460,000 to $575,000, only after the peak amount. Suppose the fund unexpectedly makes a 50% profit in the third month. In this unlikely case, the value of the investor account increases from $460,000 to $690,000. Without a high water point, the investor owes the initial fee of $15,000 plus 20% of the profit from $460,000 to $690,000, or 20% on a profit of $230,000 or an additional $46,000 in performance fees. This work extends the model of Goetzmann et al. (J Financ 58: 1685 – 1717, 2003) on the case of partial information where the expected return of a hedge fund is not observable, but is known to be high or low. The fund manager can dynamically update his belief in the real value of the expected return based on the realization of the hedge fund`s net asset value. Our main objective is to examine the impact of the uncertainty of the expected return on the price of the various fees of the fund manager and the investor`s claim.
The results show that partial information has a significant impact on the value of the costs and claim. In particular, an unupdated fund manager always underestimates the values, and in most cases the underestimated amount is very large. The closer the NET value is to the peak, or the greater the uncertainty of the expected return, the greater the underestimated amount becomes. Goetzmann W.N., Ingersoll J., Ross S.A. (2003) High-water marks and hedge fund management contracts. Journal of Finance 58: 1685–1717 Wang H., Wang C. (2010) Leverage Management. Math and Finance 3:161-183 Overall, the investor with a high water point owes $38,000 in performance commissions, which is $690,000 less than the initial investment of $500,000 multiplied by 20%. Without a high threshold below industry standards, the investor owes a 20% performance fee on all profits, which equates to $61,000. The value of a deep-sea leash is undisputed. The high seas leash prevents this «double tariff» from happening.
With a high waterline threshold, profits from $460,000 to $575,000 are not taken into account, but profits above the high-quality threshold are subject to performance-based fees. In this example, in addition to the initial fee based on the $15,000 return, this investor owes 20% on profits from $575,000 to $690,000, which equates to an additional $23,000. A high-water brand protects fund investors from double fees and motivates fund managers to perform well in order to earn fees. At this point, the highlight for that particular investor is $575,000, and the investor is required to pay $15,000 to the portfolio manager. A high water threshold is the highest level of value that a mutual fund or account has reached. This term is often used in connection with the remuneration of fund managers, which is related to performance. The highlight ensures that the manager does not receive large sums of money for poor performance. If the manager loses money over a period of time, he must bring the fund above the high water mark before receiving an Assets Under Management (AUM) performance bonus. A deep-sea brand is different from an obstacle rate, which is the lowest amount of profit or return a hedge fund must earn to charge an incentive fee. Suppose an investor is invested in a hedge fund that charges a 20% performance fee, which is pretty typical in the industry.
Suppose the investor invests $500,000 in the fund and in the first month the fund earns 15%. Thus, the investor`s initial investment is worth $575,000. The investor owes a 20% fee on this profit of $75,000, or $15,000. Panageas S., Westerfield M.M. (2009) Strong Brands: High Risk Appetites? Convex remuneration, long horizons and portfolio selection. Journal of Finance 64:1-36 A high-water brand ensures that investors don`t have to pay performance commissions for poor performance, but, more importantly, ensures that investors don`t pay twice a performance-based fee for the same performance. Several things can happen when an investor enters a fund during a period of underperformance. At Goldman Sachs Asset Management, for example, an investor who buys from the fund at a net asset value (NAV) below the high water mark will take advantage of the potential to increase the subscription net asset value at the high water bound without paying a fee. This situation is called a «free ride».
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