The high water mark principle is a cornerstone of the regulatory framework for portfolio management services. This article explains what the high water mark is, why SEBI mandates it, and how it protects investors.
What is High Water Mark?
Definition
High Water Mark shall be the highest value that the portfolio/account has reached. Value of the portfolio for computation of high watermark shall be taken to be the value on the date when performance fees are charged.
Purpose
The high water mark principle ensures that the portfolio manager does not get paid large sums for poor performance. If the manager loses money over a period, he or she must get the fund above the high watermark before receiving a performance bonus.
How the High Water Mark Works
The Principle
The portfolio manager shall charge performance based fee only on increase in portfolio value in excess of the previously achieved high water mark.
Illustrated Example
Consider a client with an initial contribution of ₹10,00,000:
Year 1: Portfolio rises to ₹12,00,000
- Performance fee payable on ₹2,00,000 gain
- High water mark set at ₹12,00,000
Year 2: Portfolio drops to ₹11,00,000
- No performance fee payable (portfolio below high water mark)
- High water mark remains at ₹12,00,000
Year 3: Portfolio rises to ₹13,00,000
- Performance fee payable only on ₹1,00,000 (excess over ₹12,00,000)
- Not on the full recovery from ₹11,00,000 to ₹13,00,000
Why This Matters
Without the high water mark, a portfolio manager could:
- Charge performance fees on recovery from losses
- Benefit from volatility without delivering genuine value
- Be incentivized to take excessive risks
Regulatory Requirements
Mandatory Application
SEBI has advised that profit/performance shall be computed on the basis of high water mark principle over the life of the investment, for charging of performance/profit sharing fee.
Frequency
For the purpose of charging performance fee, the frequency shall not be less than quarterly.
Applicability
High Water Mark shall be applicable for discretionary and non-discretionary services and not for advisory services.
Interim Contributions and Withdrawals
In case of interim contributions/withdrawals by clients, performance fees may be charged after appropriately adjusting the high water mark on proportionate basis.
How It Protects Investors
Prevents Double Charging
The high water mark prevents portfolio managers from charging performance fees on the same gains twice. If a portfolio falls and then recovers, the manager can only charge on new gains beyond the previous peak.
Aligns Interests
The principle aligns the interests of the portfolio manager with those of the client. The manager is incentivized to generate sustainable, long-term growth rather than short-term volatility.
Encourages Prudent Risk Management
Knowing that losses must be recovered before any performance fee can be charged, portfolio managers are encouraged to manage risk prudently.
Transparency
The high water mark principle provides transparency in fee calculation. Clients can verify that they are only paying performance fees on genuine gains.
Fee Calculation Tool
Portfolio managers shall provide a fee calculation tool to all clients that highlights various fee options with multi-year fee calculations. This tool incorporates the high-watermark principle wherever applicable.
Expert Legal Guidance
Anuj Desai & Associates provides expert legal advisory services on PMS fee compliance, including high water mark implementation. Our securities law experts help portfolio managers design compliant fee structures and ensure proper calculation of performance fees. Contact us for guidance on high water mark and other regulatory matters.