At first glance, it’s a fair model that protects investors from paying twice for the same performance. In practice, however, the High-Watermark model can create unexpected inefficiencies — especially in real-estate or income-distribution funds that deliver steady rather than explosive growth.
1. The Hurdle Effect
Most funds combine the High-Watermark model with a hurdle rate — a minimum return threshold that the fund must exceed before a performance fee can accrue.
Typically, this hurdle ranges from 8–10% per annum (roughly 0.7–0.9% per month). If a fund grows steadily but slightly below this level, no performance fee is triggered — even though investors continue earning positive returns.
As a result, the fund’s operation can become economically inefficient, even in periods of consistent performance.
2. Quarterly Revaluations and Delayed Recognition
Real-estate funds often revalue their assets only quarterly. Between these revaluations, fair-value gains are usually distributed linearly, so the monthly NAV calculation appears flat.
At first sight, it may look like the fund is stagnating — even though it is generating real underlying returns. This technical effect can significantly delay the moment when the High-Watermark surpasses its previous high, postponing the accrual of performance fees.
3. Global HWM Logic: Fair, but Growth-Restrictive
Another layer of complexity lies in the global definition of the High-Watermark. In most fund structures, the HWM is defined at the fund level — not per share class or per investor.
While this ensures fairness, it also creates practical challenges:
- New investors who join after a drawdown pay no performance fees until the entire fund recovers above its previous high.
- The fund manager, however, must wait for the global NAV to recover, even if new capital is already generating profits.
This global setup often delays performance-fee recognition, reducing both efficiency and incentive alignment — particularly in funds with continuous inflows or longer recovery periods.
The Consequence: Lost Compounding Effect
The fund may continue to generate returns, but the performance-fee mechanism remains inactive. This postpones the natural compounding effect that would otherwise enhance long-term results for both investors and shareholders.
In practice, even a well-performing fund can appear less profitable — simply due to how its High-Watermark model is structured.
YTD Performance Model as a More Efficient Alternative
For funds with stable growth — such as real-estate funds or income-distribution funds — a YTD (Year-to-Date) performance model can be a more efficient and transparent alternative.
This approach keeps the entire NAV invested and compounding throughout the year, while the performance fee is crystallized only once — at year-end, after investors have fully realized their return.
Key advantages of YTD models:
- Maintain fairness and transparency for investors
- Improve economic efficiency for fund managers
- Support stable growth and compounding
- Eliminate monthly fluctuations and technical NAV delays
Learn more about the benefits of YTD models — and why they can be fair and profitable for both sides — in our related article: Why YTD Performance Models Can Outperform Both Sides — Fairly
Summary
The High-Watermark model remains an important safeguard for investors, but it is not a one-size-fits-all solution. For real-estate and income-distribution funds, the YTD performance model can deliver greater efficiency — maintaining fairness, simplifying NAV calculations, and ensuring smooth performance accrual throughout the year.
Choosing the right performance-fee model is not just about fairness — it’s about long-term alignment and operational efficiency for both investors and fund managers.
