The Downside of High Water Marks: An Empirical Study
Journal of Investment Management (JOIM), Second Quarter 2012
Posted: 2 Jun 2012
Date Written: June 1, 2012
Using a large sample of hedge funds, I study the effects of the high water mark (HWM) on fund performance, risk, and fund closure. I find that as funds fall below the HWM, the standard deviation of future returns increases, the future expected Sharpe ratio decreases, and the incidence of fund closure increases. In addition to supporting predictions from models in the literature, these results resonate well with economic intuition: HWM contracts function as if the fund manager holds call options on the fund’s returns which have varying degrees of moneyness depending on how far the fund is from the HWM.
Keywords: Hedge funds, highwater marks, hedge fund performance
JEL Classification: G00
Suggested Citation: Suggested Citation