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High Water Marks

Author

Listed:
  • William N. Goetzmann

    (Yale School of Management, International Center for Finance)

  • Jonathan E. Ingersoll, Jr.

    (Yale School of Management, International Center for Finance)

  • Stephen A. Ross

    (Massachusetts Institute of Technology (MIT) - Sloan School of Management)

Abstract

Incentive fees for money managers are frequently accompanied by high water mark provisions which condition the payment of the incentive upon exceeding the maximum achieved share value. In this paper, we show that these high water mark contracts are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. We provide a closed-form solution to the high water mark contract under certain conditions. This solution shows that managers have an incentive to take risks. We conjecture that the existence of high water mark compensation is due to decreasing returns to scale in the industry. Empirical evidence on the relationship between fund return and net money flows into and out of funds suggests that successful managers, and large fund managers are less willing to take new money than small fund managers.

Suggested Citation

  • William N. Goetzmann & Jonathan E. Ingersoll, Jr. & Stephen A. Ross, 2004. "High Water Marks," Yale School of Management Working Papers ysm22, Yale School of Management.
    • Handle: RePEc:ysm:somwrk:ysm22
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    File URL: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=226161
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    Cited by:

    1. William K.H. Fung & David A. Hsieh, 2006. "Hedge funds: an industry in its adolescence," Economic Review, Federal Reserve Bank of Atlanta, vol. 91(Q 4), pages 1-34.
    2. Hodder, James E. & Jackwerth, Jens Carsten, 2007. "Incentive Contracts and Hedge Fund Management," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(4), pages 811-826, December.
    3. Francisca Richter & B. Wade Brorsen, 2000. "Estimating fees for managed futures: a continuous-time model with a knockout feature," Applied Mathematical Finance, Taylor & Francis Journals, vol. 7(2), pages 115-125.
    4. Amin, Gaurav S. & Kat, Harry M., 2003. "Hedge Fund Performance 1990–2000: Do the “Money Machines” Really Add Value?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 38(2), pages 251-274, June.
    5. Sanjiv Ranjan Das & Rangarajan K. Sundaram, 1998. "Fee Speech: Adverse Selection and the Regulation of Mutual Funds," NBER Working Papers 6644, National Bureau of Economic Research, Inc.
    6. Livio Stracca, 2006. "Delegated Portfolio Management: A Survey Of The Theoretical Literature," Journal of Economic Surveys, Wiley Blackwell, vol. 20(5), pages 823-848, December.
    7. Bill Ding & Hany A. Shawky, 2007. "The Performance of Hedge Fund Strategies and the Asymmetry of Return Distributions," European Financial Management, European Financial Management Association, vol. 13(2), pages 309-331, March.
    8. René M. Stulz, 2007. "Hedge Funds: Past, Present, and Future," Journal of Economic Perspectives, American Economic Association, vol. 21(2), pages 175-194, Spring.
    9. Andrew Metrick & Ayako Yasuda, 2007. "The economics of private equity funds," Proceedings, Federal Reserve Bank of San Francisco, issue oct.
    10. Juan-Pedro Gómez & Tridib Sharma, 2006. "Portfolio delegation under short-selling constraints," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 28(1), pages 173-196, May.
    11. Stephen Brown & William Goetzmann & James Park, 1998. "Conditions for Survival: Changing Risk and the Performance of Hedge Fund Managers and CTAs," Yale School of Management Working Papers ysm83, Yale School of Management, revised 01 Apr 2008.
    12. Stephen J. Brown & William N. Goetzmann & Bing Liang, 2005. "Fees On Fees In Funds Of Funds," World Scientific Book Chapters, in: H Gifford Fong (ed.), The World Of Hedge Funds Characteristics and Analysis, chapter 7, pages 141-160, World Scientific Publishing Co. Pte. Ltd..
    13. Getmansky, Mila & Lo, Andrew W. & Makarov, Igor, 2004. "An econometric model of serial correlation and illiquidity in hedge fund returns," Journal of Financial Economics, Elsevier, vol. 74(3), pages 529-609, December.
    14. Suleyman Basak & Anna Pavlova & Alexander Shapiro, 2007. "Optimal Asset Allocation and Risk Shifting in Money Management," The Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1583-1621, 2007 21.
    15. Richard Stanton & Nancy Wallace, 2009. "An Empirical Test of a Contingent Claims Lease Valuation Model," Journal of Real Estate Research, American Real Estate Society, vol. 31(1), pages 1-26.
    16. Gong Zhan, 2011. "Manager fee contracts and managerial incentives," Review of Derivatives Research, Springer, vol. 14(2), pages 205-239, July.
    17. Basak, Suleyman & Pavlova, Anna & Shapiro, Alex, 2003. "Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management," Working papers 4303-03, Massachusetts Institute of Technology (MIT), Sloan School of Management.
    18. repec:onb:oenbwp:y:2005:i:9:b:1 is not listed on IDEAS
    19. Diane Del Guercio & Paula A. Tkac, 2000. "The determinants of the flow of funds of managed portfolios: mutual funds versus pension funds," FRB Atlanta Working Paper 2000-21, Federal Reserve Bank of Atlanta.
    20. Marina Di Giacinto & Salvatore Federico & Fausto Gozzi, 2011. "Pension funds with a minimum guarantee: a stochastic control approach," Finance and Stochastics, Springer, vol. 15(2), pages 297-342, June.
    21. Palomino, Frederic & Prat, Andrea, 2003. "Risk Taking and Optimal Contracts for Money Managers," RAND Journal of Economics, The RAND Corporation, vol. 34(1), pages 113-137, Spring.
    22. Castaneda, Pablo, 2005. "Portfolio Choice and Benchmarking: The Case of the Unemployment Insurance Fund in Chile," MPRA Paper 3346, University Library of Munich, Germany, revised 30 Dec 2006.
    23. Franklin R. Edward, 1999. "Hedge Funds and the Collapse of Long-Term Capital Management," Journal of Economic Perspectives, American Economic Association, vol. 13(2), pages 189-210, Spring.

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