📚 PASS Investment Adviser (Level 1) Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 12.6 — Cost, expenses and fees of investing in PMS

Imagine you are reviewing a client’s portfolio statement from a discretionary PMS provider. You notice the net asset value (NAV) is 115, having recovered from a deep drawdown that saw it drop to 85, while the starting benchmark was 100. As an analyst, you must determine whether the manager is entitled to a performance fee. Simply seeing the portfolio above its starting value is insufficient; you must reconcile the portfolio’s recovery against the specific ‘high watermark’ and the ‘hurdle rate’ clauses in the management agreement.

The high watermark is a defensive mechanism that prevents a manager from charging performance fees on simple recovery. If a manager loses 20% of a client’s capital, they must generate enough profit to restore that capital to its previous peak before any performance fee can be levied on new gains. This ensures that the manager is only rewarded for creating genuine alpha, rather than being compensated for merely recouping previous losses during a market cycle.

However, the hurdle rate acts as a different barrier, representing the minimum acceptable return the investor expects before the manager shares in the profits. For example, if a PMS has a 10% hurdle rate and a high watermark of 120, the manager only earns a performance fee if the portfolio value exceeds 120 AND the annualized return surpasses the 10% threshold. This interaction creates a tiered incentive structure that prioritizes investor capital preservation and benchmark outperformance simultaneously.

Consider a case where a fund drops from 100 to 90. The high watermark is now set at 100. If the portfolio grows back to 105, the manager cannot charge a fee, because the portfolio has not crossed the 100 high watermark, despite the 16.6% gain from the trough. If the hurdle rate is 8%, the manager remains uncompensated even if the fund hits 102, as they have not yet cleared the hurdle or the watermark.

Only when the portfolio surpasses both milestones does the performance fee trigger, protecting the client from paying ‘double’ for market beta recovery. 1

Nuance

⚠️ Nuance
A common professional misconception is that the high watermark and hurdle rate operate as ’either-or’ filters. In reality, they are cumulative barriers: the portfolio must be above its historical peak to satisfy the watermark, and it must exhibit a specific rate of return to satisfy the hurdle. Candidates often err by assuming that passing the hurdle automatically grants the manager fees, ignoring the fact that if the portfolio is still below the high watermark, the ‘recovery’ does not constitute performance worth rewarding.

Check Your Understanding

Practice Question 1

A PMS portfolio is currently valued at ₹110 lakh. Its previous all-time high was ₹120 lakh, and the agreement stipulates a 10% annual hurdle rate. Which statement is correct regarding the performance fee?

Practice Question 2

If an agreement includes both a high watermark and a hurdle rate, which order of operations best describes the investor’s protection mechanism?

This is a companion read for Section 12.6 — Cost, expenses and fees of investing in PMS from PASS Investment Adviser (Level 1) by Akhilesh Gururani, available on Amazon Kindle.

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  1. The high watermark is an absolute floor based on the nominal portfolio value, whereas the hurdle rate is a relative benchmark based on the rate of return. ↩︎