High water mark and hurdle rate in PMS
A performance fee is due only on gains above the previous peak; any hurdle comes from the agreement.
A performance fee rewards the portfolio manager for gains. Two devices stop it from rewarding the wrong gains. The high water mark (HWM) stops a PM charging again for recovering losses it already caused. The hurdle rate stops a PM charging for returns the client would have earned anyway.
SEBI mandates the first and leaves the second to the agreement. That difference is the core of how this topic is tested.
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The two terms
- High water mark
- The highest value the portfolio has reached, taken on the dates when performance fees are charged. A performance fee is payable only on the increase in value above the previous HWM (Master Circular 6.1.3.6).
- Hurdle rate
- A minimum return, set in the agreement, that the portfolio must earn before any performance fee is due. SEBI's fee illustration in Annexure 4A uses 10% as an example; the rate itself is a contractual term, not a SEBI requirement.
SEBI's rules on the high water mark
- check_circlePerformance is computed on the HWM principle over the life of the investment.
- check_circleThe value used is the value on the date the performance fee is charged, not the highest intra-period value.
- check_circleThe charging frequency 'shall not be less than quarterly', so the fee cannot be struck over periods shorter than a quarter.
- check_circleHWM applies to discretionary and non-discretionary services, not to advisory services (6.1.3.8).
- check_circleWhen a client adds or withdraws money midway, the HWM may be adjusted proportionately (6.1.3.9).
The bad-year question clients ask
In year 3 the portfolio rose ₹10 lakh, from ₹55 lakh to ₹65 lakh, yet the fee is charged only on ₹5 lakh. The first ₹5 lakh merely recovered the year 2 fall back to the old peak of ₹60 lakh, and the client already paid a performance fee on that ground in year 1. This is exactly the explanation a client who paid a fee in a good year and then lost money will want before agreeing to stay.
The 20% share is our assumption for illustration; SEBI's text gives only the fee base.
Adding a hurdle: SEBI's Annexure 4A working
₹50 lakh portfolio, one year, 10% hurdle, 20% performance fee, 20% gain:
- 1
Profit for the year
20% of ₹50 lakh = ₹10,00,000.
- 2
Less the hurdle
10% of ₹50 lakh = ₹5,00,000.
- 3
Fee base
₹10,00,000 minus ₹5,00,000 = ₹5,00,000.
- 4
Performance fee
20% of ₹5,00,000 = ₹1,00,000.
How hurdle and HWM combine is in the agreement
Whether the hurdle compounds, resets each year, or is measured from the HWM varies by PM. The agreement's fee annexure and, for clients onboarded on or after October 1, 2024, the multi-year illustrations and fee calculation tool must show it. Check those before quoting a number to a client.
How XXI-A tests this
Expect multi-year numerical questions modelled on SEBI's example: the answer is the gain above the previous HWM, never the full year's gain. Conceptual questions ask which service HWM does not apply to (advisory) and what HWM prevents (fees on loss recovery). The trap is calculating the fee on the year's rise, as in ₹55 lakh to ₹65 lakh, or treating the hurdle as SEBI-mandated.
FAQs
What is high water mark in PMS?expand_more
The highest portfolio value reached on a fee-charging date. A performance fee is charged only on gains above it, so the client never pays twice for the same ground.
Is a hurdle rate mandatory in PMS?expand_more
No. SEBI mandates the high water mark for performance fees. A hurdle rate is a contractual term the PM may offer, set out in the agreement.
Does the high water mark reset every year?expand_more
No. SEBI requires it over the life of the investment, adjusted proportionately for additions and withdrawals.
How often can a PMS charge a performance fee?expand_more
SEBI says the frequency shall not be less than quarterly, so the fee cannot be charged over periods shorter than a quarter.