High-Water Marks Contracts Versus Recurring Option Contracts

Abstract

This paper analyzes a fund manager's portfolio optimization problem when compensated by either a high-water marks (HWM) contract or a recurring option contract with a fixed benchmark rate. In a model with an indefinite number of periods, the compensations are paid out annually, while the manager's portfolio decision is made in continuous time. The manager’s utility increases with the rate of the performance fee and decreases with the level of HWM and the option contract benchmark rate. Both types of contracts encourage risk taking in general. The HWM provision has a net disciplinary effect on the manager's risk taking incentive.

Keywords: delegated portfolio management, risk-taking incentive, option contract, high-water marks, hedge funds, portfolio optimization

JEL Classification: G11; G2