Performance fees for portfolio managers are designed to align the managers' goals with those of the investors and to motivate managers to aquire superior information and to make better investment decisions. A part of the literature analyzes performance fees on the basis of market valuation. In this article it is shown that market valuation faces a dilemma: on the one hand, the conditions which allow for market valuation imply that the portfolio manager perfectly hedges the performance fee. This in turn implies severe restrictions on the incentive effects of the performance fee. In particular, the fee does not motivate the manager to use superior information for investment decisions concerning the managed portfolio. On the other hand, better incentives can only be generated under conditions which exclude market valuation. In this case, the analysis has to be based on expected utility valuation.
superior information incentive effects market valuation performance fees portfolio managers