GLOBAL - Hiring external managers increases costs and reduces returns for pension funds investing directly in real estate - especially if they invest in funds of funds, according to a new report from Maastricht University.

The study of 880 pension funds' allocations between 1990 and 2009 found that switching from internal to external management resulted in a performance decline of 122 basis points.

Investors in funds of funds found their returns lowered by 202bps - a drop the report attributed to "multiple layers of fees, lack of skill and possibly greater agency conflicts".

Larger schemes performed better regardless of whether they managed their direct portfolios in-house or awarded mandates to external managers.

"Larger funds apparently have better skills, which enables them to select better properties when investing internally, and to select better money managers when investing externally," the report said.

"When investing externally, larger funds are likely to get preferential treatment, have greater monitoring capacity and may have access to better investment opportunities at lower cost."

US pension funds faced significantly higher costs overall, largely as a result of reliance on external managers to manage their direct portfolios.

"One would expect that greater attention to internal management increases the competitive pressure on the external real estate asset management industry," the report said.

Yet the study, which compared costs and performance across direct, funds of funds and REITs, found an overwhelming preference for external managers.

More than 80% of smaller pension funds outsourced management of their direct portfolios.

Even among larger pension funds - which the research suggested were significantly more likely to use internal resources - 58% managed neither their direct portfolios nor REITs in-house.

The researchers found that, whereas some direct investors significantly outperformed direct benchmarks, investors in REITs did not.

Its authors suggested this could be the result of direct managers exploiting information asymmetry in private real estate markets.

"In direct real estate," the report said, "pension funds are more likely to end up in a better-performing quintile next year if they also performed well this year, and they are more likely to perform worse in the ranking next year if they performed relatively poorly this year."