Real estate investing is now a standard way for pension funds to diversify their overall portfolios. But within the property portfolio itself, spreading risk can be difficult to achieve. The €3.3bn Electricity Supply Board (ESB) pension fund has however succeeded in developing a diversified property portfolio, as a core element of its investment strategy. And it has done so in an innovative way compared with other Irish pension funds.

As a result, returns from ESB's property portfolio have leapt over successive years. It scraped a meagre 1% return in the calendar year 2003. In 2004, however, the property component made 12%, and last year almost doubled that percentage return, to 23%.

Besides providing low correlation with other assets, such as equities, property investments also offer a valuable combination of income and capital growth, with acceptable levels of volatility.

The ESB pension fund carries out regular strategic asset allocation reviews to identify the portfolio mix which can be expected to provide the required real long term return with the optimum level of risk/reward profile.

And in its two most recent strategic asset allocation reviews, this strategic allocation to property was set at 15% - a relatively high allocation in Ireland.

However, in line with the overall approach of the fund towards its other investments, diversification is seen as critical to securing an acceptable long term return and risk profile.

So in addition to making a significant strategic allocation to property in order to spread risk within the overall fund, the trustees have also adopted a policy of diversification within the property component itself.

Part of the aim is to balance exposure to the fund's domestic market. Besides Ireland, therefore, real estate investments are spread across the rest of the Euro-zone and the UK. This is consistent with the fund's overall approach; its other investments are highly diversified across the Eurozone, as well as globally.

The current broad allocation targets to property are 50 - 70% in Ireland, 15- 25% in the UK and 15- 25% in the Eurozone.

The fund's allocation to Irish property reflects the need to match assets with liabilities, as the fortunes of the Irish property market are linked to the growth of the Irish economy, which in turn affects the fund's liabilities.

About 1% of the overall real estate allocation of 15% is invested in forestry, which provides a stable return, as well as further reducing volatility.

An important aspect of ESB's investment strategy is that decisions on allocation and on the selection of investment opportunities are fully researched and assessed.

First, investment in Ireland is through direct ownership of carefully selected properties - including office, retail and industrial buildings -- in prime locations. While the mix of sectors and property types may not strictly reflect the broad property investment market, the ESB pension fund says its focus is on securing an acceptable long-term return from a portfolio which is reasonably diverse, and well-positioned for growth. The fund does not seek to match "index" returns.

In the rest of the Euro-zone, the fund invests indirectly, recognising the need for a suitable level of diversification. Equally important is active management, supported by detailed local market knowledge. The fund uses a mix of managers and investment vehicles, selected to provide an acceptable level of return and risk profile.

In the UK the ESB pension fund has bought property through a combination of direct and indirect investments. However, the fund is currently restructuring its holdings towards greater use of indirect investing. This shift in emphasis reflects the challenges which are posed by direct investment outside its home territory, including the problems of dealing with local market conditions.

The property market of course has its own unique features, including its particular market cycles, illiquidity and transaction costs. So the ESB pension fund does not consider it appropriate to set fixed investment targets or ranges in the same way as setting them for liquid quoted securities.

The fund has therefore agreed broad allocation objectives, within which individual investment decisions are based on the available opportunities.

But the strategic allocation is not set in stone. While the last review set the fund's total property exposure at 15%, the trustees have decided that it has not been fitting to reach this level of exposure, because of the prevailing market conditions.

At the end of 2005, therefore, property investments amounted to only 11% of the fund's overall portfolio.

Furthermore, ESB pension fund warns that current market conditions could prevent potential investments from delivering an acceptable return for many years ahead. Because of this, the fund has taken the opportunity in recent years to sell a number of properties.

The fund says the challenge it faces at present is to achieve an appropriate allocation to property investments which will provide effective diversification, as well as returns which reflect real economic growth in the long term.

And as with other asset classes, the ESB fund says the cyclical nature of property markets means that timing is everything.