Global Equities/Domestic Bonds || Global Equities/Global Bonds FIGURE 11.1 Impact of Fixed Income Diversification exceed 50 percent, diversifying into international fixed income has little effect on the Sharpe ratio. When equity allocations are less than 50 percent, however, adding international bonds significantly improves risk-adjusted performance. The reason is simple: The Sharpe ratios for equities are typically higher than those for bonds, so when equity allocations are high, the effects of the equity portfolio swamp the impact of diversifying the bond portfolio. Second, strategic allocations to foreign fixed income can add another source of potential outperformance. For example, suppose that an investor had a 65 percent allocation to equity. On the basis of the figures in Table 11.1 and Figure 11.1, the investor should be indifferent between holding all bonds domestically or holding bonds in their global capitalization weights. However, by holding bonds domestically, the investor gives up the opportunity to add value through an active management program in international fixed income. Many investors have attempted to add the active component of international fixed income by structuring opportunistic mandates versus domestic fixed income benchmarks. However, unless these mandates also give the manager the ability to take short positions in foreign bonds, they do not have the same ability to generate outperformance that an actively managed strategic allocation to foreign bonds has. The role and structure of active management will be discussed in more detail in Chapter 13. Next consider how home bias affects equity allocations. Table 11.2 compares the Sharpe ratios of global capitalization weighted portfolios with those of portfolios whose equities are all domestic. As in Table 11.1, all portfolios are assumed to be currency hedged. It shows that the benefits of international diversification can be substantial. For example, the Sharpe ratio of yen-based investors can improve from 0.256 when equities are held domestically to 0.426 when equities mirror global capitalization weights. Even the risk-adjusted performance of U.S. dollar investors improves by almost 10 percent when equities include international holdings. Although many investors have already begun to internationalize their holdings, few hold equities in global capitalization weighted proportions-most retain a