Allocation FIGURE 10.6 Effect of Global Equity Diversification Our present setup also allows us to analyze the effects of global diversification in equity and bond portfolios, as well as the effect of investing in a bond portfolio with a different duration. We now turn to these issues. Example: Global Diversification Is a fund better off investing only in domestic assets or should it diversify globally? In answering this question we first look at global equity diversification and then turn to the issue of fixed income diversification. Our return assumptions clearly show that global equity has a higher Sharpe ratio than domestic equity, but also a lower correlation with the liability index. We therefore face the same trade-off as before when we were deciding between allocating to domestic equity or bonds. Figure 10.6 shows the percentage change in the RACS from investing in global rather than domestic equity. The pattern emerging from this picture is that while the overfunded plan benefits from investing globally rather than domestically, the other two plans are better off with domestic equity. The intuition for this pattern is actually quite simple when we abstract from the presence of noise once again. The overfunded plan can, at low equity allocations, match the duration of its liabilities with bonds. In the absence of noise, the plan thus basically eliminates the liabilities from the asset allocation problem. With the remaining funds, the plan faces a choice of domestic versus global equity. Since the Sharpe ratio of global equity is higher than that of domestic equity, the fund finds it optimal to choose global equity. Now, at higher equity allocations, the fund is no longer exactly eliminating liabilities from the asset allocation problem, and therefore the correlation of equity with the liability index matters in determining the RACS. Since global equity is less highly correlated with liabilities than domestic equity, it should come as no surprise that at high equity allocations the benefit from global diversification is diminished. Finally, the presence of noise also diminishes the ability of the plan to eliminate li-