A Strategy to Prevent Losses in Local Government Investment Pools

In the first half of the 1990s, some local government investment pools (LGIPs) suffered losses from derivatives investments. Although the losses came from derivatives, the actual cause of the losses was the violation of public‐fund prudent investment practices. This article provides a strategy to prevent future losses for LGIPs’ participants by looking at the pattern of return on investment of the pools. Our proposal is that rates of return on state pools that co‐move with market rates are generally an indication of adherence to prudent investment practices. We demonstrate the viability of this proposal by using co‐integration methodology. The implication is that if rates of return on a state pool do not co‐move with market rates, they may indicate the violation of prudent investment practices.