| While increased attention has been given to government cash management, there has been little theoretical or empirical research devoted to assessing whether government investment portfolios are managed prudently. The purpose of this study is to analyze prudent management of state-run local government investment pools. This study suggests that both the efficient diversification of the pools and the co-movement pattern of the portfolio returns with market rates are the most important factors to assess prudent management of the pool. The Markowitz Portfolio Theory, which is also known as Mean-Variance Theory, is discussed as a theoretical basis by which to assess the efficiency of public funds investment portfolio diversification. This study modifies Mean-Variance Theory and develops the Quasi-Efficient Frontier to explore the applicability of the Mean-Variance theory to government investment portfolios. Next, the co-movement pattern of portfolio returns with market interest rates is examined to assess if the management of investment portfolio adheres to the principle of safety, liquidity, and yield. The empirical analysis exploits the panel structure dataset for six state-run local government investment pools in United States over the fiscal year 1999-2008 by utilizing Fixed Effects estimation. The results indicate that the degree of under-diversification for risk is positively related to observed portfolio return of the pools and the pools' observed portfolio return is positively related to market interest rates. The results also show that there is no individual difference in the expected relationships between the pools under analysis. |
