In February, Roundhill filed to register six exchange-traded funds that would invest in contracts whose payoff depends on the outcome of future events (“event contracts”), including which political party wins the presidency and control of either house of Congress. The proposed ETFs are:
- RPM Democratic President ETF
- RPM Republican President ETF
- RPM Democratic Senate ETF
- RPM Republican Senate ETF
- RPM Democratic House ETF
- RPM Republican House ETF
Several other providers, including GraniteShares and Bitwise, followed suit, filing to register for prediction-market-linked ETFs that would similarly invest in event contracts tied to the upcoming presidential and congressional contests.
To this point, these contracts have been the domain of wagering sites like Kalshi and Polymarket. These ETFs would bring them even further into the financial mainstream, making it possible for investors to place bets on who will control either branch of government from the convenience of a brokerage account.
Following repeated delays, the Securities and Exchange Commission apparently asked Roundhill to hold off on launching the ETFs it had filed to register. In a statement, SEC Chairman Paul Atkins said the proposed ETFs raised “novel questions” and directed SEC staff to seek public input on how it should respond.
In that spirit, I’ll use the rest of this article to describe how the proposed ETFs would work and explain why I think they’re an idea the SEC should reject.
How They Work
Let’s start with the contracts themselves: They’re an agreement between two parties in which one agrees to pay the other depending on the outcome of a specified future event—in this case, the US presidential election in November 2028 and the midterm House and Senate elections this coming November.
The contracts are binary—once the event’s outcome is determined, the contract held by the winning party becomes worth $1, and the losing contract expires worthless. This explains why a party to an event contract is at risk of losing the entire sum they’ve wagered if they’re on the wrong side of the bet.
These ETFs will enter into event contracts mainly via total return swaps, where one party agrees to exchange returns with another, typically a market maker or bank, based on changes in the value of a reference asset. In this case, the ETF will be on the “receive event-contract return” side of the swap and, in exchange, will pay a variable fee and spread to the counterparty.
Though the event’s outcome won’t be known until it takes place, the contract’s value will fluctuate in the interim based on how the perceived odds of the outcome’s likelihood change. For instance, if an outcome thought yesterday to have 50/50 odds shifted to 52/48 today, the contract’s value would rise around 4%, and vice versa if the odds got longer. Those changes in value will make the ETF’s net asset value fluctuate as well.
Given this, these ETFs could be used in a few ways. For instance, traders might hop in and out depending on their assessment of the odds the ETFs are pricing in (which can be inferred from changes in NAV) at various points in time. Others will hold through the event’s occurrence, collecting whatever proceeds come to them based on the outcome.
Once the event occurs, the outcome is known, and the contracts settle, these ETFs won’t cease to operate. Rather, they’ll roll whatever assets they have into the event contracts for the 2032 presidential and 2028 congressional elections.
Investing Vs. Betting
In a way, investing is also a function of events and outcomes. With a stock, the key events are future cash flows, the timing and magnitude of which determine a firm’s intrinsic value. Those cash flows are, in turn, the product of numerous other interrelated events and outcomes—that is, everything underpinning sales, expenses, capital expenditures, debt, equity, and more.
But there’s a crucial difference between forecasting cash flows and trying to handicap the outcome of an event like a presidential election: Cash flows have literal value. They might be higher or lower than you think, but if your forecast is slightly off, it’s not like you lose everything.
To illustrate, imagine a hypothetical scenario in which you forecast a firm’s earnings growth will drive the stock price, such as no multiple expansion or contraction, the share count doesn’t budge, and the company doesn’t issue any debt or alter its capital expenditure. Now, suppose you were too optimistic—earnings grew slower than you predicted. Is that curtains for your investment? Hardly. The stock still should have gained to the extent earnings per share grew, even if it fell shy of your assumption.
Of course, my hypothetical scenario is not how the world works. It’s hard to predict an individual stock’s movements because so many other variables—not least, changes in its valuation multiple—come into play. But that’s one of the reasons we diversify across many stocks, as it serves to mitigate firm-specific risks, allowing us to exploit the relationship between firms’ aggregate profit growth and stock prices.
You don’t get any of that—the cash flow, the diversification effects, the compound growth—with an event contract. Its intrinsic value derives entirely from the payoff if you’re right about the event’s outcome, or the change in its likelihood in the interim.
Moreover, unlike surface-similar instruments—for instance, “catastrophe” bonds where investors invest a lump sum and receive periodic interest plus eventual principal repayment so long as a specified disaster like a hurricane or earthquake doesn’t take place—there’s no stream of cash flows to speak of, and the capital isn’t put to any economically productive use.
Bad Bet
It’s unlikely to deter those seeking a more straightforward way to profit from the outcome of a future event, political or otherwise. And, indeed, event contracts do remove other conflating factors—like the level and path of interest rates and inflation—that have so often bedeviled those trying to invest with a particular outcome in mind.
Even if event contracts and, thus, these ETFs make it simpler than ever to bet on an event, investors still have to contend with the reality that by the time they place that wager, the odds already reflect that outcome’s likelihood. In a way, it’s not too different from forming a view that something will be “good” for a stock or “bad” for a bond; incorrectly assuming that if that scenario pans out, it’ll yield a tidy profit (which it won’t if that “something” is already baked into the price).
The proposed RPM ETFs would invest in contracts tied to events that draw interest from a vast cross-section of participants. Given that, you’d expect the odds-making to be ruthlessly efficient. Does that mean those odds won’t change over time? Of course not. But the question is whether you can predict those movements in advance based on the information available to you.
That’s not unlike the challenge we face in trying to correctly predict changes in a stock’s or bond’s prices over a short horizon. It’s nearly impossible. But if we extend our time horizon, we stand a better chance of getting paid for the risk we’re courting, that payoff approximating the yield on a long-duration bond plus an equity risk “premium.” Again, there is a positive expected return.
Contrast that with an event contract, which has a 0% expected return at the time you enter into it. Why so? Suppose the event in question has a coin flip’s odds, and the outcome will be known in a year. You have a 50% chance of doubling your money in 12 months and a 50% chance of losing it all. That might be entertaining, but it’s hardly a productive use of capital.
This I Can Predict: You’d Pay for It
We don’t know how much the proposed prediction-market ETFs would cost if they were ever greenlit; the fees weren’t disclosed in the preliminary registration statements.
That said, if the SEC were to approve the ETFs in their proposed form, there’d be at least two layers of costs: the ETF’s expense ratio and the embedded cost of using total return swaps to gain exposure to the event contracts.
As mentioned earlier, the swaps are likely to be structured such that the ETF would pay a variable rate like the Secured Overnight Financing Rate (which was recently hovering around 3.6%), plus a spread that compensates the counterparty on the other side of the swap for providing the exposure and warehousing the risk.
That spread presumably won’t be as wide as you’d see on contracts tied to truly idiosyncratic, difficult-to-hedge events like who will host the Academy Awards. But it’s still likely to exceed 100 basis points, which, taken together with SOFR, would push the swap cost to nearly 5%. That is a very dear price to pay for exposure to something that has an expected return of zilch.
Brick Wall
It’s possible my argument, which is premised on questions about these proposed products’ fundamental attributes and utility to investors, will be ignored. After all, we’re living in an age of leveraged single-stock, cryptocurrency, and zero-day-option ETFs. Rather, the SEC’s misgivings probably turn less on investment merit and more on market integrity and the regulatory apparatus these proposed ETFs could test. If so, that’s beyond the scope of this article, not to mention my expertise.
Nevertheless, it seems worth keeping in mind the chief reason ETFs and mutual funds have risen to such prominence in the first place—the trust and confidence they’ve engendered among investors. They’ve been a relatively cheap, reliable gateway to global capital markets, creating trillions in wealth and advancing important goals like putting kids through college or paving the way to a secure, comfortable retirement after our working years.
These proposed products seem like the antithesis of that. They’re zero-sum and serve no economically productive purpose, such as facilitating capital formation and spurring innovation. They’re likely to be costly and push investors’ buttons to their detriment. For all of those reasons, it seems like the SEC ought to draw a line, prohibiting ETFs that invest in event contracts.
The views and opinions expressed in this article are my own and do not necessarily reflect those of Morningstar or its affiliates.
