Prediction markets let investors take positions on outcomes such as election results or whether an economy enters recession. Proposed ETFs could bring exposure to some of these events into investors’ existing brokerage accounts.
For institutional investors and family offices, this could offer a way to protect against a specific event while retaining existing investments. A manager might want to retain shares in an exporter while buying a contract that pays if a candidate promising higher tariffs wins an election. However, a payout on the event does not necessarily cover the loss on the shares. The investor must assess both the price of the contract and how effectively it protects the portfolio.
The products reviewed for this article remain proposals at the moment. Their issuer disclosures state that the registration statements are not yet effective and investments cannot be accepted.
The price matters as much as the prediction
A binary event contract has two possible outcomes. A contract might pay $1 if an event happens and nothing if it does not. Before the result is known, investors trade it at a price reflecting their expectations.
Suppose a contract costs $0.40. If the event happens, the buyer receives $1 and makes a $0.60 profit before costs. If it does not happen, the buyer loses the $0.40 paid. An investor who believes the event has a 55% chance of happening would regard that price as potentially attractive.
Using that estimate, the average expected payout is $0.55, compared with a purchase price of $0.40. The difference is $0.15 before costs, although any individual contract still pays either $1 or nothing.
The probability estimate may be wrong. Correctly predicting an outcome is not enough to establish an attractive investment: a likely outcome can be overpriced. Market prices are useful indicators of expectations, but they are not reliable measurements of the actual chance of an event. Limited trading, concentrated participation and investor sentiment can affect prices.
An ETF’s share price reflects its underlying investments and expenses, and may trade above or below the value of its net assets. Investors therefore need to examine the underlying event contracts to understand the probability being priced into the market.
A payout may not cover the portfolio loss
For the exporter portfolio described earlier, an election-linked contract would target the political outcome more directly than selling a broad equity index. Whether it provides sufficient protection, however, depends on how the resulting policy affects the companies held.
The eventual tariffs, exemptions, exchange rates and companies’ ability to adjust would all influence losses. The contract might pay even if the shares suffered little damage. Alternatively, the shares could fall because of a different policy decision and the contract might pay nothing.
This mismatch is known as basis risk. To decide how much protection to buy, investors need to estimate potential portfolio losses under different outcomes. A fixed contract payout also remains the same regardless of how severe the portfolio loss becomes. An equity put option, by comparison, pays according to the share or index price and the option’s terms.
Investors therefore need to compare the event contract with options, futures or a reduction in the original holding. The best choice depends on the risk being covered and the cost.
The rules decide whether the contract pays
The wording of the contract matters. Investors would be buying exposure to the events specified by the ETF, rather than gaining access to prediction markets generally.
One preliminary recession-ETF filing illustrates the point. It defines the relevant event using two consecutive quarters of negative US real GDP growth, based on specified releases. Whether the contracts pay depends on the listing market’s rules. An investor could believe the economy was in recession without the contract meeting its payment conditions. The data used, observation period and treatment of revisions therefore require attention.
Under the same proposal, the fund would obtain exposure mainly through over-the-counter swaps linked to the event contracts, rather than buying them directly. Returns would therefore depend on how those contracts settle and on the swap counterparties meeting their obligations. Investors would also need to examine the collateral arrangements: Treasury securities held by the fund could be used to settle amounts owed under the swaps if the referenced contracts paid nothing.
The ETF’s next step also matters. If it takes exposure to another event, an investor could end up holding a position that no longer provides the intended protection.
Investors must be able to trade when needed
An ETF listing does not guarantee that a large order can be executed at an acceptable price. The underlying contracts may trade infrequently, and prices may change sharply after important news.
Institutions need to assess how much can actually be bought or sold, the prices available and whether market makers can support the order. They should also examine whether new ETF shares can be created or existing shares redeemed when demand changes.
For an Asian trading desk, US news arriving while the ETF’s exchange is closed creates another difficulty. The investor may have to wait until the next session, when prices could be substantially different. Access requires separate checks: a US filing does not establish that a Hong Kong investor’s broker will offer the product or that the investor’s mandate permits it.
Prediction-market ETFs could help investors manage specific event risks while retaining their core holdings. However, their usefulness will depend on the purchase price, the ability to trade at the required size and how closely the payout matches the potential portfolio loss.