ETFs May Be Blurring the Line Between Gambling and Investing

To paraphrase a variety of sayings about making money in risky endeavors, the easiest way to get to $1 million is to start with $2 million.

Historically, gambling and investing have been handled differently by the average American. The latter, of course, is intended to build wealth over time. But as access to gambling has dramatically expanded in recent years in the US, with sports betting and prediction markets available on anyone’s smartphone, the behaviors and attitudes around it have arguably bled into the investing world. There is now a booming new menu of exchange-traded products that let investors take risky, short-term stances, and that development in the ETF industry has some observers sounding the alarm. 

“There really are few parallels between investing and gambling, but there are many close parallels between speculation and gambling,” said Robert Johnson, professor of finance at Creighton University’s Heider College of Business. “And, unfortunately, the line between speculation and gambling is not only getting blurred, but it is being eliminated.”

Playing the Odds

There are examples in the investing world that resemble speculation or gambling, Johnson said. Those include crypto assets, picking stocks in the electric vehicles market and leveraged ETFs (which in some cases overlap with crypto and EV stocks). “There is no way to value cryptocurrencies other than the greater fool theory — the hope that some greater fool will pay you more than you paid,” he said. “It is the consummate bubble, and investors should stay far away from cryptocurrencies in general and bitcoin specifically.”

A growing number of asset managers might disagree with that. It’s now common for traditional financial companies to offer access to them. And some firms even recommend small allocations to bitcoin for wealth management clients. The latest company to cave to the crypto craze, Vanguard, allows brokerage clients to buy bitcoin and other crypto ETFs, but it doesn’t include memecoins. It’s also notable that Vanguard doesn’t include leveraged or inverse ETFs on its brokerage platform. Broad market index ETFs are appropriate for most investors, Johnson said. Leveraged ETFs, though, which amplify gains and losses and often reset daily, are not, he noted.

Those products are increasing in number and size:

• Issuers continue to give the leverage treatment to ETFs focused on single stocks or crypto. As of the end of November, there was a total of $129 billion in US leveraged equity ETFs among 464 products, data from Morningstar Direct show. While $6.7 billion flowed into those products over the past 30 days, more than $10.6 billion flowed out year-to-date, while about $8.6 billion went into inverse equity ETFs so far this year.
• Still, those products have been almost entirely limited to 2X leverage, at least in the US. Though the Securities and Exchange Commission during the Trump administration has proved itself friendlier to the industry, it recently kicked back product filings that sought 3X or 5X leverage. 
• Issuers make it clear that these funds are meant to be held briefly and are unsuitable for most investors. They are designed for frequent, experienced traders who are well aware of the risks.

Right Next Door

Robinhood and other brokerage systems have helped trading skyrocket in popularity, especially since the COVID-19 pandemic, when many people were trapped indoors and had an abundance of time on their hands. While stockpicking can be inherently risky, the stakes have been pushed higher with the availability of prediction markets, or yes/no derivative contracts for the outcome of almost any event imaginable. 

It’s also big business:

• Prediction markets Kalshi and Polymarket have valuations around $10 billion, Bloomberg recently reported.
• Polymarket, which recently began accepting US users after being cleared by the Commodity Futures Trading Commission to operate (following its ban in 2022), had about 470,000 active users in November, according to data from The Block.
• Kalshi, meanwhile, had about $19.5 billion in volume during November, significantly ahead of Polymarket’s $12.7 billion, according to The Block.

Still, there are differences in the kinds of information people have and how they use it that can distinguish between gambling and investing, said Valeria Martinez, CEO of Bettingladies.com, an online community of women who bet on sports. “Investors rely on fundamentals and disclosures, while bettors rely on performance data, models and market sentiment,” she said. “Perhaps where the two overlap is in the mindset. People today are simply more used to making probabilistic decisions in all areas of life, whether it’s choosing a stock or picking a team.”

A former CFTC enforcement attorney who now defends white-collar clients said risky behaviors that start while gambling can snowball into investing, and at great costs. “Investors who slip into speculative, emotion-driven behavior become far more vulnerable to fraud, market manipulation schemes and high-pressure sales tactics,” said Braden Perry, partner at Kennyhertz Perry. “The behavior that begins as entertainment trading can develop into misuse of margin, unauthorized trading or increasingly desperate attempts to recover losses. Those situations often lead to regulatory investigations or even criminal exposure.”

What Could Go Wrong? Even for stocks with net positive returns, leveraged ETFs held for longer than a day can underperform those target stocks because of decay, caused by their daily resets, amplified losses during volatility and fees. But big losses can also happen quickly, as seen during 2020’s extreme volatility, when inverse VIX exchange-traded notes lost nearly all their value and closed, Creighton University’s Johnson said. A more recent example is UK-domiciled GraniteShares 3X Short AMD ETP, which erased its value in a single day in October after Advanced Micro Devices’s stock jumped 38%. “In the hands of amateur investors, leveraged ETFs and ETNs are weapons of mass wealth destruction,” Johnson said.

What’s most worrisome to Aaron Randak, founder of Golden Acre Wealth Management, is the great wealth transfer, in which younger generations stand to inherit tens of trillions of dollars from baby boomers. The success stories of a few people in prediction markets might be what younger people most often see, rather than the risks. And that could potentially impact investing behavior down the road. “It could be an overall positive for the world to have these prediction markets, because it shines a light on the major events,” he said. When it comes to investing, leveraged ETFs can be very useful for highly experienced traders and institutional investors, but “the younger investor doesn’t have any clue what research is needed.”