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Gambling and Gaming
Investing: A Pretentious Word for Gambling?

Gambling and Gaming
Investing: A Pretentious Word for Gambling?

Doug Litowitz



[Editor's Note, in the third part of a five-story series from the September issue of Modern Trader, Doug Liltowitz questions the broader definitions of gambling and investing. See Part 1, right here]

 

Is there any difference between a quant who goes to Wall Street and one who goes to Vegas? There are two schools of thought on this question. 

The first school argues that there is little meaningful difference between most investing and most gambling, and therefore investors don’t deserve an extra dollop of sanctimony and grandeur; in fact, they need to be cut down to size and labeled for what they are: Glorified gamblers. 

The second school argues that investing differs in kind (and not just in degree) from gambling, and this difference carries moral weight because investors benefit society by producing a net gain in social value, whereas gamblers compete in zero-sum games among players (or negative sum games once we factor the cut given to the house). An investor improves the world. A gambler may improve his own world, but he leaves the outside world unchanged. 

These opposing positions first came to a head in reaction to Mark Cuban’s announcement in 2004 that he was starting a “gambling hedge fund” whose sole strategy would be betting on sporting events. On his web log “Blog Maverick” he said, “It’s an idea whose time has come.”

But the idea had already arrived. In 2002, Wired magazine ran a story about investment funds formed to back electronic trading on horse racing at the Hong Kong Jockey Club. Some of the funds were formed by star bettors as anchor investors and soon attracted dozens of outside investors who supplied a pool of money, essentially a fund. At the Hong Kong track (like many others) payouts were based on the public’s shifting opinion of the odds of a particular horse, creating arbitrage opportunities that were ripe for algorithms: “Racing has become more and more like a stock market model,” says one insider. Horses should be thought of as Dell or Microsoft — their past performances are the equivalent of economic charts that provide fodder for the Street’s quantitative analysts.

At the time, computer-assisted betting was not illegal in Hong Kong, nor did the racetrack prohibit it, but there was concern that ordinary gamblers would be scared to pit themselves against computer programs. The article ended by noting that similar computer-assisted trading was detected at racetracks in the United States. And that was back in 2002.

Cuban never set up his gambling hedge fund. It was not clear why, but lawyers (myself included) argued that such a fund was likely to be illegal unless restricted to, say, a limited group of accredited investors in Nevada. 

But if Mohammed, err Cuban, didn’t come to the mountain, the mountain finally came to Mohammed. Last month, Nevada enacted laws to legalize gambling funds. Meanwhile, in other parts of the world, gambling funds are already up-and-running, with mixed results. One UK sports betting fund, the Galileo Fund, collapsed. Another fund, Priomha Capital Sports Hedge Fund, just relocated to Gibraltar and reportedly has been making a tidy profit. 

Cuban’s original blog post remains important because he clearly articulated the skeptical position that investing is simply gambling under a different label. His point was that in both stock investing and sports betting, there is a similar amount of publicly available information on which to base a wager on an uncertain outcome. Here is Cuban, in his inimitable style:

“It’s not unusual to hear people refer to trading stocks as no different than going to Vegas. They are right. Gambling is gambling... Unlike the stock market, you know the [Casino] rules exactly. You know without question that the house is going to play by the rules. The gaming commission appears to actually enforce rules of play, unlike the SEC... A sports or blackjack or poker bet doesn’t have value beyond that game or hand. In that respect it’s just like the hundred of millions, if not billions, of options that are traded, but never converted on stocks, commodities, and other assets around the world. Just what hedge funds do on a daily basis, and just what I plan on doing.”

This view is bolstered by the fact that the legislation which clarified the trading of credit default swaps (the Commodity Futures Modernization Act of 2000) contained an explicit carve-out exempting swaps from gaming laws. One wonders why this carve-out was necessary unless it was meant to allay legitimate concern among lawmakers that swaps (at least naked swaps) were in fact no different from gambling. 

Even stranger, most state laws (such as the Illinois Penal Code) define “gambling” to include “any contracts to buy or sell, at a future time, any grain or other commodity whatsoever, or any stock or security of any company...” Unless the trade is made through an entity regulated by the government. The law seems to say that “investing” is just state-approved “gambling.” In other words, the activity is not different, only the willingness of the participants to be held to government regulation. Of course, regulated trading and investing serves an underlying economic purpose, both in capital markets and futures and options markets. Perhaps this is the greatest and most relevant distinction. 

A final consideration in favor of conflating investing and gambling is the fact that stocks typically are held for such a brief period of time that most traders cannot (and do not) read the filings of publicly traded companies, so we need to drop the pretense that investing is inherently tied to content. Some sports bettors know more about the content of the teams in their wagers than investors know about the content of the companies that they trade. 

The opposite side of this debate is staked out traditionalists who insist that investing is a different animal than gambling. These people are not naïve. They know very little social contribution to society comes from massive trading in derivatives that float above the real world (in the same way that bets on the Super Bowl have no impact on the fortunes of the teams). However, they insist that there remains an irreducible core that enables a real company and real people to create a real product that makes everyone better off, and also a sense in which derivatives can be used to make reasonable hedges that help companies plan for the future. At the end of the day, they argue, companies use the financial markets to raise money to build computers, houses, cars and the myriad devices that make modern life possible, and to reduce their risks by locking in prices on fuel and commodities. 

The giants of industry, from past legends like Carnegie, Ford and Rockefeller — down to modern day titans like Gates, Jobs and Ma — actually built things and did not sit around a velvet-draped table redistributing money among themselves after giving the house a cut. 

It is this kernel of social utility that supposedly gives investing its cachet. The idea is sometimes expressed that gambling involves an element of pure chance (like the draw of a card), whereas investing involves events that are not pure chance but are theoretically predictable through intelligent effort (for example, an intelligent investor realized after extensive research that Enron was a house of cards; it was not an insight drawn from a deck of cards). 

Investors, like gamblers, play for money; but they also play for social utility, whereas gamblers are only playing to make money, not to create a project. This is precisely why gambling is synonymous with the word “gaming” — namely that gamblers are engaged in a game, whereas investors are engaged with the world. 

This is bolstered by the raw valuations: Forbes values the entire Major League Baseball of all teams at $25 billion, which is a tiny fraction of the numbers that investors generate. Although CNN estimates that $280 billion is spent on sports betting across the entire country, that is still a lower number than the trillions in the investment world. The day after the Super Bowl, the bets are settled, but nothing new is built for the NFL.

Furthermore, the traditionalists point out that investing is a profession that imposes fiduciary duties on fund managers, traders and brokers. The SEC, at least, sees a difference between investing and gambling, because they have punished several fund managers for using client money to make wagers on sporting events — clearing saying that gambling is not a legitimate investment strategy. Investing therefore involves an element of trust and prudence that is lacking in gaming; yet gamers can counter this by saying that a lone investor has fewer fiduciary duties than a gambler who bets on a pool of money supplied by others. And both of them have the same moral hazard of doubling down and taking wild risks to regain their losses. Thus for every example of an investor who gambles, we can find a gambler who invests.

The debate — like many others — probably comes down to the judicious use of language and the ability to live with fuzzy concepts. An acorn becomes an oak tree, but we cannot say exactly when. “Gambling” and “investing” are like that; they have elements of each other and are impossible to totally disentangle. Virtually every investment has an element of gambling in it, and virtually every wager has some element of investment in it. 

Take Stock Battle. In this “game,” participants paid a small entry fee to build a model stock portfolio and the winner got a prize based on the entry fee of the other participants. The whole thing was done in mock format (the trades were not real) because the players could not afford the real cost of trading and high commission fees. The SEC recently sent the company a cease-and-desist letter claiming that they were dealing in “unregulated security based swaps.” The company announced that it lacked the funds to become registered, and folded. 

In this case, the SEC is wrestling with the grey area between classic investing and classic gambling, but that is precisely where there are no clear paths to follow.

We cannot untangle the exact difference between investing and gambling. Certain “investors” are “gamblers” and some “gamblers” are “investors.”

Go to Part Four: The Wall Street Casino

About Doug Litowitz

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Doug Litowitz is a hedge fund lawyer and a former law professor. 
















































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