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Going Long On Election Knowledge - Investing In Information With The IEM

The most valuable commodity is information. I could hit the thesaurus and start coming up with different words for "information", but I won't do that - you get the point. Every investment one makes is, despite its underlying instruments, at its core, an investment in information. Whether you think a particular grain or metal will go up or down in value is the direct consequence of your information and the faith you have therein. In that way, buying a stock, or a gold contract, or a mutual fund, in essence, can be considered an investment in an information derivative. As a general rule, I'm not much of a fan of derivatives, whenever possible I prefer to invest in an instrument directly. Lucky for folks like me, there happens to exist a market that trades directly in information.

The Iowa Electronic Markets is commonly referred to as a stock market for predicting the future. More accurately, it's a futures market where the underlying commodities are discrete, real-world events. The market bills itself as follows:

The IEM is an online futures market where contract payoffs are based on real-world events such as political outcomes, companies' earnings per share (NYSEARCA:EPS), and stock price returns.

I, of course, realize that this is very similar to Intrade and other information market sites that offer contracts based on real-world events. The IEM, however is different in two important ways. First, it is entirely not for profit; there is no "house", making money on the trading activity, nor any recurring custodial fees, nor any party interested in impeding your withdrawals - the market is run by the University of Iowa as an educational resource of the business school. And second, most importantly, the IEM is entirely legal in the United States. The same cannot be said of other online information markets.
Regardless, here's basically how the IEM works using the current US Presidential Election as an example. The two outcomes for which contracts are issued by the market are:

  1. Democratic Victory (in this case, President Obama)
  2. Republican Victory (in this case, Governor Romney)

There are precisely the same number of contracts issued for each outcome, and the price for each contract trades between $.00 and $1.00, such that the total value of the two contracts combined is $1.00. The contracts trade on an open market with the familiar bid/ask market pricing structure. When the election is over, any contracts held for the winning candidate are redeemable for $1.00, regardless of what they cost, and any contracts held for the losing candidate are redeemable for $0.00000 (repeating, of course). As of writing, the Democratic contract (Obama victory) is trading at $0.750, and the Republican contract (Romney victory) is trading at $0.250. So, if you were to today purchase 100 Obama contracts for a total of $75.00, should the president win reelection, on Wednesday your contracts would be worth $1.00 each, or $100.00 total, good for a 33.3333 (repeating, of course) percent return on investment; alternately, if you were to buy 100 Romney contracts, your cost would be only $25, but should the governor win the election, you'd be looking at a 300% ROI.

(A quick aside, the contract is actually for the winner of the popular vote, rather than the winner of the electoral college and presidency, though the two are not always one and the same, you get the point.)

The market also allows participants to functionally short contracts by purchasing the same number of each contract (for $1.00 per bundle) and then selling any sub groups of contracts, in essence, betting that the price of the contracts held will go up in value compared to the price of the contracts sold. Since the two outcomes are mutually exclusive, they have a nearly one-to-one negative correlation.

Source: Iowa Electronic Markets

All that said, the IEM is actually most notable not just for facilitating bets seen to maturity (when investors take delivery of their info-commodity), but for providing a market throughout the election season, thereby becoming something of a barometer for overall sentiment around the race at any given moment. In fact, historically, the IEM has been shown to be a better predictor of the outcomes of elections than most major polling sources. The ridiculous graphic over there (which came directly from the IEM's website) provides an illustration of this fact from the 2008 presidential election. The price of a specific contract, in essence, represents the market's belief as to the probability of the associated event occurring. The theory goes that these markets end up being more accurate than polls because when people are forced to vote with their wallets, as much as they may like one candidate or the other, they're still Americans after all, and Americans rarely pass on an opportunity to make some cash.

So, back to the current year, when I say that the Obama contract is trading at $.75 to the Romney contract's $.25, this implies that, as of now, the market is giving Obama a 75% chance of winning the popular vote to Romney's 25%. Note how much more strongly the market is predicting an Obama victory than are most pollsters. However, this does not mean the market believes it's going to be a tremendously lopsided victory, in fact, just the opposite, as the IEM also offers a proportional vote contract that pays out based on the relative vote share for the major-party candidates (Republican or Democrat). That is, if you happen to be holding a Romney contract in this market, and Romney ends up winning, say, 48% of all votes cast either for Romney or Obama, that contract will be worth $.48, while an Obama contract would be worth $.52. As of writing, the Obama contract is currently sitting at $.505, while the Romney contract is trading at $.492 (an enterprising arbitrageur could take advantage of those totals not summing to $1.00).

So, the IEM is giving Obama a 75% chance of winning the popular vote, but only edging Romney out by something in the neighborhood of 1% of all votes cast for the two major candidates. Agree with those sentiments? If not, I know a place you could potentially make a profit from your contrarian sensibilities.

It's been said that knowledge is power, and for most investors power is money, but in the information markets, interestingly, money is also apparently knowledge.

If you're interested in investing in, or just learning more about the IEM and the presidential markets check out the following (I swear I'm not getting any kickbacks or anything, I'm just a fan):

NB: Obviously I've chosen to focus on the presidential election in this post, but the IEM offers contracts for all kinds of other events, often around politics, but also concerning miscellaneous goings on in the popular zeitgeist. All of which are, naturally, very, very interesting. It's a great market to follow.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.