Over / Under
By: Tahir Rhemtulla & David Wade
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
Investment professionals ranging from Warren Buffet to Benjamin Graham argue that people should invest in what they know best. Although many investors spend more time watching and analyzing sports than they do reading annual reports, the market to make sophisticated investments in sports has not yet developed. Betting on sporting events dates back to Ancient Greece over two thousand years ago. In the 19th century, betting on horse races became a popular activity in England, and has remained a widespread pasttime ever since. Today, sports betting has grown due to the rise in popularity of professional sporting leagues and a changing regulatory landscape. Widespread adoption of the Internet has enabled the sports betting market to grow to the point where now, 1 in 4 Americans place bets annually.
The Hot Streak
The sports betting market in the European Union alone is expected to grow at a CAGR of 6.8%, from its current size of €263B. Because of the growth in this industry, many renowned investors have begun to view the evolution of sports betting as a lucrative opportunity – yet little effort has been put forth to capitalize on the fragmented market. Although sports betting funds are a relatively new concept, they have generated sizeable returns for early investors. In 2009, the first sports betting fund was raised by Priomha, an Australian investment management firm. The Cloney Multi-Sport Investment Fund (Cloney) invests in sporting events stretching across several professional leagues. By the end of 2011, the fund generated an astounding return of 118%, outperforming the S&P/ ASX200, which lost 17.4% over the same time period. The fund’s mandate is to either take a long or short position based on the presence of intrinsic value in a bet. The fund is administered with stringent portfolio and risk management procedures, and is audited quarterly. With returns that seem too good to be true, the success of inaugural sports betting funds raises several questions to potential investors. First, how does the pricing of events differ from their intrinsic value? And second, how does an investor identify intrinsic value to generate returns?
The Mispricing of Events
The sports betting market behaves just like the stock market: irrationally. A significant irrationality in the sports betting market arises from the ‘home’ bias; the notion that investors are three times more likely to invest in local firms despite the benefits of a more diverse portfolio. In the sports betting market, this bias is even more pronounced as a result of home team allegiances. In the NFL for example, a game between the most popular team (the Dallas Cowboys) and the least popular team (the St. Louis Rams) will result in significantly more people betting on the Cowboys, all other things being equal. Biases are also present in horse betting in China. A disproportionately high percentage of bets are placed on the #8 horse, simply because the number 8 is lucky in China. As a result, when the line is open and money starts to flow in on the #8 horse, the bookmaker will alter the odds for the other horses in an attempt to “balance the books.” As people are incentivized to bet for other horses, the inflow of cash is more evenly distributed so that the bookmaker is protected in case the #8 horse wins. Such irrationality leaves a huge gap for professional bettors to generate profits by using more rational measures to determine probable outcomes, and in some cases, get better odds on the likely winner. Institutional investors drive equity prices. In public markets, institutional investors are generally considered to be more sophisticated and accurate in their valuations than retail investors, as they are more familiar with the stocks being traded. However, in the sports betting market, the volume of institutional betting pales in comparison to the volume of retail bets placed. Although there is some evidence of sophisticated retail investors, the majority of bets are made by retail investors who exhibit favoritism and the home bias, allowing their sporting allegiances to influence their investment decisions. As a result, large pricing discrepancies are more frequent.
In the days prior to a game, an opening line is set by bookmakers using their own internal measures. This is the first set of odds consumers are able to bet on. Bookmakers hope the opening odds will attract an equal number of bets on both sides, but this is rarely the case. During the lead up to the game, and through the game itself, supply and demand pressure continuously changes the line as the market reacts to new information. Thus, the result of a bet is not binary: by taking new positions as the line changes, profits can be locked in and positions can be hedged to protect downside.
To contrast the movement of odds in a sports betting market, consider the process for pricing an IPO. An initial price range is set and then re-established once demand is taken into consideration. The mispricing that would occur if the shares of an IPO were offered to the public based on the investment banks’ opinion of what the price should be, without actually testing supply and demand during the road show, could be disastrous. Sophisticated investors would grab as many shares as they could from their broker if they believed the price was too low and alternatively short it if they believed it to be overvalued. If this was the case, investors would make a fortune based on pricing errors. With the line on hundreds of sporting events being set every day, the potential for mispricing is rampant. Bookmakers are fine with mispricing according to the probable outcome as long as it leads to their desired result: a balanced book where an equal amount is bet on each side of the outcome. In a market where mispricing is ubiquitously accepted, opportunity abounds.
Identifying Intrinsic Value in a Mispriced Game
In the stock market, investors ultimately value equities on the ability of a company to generate cash into the future. To do so, analysts take historical data to extrapolate future results. In the sports betting market, a similar process can be used to determine the potential value of sporting events. By using historical statistics an generate probable outcomes. The variables that can be inputted are limitless: team morale, recent match-ups, injuries, weather, and starting lineups. This is a highly subjective process; good analysts in both sports betting and the stock market alike can determine value and benefit by knowing what factors are the most important drivers of future performance. Institutional sports betting should be largely driven by advanced quantitative models, and if a model’s prediction differs from what the current line implies, then betting on that event is warranted. This process is precisely what many online sports handicapping services offer. They continuously test and tweak their software until they are comfortable with a given system. Most of these services boast year-over-year positive returns with a very low number of losing seasons and have been successful in consistently recognizing profit opportunities in several lines. Sportrends, for example, has generated 22 consecutive winning seasons, while Shark Handicapping has produced winning seasons in 14 of the past 16 years.
Relative performance of Cloney sports betting fund comapred to a hedge fund and the market index
Taking Sports Betting Mainstream
The cultural stigma associated with gambling, primarily due to the negative impact gambling can have on people’s lives, is a key reason why it has not been implemented on an institutional level. Betting can lead to addiction and highly irrational behavior, and although most people bet within their limits, this is not always the case. Because of these negative perceptions, established investment management companies have been hesitant to risk tarnishing their reputation by marketing a fund based on betting. Yet it is important to distinguish between the compulsive behavior found in many amateur gamblers and the strict decision criteria that would guide a sports fund. Decision criteria based on proven quantitative models will allow a sports fund to market its positions as investments rather than ‘bets’, avoiding the stigma associated with the gambling community.
The Right Time to Bet
Fast growth in the market size of retail betting means there is now enough liquidity to place large bets on a widespread number of sporting events. Transaction costs are also declining as a result of increased competition among sports betting market makers and exchanges. These conditions are making it possible to bet larger amounts on a wider range of events, increasing the feasibility of creating a fund.
There is little competition from other funds, resulting in higher management and performance fees in the industry. For example, the Priomha fund charges performance fees of 30% on returns. To start a successful fund with superior returns, the most crucial factor would be attracting a talented team of analysts, similar to a successful hedge fund. A combination of leading sports industry personnel and PhD-level quantitative experts would provide an ideal investment team. Industry experts should be sourced from wide-ranging backgrounds in sport – from former player agents to assistant general managers to ESPN sports analysts. The presence of industry experts would be a key competitive advantage for capturing qualitative factors such as team morale, performance in a tighter checking game, and the ability to handle a pressure situation – factors that the average sports bettor may overlook. Combining these two groups’ expertise to produce a quantitative predictive model would be the most appropriate structure for the investment team.
It is also vital to have extremely prudent risk management procedures. Only small proportions of the fund’s assets would be bet on any given event, and sufficient capital would need to be available to hedge lines as games progress. A system of checks and balances from upper management would ensure that capital is only allocated to the investment teams whose models were currently working with enough conviction to successfully predict future outcomes. This way, the fund would only invest in sports where it is has a competitive advantage, increasing the chance of success. The negative stigma associated with sports betting is slowly fading as funds like Cloney demonstrate that rampant mispricing can transform a sports bet into a sports investment. Given the popularity of sports betting among the public and the ever-growing search for alternative investment vehicles, investors are increasingly willing to invest in a sports fund. Low bond yields and uncertainty surrounding the equity market has pushed investors to seek returns from non-traditional sources, and the sports betting market is primed to deliver strong returns to those who take the first steps. As Wayne Gretzky once said, “You miss 100% of the shots you don’t take.” Similarly, you miss 100% of the bets you don’t make.
